Chapter 1: Conducting Due Diligence: an
Overview
Due diligence phase of any acquisition- the
study of the risks that the deal poses- can
make the difference between success and
failure.
Legal foundations
> Legal origins: common law. the common
law system arose in medieval England after
the Norman Conquest and is still in use there
as well as in the US.
>the precise origins of due diligence are lost
in the mists of time.
>Black Legal Dictionary: the diligence
reasonably expected from, and ordinarily
exercised by, a person who seeks to satisfy a
legal requirement or to discharge an
obligation.
>Roman Law concept of diligentia. 2 types:
Chapter 4: Legal Compliance Review
Risk arising from liability arising from legal
action from failure to comply with mandatory
legal requirements.
1. familiar with the legal system
2. familiar with the field
you are looking at possible suits against the
acquirer and the acquiree (both buyer and
seller).
A responsible due diligence process, well
documented, can provide a strong defense
against such legal actions.
determine the legal profile of a company to
determine the strength of a company’s legal
compliance program in general. —> it is
important to know the applicable law.
1. common law
2. statutory law
1. UCC uniform commercial code
3. regulatory law- composed of
administrative regulations and
executive orders, which are rules set
forth by the executive branch of the
government.
Acquirers need to remain current on new legal
developments in order to assess liability risks
in companies being acquired.
As mentioned, there are laws emanating from
legislative bodies, rules coming from
regulatory bodies, and judicial interpretations
of all of these. Yet the goal is not impossible.
Every acquiring company can benefit from
having on staff or retaining qualified attorneys
with expertise in business law. The most
senior attorney (typically called the general
counsel) should be familiar with the laws that
are most important to the company. Such an
attorney is likely to have a solid grounding in
the most generally applicable laws, or to have
staff members with such a grounding.
⁃ these attorneys subscribe to
specialized publications that keep
them abreast of curreNt developments
How attorneys can remain cognizant of
federal law
1. case law: check various online sources-
westlaw
2. statutory law, federal and state: any
free legal online source
1. Codes, state laws, Uniform
Commercial Code and other
uniform laws
2. For legal developments
generally- periodicals- the
business lawyer
Sources of litigation
Acquirers face exposure to many kinds of
lawsuits based on many different sources of
law.
Post acquisition lawsuits stem from two
causes, which may coexist in any particular
case.
1. the acquirer may be sued for its own
negligence in making the acquisition.
failure to fulfill their statutory duty of
due care by failing to ask questions
that could have uncovered an obvious
risk.
1. law suits may allege lack of due
diligence or they may target
some technicality that the
acquirer missed during due
diligence
2. Violations of law by the
company it is buying -even if
these actions occurred prior to
the sale of the company
3. If an acquirer can show due
diligence in making the
acquisition, the acquirer can
escape liability
2. Minimizing liability it inherits from the
seller: build connections in to the
acquisition agreement that it cosigns
with the seller. the agreement can
 state that the risk of undisclosed
liabilities will fall on the seller.
1. Litigation analysis- analyze
pending litigation
2. Compliance review- assess
legal compliance
Litigation Analysis
An examination of:
1. Existing claims against the company to
determine their validity and their
potential dollar impact.
2. Litigation trends within the industry to
determine points of vulnerability
By whom: ideally conducted by attorneys who
specialize in commercial or corporate
litigation and who are familiar with the seller’s
industry.
This analysis is conducted throughout the
M&A process, including the following phases:
1. planning and finding:
2. valuation: allocate known liabilities in
accounting for a transaction ,and will
want to adjust pricing accordingly
3. financing: satisfy lenders requirements
4. structuring
5. negotiation: accuracy of
representations and warranties
6. closing
7. analysis of insurance coverage
How to determine validity and exposure
of suits, both current and potential
1. setting material amounts (but certain
types of cases might merit close
attention no matter what the financial
exposure might be)
1. no absolute thresholds PCAOB
use the terms material and
significant but do not give
numeric definitions of either
2. Materiality- internal materiality,
so called authorisation limits
1. may be a given amount
or a percentage of
profits, depending on
the sales or size of the
company
2. determine cost counsel-
asking an estimate, out
of court or ADR
LITIGATION REVIEW
1. SET PARAMETERS:
 What is material
 Time and budget
2. IDENTIFY cases that require special
attention regardless of amount. Eg. Labor
cases.
Cross default clauses, if the company defaults
in any other creditor will result to a default in
this loan.
Those against directors or officers of the
company, it is an indicator of possible risk.
3. ASK FOR A LIST / SCHEDULE ALL
LITIGATION
Interview the legal counsel
4. Examine / verify files in court
 Verify with independent sources.
 Should have authority from the clients
What do you want to look at:
1. Insurance
2. Sunk costs
3. Opinions on the litigation process
Cases that should be considered first
Those which have adverse impact on the
defendant company’s business operations,
and thus the business operations of the
combined company— the ripple effect
Consider insurance policies
Compliance review
Whether the company is in good legal
standing.
Whether any charter documents are violated.
Is the company acting ultra vires.
Compliance officer is needed. Data protection
officer
Does the seller have an active compliance
program
The astute acquirer will want to know the
likelihood of different types of lawsuits that
may occur following an acquisition.
Main constituencies that might file lawsuits
against an acquirer
1. Employees
2. Shareholders / members / directors /
investors
Shareholders’ agreements
1. eg. 75% should approve not the
normal majority.
3. Customers
4. Government
5. Creditors
Transactional due diligence
Chapter 5: The Documentation and
Transaction Review
in addition to financial, operational and legal
risks, managers must focus on the risks that
arise form the transaction itself- risks that can
be mitigated through the effective negotiation
and acquisition agreement and through paper
closing procedures.
Transaction and Documentation review deals
with risks inherent in deal making itself - the
negotiating and red tape aspects.
acquisition agreement:
purpose: sets forth the legal understandings
of the buyer and the seller about the
transaction
1. Structure and terms of the
transaction
2. Important legal issues that affect
the company
3. obligates both parties to do their
best to complete the transaction
4. obligates the seller not to change its
company in any significant way before the
deal closes
5. what happens if before or after the
closing, the parties discover problems that
should have been disclosed in the agreement
or before closing…
Basic goals:
1. Basic terms and conditions
2. Disclosure of relevant facts- risks
3. Obligation of parties
 good faith of each party to complete
the transaction
4. status quo- before the deal actually closes,
you have to abide by the status quo.
Obligation not to change the material things
of the company.
5. how the parties intend to manage or
address the risks you intend to recover.
Others: exit clause / exit or termination
mechanism
The negotiation of the agreement is an
effort by the buyer and seller of a
company to allocate the risk of major
economic loss attributable to defects in
the company that surface after the
signing of the acquisition agreement,
both before and after the closing.
Right to cancel the transaction or
change the price in the event of
unforeseen events of a material nature.
(MATERIAL ADVERSE CHANGE) MAC
Exception: MAC carve outs - eg
reasonable expectation language helps to
insulate agreement against MAC factors
case of Tyson: material change is a drop in
revenues of 10% or more
note that the seller cannot back out once
there are positive developments in the
company so to correct the buyer bias, a seller
may ask for:
⁃ deposit: no damages in the event of a
breach of contract
alternatives: escrow account
*a seller should make a strong effort to get a
deposit large enough to cover all of its
expenses and to limit the time given to close
the contract so that the company is not off
the market too long.
*if the buyer has the flexibility to walk away
from the deal because of negative events, the
seller should also have this flexibility with
regard to positive events—or even better
offers. But there should be financial sanctions
against parties that “walk” from near-com-
pleted deals without substantial caus
⁃ a liquidated damages provision
⁃ transfer or risk to the buyer as the
date of signing not the date of closing
Liquidated damages: when a buyer backs out
for reasons beyond the control of the seller.
The seller wants to be as certain as possible
of at least two things: (1) that the closing will
occur as soon as possible after the agreement
is signed, and (2) that no post closing events
will require a refund of any of the purchase
price.
Conversely, the buyer wants certainty (1) that
it will have as much time as possible to
conduct due diligence after the agreement is
signed, and (2) that it will be able to get some
or all of its purchase price back if negative
events occur after the closing.
The buyer would like the flexibility to abandon
the transaction in the event that it discovers
any financial, operational, or legal defects in
the candidate company.
Major parts of an acquisition agreement
1. Introductory manner: intentions of the
parties,
 2. Price mechanics of the transfer :
defines the structure: disposition of
assets/ shares or merger
3. Representation and warranties of the
buyer and seller
- the seller makes detailed statement
about the legal and financial condition of the
company
-buyer: assurances on the transaction itself
will not have adverse effects upon the
property to be conveyed
*material: important to an average,
reasonable investor in determining whether
to make a given investment.
*best knowledge- effect of allocating to
the buyer all the risk of defects that
no one knows aboutcovenants of the
buyer and seller
*Best knowledge after due inquiry:
gives the obligation to inquire
-most important: fs,
litigation,undisclosed liabilities, taxes
-management buy-out: managers who
are buying the company know more about the
strenghts and weaknesses of the company
Covenants: defines the obligations of the
parties with respect to their conduct during
the period between the signing of the
agreeement and the closing.
1. conditions to closing section: lists the
conditions that must be satisfied before the
parties become obligated to close the
transaction, and thus controls whether the
buyer or the seller can “walk” from the deal
with impunity
2. indemnification section : establishes the
liability, if any, of each party to the other for
problems discovered after the closing.
Major Parts of the Agreement
Introductory matter- sets the stage for the
deal; begin by describing the intentions of
each of the parties
Price and mechanics of the transfer-
identifies the structure of the transaction
Representations and warranties of the
buyer and seller – the seller makes detailed
statements about the legal and financial
condition of the company
Covenants of the buyer and seller-
obligation to do something, promise to do
something
Conditions to closings Indemnification
Termination procedures and remedies
Legal miscellany

4. conditions to closing
lists conditions that must be fulfilled if
the transaction is to close. if the conditions
are not fulfilled, then either party, depending
on the circumstance may avoid completing
the transaction.

phases of closing: preclosing, closing and

postclosing
preclosing: dress rehearsal for the
closing
postclosing: document distribution—>
easier when there is document checklist, and
cleanup—>

⁃ indemnification
⁃ termination procedures and remedies
⁃ legal miscellany

Risk of general economic downturn

usually the seller, but in the event of
significant problems, renegotiation can arise.

Components of the Agreements