baker & mckenzie - acquisitions _ due diligence

7/17/2019 Baker & McKenzie - Acquisitions _ Due Diligence

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青山・青木法律事務所

Acquisitions – Due Diligence(Purchaser’s Perspective)

ACQUISITION OF INTERESTS IN OVERSEASPROJECTS SEMINAR

JULY 2006



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1 What is a Pre-Acquisition Review/Due Diligence Investigation?

1.1 A "due diligence investigation" simply means a pre-contract or pre-completion check (i.e. a

pre-acquisition review) on a range of factual, financial, legal, accounting, business and othermatters relating to the target business. The review aims to ensure, as far as possible, that the

purchaser knows what it is getting, should it proceed with the purchase; or to assure the

purchaser that the business is indeed as represented by the vendor, before the purchasercommits itself to go forward.

1.2 The term "due diligence" is coined from the requirement of a companyand its officers as a

matter of good practice and responsibility (to shareholders) to exercise due diligence inverifying the state of the purchase it is about to make, before making it. As indicated above,

the diligence exercise can be divided into a number of different areas, determined by theirsubject matter, with each discrete area being investigated by those experts who have therelevant specialist expertise. Although the terminology may vary, the broad categories of

review are:

(a) Legal due diligence. On any significant acquisition, the prospective purchaser willwant to be sure that the vendor, and (in the case of a share purchase) the target

company, have good title to the assets being bought and to know the full extent of any

liabilities it will assume. Accordingly, legal due diligence is carried out by lawyersand focuses on matters such as contracts, compliance with law, corporate structuresand governance, anti-trust, exchange control, litigation, employment, pensions,

intellectual property, real property and tax.

(b) Business due diligence. Business due diligence looks at broader issues such as the

market in which the target business operates, competitors, the business' strengths and

weaknesses, production, sales and marketing, research and development, etc. The

aim of business due diligence is to test the assumptions that the purchaser will havemade in its acquisition plan and to identify the management action required by the purchaser to take effective control of, and reduce risk in, the target business once the

deal has closed. The team carrying out the business due diligence will include orinvolve the purchaser's own personnel, as only they will be able to make effective

judgements as to the commercial importance and potential risk brought to light by the

information uncovered.

(c) Financial due diligence. As part of the due diligence process, the purchaser will

usually instruct accountants to prepare a report (the accountants' report or long-form

report) on the financial aspects of the target business. This financial due diligence isnot the equivalent of an audit and the accountants' report will make this clear.

Financial due diligence focuses on those areas of the target's financial affairs that are

material to the purchaser's decision, so that the purchaser can assess the financial

risks and opportunities of the deal and whether, given these risks and opportunities,the target business will fit well into the purchaser's overall strategy. Financial due

diligence may also help quantify:

(i) potential synergies;

(ii) the best acquisition and financing structure;

(iii) the impact of the acquisition on the purchaser's performance statistics; e.g.,where the purchaser's accounting policies are more conservative than those



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followed in the target business, it may be necessary to make appropriateadjustments in order to measure the true impact.

Part of the accountants' investigation will be to review the target's audited accounts.

Where the purchaser is a listed company, depending on the size of the acquisition,

and depending on local regulatory requirements, it may need to give shareholders

certain financial information about the merged group. Again, accountants will needto review the target's figures in order to provide this information.

(d) Other due diligence. Depending on the nature of the target's business, the purchasermay instruct other experts, such as environmental experts, surveyors, IT or otherrelevant specialists. For example, the acquisition of a manufacturing or processing

company, or one whose assets include land currently or previously used for industrial

processes, will raise questions about potential responsibility for any clean-up andliability generally in relation to environmental damage. To answer these, some form

of environmental due diligence will be required.

2 The Role of the Legal Pre-Acquisition Review

2.1 The aim of the legal pre-acquisition review is to enable the purchaser to understand the

target's business and structure from a legal viewpoint. It should also provide the purchaserwith the information necessary for it to assess the target business and make its final decision

whether to invest on an informed basis. The review should enable the purchaser and its

advisers:

(a) to identify any procedural, legal or contractual problems associated with effecting the

transaction, e.g., necessary exchange control consents, foreign investment approvals,

government and other regulatory approvals, third party consents, stock exchange

requirements, anti-trust or merger referral issues, etc.;

(b) to understand the type and extent of the risks and liabilities attaching to the target andits business, e.g., product liability exposure, warranty exposure, litigation exposure,environmental liabilities, etc.;

(c) to verify the accuracy of any representations or warranties already made by the

vendor in a signed acquisition agreement, or identify suitable representations,warranties and indemnities for a prospective acquisition agreement and, if

appropriate, any adjustments to the purchase price.

2.2 The results of the review may have a major impact on the perception of the transaction; e.g.,the purchaser may decided to proceed with the transaction on the basis that its advisors have

given the deal a clean bill of health; the purchaser may pull out of the transaction altogether;the purchaser may renegotiate the deal; the purchaser may reduce the price; the purchasermay exclude part of the business; the purchaser may move from a share purchase to an asset

purchase; or the purchaser may restructure the transaction in some other way.



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3 Scope of the Investigation and Report

3.1 Scope of investigation

(a) The scope of a due diligence investigation will depend on a combination of some or

all of the following factors:

(i) Purpose of the acquisition. For example, where two companies are lookingfor a trade advantage or element of synergy through a merger, theinvestigation will focus on matters such as economies of scale, marketing

advantages and competition issues;

(ii) Nature of the business being investigated. This will cover such things as,

the likely areas of concern and risk, geographical spread, and the major

operating components;

(iii) Purchaser's risk comfort level. Some purchasers will be comfortable withhigher potential risk exposure than others;

(iv) Expense/budget. Cost should always be borne in mind. The extent of the

due diligence exercise should be in keeping with the value and importance of

the acquisition to the purchaser and the potential risk;

(v) Timing. The extent of the enquiry may necessarily be limited by the

timetable of the acquisition or because the vendor is sensitive about theexercise. A full due diligence enquiry may not be appropriate where a quick

sale is a priority, e.g., where a long investigation might allow another purchaser to outbid the initial purchaser; or where the delay, intrusion and

interruption to the normal running of the target business might be

unacceptable to the vendor, etc.

3.2 Scope of report/materiality

(a) It is usual to attempt to restrict the scope of the due diligence by some form ofmateriality test by reference to both:

(i) amount, e.g., by putting a monetary floor on the value of contracts entered

into/matters where the sums involved are in excess of this threshold(calculated by reference to market value); and

(ii) the nature or term of the obligation or asset, e.g., "major issues"; "material

contracts"; contracts entered into "outside the ordinary course of business",

etc.

(b) To reflect these limits, reports are usually divided into one of two broad categories:

(i) Full Report - which consists of a complete audit of the target businessincluding an in-depth summary of the target's material contracts; and

(ii) Exceptions Only Report - which focuses only on matters material to thetransaction and highlights exceptions to business or market practice.



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(c) Ultimately, although it is the purchaser's call as to what is or is not material, or whatis or is not within the ordinary course of business, the scope of the actual

investigation to be carried out and the form of report to be made must of course beagreed and clearly set out before any work is commenced.

4 Work Allocation and Team Composition

4.1 Work allocation and responsibility

(a) Once the overall scope of the review and the level of reporting has been established

and the full due diligence team has been selected, the purchaser should define theroles of each of the various advising teams. This is to minimise costs and overlap and

to clarify exactly what information should be reviewed by whom. Where a large

number of professional advisers are involved, it is imperative to clarify what the

reporting lines are and who is acting for, and reporting to, whom.

(b) Often the purchaser and the target business will request the investigating accountantsand lawyers to cooperate in arranging and ordering the scope of the review, particularly to avoid duplication of effort and expense.

4.2 Single or multiple reports

The purchaser may also wish to consider whether a detailed report from each set of specialistadvisers is appropriate, given the time available, the size of the transaction and the

information sought. For example, the purchaser may wish the legal advisors to produce one

report based on information supplied to it from all other due diligence team members(although this would not include the investigating accountants report). There is no hard and

fast rule as to the allocation of each due diligence issue, and it will very much depend on the

nature of the transaction, the sophistication of the purchaser and the time involved.

4.3 Due diligence coordinator

(a) To ensure a clear demarcation of the responsibilities of the various advisers, one

adviser is ordinarily appointed to co-ordinate the whole due diligence reviewexercise. The co-ordinating role will usually be played by the adviser who is closest

to the commercial negotiations. It is one of the functions of the co-ordinator to

ensure there is no duplication of effort and that there are appropriate lines ofcommunication between the different due diligence teams.

(b) The co-ordinator, in conjunction with the purchaser, should also determine whether

any due diligence team member's report or findings should be shared or reviewed bythe other members of the team. In particular, the purchaser's legal advisor's report

should be reviewed by the reporting accountants and vice versa. The team membersresponsible for reviewing any property and environmental issues should liaise and pool their information. Finally, the legal advisors drafting and negotiating the

warranties and indemnities should review the results of all due diligence

investigations. The key is good communication at all stages.



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4.4 Composition of the legal review team

It is essential that within the legal diligence team there are people with the necessary skills to

carry out the investigation in all of the areas which have been agreed as falling within thescope of the legal review.

5 Sources of Information in the Due Diligence Process

5.1 Pre-Acquisition Review Questionnaire

(a) The purchaser will need to ask the vendor for details and information about the

proposed target and its business. This request ordinarily takes the form of a pre-acquisition review questionnaire (the " Questionnaire") which is dispatched to the

vendor to enable it to produce the relevant documentation and information for review.

The Questionnaire is prepared by the purchaser's legal advisors, in conjunction withthe purchaser itself and its other advisors.

(b) When compiling the Questionnaire, the purchaser and its advisors should consider the

following issues:

(i) What information is already available? The Questionnaire should be tailored

so as to exclude questions relating to information that the purchaser or its

advisers already have, as duplication of information wastes time and costs.

(ii) Is the Questionnaire to embrace all types of due diligence enquiries? Forexample, if the purchaser has appointed investigating accountants or other

professional advisers, then consideration should be given as to whether suchadvisors will want to submit their own questionnaires, or whether a combined

list is to be submitted. If each set of advisors is to submit a separate list, care

should be taken to avoid duplication of enquiries, as this can antagonise thevendor.

(iii) What is important? The Questionnaire should be drafted in the context of the

objectives that the purchaser used in selecting the target and its post-acquisition strategy, as well as the existing knowledge of the purchaser.

(c) It is clear, therefore, that drafting the Pre-Acquisition Review Questionnaireappropriately is a key to starting off the due diligence process in an efficient manner.Making enquiries of matters that are irrelevant or a duplication of requests only serve

to increase the time the due diligence process takes and the costs involved. An initial

meeting between the purchaser and its legal, financial and other advisors to produce atailored Questionnaire is always a recommended first step.

5.2 Searches

At the same time as preparing the Questionnaire or even beforehand, the purchaser's advisers

should consider which external searches they would like to make with respect to the target

business. While these will not be mentioned expressly in the Questionnaire, verifying facts by conducting appropriate searches of public registers is an important part of the review. Adetailed examination of the searches that may be carried out is outside the scope of this

document, but as a minimum, the following searches should be considered:



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(a) Companies Registry In any transaction, whether it is the acquisition of shares in acompany or the acquisition of assets from a company, a company search (or its

equivalent) should be made against:

(i) the target;

(ii) all subsidiaries of the target;

(iii) the vendor of the target business; and

(iv) any guarantor.

Company searches may reveal the constitutional documents of a company, its latest,filed audited accounts and any encumbrances that there may be over the assets of a

company and possibly the insolvency of any company. However, as many registers

are often out of date and are dependent on the accuracy of the information filed by therelevant company, care must be taken not to place too much reliance on results.

(b) Insolvency An insolvency search should be made to ensure that no winding-up oradministration petitions have been presented against the vendor, the target or itssubsidiaries.

(c) Intellectual Property Searches may be made of the trade marks registry and patent

office or their equivalents.

(d) Real Estate/Property Searches Where available, searches may be made at the Land

Registry, Land Charge Registry or their equivalents.

5.3 Data rooms

(a) In order to control the delivery of information, preserve confidentiality and limit the

disruption to the target business or its personnel, the vendor or its advisers may use adata room. In some cases this is done prior to marketing the business, often under

cover of an internal review or audit. Essentially this involves the vendor bringing

together and cataloguing or indexing the important documents relating to the business(i.e., all contracts, title documents, licences, accounts and other records commonly

reviewed in a due diligence investigation). This is generally done with the assistance

of its lawyers. The documents are then made available to the due diligence team for

review.

(b) There are several advantages to this from the vendor's viewpoint:

(i) it can be done offsite, to avoid rumour or loss of secrecy about the potentialtransaction;

(ii) it can allow for review but without allowing copies to be taken, hence the

need for a particularly detailed index;

(iii) it can be used to make the information available to a series of potential

purchasers, or contemporaneously to a number of interested parties where the

business is being disposed of by a form of controlled auction/tender process;and

(iv) it limits the exercise by definition to what is contained in the data room.



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(c) Whether this process will be wholly acceptable to a purchaser will vary from case tocase. It will generally be satisfactory as a preliminary exercise to determine for the

purchaser if it should proceed further and to enable it to generate more tailoredrepresentations and warranties, but a significant benefit will be lost if the opportunity

for interviews with personnel and clarification of issues by responses to requests forfurther information are not also made available.

5.4 Interviews

(a) While a great deal of the pre-acquisition review will be taken up with reviewing

documents elicited by the Questionnaire or in the data room, some of the most

valuable information may be obtained from interviews and discussions with thevendor's and/or the target's advisers and personnel. These individuals will be able to

relate documents and issues to their context, to observe on relationships and morale,to comment on things like warranty claims experience or on the likely outcome ofnegotiations, disputes or proceedings, etc. and generally to fill in the picture behind

the documentary information reviewed.

(b) The list of people who might be interviewed includes:

(i) legal advisers;

(ii) auditors;

(iii) actuarial consultants;

(iv) insurance risk managers or brokers; and

(v) the target's personnel (i.e. chief executive, managing director, finance

director, tax controller, personnel manager and generally those in senior positions with direct operational control and responsibility).

(c) In relation to the target's personnel, unless the rationale for the acquisition is known

to involve the wholesale removal of management from the target, managers are likely

to have every incentive to co-operate with their new owners by disclosing, often withmore candour than the vendor, the concerns about the business that they have. In an

amicable transaction, personnel who expect to continue in their posts after the

transaction is completed can be surprisingly frank and helpful. It is for this reasonthat vendors, particularly on auction sales, will try to restrict access to continuingmanagement.

(d) In conducting interviews, care must be taken to comply with confidentialityundertakings and also to assess the level of reliance which may be placed on the

responses.

6 Presentation of Information

6.1 Organisation of Reporting

(a) Because of the fact that the due diligence report is often an integral part of fastmoving, pressurised negotiations, it is essential:



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(i) to set up a method of clear reporting to both the purchaser and the negotiatingteam of major issues in real time and

(ii) to ensure at the same time that all other issues and facts are brought to the purchaser’s attention as quickly and efficiently as possible.

This is both as an aid to negotiations and because any one or more of the issues raised

might actually be a deal-breaker in the purchaser’s eyes.

(b) The due diligence co-ordinator, in conjunction with the purchaser, must therefore put

into effect a reporting strategy and set up effective lines of communication to ensurethat major issues are reported quickly and decisions with respect to risk areas taken promptly. In setting up lines of communication:

(i) the co-ordinator should make it clear to whom the due diligence team

members (including local offices and foreign counsel) should be reporting;

(ii) the purchaser should select key members of its personnel who will be in a

position to receive the information presented to it by the team and to evaluateand take decisions on issues that arise; and

(iii) the purchaser should also inform the team members whether or not the

transaction is confidential within its organisation and, if so, how the team can

safely communicate with it.

6.2 Format of Report

(a) Clearly, for major issues immediate contact (by telephone, email or fax) is essential.Otherwise the usual process is to build up over a period a report broken down into the

following broad sections:

(i) Introduction - a description of agreed scope of report and qualifications anddisclaimers;

(ii) Executive Summary - a bullet point list of major items cross-referenced to themain report;

(iii) Main Report - a detailed sectionalised report generally following the order of

the Pre-Acquisition Questionnaire (see paragraph 5.1 above) broken downinto relevant jurisdictions (where appropriate) and cross-referenced to the

annexures; and

(iv) Annexures - copies of key source material, contracts, leases, etc. all clearlyindexed. A well ordered and indexed set of copies of the documents received

and reviewed should therefore be provided as annexures to the report as this:

(A) enables the purchaser to refer to the source material for clarificationof issues cross-referenced in the report; and

(B) gives the purchaser a readily accessible dossier of important

documents for future use and reference after the transaction closes.

(b) The clear collation, management and indexing of the materials received or reviewed

is important for recording purposes, disclosure letter issues, and to enable ready



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access to the source materials. Putting proper systems into place at the outset of theexercise greatly facilitates the process.

(c) In practice, however, the report is likely to be prepared in draft outline and submittedto the purchaser in draft as soon as there is a meaningful body of information on

which to report. The draft report is then updated as further information is receivedand continues to be periodically supplied to the purchaser in draft form with major

changes arising from new or additional information duly highlighted.

6.3 Analysis of Results

As necessary, meetings may be set up between the purchaser and the due diligence team todiscuss issues in detail. These may be:

(a) ad hoc to discuss major issues as they arise;

(b) regular progress meetings to allow the purchaser to highlight issues which it

considers to be of concern in connection with the ongoing transaction and to

determine how these may be dealt with; or

(c) a combination of the two.

7 Conflicts

Conflicts arising during the course of the investigation will need to be addressed on a case by

case basis in accordance with applicable conflict rules and will generally be surmountable.

8 Confidentiality

Confidentiality issues impact on due diligence investigations in a number of ways.

8.1 Confidentiality of Negotiations. For various business reasons, the vendor and the purchaser

may wish to keep the fact that negotiations are taking place as confidential as possible for as

long as possible.

(a) Vendor. The vendor may be concerned about the effects of prematureannouncements on its share price (where listed), employees, key suppliers and

customers, outstanding negotiations for contracts of supply, etc. It will also beextremely concerned at the effects on the target business of a potential purchaser

being seen to pull out of negotiations by reason of issues arising on due diligence.

The problem is compounded if the vendor, in trying to sell a business, has to go

through the due diligence exercise with a series of suitors. In addition, therefore, toany confidentiality undertaking agreed between the vendor and the purchaser, thevendor may seek to restrict the conduct of the due diligence investigation so that it is

routed through the vendor's financial or legal advisers or certain specific executives.Alternatively, it may use a data room (see paragraph 5.3 above).

(b) Purchaser. From the purchaser's perspective, it is crucial that its advisers not only

observe any confidentiality agreement, but also:



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(i) discuss the possible use of code names and, if agreed, use them in alldocuments and communications;

(ii) communicate only with personnel authorised to know;

(iii) communicate only with those of the vendor's personnel with whom they are

authorised to deal; and

(iv) do not send open communications (e.g., by fax) which might come into thehands of unauthorised personnel.

(c) Listed Companies. Where the purchaser or the vendor (or their holding companies)

are listed companies, extreme caution should be exercised with respect to thedissemination of information relating to negotiations, and the execution of the saleand purchase agreement, as such matters will often involve or constitute price

sensitive information.

8.2 Confidentiality of Information

(a) Before the purchaser or its advisers are allowed access to the vendor's materials, the purchaser will normally be required to enter into a confidentiality agreement. Often

these will require the purchaser to agree to procure that its advisers observe the

confidentiality agreement as if they were parties to it. Sometimes, however, the

vendor will seek to obtain a direct covenant from the purchaser's advisers. This isespecially the case where materials have been placed in a data room, as data roomrules will usually contain additional confidentiality provisions.

(b) Such agreements also commonly provide for the return or destruction of all

documents supplied to or copied by the purchaser and its advisers, and any analyses

or reports prepared therefrom, if the deal aborts.

9 Relationship between the Pre-Acquisition Review and Representations andWarranties

9.1 Obtaining comprehensive representations and warranties is of course very much part of the

negotiation process. They are not, however, a substitute for an in-depth pre-acquisition

review, for the following reasons:

(a) Whilst breaches of representations or warranties may, depending on the terms of theagreement, give rise to a right of rescission if discovered before completion (or

immediately afterwards in some cases), they will generally only give rise to a right toclaim damages or an indemnity from the vendor after completion. Purchasers prefer

to know about problems before they are committed to proceed, rather thandiscovering them after the event.

(b) Representations and warranties will often be subject to awareness and/or materiality

qualifications, and to thresholds and de minimis provisions. Thus a particular breach

may not in practice result in any compensation to the purchaser.

(c) Even if a breach is not covered bysuch qualifications, the vendor may not be able to

pay or may resist the claim (thus distracting the purchaser's management from otheractivities and involving the purchaser in cost), or the breach may have such an effect



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on the business that the purchaser is unable to realise its plans or expectations for the business.

9.2 Although contractual protection in the form of representations and warranties is no substitutefor a thorough due diligence exercise, it may offer some comfort for the purchaser in relation

to those areas of the target business where it has not been possible, or would be impractical ordisproportionately expensive, to effect a full investigation, for example where time is short

and due diligence is limited. In these circumstances, the purchaser should at the very leastseek to investigate key issues so as to enable it, amongst other things, to:

(a) ensure that warranties and indemnities are appropriately wide;

(b) consider whether to negotiate a retention of the purchase price to cover potential

warranty claims;

(c) propose a price adjustment; or

(d) provide for particular sorts of problems to be solved as pre-conditions to completion,

e.g., the obtaining of consents to the change of control or waivers of other awkward provisions in major trading agreements, etc.

9.3 Just as the strength of the contractual protection sought can be influenced by the extent of the

due diligence, so the extent of the due diligence exercise can be influenced by the contractual

protection offered. For example, where a large, solvent, vendor is prepared to indemnify the purchaser for any liability relating to the pre-acquisition period arising in the target after thesale, the purchaser might be prepared to carry out more limited due diligence.

10 Issues Arising On Cross-Border Acquisitions

10.1 Where the target business or part of it is located or operated in another jurisdiction, or jurisdictions, further complications arise. Cross border transactions, by their very nature,

throw up a number of added risks and challenges. These fall broadly into four categories:

(a) Legal. Purchasers should assess carefully the impact of a foreign country's law on atransaction. It is essential at the outset to identify any governmental, investment,

legal or regulatory consents which might impact the feasibility, timing or costs of

effecting the transaction as it relates to the target in that jurisdiction or at all; e.g., dothe country's employment laws make the potential cost of a post-acquisitionreorganisation prohibitive? Does the nature of the target's business mean any

regulatory approvals would be required?

(b) Practical. Some jurisdictions may impose timing and access constraints by reason of

bureaucracy or secrecy of government departments, language difficulties,unavailability of the type of property and company registration details available

elsewhere, inability to carry out searches, etc.

(c) Logistical. On a practical level, there may be difficulties relating to language, the

added number of people involved, time differences, and so on. In a multi- jurisdictional transaction, information technology may become a vital tool inmanaging the due diligence process. E-mail communication may ease the process of

communicating with different locations and a transaction website or extranet could be



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used to make available relevant information such as instructions and weekly statusreports.

(d) Cultural. In some jurisdictions, investigations of the level which have now becomegood practice in the US or UK may be seen as damaging the spirit of mutual trust

between vendor and purchaser or even as a sign of mistrust or bad faith on the part ofthe purchaser. Persuading the vendor to cooperate and obtaining both timely and

useful information may therefore require sensitive handling.

baker & mckenzie - acquisitions _ due diligence

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