CHAPTER 3 TEN CRITICAL DUE DILIGENCE ISSUES THAT CAN SPOIL YOUR DAY (OR DEAL)
| Jurisdiction | United States |
(Apr 2010)
TEN CRITICAL DUE DILIGENCE ISSUES THAT CAN SPOIL YOUR DAY (OR DEAL)
Dorsey & Whitney LLP
Seattle, Washington
(206) 903-8856
CHRISTOPHER L. DOERKSEN is a Partner at Dorsey & Whitney LLP in Seattle, focusing on M&A, financings, securities laws and general corporate matters. As a member of the firm's Canada Practice Group, a significant portion of his practice is devoted to advising Canadian clients on U.S. cross-border transactions. Mr. Doerksen's recent experience includes gold and uranium transactions ranging from small asset acquisitions valued at a few hundred thousand dollars to acquisitions of companies with numerous subsidiaries across several states valued at several billion dollars.
March 22, 2010
Introduction
In a merger or acquisition ("M&A") transaction in the natural resources sector, the buyer commonly, and appropriately, focuses its due diligence efforts on the technical, environmental, property title and financial aspects of the acquisition and the structure of the transaction. The executive or attorney running the transaction must, however, keep a broader view of the landscape. This paper discusses 10 critical due diligence issues that can spoil an otherwise beneficial transaction.1
1. Corporate Governance
Corporate Existence
The most basic question is whether the company you're dealing with exists. While this is usually taken for granted, it's not always true, and should be verified by ordering good standing certificates for the company early on in the process. We have encountered a number of situations in which the target company had forgotten to file its annual report, resulting in the administrative dissolution of the company. In some cases, state law will permit the company to be reinstated prior to the planned merger or stock purchase. However, in one transaction with which we are acquainted, the period during which the company could be reinstated had already passed. Fortunately, the directors remained associated with the company, and under the
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applicable state law, the directors of the dissolved company retained authority to sell the company's assets as part of the wind up of the dissolved company. The transaction therefore proceeded as an asset sale.
Other Corporate Governance Problems
The buyer's ability to assess a target company's corporate governance history is somewhat limited. The buyer can review the company's corporate minute books, stock records and related documents, but it's important to remember that this is just paper - it may be incomplete and it may be wrong. That said, some very interesting things can be concluded from that paper, or the lack of it.
The Paperless Company
In the worst case, the target company has no minute books or stock records at all. While this seems outlandish, it does happen on occasion, with shell companies, subsidiaries or entities that have changed control without a proper transfer of records. We know of one company that completed a reverse takeover of a shell company that had no minute books or stock records. As a result, the successor could not verify, among other things, who owned the remaining position in the company, how many shares were outstanding or whether these shares were validly issued, fully paid and non-assessable. Had the company conducted appropriate due diligence in advance, it could have avoided the transaction, and saved itself the resulting cost and damage to its financeability, which was substantial.
Dark Periods
More common is the target company with substantial dark periods, for which records were lost or were never prepared, followed by a renaissance period in which directors and officers were appointed, new share certificates were issued, meetings were held and corporate
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niceties were followed (the corporate equivalent to a new paint job). The same risks apply as with the paperless company, but to a lesser degree. The buyer must decide whether these risks are manageable, through indemnification, structuring the M&A transaction as an asset purchase or otherwise.
Critical Flaws
When dealing with better run target companies that have relatively complete corporate histories, buyer's due diligence review can be made, or broken, by the quality of the review that is undertaken of the target's corporate records - something often delegated to an inexperienced, junior lawyer. Senior lawyers must adequately supervise their junior lawyers to ensure that critical flaws are not overlooked.
Among the many examples of things we have found in a detailed minute book review are:
• a company that acquired all of its assets by merger, but whose corporate records did not include a copy of the merger agreement or related board or shareholder approvals, bringing into question the ownership of its assets;
• a company's failure to obtain statutorily-required shareholder approvals, thereby invalidating a major transaction;
• failure of the initial incorporator of a company to appoint the initial board, bringing into question future corporate acts; and
• a company that unknowingly created a capital structure resulting in the maximum Delaware franchise tax - $160,000 per year.
False Prophets
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On occasion, falsified documents may be found among the target company's records. Where we have discovered this, it has usually been a backdated document, discovered as false by virtue of a more recent date in a fax stamp or file name footer.
2. Corporate Approvals
The buyer, seller and the target company, if different, must each evaluate the corporate approvals required to effect the transaction. Mistakes can occur, particularly if the buyer forgets to make the required evaluation of itself or the buyer relies on the seller to make the required evaluation of the seller or target company, and does not double-check the seller's analysis for accuracy. Failure to obtain required corporate approvals may invalidate your M&A transaction.
Shareholder Approval
Understand whether shareholder approval of an M&A transaction is required, and at what levels. Different transaction structures may generate different answers, as may different states of incorporation, stock exchange listings and the party's particular organizational documents (and those of its parents, if any). To determine whether shareholder approval of a transaction is required, you will need to know the proposed transaction structure, and review the relevant state statute, stock exchange requirements and entity organizational documents. In the case of an asset sale, you may also need to evaluate the nature and value of the assets, because many states require shareholder approval if the sale constitutes a sale of all or "substantially all" of the assets of the company, as that term is interpreted under the applicable state's laws.2
Subsidiaries
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If the transaction is being undertaken at a subsidiary level, do not forget to obtain the approval of the subsidiary's board and, if required, its shareholders.
Related Party Transactions
Many states have laws that provide any shareholder with the right to challenge in court an M&A transaction in which a director or officer has a material interest, and to have the transaction invalidated, unless either:
• the company obtains the approval of the independent directors or independent shareholders in a manner prescribed by state law; or
• the court in which the challenge is brought, applying its own business judgment, considers the transaction to be fair to the company.3
When a transaction falls within the scope of one of these laws, the approval of independent directors and/or independent shareholders should be obtained in the manner specified by the state statute if at all possible. Otherwise, the parties should understand the risk that any shareholder could seek to invalidate the transaction and, if a shareholder does so, the fate of the transaction may be withdrawn from the business judgment of the board and its shareholders, and put solely within the hands of the court.
Other Entity Structures
If a party to the transaction is not a corporation, other types of entity approvals may be required, such as the approval of partners in a partnership or members of a limited liability company.
3. Contractually Required Approvals
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The scope of contractually required approvals for an M&A transaction varies by transaction structure.
Asset Purchase
In an asset purchase, every single contract is being assigned. Therefore, every single contract must be reviewed to determine whether it has restrictions on assignment that would require third party consent. While it is possible to complete an asset purchase without having reviewed every single contract, the buyer should do so only with the understanding that the contract may not, in fact, be transferable and the buyer may not successfully acquire the contract. Similarly, without having undertaken the required review, the seller should understand that it may be left with the liabilities underlying a contract if the contract proves non-transferable, or it may subject itself to termination of the contract or damages for breach of contract, if it attempts to transfer a contract in violation of an anti-assignment clause.
Stock Purchase
M&A transactions are often structured as stock purchases, the purchase by the buyer of all of the outstanding shares of a target company, in order to limit the number of third party consents that are required. This is because in a stock purchase, the target company's...
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