Don't ignore electronic due diligence: potential acquirers would do well to apply sophisticated electronic methods to quickly search email and other electronic data for lurking liabilities.

• Author: Thornquist, David K.
• Position: Mergers and acquisitions

When a company is rumored to be a takeover target, bad things can happen. Top executives may accept job offers with rival companies, taking key employees with them. Sales managers and account executives may send out resumes and make copies of confidential customer information. R & D scientists may copy proprietary data, fearing their jobs may be at risk. Sales staff, hungry for last-minute commissions, can hype sales results or sell at deep discounts. Senior executives who may have been massaging the numbers or overseeing aggressive accounting methods can delete incriminating email and documents.

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If the acquirer carries out traditional due diligence and focuses primarily on checking sanitized, vetted reports and interviewing key employees, it may completely overlook the candid, liability-laden statements that are crucial to understanding the target, warts and all. If problems surface after the merger is completed, followed by a sharp drop in the company's stock price, an influx of class-action lawyers will follow. And you can be sure that these lawyers will seek disclosure of the email and other electronic records that should have been weighed by the acquirer and its advisors in the due diligence process.

Why will these class-action lawyers be so successful at digging up the dirt? Because modern plaintiffs' lawyers have become adept at electronic data discovery. They know how to cut through the mass of irrelevant and redundant data and go right to the negative and incriminating stuff. They can recover email and other electronic data considered lost or destroyed when someone pressed "delete."

The ability of powerful and sophisticated search tools to review masses of data quickly and thoroughly, coupled with savvy sampling techniques, is changing what a party conducting diligence can and should know using "reasonable care." The due diligence standard is defined by case law. Typical is a federal court's holding that an underwriter conducting due diligence must show that it "did not know, and in the exercise of reasonable care, could not have known, of [the] untruth or omission" of the investor disclosure in question (Software Toolworks Sec. Lit., 50 F.3d 615 (9th Cir. 1994)).

The level of diligence that is "due" is measured, in part, by what material liabilities may lurk. An exhaustive search for every potential source of liability is neither feasible nor legally required. It would be prohibitive, in terms of money and...