The Importance of Due Diligence in Corporate Transactions
In the context of private acquisitions and disposals in corporate law, due diligence (hereafter ‘DD’) is the process by which a buyer ‘investigate[s] the target business and its assets and liabilities before entering into a legally-binding sale and purchase agreement’. Business lawyers and various other actors involved in the DD process allow significant value to be added to transactions. Accordingly, this essay submits that DD is the most important part of the acquisition process, and to that end, will offer a threefold discussion. Firstly, the function of DD will be analysed, in order to explain how it has a more significant role to play than other aspects of a corporate transaction. Deal theory will assist in supporting this assertion. Secondly, a discussion of the consequences which can follow from inadequate DD (and their impact upon the overall acquisition) will further illustrate the necessity for a properly conducted process. Finally, the argument will be consolidated by briefly recognising two reasons why the importance of DD will be enhanced in future acquisition processes – namely Brexit, and technological investment. This will allow for an appropriate conclusion that properly conducted DD is, and will continue to be, paramount in order to ensure successful corporate acquisitions and disposals.
Part 1: The function of DD proves why it matters more than any other part of the acquisition process
For purchasers, DD forms the major part of the information gathering and planning stage. That is to say, it is the crucial fact-finding exercise which serves to identify any existing issues with the target company before the deal is completed. For example, on a sale of shares, it is ‘fundamental’ to ensure through legal DD that the seller has good title to them. DD can reveal a range of information, from common risks and ongoing business liabilities of which the buyer needs to be aware, to problematic material facts which could ‘break’ the deal altogether. Prior to substantive analysis, then, it becomes clear that a properly conducted DD process will place the buyer in the best position to close the deal and successfully carry on the business of the target company post-completion.
It is important to note that DD is a broad concept that can cover a significant number of areas - primarily legal, business and financial. Slaughter and May have described it as a ‘term of art rather than science’. This is markedly different from more conventional aspects of the acquisition process, such as the formalities of drafting contractual documents. It is extremely flexible in that it can be adapted to client’s needs. For example, in ‘quick sale’ deals (those with ‘very short fuses’), buyers may instruct their legal advisers to only provide the key material facts of the target company. The integral role of DD in the acquisition process is therefore exemplified by the fact that it does not insist upon a rigid ‘box-ticking’ criteria, which would be unworkable in the diverse modern corporate context. This ensures, crucially, that DD is never completely ignored in practice. Some degree of prior investigation is always required, though it is recognised that comprehensive fact-finding is not appropriate in every case. Even if no ‘red flag’ issues are discovered, the DD process tends to have an impact upon valuation and price – some of the basics of the deal.
It is therefore difficult to assert that other factors of the acquisition process are more important than DD. For example, subsequent negotiations between the parties might be argued to have greater importance since this process leads to the final deal being struck. Negotiations, like DD, are highly personal exchanges between the parties and arguably another ‘art’ form in corporate law. However, such a view is rebuttable by the fact that effective negotiations are a product of a thorough DD process. Only with the relevant knowledge of the target company’s assets and liabilities can a buyer ultimately build up a ‘full picture’ which they can use to complete the deal.
The macroeconomic view of deal theory can assist in supporting the claim that DD is the most important aspect of the acquisition process. Gilson stated that ‘[i]f what a business lawyer does has value, a transaction must be worth more, net of legal fees, as a result of the lawyer’s participation’. This essay argues that business lawyers, while instrumental in the acquisition process from start to finish, add the most value to transactions in the course of the DD process. This is true for two principal reasons. Firstly, business lawyers increase the efficiency of the DD process, which creates a similar knock-on effect for the rest of the acquisition. The purchaser’s solicitors often ‘take responsibility for co-ordinating the exercise on behalf of the purchaser’. They are tasked, alongside other professional advisers, with ‘verifying the accuracy of the seller’s representations’. They reduce asymmetric information by delivering a legal opinion in the form of the DD report and other advice. This rings true with Okamoto’s view of business lawyers as ‘reputational intermediaries’. Consequently, once the DD process is complete, and any outstanding issues have been identified, this allows the rest of the acquisition to proceed fluently. Crucially, this irons out potential future problems post-completion.
Secondly, business lawyers create an enhanced degree of clarity and confidence for their client during the DD process. They convey information to the client in a way which simply and explicitly outlines the material points in relation to the target company. The information revealed by the DD process could radically alter the decision of the client to proceed with the transaction. This might be unachievable by the client alone. Even where the client could conduct the DD work themselves, this would likely consume so much time that their efforts would become disproportionate to the overall value of the acquisition. This clearly proves that business lawyers’ involvement in the DD process puts the client in a strong position to progress towards finalising the transaction. As Mullins and Thornton point out, if the DD process reveals that the seller’s representations are accurate, ‘the buyer’s confidence in the original valuation increases’. While it may be true that business lawyers are merely ‘transactions costs’, this is outweighed by their overall value creation on completion.
Part 2: The importance of DD is exemplified through the consequences of an inadequate process
Inadequate DD ‘can cause serious damage to companies and their boards of directors’. The most common form of such damage is financial, which can stem from litigation, indemnities or other unknown liabilities. It can cost the jobs of various actors within the company, or even the company itself in a post-completion insolvency situation. However, since DD is a very broad concept, an inadequate process can create far wider-reaching consequences. For example, assume the target company in the acquisition handles toxic substances, some of which have contaminated the earth. If the purchaser’s DD investigation in this scenario is inadequate (for example, they have merely conducted a ‘desk-top’ survey when they should have taken soil samples) they risk being held liable for negligence, nuisance and other environmental damage. This is compounded by the prospect of poor publicity and shaming of the company for lack of social responsibility, particularly if it already has a potted environmental track record. This can be catastrophic to the successful integration of the business post-completion. One can therefore clearly recognise how it is well within the interest of the buyer’s board of directors to ‘emphasise the importance of… a well thought-out [DD] process’.
An example of inadequate legal DD was illustrated in the recent decision of Main & Ors, which concerned claims for negligence, breach of contract and breach of trust by various parties against a firm of solicitors. Jackson LJ in the Court of Appeal affirmed Foskett J’s observation in the High Court that adequate DD had not been conducted, and the claims were therefore well-founded. The defendant solicitors were held fully liable for failing to advise the claimant purchasers of the inherent risks involved in the acquisition process. Interestingly, this was the first case of its kind to signal the importance of properly conducted DD to both buyers and lawyers. This was not only because of the claims which were brought, but equally due to the inevitable acrimony which would have ensued between the parties.
When discussing how DD can prevent negative consequences in an acquisition process, it is important to appreciate how contractual protections (such as warranties, indemnities and disclosures) are not sufficient to negate the need for DD. It follows from the ‘caveat emptor’ (‘buyer beware’) principle in English law that ‘most purchasers want to make their purchase with their eyes open’, and, to that end, will seek contractual protections. Nonetheless, ‘they do not…prevent the purchaser from doing a bad deal’ and should not be regarded as ‘cast iron protection against any problems which may arise’. Carrying out as much DD investigation as possible allows for price verification, drafting of the main acquisition agreement and planning for the continued running of the business post-completion. It is therefore true that an inadequate DD process (which still consumes considerable time, money and effort) is of little value due to the ‘financial calamity’ it can create later in the acquisition process. The fact that contractual protections should be regarded as a ‘fall-back position’ proves that properly conducted DD to the extent suitable for the buyer’s needs is clearly the pre-requisite to a successful transaction.
Part 3: Imminent future challenges and technological investment will further enhance the importance of a properly conducted DD process
The impact of the Brexit referendum upon corporate law in the UK will render the need for properly conducted DD even more crucial in the context of acquisitions and disposals. Buyers in this period of uncertainty are being encouraged to broaden their DD ambit into issues such as ‘European registered intellectual property, foreign employees, and contracts with third parties based in the EU’. This will become vital as boundaries, companies and people begin to shift over the coming years. Therefore, the inherent function of the DD process in the information-gathering and planning stage is once again apparent. Buyers now feel inclined to investigate the target company further in anticipation of any material issues which may arise. Further, the introduction of legislation such as the Bribery Act 2010 ‘inevitably means that buyers will now wish to carry out more investigations than would previously have been the case’. The willingness to devote time, money and effort into the DD process proves that buyers regard it as an essential means of preventing complications later on in the acquisition process.
Equally, technological investment into virtual data rooms further supports the argument that DD is the most integral aspect of the acquisition process. While existing ‘physical’ data rooms remain popular for conducting DD, they possess both advantages and disadvantages. Virtual data rooms therefore complement them and aim to simplify and streamline the DD process. For example, their ease of access via the internet allows potential buyers to visit the data room at their own convenience, rather than attempt to conduct the majority of the DD work at a single ‘physical’ session. Importantly, they can then spend more time thoroughly studying key documents, and identify potential further issues. Investment in technology therefore aims to eliminate any possibilities of human error which can lead to the aforementioned severe consequences for the transaction.
This essay has shown that DD is the most important part of the acquisition process. It is a ‘quintessential step’ where business lawyers’ value-creation in the transaction is concentrated, since they are able to catalyse its efficient overall progress. Its inherent function is further exemplified when one appreciates the severity of the consequences which can arise following an inadequate process. Technological investment into DD proves that there is great interest in reducing the risk of potentially costly errors in transactions. Imminent future challenges facing corporate law in the UK and the wider global arena supports the existing argument for thorough DD as an objective good in any acquisition process.
Word count: 1997
Bibliography of Sources Cited and Consulted
Andrew Stilton, Sale of Shares and Businesses (4th edn, Sweet & Maxwell 2014) Online via Westlaw UK <https://login.westlaw.co.uk/maf/wluk/app/document?access-method=toc&src=toce&docguid=IDFF12BD0C98711E4A4A18569579DF2E5&crumb-action=append&context=7> accessed 07 January 2018
Darryl Cooke, Private Equity Law and Practice (5th edn, Sweet & Maxwell 2015)
Kurt Vonnegut, God Bless You, Mr Rosewater (first published 1965, Vintage 1992)
Ronald J. Gilson, ‘Value Creation by Business Lawyers: Legal Skills and Asset Pricing’  94 Yale L.J.
Terry Mullins and Barry Thornton, ‘The Role Of Due Diligence In The Business Valuation Process’  Journal of Business and Economics Research vol. 5 no. 5 63
Karl S. Okamoto, ‘Reputation and the Value of Lawyers’  74 Or. L. Rev. 15
Umakanth Varottil, ‘Due diligence in share acquisitions: navigating the insider trading regime’  Journal of Business Law 237
Published corporate documents:
Due diligence and disclosure in private acquisitions and disposals, Slaughter and May (2007)
Disclosure in M&A transactions: UK and US perspectives, Bryan Cave LLP (2013)
M&A Directions: Getting the most out of your M&A Legal Due Diligence, Ashurst (2017)
M&A: The intersection of due diligence and governance, Deloitte (2016)
Corporate Articles and Blogs:
Peter Coats, ‘Buying a business: The legal process – Due diligence’, (RadcliffesLeBrasseur, 18 August 2017) <http://www.rlb-law.com/briefings/corporate/buying-business-legal-process-due-diligence/> accessed 06 January 2018
James C. Freund, ‘Teaching Problem Solving: New Business Lawyers Need to Know How to Find the Deal: A Lawyer’s Perspective’ (Business Law Today, July/Aug. 1999) <https://apps.americanbar.org/buslaw/blt/8-6problem.html#lawyer> accessed 06 January 2018
Debbie King, ‘To Buy or Not to Buy? Due Diligence in Light of Brexit’ (Farleys Solicitors LLP, 7 April 2017) < https://www.farleys.com/buy-not-buy-due-diligence-light-brexit/> accessed 06 January 2018
David Niven, ‘Court of Appeal finds for purchasers in £5million failed holiday homes venture’ (Penningtons Manches, 1 August 2017) < https://www.penningtons.co.uk/news-publications/latest-news/2017/court-of-appeal-finds-for-purchasers-in-%C2%A35-million-failed-holiday-homes-venture/> accessed 06 January 2018
Employment due diligence – share and asset purchase, Lexisnexis
Eurocopy plc v Teesdale and others  BCLC 1067
Infiniteland Ltd and John Stewart Aviss v Artisan Contracting Ltd  EWCA Civ 758
Various Claimants v Giambrone and Law (A Firm)  EWHC 1946 (QB)
Main & Ors (Giambrone & Law (a firm) & Ors)  EWCA Civ 1193
BPE Solicitors v Hughes-Holland  UKSC 21
Bribery Act 2010 (2010 c.23)
Financial Services Act 2012 (2012 c. 21)
Mastering Corporate Due Diligence, September 2017, LexisNexis
 Andrew Stilton, Sale of Shares and Businesses (4th edn, Sweet & Maxwell 2014) Section 5-001. Online via Westlaw UK <https://login.westlaw.co.uk/maf/wluk/app/document?access-method=toc&src=toce&docguid=IDFF12BD0C98711E4A4A18569579DF2E5&crumb-action=append&context=7> accessed 07 January 2018
 Due diligence and disclosure in private acquisitions and disposals, Slaughter and May (2007) 3
 Ibid. n1 Section 7-002
 Ibid. n1 Section 7-010
 Ibid. n1 Section 7.5.3
 M&A: The intersection of due diligence and governance, Deloitte (2016) 2
 Ibid. n2 6
 Disclosure in M&A transactions: UK and US perspectives, Bryan Cave LLP, Lexology (2013) 1.
 Ibid. n6
 Ronald J. Gilson, ‘Value Creation by Business Lawyers: Legal Skills and Asset Pricing’  94 Yale L.J. 239
 See James C. Freund, ‘Teaching Problem Solving: New Business Lawyers Need to Know How to Find the Deal: A Lawyer’s Perspective’ (Business Law Today, July/Aug. 1999) <https://apps.americanbar.org/buslaw/blt/8-6problem.html#lawyer> accessed 06 January 2018
 Ibid. n2 8
 Terry Mullins and Barry Thornton, ‘The Role Of Due Diligence In The Business Valuation Process’  Journal of Business and Economics Research vol. 5 no. 5, 64
 Karl S. Okamoto, ‘Reputation and the Value of Lawyers’  74 Or. L. Rev. 15, 17
 Ibid. 14
 Ibid. n13
 Ibid. n10 241
 Ibid. n6 1
 Main & Ors (Giambrone & Law (a firm) & Ors)  EWCA Civ 1193
 Ibid at 34 (v)
 Various Claimants v Giambrone and Law (A Firm)  EWHC 1946 (QB) at 443
 David Niven, ‘Court of Appeal finds for purchasers in £5million failed holiday homes venture’ (Penningtons Manches, 1 August 2017) < https://www.penningtons.co.uk/news-publications/latest-news/2017/court-of-appeal-finds-for-purchasers-in-%C2%A35-million-failed-holiday-homes-venture/> accessed 06 January 2018
 Ibid. n2 6
 Ibid. n1 Section 5-001
 Ibid. n2 6.
 Ibid. n13 64
 Debbie King, ‘To Buy or Not to Buy? Due Diligence in Light of Brexit’ (Farleys Solicitors LLP, 7 April 2017) < https://www.farleys.com/buy-not-buy-due-diligence-light-brexit/> accessed 06 January 2018
 Bribery Act 2010 (2010, c. 23), particularly s7(1)
 Ibid. n1 Section 7-023
 Umakanth Varottil, ‘Due diligence in share acquisitions: navigating the insider trading regime’  Journal of Business Law 237, 237