CORPORATE DUE DILIGENCE FOR MERGERS AND ACQUISITIONS OF NATURAL RESOURCES COMPANIES
| Jurisdiction | United States |
(Nov 1994)
CORPORATE DUE DILIGENCE FOR MERGERS AND ACQUISITIONS OF NATURAL RESOURCES COMPANIES
Holme Roberts & Owen LLC
Denver, Colorado
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Introduction
A prospective buyer of a company has a very simple goal in conducting due diligence prior to the acquisition of a company — to reach an acceptable level of assurance that the buyer will realize the value of the business that the buyer is paying for. This involves confirming the existence and ownership of the assets of the business and, when a merger or stock acquisition is involved, the identification and quantification of liabilities and commitments of the company being acquired. Achieving the goal of value realization requires an understanding of the concerns about a company's value and the methods available to identify, quantify and deal with the concerns.
Timing of Due Diligence
From the standpoint of a prospective buyer, in an ideal world a complete investigation of a company should be performed prior to entering into a binding commitment to purchase the company. At that point, the purchaser could decide whether to make an offer and, if the decision is to proceed, the price and all other terms of the offer could be finalized, all based on full information about the benefits and drawbacks of the purchase.
A number of factors usually make this ideal world unrealistic. If the buyer is not committed to the purchase (subject only to objective conditions) then, under contract law requiring consideration from both sides, the owners of the target company will not be bound to sell the company. Under these circumstances, the target may not be willing to put up with the disruption of a full due diligence investigation. In addition, the target company will be reluctant to allow due diligence to be performed on it if the prospective purchaser is not committed to maintain the confidentiality of information considered proprietary by the target company.
These factors may lead to a sequence of agreements binding the target and the prospective buyer to increasing levels of commitment to a deal. The first commitment by the prospective buyer to the target it desires to evaluate (but is not yet ready to commit to because it lacks detailed information) may be made in a confidentiality agreement pursuant to which the prospective buyer is provided access to proprietary information of the target in return for a commitment to keep that information confidential and to use it only for the purpose of evaluation. A form of confidentiality agreement is attached.
At this point the parties will not have agreed to any transaction. While due diligence is then undertaken by the
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prospective buyer in order to determine the feasibility of a deal, the investigation may not be carried out to the fullest extent contemplated by the prospective buyer prior to any closing of a transaction.
If the investigation conducted under the confidentiality agreement is satisfactory, the parties may then attempt to negotiate a definitive agreement. This stage is particularly important from a due diligence standpoint because the target will be attempting to negotiate a document that binds the prospective purchaser to complete the deal without any "outs," while the prospective purchaser will be attempting to negotiate a document that provides outs if a more thorough investigation reveals problems with the target not contemplated by the buyer. This is the stage at which schedules become crucial.
From the standpoint of the prospective buyer, the ideal contract would provide representatives and warranties by the target that no problems of any sort exist for the target. For example, the target would represent and warrant that there were no problems with title to its property, no environmental issues, no litigation or claims, no tax problems, etc. The prospective buyer would be able to feel comfortable that if it found any violation of any of those representations and warranties, it could either refuse to close and walk from the deal, sue the target for breach of contract, close and hold the target liable for breach, or some combination thereof, depending on the contractual provisions.
From the standpoint of the target, however, this form of contract would give the prospective buyer an unacceptable "due diligence out." In order to avoid that possibility, the target should attempt to identify any matters that ought to be expressed in the contract as an exception to its representations and warranties. For example, the target may draft a litigation clause that states "Except as provided in Schedule 5, there is no litigation, claim, etc." If the buyer executes a contract containing the scheduled exceptions, the litigation or claim could not then be the basis for the prospective purchaser's decision to terminate the deal. In fact, if the prospective purchaser were to do so, it would have breached its obligation under the contract to close the transaction.
Consequently, when items are scheduled as exceptions to representations and warranties by the target, the prospective buyer must conduct its due diligence on those items prior to the execution of the contract to determine whether it is willing to go forward with the deal in spite of
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the scheduled item. It cannot wait to make that decision until after the contract is executed.
When the contract is executed with all scheduled exceptions to the target's representations and warranties, the due diligence investigation of the buyer would then be focused on ascertaining whether any other matters not scheduled as exceptions exist that would make the deal unattractive. The process during this period has elements of "proving the negative." The investigation is focused on determining whether any additional matters exist that should be cause for concern.
Finally, depending on the terms of the contract concerning post-closing responsibilities of the target's owners, due diligence may continue well after the closing. For example, if the contract provides that the target's owners are responsible for any breach of their representations or warranties for two years after closing, the buyer would remain interested in investigating any problem areas in order to make any claims that are available against the target's owners during the indemnification period.
Due Diligence Team
Due diligence investigations require knowledge in a wide variety of areas. A fully staffed team of investigators for a prospective buyer of a company would include attorneys or other experts knowledgeable in corporate, tax, environmental, ERISA, property and labor law, as well as accountants capable of analyzing and evaluating the financial statements of the target. These experts should be involved not only in the due diligence investigation but in the drafting of contract provisions covering their areas. A general corporate attorney drafting an ERISA or environmental section of a contract is a dangerous lawyer. It is not safe to assume that the section concerning those areas written 12 months ago for another deal must be good enough for the current deal. Laws and regulations change, cases are decided and new thinking is developed. A fresh review of the contract language is always wise.
Checklists
A thorough checklist of matters to be reviewed in a due diligence investigation (such as the checklist attached) is both a blessing and a curse. It is a blessing because it contains the best current thinking about significant matters that should be reviewed, and helps to insure that nothing on the list is overlooked. It also serves as a method of communication between the prospective buyer and the target
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concerning what is expected to be supplied by the buyer for review.
The checklist is a curse, however, to the extent it is relied on as a substitute for a thorough, diligent investigation of the target. The goal may become checking off all items on the list rather than burrowing into the buyer's business to find problems not readily apparent to the eye. It is not enough to get access to the corporate minutes, read them and check the box. Matters acted on, or even referred to obliquely, in the minutes should become the basis for additional inquiries of management and other employees of the target.
The checklist is also a curse because it is tempting to conclude that when the list has been provided to the target and materials have been produced in response thereto, the search for materials is ended. This places too much trust in the target's employees. Follow-up inquiries and nagging reminders are almost always required in order to become comfortable that all requested material has been provided. It is too easy for an employee of the target to conclude that his work is done if he supplies the "contracts file" in response to a request for all material contracts.
The investigator may profit from...
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