Legal issues in structuring a company acquisition – Part 2

Legal due diligence is a central component of the acquisition process. It is not merely a document-reading exercise. A well-organised review structures the information flow, identifies the risks that matter to the buyer and presents the findings in a form that can be used for the acquisition decision and the acquisition agreement.

In short: A useful due-diligence process does not end with a long list of risks. It also explains which risks matter, how they may be mitigated and how they should be reflected in the acquisition agreement.

1. Organising legal due diligence

The M&A lawyer generally receives the information required for the corporate legal due-diligence report through a data room. The process should be organised from the outset by defining the engagement, scope, document request, access rules, confidentiality requirements and Q&A procedure.

Depending on the transaction, the process may also include management interviews, site visits, discussions with advisers and searches of public registers.

2. The data room as the central source of information

2.1 Physical data room

Traditionally, target-company documents were made available in a physical room at the seller’s premises or at an adviser’s office. The buyer’s advisers could review the documents during a limited period and subject to detailed rules.

Typical rules could address opening hours, personal access, permitted users, copying and photography, removal of documents and confidentiality.

2.2 Virtual data room

Today, information is generally reviewed in a virtual data room. This is a technically protected digital collection of documents rather than a physical room. Access may be controlled through individual accounts, passwords, encryption, multi-factor authentication, role-based permissions, time limits and activity logs.

A virtual data room can facilitate simultaneous review by different advisers and improve the documentation of disclosures and access. It does not, however, replace legal analysis.

2.3 Data-room index and document request list

The data-room index structures the documents made available. The buyer’s document request list describes the information and documents requested from the seller.

A well-designed request list helps define the scope, identify gaps, monitor disclosure and prepare the final report. It should be tailored to the transaction structure, target business and industry rather than copied mechanically from another deal.

2.4 Q&A process and data-room rules

Missing or unclear information can be requested through a question-and-answer tool. Questions, answers, supplemental documents, responsible persons and open issues should be recorded in a traceable way.

Data-room rules typically govern permitted users, access credentials, downloading, printing, storage, use, return or deletion of documents and consequences of confidentiality breaches.

3. Typical documents reviewed

Depending on the scope, the M&A lawyer may review incorporation documents, articles, commercial-register extracts, shareholder lists, shareholders’ meeting minutes, resolutions, capital measures, transformations, enterprise agreements, management appointments and documents relating to subsidiaries and joint ventures.

The existence of a document in the data room is not by itself evidence that the disclosure is complete or that the document is legally effective. The review must also identify gaps, inconsistencies and further questions.

4. Information sources outside the data room

The data room is important but not exclusive. External sources may include commercial registers, company registers, official publications, patent and trademark databases, regulatory databases, insolvency notices, credit agencies, industry sources, press reports, the target’s website and information from competitors or market participants.

External research can reveal inconsistencies or undisclosed issues. Its scope should nevertheless remain connected to the engagement, the target’s business and the buyer’s objectives.

5. Tailoring the due-diligence scope

There is no standard legal due-diligence report that is equally suitable for every target. The M&A lawyer should understand the transaction objectives, the business model and the relevant industry.

Useful sources may include the information memorandum, the target’s website and presentations, press reports, discussions with the buyer, management interviews, conversations with auditors and tax advisers, and site visits.

A risk-based review focuses on issues that may materially affect value, operations, regulatory approval, the acquisition agreement or the viability of the transaction.

6. Structure of a legal due-diligence report

The report has no mandatory universal format, but it commonly includes:

• cover page,
• table of contents,
• list of abbreviations and definitions,
• engagement letter and scope,
• introduction and methodology,
• limitations and disclaimers where appropriate,
• executive summary and key deal issues,
• detailed legal analysis,
• appendices such as the list of reviewed documents.

The report should distinguish, where useful, between facts, legal assessment, risk level, open questions and recommended action.

6.1 Full-Fledge and Red-Flag reviews

A Full-Fledge Due Diligence is designed to be comprehensive within the agreed scope. A High-Level or Red-Flag Due Diligence focuses on material risks and critical transaction issues. The selected approach should be clearly defined in the engagement and explained in the report.

6.2 Executive summary and detailed analysis

The executive summary should allow the client to identify the most important issues quickly, including material risks, open questions, purchase-price implications, signing or closing risks and potential deal breakers.

The detailed analysis should then explain the underlying documents, facts, legal assessment and recommended measures.

7. Findings and solutions

A useful report does more than identify liability risks. It should also explain their practical significance and propose ways to mitigate or allocate them.

Possible responses include:

• remedying the issue before signing,
• making remediation a closing condition,
• agreeing an independent warranty,
• negotiating an indemnity,
• including a covenant,
• adjusting the purchase price,
• retaining part of the purchase price,
• using insurance or other security, or
• excluding the risk or terminating the transaction.

As a general distinction, abstract risks may be addressed by independent warranties, while identified and specific risks may be covered by indemnities. Operational matters may be addressed through closing conditions or covenants.

Whether a risk is a deal breaker depends on the commercial objectives, financing, risk appetite and the possibility of contractual protection.

8. The buyer’s perspective

8.1 Is due diligence mandatory?

Under the legal position in 2018, a private buyer is generally not under a universal obligation to conduct due diligence. For a corporate buyer, the directors or managing directors must consider whether the acquisition decision is based on an adequate information base.

Company directors generally have a recognised business-judgment margin, but it is not unlimited. The decision should be informed, responsible and directed towards the company’s interests. A material acquisition decision made without adequate information may create liability risks.

8.2 Buyer knowledge of defects

Information obtained in due diligence may also limit the buyer’s later warranty claims. Under the principles set out here, the seller may argue that the buyer knew, or in certain cases should have known, of a defect. The knowledge of an external adviser may also be attributed to the buyer under applicable rules of attribution.

The parties should therefore define the treatment of disclosed information and knowledge attribution clearly in the acquisition agreement.

9. The seller’s perspective

9.1 Seller disclosure duties

Because of the economic importance of an acquisition and the usual information imbalance, the seller may have enhanced duties to disclose material circumstances. The seller may need to disclose matters that are material to the buyer’s decision and which the buyer could reasonably expect to be disclosed.

Significant liabilities that could threaten the target’s solvency or continued existence are particularly important. Merely placing a document in a large data room may not be sufficient if the significance of the risk is not reasonably apparent.

9.2 Sale by one shareholder

If only one of several shareholders intends to sell, that shareholder must take the legitimate interests of the co-shareholders into account. Confidential company information should not automatically be disclosed to potential buyers, especially competitors.

The articles or shareholders’ agreement may contain consent requirements, transfer restrictions, pre-emption rights, tag-along or drag-along provisions, or restrictions relating to competitors.

10. The target company’s perspective

10.1 Confidentiality and business secrets

Directors and managing directors must balance the buyer’s information needs against the target’s interest in protecting trade secrets, personal data, customer information, negotiations, strategies and other confidential information.

A case-by-case assessment is required. The transaction’s stage, the identity of the potential buyer, the likelihood of misuse and the safeguards in place are relevant.

10.2 Safeguards

Risks may be reduced by using an NDA, limiting the user group, applying data-room controls, anonymising or aggregating particularly sensitive information, prohibiting downloads, requiring return or deletion, agreeing contractual consequences for breaches and obtaining shareholder approval where appropriate.

If multiple bidders are involved, the management should also consider its duty to treat competing offers neutrally and consistently.

11. M&A adviser liability

The due-diligence report often forms the basis for the buyer’s or seller’s decision to proceed with the transaction.

An adviser may face liability to its client if the adviser inaccurately presents the documents, fails to communicate material risks within the agreed scope or provides incorrect advice regarding legal, economic or technical consequences.

The engagement, scope, quality of the documents, recognisability of the risk, communication of uncertainties and documentation of the review may all be relevant.

A seller’s adviser may also assume responsibilities towards third parties through a reliance letter, for example towards a financing bank relying on the report. Reliance letters commonly contain caps, disclaimers and restrictions on use and distribution.

Under exceptional circumstances, advisers may also face tort liability where information or financial statements have knowingly been prepared or presented incorrectly.

12. Practical checklist

For the buyer and advisers:

• define the transaction objectives and material risks;
• agree the scope;
• prepare the document request list;
• establish data-room access and Q&A responsibilities;
• review relevant public sources;
• prioritise material risks;
• distinguish facts, legal assessment and recommendations;
• track open issues through signing and closing;
• reflect risks in warranties, indemnities, covenants or closing conditions.

For the seller and target:

• prepare the disclosure strategy and document set;
• put confidentiality arrangements in place;
• protect sensitive information;
• verify disclosure authority and shareholder approvals;
• check consistency and completeness;
• clearly disclose material risks;
• limit access and downloads;
• provide for return or deletion;
• treat multiple bidders neutrally.

For M&A advisers:

• document the engagement and scope;
• tailor the report to the client and transaction;
• identify solutions rather than merely listing risks;
• flag uncertainty and missing information;
• prioritise findings;
• address liability limitations and reliance issues;
• define the limits of the adviser’s mandate in foreign-law and specialist matters.

Legal notice

This article provides general information based on the law and M&A practice as of 2018. It is not a substitute for reviewing the specific transaction, target company, due-diligence engagement or acquisition agreement.