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  • Cristina Lefter

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

Updated: Jul 6, 2023

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.”

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