Legal Due Diligence

An introduction

RA Dr Bernd Grama, LL.M (Columbia)

Literature

Heidinger Albeseder; Due Diligence (Orac 2001)

Hofmann; Due Diligence – Möglichkeiten und Grenzen des Managements (Verlag Ö, 2006)

Essentials

What is due diligence?

No legal definition of DD in Austrian Law

DD is an extensive examination of the company to be acquired (review of all important documents)

In other words:

to identify the big problems and the black holes prior to the acquisition of assets or shares of a company

DD is conducted before a buyer/seller is committed to a deal

Due Diligence is a multi-disciplinary exercise -> team work!

Roots of Due Diligence

U.S. Securities Act of 1933

The issuer (among other parties like all those who signed the registration statement) is liable for wrong or missing information about material facts in the letter of registration.

But the issuer is able to free himself form liability if he is able to prove that after reasonable investigation he had reasonable ground to believe that the statements were true and not misleading (due diligence defense).

The requirement of a reasonable investigation to become free from liability is the reason why the management started to keep records of the financial and economical situation of their company

This was the origin of due diligence

During second half of 20th century important for all kind of transactions (provides information and discloses risks)

Legal Due Diligence

Distinguish:

Legal due diligence (lawyers)

Financial DD (accountants)

Commercial DD

Tax DD

Environmental DD

Technical DD

Human resources

Further specialist DDs: Marketing, media expertise…

Legal Due Diligence

Types

Buyer’s DD (most common)

Seller’s Legal DD

IPO

Internal control measures

Other reasons

Main reasons for legal DD

1. Identification of any defects in the enterprise (defects of title), that might give rise to a warranty claim or a claim for damages

2. Determination of liabilities connected with the business to avoid litigation

3. Secure transfer of all existing contractual relations and submission of all required statements of consent and authorisation

4. Examination of all legal and administrative requirements for a continuation of the conduct of business

5. To comply with standard of a prudent business merchant (management board of acquiror)

Legal Due Diligence

Legal DD is usually performed by the buyer’s lawyers, but:

Chartered accountants also review legal documents (corporate documents, important contracts)

Lawyers typically ask for financial statements and related reports

Limits:

It is a misconception that full transparency of the target corporation can be created through and during a due diligence process

Reasons:

Time pressure -> priorities

Not only consider past documents –> also their future relevance

Highly complex matters

What does legal DD cover?

Typically legal due diligence covers

1. Company structure / shareholdings

2. Transactions

3. Contracts and trade agreements

4. Real estate and other major assets

5. Permits

6. Public subsidies

7. Collective labor law issues / Individual labor law issues

8. Pensions

9. Product Information

10. Insurance

11. Intellectual Property

12. Litigation

13. Environmental Issues

Example: M&A Transaction

The purpose of a due diligence during an M&A transaction is to gain information about

the target company and

risks of the transaction.

A due diligence review is done in almost all M&A transactions, provided that the value involved is somehow significant

Procedure

Timing

Timing of the due diligence process varies

Depends on the circumstances of the particular transaction:

1. before a share purchase agreement (SPA) is signed but after execution of a letter of intent (LOI) (common scenario)

2. after an SPA has been signed but before closing

3. after closing with the contractual possibility of a post closing adjustment of the purchase price

Procedure

1. Letter of intent (LOI)

2. Confidentiality Agreement

3. Request list and preparation of DD

4. Review of documents (→ Data Room)

5. Report

6. Consequences

Letter of Intent

There is an agreement to agree

Letter of intent (LOI)

Letter of intent is a preliminary agreement, also known as:

memorandum of understanding, commitment letter, heads of terms

Written document between parties

Negotiations have reached an advanced stage

Agreement on intentions and expectations

Function

Summarize the broad terms of what has been agreed on

Put in writing a “step-plan” how negotiations shall go forward

Letter of intent (LOI)

Binding?

generally no → not binding on the parties in their entirety.

but many LOIs contain provisions that are binding, such as:

non-disclosure / confidentiality agreements,

a covenant to negotiate in good faith, or

a stand-still or no-shop provision promising exclusive rights to negotiate - EXCLUSIVITY

Purpose?

explain the key points of a complex transaction

provide exclusivity for negotiations for a certain period

provide security if deal collapses during negotiation (break-up fee)

Typical topics

Timetable

Opportunity to agree on the timetable

secure access and necessary cooperation

Key warranties and indemnities

To flag the main warranties and indemnities expected

Purchase price and consideration

Price negotiations should be in the final phase

Standstill agreement

Not to conduct negotiations with third parties for a limited time

→ affects the buyer’s bargaining position

Binding provisions

Various binding provision can be negotiated

Advantages

Speeds up a deal and makes final agreement easier

Parties agree on basic terms and structure

→ LOI serves as a roadmap for the final agreement.

Contains binding provisions which help get the deal done

Some binding provisions are important to agree on

Period of exclusivity

→ Standstill agreement

It can help to secure financing

For banks and other lenders

→ before committing to finance a transaction

Enforceability

Depends on:

1. The context of the negotiations

2. The language used in the LOI

a) Intent to be bound

b) Parties agreement to the essential terms

3. The size and complexity of outstanding issues which remain unresolved

The confidentiality agreement

Non-public business information

Confidentiality Agreement

Confidentiality Agreements restrict the

distribution and

use of information disclosed in the due diligence process

1. Potential buyers are often competitors

2. Seller may be reluctant to disclose non-public information to any potential buyer

3. Buyers are generally unwilling to make their offer unless given access to non public information (such information is generally crucial in determining whether the envisaged business model will materialize)

Confidentiality Agreement

Who is bound? Entire company of buyer and seller? Seller will insist that buyer includes all team members in the NDA/CA Advisers (e.g. lawyers)

What is covered? Basically everything except:

Information which is generally available to the public Information which was already in the possession of the receiving party Information which is independently developed by the receiving party Information which is received from another source without any restriction on use or

disclosure

How long does it last? Time limit → usually between 1 and 5 years

Breach of confidentiality

Violation gives the other party the right to sue for

Cease and desist and

Compensation for damages suffered (eventually penalty clause)

In practice

Very difficult to prove if

a) an obligation has been violated

b) a loss has been suffered

Therefore

Practically no court cases for breaches of confidentiality

If possible: Penalties regardless of fault in the NDA/CA

Request list and preparation of DD

Request List and preparation of DD

Send due diligence request list to target management

Target Management has to install a data room (either at the premises of target company or in the office of seller‘s counsel)

Data Room needs to be well prepared – decisive for success of due diligence

Set up due diligence team – team leader (specializations; often junior associates involved) (multi-jurisdiction discipline)

Make sure that team members have some preliminary information regarding target

harmonize formatting (numbers, dates, abbreviations for the target etc.)

Coordinate meetings with accountants who are conducting Financial DD

The review of the documents

„no warranties for obvious deficiencies which are evident in public records”

§ 928 ABGB

Doing the due diligence review

Where to get the information?

1. Data room

The data room enables interested parties to view material relating to the business in a controlled environment

Data room rules state if documents are allowed to be copied

2. Written questionnaires

Directed to the management of the company

Covering the issues of the → Request list

3. Site visits

Legal team might visit the site of the target company

Data room

Traditional data room

Physically secure continually monitored room in the seller’s offices

Should contain hard-copies of all relevant documents and information

Only one legal due diligence team can enter the room at the same time

(sometimes data room at seller’s office and at seller’s counsel)

Data room

Virtual data room

Alternative to the physical room, in the form of an extranet

An Internet site with limited and controlled access

using a secure log-in supplied by the vendor/authority

can be disabled at any time by the vendor/authority if a bidder withdraws from the transaction process

Usually no forwarding, copying, or even printing of displayed documents

Record is kept for each document – who saw it, when and for how long

Virtual Data Room screenshot

Pros and cons of virtual data rooms

Pro

Is accessible 24/7

No need for couriers to move or update documents

Many DD teams can access files at the same time

Information can be added or removed at any time

Cost and time saving

Transparency

Con

Can be difficult and time consuming to open documents

Screen handling is more tiresome

Security issues

Review Contents

Corporate Issues 

Present group structure (extract from the commercial register)

Minority rights of shareholders

Articles of Association/Charter

Shareholders’ agreement

Contracts and other titles for acquisition of shares

Related Party arrangements

Minutes of Meetings (board, shareholders)

Corporate restructurings (mergers, spin-offs…)?

Review Contents

Third party influence on the corporation

Trust agreements

Pledge of shares

Silent partnerships

Special dividend rights

Affiliated companies

Liabilities assumed for third parties

For affiliated companies

For others

Participations in other companies

Shares in corporations

Cooperation Arrangements

ARGE

Joint Venture

Review Contents

Governing bodies

Board of directors

Supervisory Board

Advisory Board

Personnel

Organization chart

Management contracts

Collective bargaining agreements

Plant agreements

Social security benefits

Members of work councils

Proxy employees

Pension fund coverage

Strikes and lock-outs

Workforce reduction

Review Contents

Contracts

Contracts for services

Consultancy agreements

Lease contracts

Outsourcing

Franchise

Supply contracts

Standard terms of business (AGB)

Litigation

Disputed legal relations

Current and imminent proceedings

Arbitration proceedings

Reserves in balance sheet

Insurance coverage

Risk evaluation

Review Contents

Real Estate

List and details of all real estates

Extracts from land register

Purchase agreements

Leases

All contracts

Side Agreements

Rent adjustment (attention: §12a (2) MRG)

Public law permits

Trade licenses

Plant permits

Zoning plans

Construction permits

Emissions certificates

Environmental impact assessment

Environmental documentation

Environmental audit

The due diligence report

„Heavy on facts, light on advise“

Due diligence report

Lawyer reports client on all issues revealed

→ Lawyer‘s general duty of care

With special regard to:

1. Missing information or data (often incomplete)

2. All revealed risks

3. Nature and size of debt, liabilities

In Austria and Germany: key recommendations

USA and UK: Usually no legal advise and conclusions

→ No legal opinion

Report disclaimers

No recommendation to buy or sell

“DD report only contains advice according to Austrian law or jurisdiction involved”

→ Lawyer disclaims responsibility for legal consequences in other jurisdictions (if local law firm engaged to conduct due diligence)

Reliance Letter

Common in private equity transactions (buy-in or transaction by private equity companies)

often the due diligence report is forwarded to the financing banks in private equity deals

The reliance letter states the terms and conditions, especially limitations of liability of law firm

Consequences

Consequences of the legal due diligence

1. Cancellation of the transaction

2. Reduction of the original purchase price

3. Restructuring of the deal

4. Reps and warranties (→ SPA)

5. Conditions precedent

Costs of DD

DD is very expensive

DD-team consists often of 4-10 lawyers

Spend 5-10 days (10 hours per day) in the data room (hourly rates of associates range between EUR 220 to 280)

Drafting of report takes 2-4 days (10 hours)

Costs between EUR 30K to 250K

END

Thank you for your attention!