03 Nov Why a due diligence investigation is essential in commercial transactions
In 2012, a giant global computer manufacturing company, Hewlett-Packard (“HP”) decided to acquire Autonomy as part of its overall plan to move away from computer hardware to more profitable computer software. HP conducted a due diligence on Autonomy and proceeded to acquire it for a price of $11.1 billion. Unbeknown to HP, the due diligence failed to pick up that the income statements, balance sheets and cash flows were inaccurate. As a result of this commercial blunder, HP incurred a loss of $5 billion. Following this incident, HP was sued by its shareholders for negligence in missing red flags and not performing adequate due diligence the Autonomy acquisition.
This is one of many big companies that have suffered huge financial losses as a result of botched due diligence investigation that failed to disclose material aspects of a commercial transaction. BMW faced the same predicament in its £800 million acquisition of Rover in 1994 which resulted in a £790 million loss. The Barclays Bank was fined £72 million by the UK’s Financial Conduct Authority for failing to conduct proper due diligence checks on a group of ultra-high-net-worth clients who used the bank to move £1.88 billion of funds in 2011 –2012. It is against this background that this article seeks to explore the importance of and the value that lies in a due diligence exercise in commercial transactions.
Due diligence investigations are a common occurrence in different sectors of the economy as a measure of curbing various forms of misrepresentations and even fraud. Before opening a bank account or a credit account with a financial credit provider a person is subjected to a due diligence investigation in order to determine the authenticity of the information he/she provided and / or the risks involved in dealing with such a person. It is important to note that due diligence investigations are also very common in merger and acquisitions transactions involving, inter alia, corporate companies and small businesses.
Sadly, most commercial lawyers have bemoaned a prevailing trend amongst most of their clients not to heed their advice in respect of conducting a due diligence investigation before entering into a commercial transaction. This is precisely because this reduces their effectiveness and ability to manage risk as it is difficult if not almost impossible to manage and mitigate risks that they are unaware of. The negative attitude by clients may be attributed to the fact that a due diligence investigation is expensive and time consuming, when seen in isolation of its benefits.
Understanding the concept of due diligence
Due diligence refers to the care that a reasonable person should take before, inter alia, entering into an agreement, financial and/or commercial transaction with another party. Its purpose is to investigate and establish as clearly as possible the factual position in relation to a target company’s operations and to identify areas of risk. It must not be seen as a mere box ticking exercise. In most instances, it is usually the purchaser who conducts a due diligence on the target company with the intention of ascertaining whether to proceed with the transaction, ring-fence, exclude or limit the risks and/or to negotiate warranties or the purchase price. However, in some cases the seller may conduct a due diligence on the purchaser in order to ascertain whether or not the purchaser has the financial capacity to enter into such a commercial transaction.
It is important to note that lawyers advising either party to the transaction, are the ones that actually coordinate the due diligence process. Where a business is sold as a going concern, a due diligence may also reveal the nature of the existing contractual obligations of a target company that the acquiring company may have to adhere to as a consequence of taking over the target company.
There are two common ways of going about a due diligence. Firstly, a due diligence can be conducted and completed before an agreement providing for the transfer of shares, a business or assets is prepared and signed. Secondly, the relevant agreement, normally a sale of shares or a sale of business agreement, can be prepared and signed and made subject to the completion of a due diligence. The second option is usually preferred and is consonant with market practice as it helps mitigate risks.
Regarding the scope of the legal due diligence, it usually covers an investigation into some of the following issues corporate, commercial contracts, employment, intellectual property, information systems, environmental health and safety, regulatory compliance, competition, litigation, property and tax. In instances where there is a need to look at non-legal areas other relevant experts will be invited to review and comment on such documents.
What to expect in a due diligence
Here are some of the most common steps that are usually followed when commercial lawyers conduct a due diligence:
Client gives mandate: A client must give the commercial lawyers conducting the due diligence a clear mandate regarding the scope and the most important information that to be looked out for. In turn the lawyers will advise the client on the practicability of this scope. This greatly helps in saving time and costs as well as adding value to the client.
Sign a Non- Disclosure Agreement: An essential tenet of the due diligence exercise is information sharing. This process involves giving access of your company’s information to the other party. A need arises to secure such information through entering into a non-disclosure or confidentiality agreement with such party. This promotes transparency which enhances risk management in commercial transactions.
Preparation of a Due Diligence questionnaire: This step requires a questionnaire to be prepared that probes relevant questions which are pertinent to obtaining accurate and useful information. In order to derive value, the client must make use of lawyers who have experience and expertise in conducting such investigation.
Access to data room: The party upon which the due diligence is being conducted must deliver or grant to the lawyers conducting the due diligence access to certain documents that are relevant to the transaction or would have been requested for review by the lawyers. These documents may either be hard or soft copies. However, in exceptional circumstances, there may be a need for the lawyers to do a face to face consultation with the staff of the target firm in order to clarify certain issues.
Review of documents: After having been granted access to the documents the lawyers will then start to reviewing these in order to understand the business operations and identify any potential risks of the target company. This process is very central to the entire due diligence process and if not done properly may result in severe financial and legal risks in the future for the acquiring company such as litigation or acquiring or merging with an insolvent company.
Report: After concluding the review of the documents provided, the lawyers must then prepare a report summarising the details and the outcome of the reviewed documents pertinent to the transaction. In this report the lawyers will usually ‘red flag’ likely to be contentious issues which can either make or break the transaction. It is from this report that the client will be able to make a decision on how they should proceed with the transaction.
The importance of a due diligence in a commercial transaction
- A due diligence is important as it helps the client with identifying potential risks that may render it unwise to acquire the target company.
- The outcome of a due diligence can be instrumental in negotiating the price that the target firm is being sold for.
- A due diligence ensures contractual protection through warranties and indemnities which secures the client from any potential future risks that are usually of a litigious nature and creates certainty.
- A due diligence enables the acquirer to verify the information provided by the target firm. This assists in mitigating the risk of fraud and other forms of misrepresentations.
- A due diligence helps inform the client in order for him to make well informed decisions in respect of the transaction and provides the purchaser with an understanding of the day to day running of the target company.
The consequences of not conducting a due diligence are dire for the purchaser as he or she may among other issues acquire a company that is insolvent, burdened with debts and exposed to severe litigation. Clearly, the value of a due diligence must not be underestimated. It is an investment that is worth it in order to secure their immediate and future commercial interests. In order for businesses to avoid falling in the same pit that HP, BMW and Barclays found themselves in, businesses need to engage the services of commercial lawyers who have vast experience and skill in conducting comprehensive due diligence investigations. Commercial lawyers are better placed to conduct such investigations because they have an eye for detail, are able to identify immediate and foretell future risk, understand how companies work as well as their thoroughness in their investigative approach of the operations of a business.