CHAPTER 6 DUE DILIGENCE AND CLOSING ISSUES
| Jurisdiction | United States |
(Nov 1995)
DUE DILIGENCE AND CLOSING ISSUES
Welborn Sullivan Meck & Tooley, P.C.
Denver, Colorado
You've hammered out the deal, negotiated and signed the Purchase Agreement and are looking forward to the Closing. Only one detail remains — confirming that your Buyer is going to get what it bargained for and/or not acquire in the process so many problems that the peacock becomes an albatross. Thus starts the due diligence period, at the end of which the deal that closes may bear little resemblance to the one that was struck.
This paper will cover the period commencing with the signing of the Purchase Agreement and ending with Closing, the traditional "due diligence" period. The due diligence process actually begins when the Buyer's representatives first enter the data room or receive the sales material and doesn't end until the post-Closing survival periods expire. However, the same disciplines apply throughout and I have assumed that the pre-signing and post-Closing review will be as diligent and thorough for their respective purposes as that conducted during the period discussed. The paper will not cover two key due diligence areas, environmental and third party dealings, since these will be addressed by others. Also, certain important areas, most notably those dealing with title and corporate and securities matters involved in stock deals, will not receive the analysis they deserve because of restrictions on the length of this paper. However, several of the papers cited in the bibliography deal with these areas in greater depth and hopefully they will serve the needs of those who seek greater guidance. Finally, the usual disclaimer in papers dealing with due diligence — this paper is not intended to be a scholarly treatise since there is very little case law dealing with due diligence and the few cases reported are fact specific; rather it is intended to be a practical guide, a "nuts and bolts" approach to due diligence, based on the author's experience and observations and those of others.
I. Introduction.
Few deals crater because of problems discovered during the due diligence review, but many are renegotiated and it is the rare deal where the purchase price is unaffected. It is important to remember at the outset that the parties have conflicting due diligence goals. While normally both want to retain the deal they've negotiated, the Buyer will want the review to confirm its assumptions, identify and solve problems, reduce the purchase price at Closing, and, ideally, eliminate the "dogs." On the other side, the Seller, while sharing the Buyer's desire to retain the deal and solve problems as they arise, will want to keep the purchase price intact at Closing, avoid escrows, argue about defects and breaches post-Closing, and keep the dogs in the deal. It is important to keep these conflicting goals in mind as you organize for the due diligence effort and work through the process.
It also is important to establish your goals for the review. Your job is to see that the Buyer gets what it paid for or may recover against the Seller if it receives something less.
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You'll learn quickly that, notwithstanding all you hear about the importance of the due diligence function to the overall process, there are few due diligence heroes and a Buyer's kudos are normally reserved for the negotiator of a favorable Purchase Agreement. If your due diligence effort is successful, i.e., if the Buyer realizes its goals, your reward is the next deal; if the Buyer is disappointed with the result, you're fired. It's as simple as that. One last warning — if you find problems, you'd better have solutions to suggest; and busting the deal is rarely the answer the Buyer wants to hear.
II. Getting Organized.
It may be a clicheacute;, but the time devoted to organizing and structuring your due diligence effort and designating your team is time well spent, no matter how critical the timing. Throughout the process, you should keep in mind the four keys to a successful due diligence effort:
• Know the properties.
• Know the parties
• Know the Purchase Agreement.
• Know your team.
A. The Properties.
Knowledge of the properties, including the price paid for them and their respective values, is a critical component to organizing the due diligence review.
1. Purchase Price.
In a nutshell, the higher the price, the greater the effort. Few Buyers are willing to authorize a comprehensive review for a $50,000 deal.
2. Number and Value.
The more extensive the properties, the longer due diligence will take, assuming the properties are of equivalent value. Of course, this is rarely the case and if there are one or two high value properties in the deal, you can devote your efforts to these to the exclusion of the others. The rule of thumb is to concentrate on the properties constituting 80% of the value and worry about the remaining 20% after Closing, if at all, particularly if you have a survival period for submitting title defects. But again be cognizant of your Buyer's goals; if there are certain properties it would like to eliminate, even if they're lower in value you'd better include them in your review.
As to the often heard admonition that you can have as big a problem with a low value property as with a higher value one, in my experience few Buyers want you to waste precious
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due diligence time and money scouting for problems on properties that have little or no value associated with them. At best you may be able to scope an environmental review that might identify problems involving these properties. But if you can't, most Buyers are satisfied with assuming the risks of following the 80/20 rule.
3. Producing or Non-Producing.
Producing properties are likely to have prior title opinions and division orders, thereby saving time and money as far as title review is concerned. Of course, the flip side is that producing properties are more likely to have associated baggage, e.g., environmental contamination, royalty claims, litigation, contractual disputes. Thus, the ratio of producing to non-producing properties may not make your life any easier, but it will influence how you scope your review.
4. Operated or Non-Operated.
Operated properties create their own unique problems, such as delinquent accounts, compliance with the operating agreement, environmental compliance, and obtaining approvals of changes in operator. However, the pluses normally outweigh the minuses — easy access to the books and records for the properties, including in all likelihood the most complete title records; expedited equipment inspection and a jump start on environmental review; and the cooperation of field personnel. For non-operated properties, you may have to rely on the cooperation of the operator, which has little incentive to do so. Of course, if you already operate some or all of the properties, your review becomes a lot easier (or non-existent, except for title) and this may also be the case even if all you have is a working interest in the properties.
Another thing that may be significant to your review is the operator of a property. This will not affect your title review, except to the extent that certain operators keep better records and are more cooperative and forthcoming than others, but it may well influence your environmental review and plans for visual inspection. Many times a Buyer is willing to take the risk as to environmental compliance and equipment condition for a non-operated property if it knows and/or and has confidence in the operator.
5. Oil or Gas.
If the properties are primarily oil producing, your environmental hot button will be pushed. But gas producing properties bring their own set of problems, such as the payment of shut-in royalties, gas balancing issues, compliance with transportation and purchase contract provisions, and Section 29 certifications. Again, the classification of the properties is likely to dictate the focus of your review, rather than to lessen the time it takes to conduct it.
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6. Location.
The location of the properties may cause you to alter the scope of your review. For example, the 80/20 rule may work in most instances, but if the properties constituting the 20% are located in Louisiana, you may want to consider refocusing your due diligence effort. Location may also be significant as to the difficulty of the title review. Few title examiners (except those with high per diems and unlimited expense accounts) would argue that they prefer to clear title in East/South Texas, with its multitudinous ownership interests and where unrecorded instruments are as much the rule as the exceptions, versus the Rocky Mountain Region, where Federal, State and large land holdings predominate.
B. The Parties.
In determining how to organize your due diligence effort, it is important to know how the parties are likely to facilitate or hinder your effort. I have already discussed the common and/or diverse goals of most Buyers and Sellers, but the philosophy of a particular Buyer or Seller towards this deal or towards acquisitions/dispositions in general may be equally important in establishing your priorities. For example, how anxious are the parties to do the deal? Does one have leverage on the other? Is timing critical to the Buyer? Is it critical to the Seller? Is there a lender involved and, if so, will it be your principal contact? Are there any true "deal breakers"?
1. The Buyer.
The Buyer is your client, so you had better have a clear idea of what it expects from you. But you also need to know your expectations of the Buyer. Is it a deal closer or is it skittish, risk adverse and likely to walk if too many problems surface? Is it a hard bargainer when it has leverage? Will it want to squeeze every nickel out of a defect or drop the immaterial ones? Does it need financing...
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