M&A Concepts: “Due diligence” and “Disclosed Information”

In our previous article on reps and warranties, we mentioned that these are qualified by reference to information disclosed/known to the seller/buyer. Two important concepts are highly relevant for determining what "disclosed", "buyer's knowledge", "seller's knowledge" actually mean: the concept of due diligence (sometimes translated in Romanian as "legal/tax/financial analysis, etc.", although probably an accurate translation would be "due diligence [of the transaction]") and the concept of disclosed information.

Due diligence is the analysis carried out by the potential buyer on the target company (sometimes the seller prepares such an analysis for the benefit of the buyer, with the nuance that, in this case, the buyer will be able to rely on the conclusions of experts (lawyers, financial consultants, tax consultants) as if they had been hired by the buyer). In Anglo-Saxon literature and practice, due diligence has received several definitions, all leading to the idea of diligence, of research effort in order to identify risks.[1]

The Romanian Civil Code refers to the concept of due diligence in the context of the warranty for defects that the seller owes to the buyer for the object of sale. According to Art. 1707 para. (2) of the Civil Code, "A defect is concealed if, at the date of delivery, it could not have been discovered, without expert assistance, by a prudent and diligent buyer." Thus, Romanian civil law (i) starts off from the premise that a buyer should be prudent and diligent; but (ii) also indicates that the fact of calling on expert assistance has the concrete effect of limiting the seller's liability, as a result of the hidden defects becoming known to the buyer. Thus, disclosed information – that was brought to the attention of the experts providing assistance to the buyer - has the effect of limiting/excluding the seller's liability for hidden defects. The important nuance to bear in mind is that the above provision concerns the immediate object of the sale (in this case, the shares) and not the target company itself. For the latter, the allocation of risk between the parties to the transaction will remain contractual.

Due diligence analysis usually covers a wide range of issues concerning the target company, including: the financial situation of the target company and forecasts for the coming financial years, legal assessment of the target to identify legal risks, tax assessment of the target to identify tax risks, environmental implications (e.g. if the target operates in an industry with environmental impact).

From a contractual point of view, however, due diligence analysis is a buyer risk management tool,[2] because it is of crucial importance in determining what is meant by disclosed information and, consequently, in defining the buyer's knowledge of the subject matter of the sale, with consequences on the possibility of limiting the seller's liability. As mentioned in our previous article, according to the Romanian Civil Code (art. 1707 para. 4), the seller does not owe a warranty against defects of which the buyer was aware when the contract was concluded.

Due diligence analysis is usually carried out by third parties, professionals in the subject matter of the analysis, and is finalised by a due diligence report summarising the relevant issues identified. The legal due diligence report is an essential document for the buyer, as it contains details of, among other things:

• title to the object of sale (e.g. title on shares);

• any ancillary rights in rem which may encumber it (mortgages);

• any onerous obligations assumed by the target company (e.g. the obligation to pay substantial bonuses on termination of management contracts - so-called golden parachutes), and of

• other existing exposures of the target company, not materialised through fines or other sanctions, but within the applicable limitation periods and with the potential to materialise (e.g. potential significant liability of the target company for past breaches of law: breaches of tax, competition, environmental or data protection laws or the existence of significant litigation/disputes with significant financial stakes).

The level of accuracy of the reporting in the legal due diligence report depends to a large extent on two aspects: (i) the quantity and quality of the information provided by the seller to the buyer's team of experts; (ii) the level of professionalism and knowledge of the law, as well as the ability to think critically and in a flexible, commercial way (and not rigidly and outside business realities) of the lawyers involved in the process.

As regards the first element, the consequence of insufficient or incomplete information is that the seller will not be able to rely on a limitation of his/her/its liability on the basis of the disclosed information, since it has not been disclosed in a way which enables the buyer to know and appreciate the risk (fully and fairly disclosed).

As to the second element, the seller will be able to rely on the limitation of its liability to the extent that the information disclosed is sufficient and accurate, even if the buyer's advisers (including lawyers) did not have the ideal agility, knowledge or even time to identify the risks and expose them to the buyer.[3] Here then is the importance of involving lawyers in the due diligence process: ultimately, if the information about the target company is fully and fairly disclosed (as is the market standard) i.e. in a full and fair manner and in sufficient detail to enable the buyer to identify the nature and implications of the disclosed problem, then the buyer's ability to correctly manage the legal (and, to an important extent, the financial) risk of completing the acquisition depends to a substantial extent on the quality of the legal advice received.

Due diligence - a stage in M&A processes that consumes resources, time, patience, but is necessary and without which it is not possible to move forward in the context of a realistically thought out and committed acquisition process.

[1] Robert F. Bruner, Applied Mergers and acquisitions (Wiley 2004), p. 208 - “Due diligence is research. Its purpose in M&A is to support the valuation process, arm negotiators, test de accuracy of representations and warranties contained in the merger agreement, fulfil disclosure requirements to investors, and inform the planners of postmerger integration. Due diligence is conducted in a wide variety of corporate finance settings, and is usually connected with the performance of a professional or fiduciary duty. It is the opposite of negligence. One dictionary declared that “due diligence” is: <<Such a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstances; not measured by any absolute standard, but depending on the relative facts of the special case.>> (From page 457, Black’s Law Dictionary, 6th ed., 1990, Henry Campbell Black, ed., St. Paul, MN: West Publishing Company). In a classic definition, a court defined diligence as: <<Vigilant activity; attentiveness; or care, of which there are infinite shades, from the slightest momentary thought to the most vigilant anxiety. Attentive and persistent in doing a thing; steadily applied; active; sedulous; laborious; unremitting; untiring.>> (National Steel & Shipbuilding Co., v. U.S., 190 Ct.Cl.247, 419 F.2nd 863, 875)”. [2] Ibid. p. 209 - “(…) due diligence is a risk management device. Investing in due diligence is like investing in R&D [n.n. research and development]: you’re not sure what the payoff will be, but the right to find out is worth enough to buy. (…) risk bearing is always costly. There is no free lunch. Making a fair comparison, broad and narrow reviews are equally costly (your acquisition target will try to make you think otherwise). To take an absurd example, it would seem to be cheapest to go without any due diligence review. But this judgement of expense ignores that in doing so you bear the risk entirely, like self-insuring your car or health, which can be dangerous (though it may have cash flow benefits in the short term).” [3] Ibid. p. 7 - “Due diligence. This is the structured search for risk. Here again, we have a discovery process that depends on both organized inquiry and agile thinking. […] due diligence is least successful when reduced to rote fact checking. Instead, the right way to discover hidden risks is to research curious details, anomalies, inconsistencies, and discontinuities – all under tight time pressure and efforts by the seller to put a gloss on things. Here, the uncertainty of conduct arises from the investigator’s stamina, care, and capacity for critical thinking.”

M&A Concepts: “Representations and Warranties”

In all sale purchase agreements (SPAs), whether it is a transfer of shares in a company (share deals) or business (asset deals or business transfer agreements), there is a section entitled "Representations and Warranties", often translated in Romanian as "Declarații și Garanții". In Anglo-Saxon law, "Representations and warranties are clauses in the definitive merger agreement that establish the required condition of the buyer and the target firms at the time of signing the agreement, and again at closing. Failure to meet these conditions will usually trigger a renegotiation of price, or even cancellation of the deal."[1] The nuance between the two concepts can be summarized as follows: "A representation (or “rep”) is a statement of fact; a warranty is a commitment that a fact is or will be true. Together, these present a profile of the target (…) at the date of the transaction."[2]

From the perspective of Romanian law, the distinction between the two is not necessarily one of substance, since both the reps and the warranties are in fact guarantees of the seller in respect of (simply put) the company that is the object of the sale.

This comprehensive list of guarantees takes into account not only the subject matter of the sale per se (which, by assumption, represents the shares in question), but the state of the company as a whole. In practice, from the perspective of the Romanian Civil Code, the seller's guarantees in respect of the shares that are the subject of the sale would be limited to the guarantee for eviction (guarantee that the seller is indeed the owner of the goods that are the subject of the sale) and the guarantee for defects (guarantee that the shares were legally issued/subscribed etc.), without the seller guaranteeing in any way the substance of these shares i.e. the business that is taken over following the sale. Therefore, reps & warranties are required to add guarantees by the seller with regard to the value actually conveyed by the transfer/sale of shares/business/goodwill.

Reps & warranties are also a contractual risk allocation tool between seller and buyer, being closely linked to the due diligence process (legal analysis carried out on the target company) and to the disclosure of information by the seller carried out either as part of the due diligence or separately via a disclosure letter (concepts to which we will refer in later articles).

How does this contractual risk allocation work? According to the Romanian Civil Code (art. 1707 para. 4), the seller does not owe a guarantee against defects that the buyer was aware of when the contract was concluded. In other words, the seller cannot be held liable for those defects which, in the contractual understanding of the parties, are deemed to be known by the buyer because they were [fairly] disclosed during the due diligence process. This is in fact a qualification of reps & warranties, which could be interpreted (by way of example) as follows: the seller is liable for matters relating to the condition of the company under a warranty provided that those matters which may diminish the value of the target company or which may create damage to the buyer have not been disclosed to the buyer in a full and fair manner and in sufficient detail to enable the buyer to identify the nature and implications of the matter disclosed (fully and fairly disclosed).

Another example is qualifying reps & warranties by reference to the seller's knowledge. An example of such a clause would be: the seller warrants that, to its/his/her knowledge, the company is not in a position not to perform fully and adequately its obligations towards any of its contractual partners.

The above examples represent reps & warranties qualifications inspired by Anglo-Saxon law but operating under Romanian law with an important nuance. According to Art. 1708 para. (2) of the Romanian Civil Code, "a clause which removes or limits liability for defects is void in respect of defects which the seller knew or ought to have known at the time the contract was concluded". Therefore, Romanian law does not allow for a qualification of reps & warranties by reference to the seller’s knowledge (usually with respect to the object of the sale i.e. shares) to lead to the complete exoneration of the seller from liability for defects she/he/it knew or should have known, but at most to the exoneration from liability for defects she/he/it did not know (and - our addition - was not obliged to know).

In addition, according to the Civil Code, the guarantee for hidden defects also applies when the goods sold do not correspond to the qualities agreed by the parties (Article 1714 of the Civil Code). In other words, the parties can contractually agree that certain characteristics of the target company are "agreed qualities", with the consequence that the limitations agreed by the qualifications in reps & warranties will be removed (or rendered ineffective) by the mandatory provisions of the Civil Code which oblige the seller to be liable for hidden defects even if she/he/it was not aware, but should have been aware of them. The qualification of certain characteristics as "agreed qualities" is usually the result of the buyer's insistence, precisely to obtain the impossibility of exemption from liability for defects which the seller knows of or ought to have known of.

How can such a legal provision be handled from the seller's perspective in the SPA? We believe that full and fair disclosure of all information concerning the target company prior to signing the SPA is the most effective way to limit the seller's liability, as the buyer will not be able to raise a claim for a defect which was made known (or is considered to be made known) in the context of the due diligence process. It should be noted here that the notion of "knowledge of the buyer" is again debatable, as its content can be contractually defined (e.g. it can be the actual knowledge of certain persons in the buyer's management or in the transaction team). If, however, the buyer insists on retaining the right to compensation for a defect that has been disclosed to her/him/it, the parties may discuss whether to introduce into the contract an indemnification mechanism or additional obligations for the seller to remedy the known defect before or after the transaction is completed.

The content of the list of reps & warranties is brough forward in light of the buyer's business requirements and negotiated to match the level of warranty the seller is willing to grant. This list must always be seen by the seller in the context of the contractual provisions as a whole, in particular by reference to the definitions assigned to the concepts of "disclosed", "buyer's knowledge", "seller's knowledge". The final version of the clauses on reps & warranties must however lead to contractual balance, since only such a context is likely to create the premises for voluntary performance of obligations.

[1] Robert F. Bruner, Applied Mergers and acquisitions (Wiley 2004), p. 641. [2] Ibid, p. 769.

M&A Concepts: Intro

LegalBrain aims to produce a short series of articles on the use of the most common Anglo-Saxon law concepts in company acquisitions under Romanian law. What do "reps and warranties", "indemnities" or "limitation of liability" mean and how can they be understood in the light of Romanian law? How do these contractual provisions work and what purpose does each of them serve? In the series of articles "M&A Concepts", we will try to address each of these elements from the perspective of the Romanian entrepreneur (or - to use another term - business owner), who is considering selling his/her business and wants to clarify these notions before entering negotiations with potential buyers (often much more experienced in this kind of transactions).

The term "M&A"/ "mergers and acquisitions" often refers to the sale of shares/stocks or, in simpler terminology, sales of companies. In Romania, for the sale of companies, standard industry models of sales contracts inspired by Anglo-Saxon law (or in some cases, even governed by English law) are used i.e. "sale purchase agreements" or "SPAs". Some of the concepts used in M&A in English law can be found in Romanian civil law, but others require contractual technique to supplement the clarity provided by the (mandatory) case law in English law. The need to understand these standard concepts is particularly acute for those who are in the process of selling their business.

The sale of shares is governed by the Civil Code (as a general law) as well as by Company Law 31/1990 (as a special law). Therefore, the contractual freedom provided for by civil law also applies to M&A transactions, the parties having the possibility to include in their voluntary agreement any provision, within the limits imposed by law, public policy, and morality (art. 1169 Civil Code).

The Civil Code contains concepts similar to the most popular M&A concepts in Anglo-Saxon law. By way of example we could mention: (i) reps and warranties, which can be equated with the seller's warranties (title warranty and warranty for hidden defects) protecting the buyer against losing the title over the purchased asset and against potential defects in the asset being sold (defects of which the buyer was unaware at the time of sale); (ii) limitations of liability are equivalent to the conventional limitations of liability in Romanian civil law, including the nuance that the seller's liability cannot be excluded or limited by contract for material damage caused by an intentional or grossly negligent act - art. 1355(1) Civil Code).

Other concepts do not have such a clear counterpart, such as the qualification of warranties by reference to the knowledge (actual or constructive) of the seller. While in Anglo-Saxon law, the qualification (limitation) may be given by full and fair disclosure (a concept clearly explained in case law), in Romanian law the clause that removes or limits liability for defects is void in respect of defects that the seller knew or should have known at the time the contract was executed - art. 1708(2) C. civ. But what does "should have known" mean? Certainly, the case law of the Romanian courts has also touched on this subject, but without the certainty that in a future case, the solutions given previously will be repeated (with some limited exceptions, the case law in Romanian law being binding only on the parties involved in that dispute).

We will deal separately with each of these concepts typical of M&A transactions in order to try to find their correspondence in Romanian law and to discuss the problems that may arise in their practical interpretation.