Due Diligence
Best Practice Summary

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Due diligence is the reasonable and prudent investigation of a person, corporation or other entity, conducted prior to the consummation of a transaction with such person or entity. The goal is to understand fully the business of the target entity and to fully identify any potential risks to the consummation of the transaction or to the future economic interests of the party doing the investigation. Key investigations will include:

• Understanding the business and evaluating the fair market value of the business
  
  
• Identification of corporate structure, ownership and record keeping
  
  
• Analysis of strengths and weaknesses
  
  
• Identification of potential liabilities and/or material risks
  
  
• Identification of third-party consents and approvals (i.e. landlords, government agencies) required for completion of the transaction
  
  
• Ensuring accurate disclosure of information and representations outlined in the transaction document
  
  
• Gathering necessary information to support legal opinions.
  

The Process

Be Organized from the Start
Depending on the nature of the transaction and the goals of the diligence review, attorneys, company management and consultants will be reviewing the results. It is important that the process and the resulting work product be organized and easy to work with.

Once the parameters of the review are established, the process will begin with a due diligence request. The request should be tailored to cover any concerns of the client while including the suggestions intellectual property, benefits, environmental and litigation specialists who may be assisting. Whether the review will take place on-site or at counsel's office and the process for compiling and controlling the documents will need to be determined.

If the number of documents is manageable, they may be tracked using a due diligence checklist with corresponding folders of documents contained in accordion files or in a storage box in an office for easy retrieval. For larger reviews, a conference room or empty office may become a temporary data room.

Organizing the Data Room (or War Room)
A data room is where all due diligence documents can be set up and managed. It is helpful to maintain a checklist or inventory numerically indexing all documents contained in the data room. Corresponding numbered folders are helpful to keep track of documents.

If your role is to run the data room for outside reviewers, it is imperative to maintain constant control of documentation. It may be helpful to establish and distribute written data room procedures that will detail the hours available for review, how to schedule appointments and document removal or copying procedures. Copy requests should be submitted in writing and should be fulfilled by a supporting secretary so that a paralegal or attorney is always present to ensure the integrity of the documents.

The Equipment

If you are part of the team that will be conducting the review, there are some suggested items to bring with you are:

• A Dictaphone (consider using only one side of every tape to avoid recording mishaps);
• A copy of your firm's standard bylaws and charter documents for comparison purposes;
  
  
• Relevant statutes and regulations;
  
  
• The letter of intent, term sheet and transaction agreement to reference for the deal structure;
  
  
• The list of objectives if not incorporated into the diligence request.

The Review

As discussed above, the parameters of the review will vary depending on the nature of the transaction (IPO v. stock sale v. asset sale, for example). Certain fundamental principals will guide any transaction.

Confidentiality
Regardless of the type of transaction, conducting the due diligence review will bring the team in contact with in-depth financial and operational data about a business. If the sale or offering falls through, the company will want to make certain that such information remains confidential.

Confidentiality agreements may be entered into between the parties acknowledging that the information and documents being provided are being disclosed in confidence and that copying or distribution to disinterested third parties is prohibited.

Antitrust; Mergers and Acquisitions
With respect to mergers and acquisitions, antitrust laws prohibit competitors from engaging in any communications or agreements. Therefore, when competitors enter M&A negotiations, consideration must be taken when sharing certain information during the due diligence process to avoid raising antitrust concerns. Executing a confidentiality agreement will help to limit the way such information is used and shared. Certain information such as pricing and business strategies should be limited regardless of the existence of a confidentiality agreement. During the pre-closing phase, the parties are still viewed as competitors under antitrust laws, therefore, antitrust sensitive issues should not be discussed.

Attorney-Client Privilege
Producing documents to the other side may jeopardize attorney-client privilege. Entering into a confidentiality agreement may improve the chances of maintaining this privilege.

Documents that may be subject to attorney-client privilege should be carefully analyzed to determine if disclosure is necessary pursuant to the terms of the agreement or by law. The general rule is to make disclosure of confidential documents as limited as possible.

Need assistance? Virtual Paralegal Services provides paralegal services including UCC searches and filing and document retrieval services in all 50 states. For more information contact us at [email protected].

What to Look For
The due diligence review can encompass every legal specialty. Whether public searches and document copies will be ordered to verify the information provided will be determined by the nature of the deal and the budget set with the client. Below are many of the specialized areas that are often encountered and some specifics of the review within each specialty.

Entity Existence and Status
First and foremost, the existence and legal status of the entities involved in the transaction should be researched. The sources of this information are varied and will include documents provided at the target company or by its counsel, or information retrieved from public sources. The Internet provides access to a great deal of information about the operations and finances of many companies.

For all companies, both those publicly traded or closely held:

• Certified copies of the formation documents and amendments of the target entities can be obtained from the applicable Secretary of State. You can also confirm if the entity has legal existence and is in good standing by checking at the relevant secretary of state's web sites or by ordering the appropriate Certificates (of Good Standing or of Legal Existence, as appropriate in the particular jurisdiction) from the Secretary of State.
  
  
• If corporate or franchise taxes are not collected by the Secretary of State, the Good Standing Certificate will not certify to tax status. A separate Tax Clearance Certificate or Certificate of Tax Good Standing may be obtained from the appropriate state department. Such requests can take weeks or even months to obtain so if a tax status certificate is desired, it should be considered early.
  
  
• UCC searches may be ordered through LeapLaw's UCC Connection or via Virtual Paralegal Services in the appropriate jurisdictions to identify security interests in personal and intellectual property and fixtures. The provisions of Revised Article 9 of the Uniform Commercial Code must be considered when determining search locations, but that discussion is too lengthy to take place here. Additional information regarding UCC Searches may be found at LeapLaw's UCC Best Practice Summary.
  
  
• The existence of federal and state tax liens may be identified by having searches conducted at the federal district court, the Secretary of State's office and, in some jurisdictions, at the county recorder or city clerk's office.

For more information regarding public searches see LeapLaw's Public Searches Best Practice Summary.

Best Practice Tip: It is often more time and cost-efficient to use a service company to conduct searches, even local ones when considering transportation cost and time and possible wait time at the filing office. As long as the corporate name and jurisdiction provided to a search company are accurate, search companies generally retrieve documents for a set price regardless of transportation and waiting times that may occur.

For publicly traded companies:

• The SEC's Search EDGAR will provide copies of all filings made with the Securities and Exchange Commission.
  
  
• Dunn & Bradstreet will supply information regarding the company's financial condition.
  
  
• Information on a company's competitors can be found in Hoovers.
  
  
• General information about a company's business and history may exist on its own web site, if it has one. Additionally, copies of its Annual Reports and press releases about the company and its management may also be available here.
  
  
• A company's "glossy" Annual Reports can be obtained online at Annual Reports or at the company's web site.
  
  
• A Nexis search will produce all articles and press releases about the company and/or its management.

Minute Book Review
The minute book or records book of the entity will contain at minimum the formation documents of the entity, the bylaws or operating agreement of the entity, any board of director and stockholder (for a corporation) or member and manager (for a limited liability company) minutes and resolutions, foreign qualifications of the entity and stock or membership interest certificates and ledgers. It may also contain state annual report filings and IRS filings.

The minute book is a good place to start to answer entity existence and status questions. And since bylaws or operating agreements are not public records so are not filed with the secretary of state, the minute book will be the place to obtain those documents. It should be noted that some non-profit entities may file their bylaws with a state agency as part of a charity registration, but that will not be discussed at length here. Bylaws and operating agreements will contain the organizational structure and rules for the conduct of the business. They may range from simple, or "plain vanilla" to complex. Managerial and voting requirements should be reviewed to assist when reviewing meeting minutes or resolutions. In a corporation, all major corporate actions must be approved by the board of directors and, in some instances, the stockholders. Approval requirements will be set by the formation documents, by the bylaws and by state law. You should confirm that corporate actions were properly approved, meetings properly called and held and officers and directors properly elected.

Securities Laws
The due diligence review with respect to offerings is conducted to meet all responsibilities imposed by law in the preparation of the registration statement. The Securities Act of 1933 and the Securities and Exchange Act of 1934 impose liability for any deceptive or omitted material statements contained in a registration statement (including the prospectus and private placement memorandum). Purchasers who are subject to false statements may recover damages from the Issuer, Issuer's directors, Issuer's officers, accountants, underwriters and/or other persons who contributed to the preparation or certification of the registration statement. Generally, due diligence, the "reasonable investigation" of facts and circumstances such that the preparers believed there were no material omissions or false or inaccurate statements, is the standard of defense against any claim of liability.

Part of the due diligence process for initial public offerings is the forwarding of directors and officers' questionnaires. Information provided by the directors and officers is relied upon by counsel when completing registration statements and other Securities and Exchange Commission (SEC) filings. For SEC filing and registration purposes, other due diligence actions may include:

• Interviewing Issuer's officers to access and confirm certain information;
  
  
• Scour Issuer's financial statements and notes relating thereto;
  
  
• Participate in drafting sessions;and
  
  
• Identify competitors, nature of products or services as well as the Issuer's particular weaknesses

Intellectual Property

Assuring the title and transferability of intellectual property rights is a very important part of due diligence. Understanding the different types of intellectual property will help to conduct a meaningful review:

Trade Secrets
The diligence review will seek to identify a company's trade secrets and processes for protecting the same. Trade secrets are processes, inventions, customer lists or other proprietary information that may provide a company with an advantage over competitors. Unlike other intellectual property, trade secrets are not disclosed to the government or the public and do not have statutory protection; they are protected through contractual agreements and the ability to sue for their theft or misappropriation. Confidentiality agreements, non-disclosure agreements and non-competition agreements will contain provisions to protect trade secrets. Other examples for diligence purposes include client and supplier lists, internal computer programs, pricing structures and similar materials and knowledge that represent great value to a business.

Patents
Under the patent laws, inventors are granted the right to exclude others from production or use of the inventor’s discovery. The invention must be novel, useful and not obvious in nature. Generally machines, processing methods, man-made products and compositions of matter are the four types of discoveries or inventions eligible to be patented. Patents are granted for a limited amount of time (currently 20 years from the date of application) under U.S. patent laws. Patent applications are submitted to, and granted by U.S. Patent and Trademark Office (USPTO). If an application is rejected, the decision may be appealed to the USPTO. Further review is also available through the United States Court of Appeals for the Federal Circuit or in the United States District Court of the District of Columbia.

LeapLaw's Intellectual Property Connection provides a link to the USPTO that may be used to confirm the title holder and the "right to use". It is important to note that the USPTO grants secrecy to patent applications for the first 18 months. Therefore, although a thorough search may be performed, obtaining certain information is nearly impossible.

Trademarks
Trademarks do not have to be registered with the USPTO in order for an owner to have a valid claim of ownership. Trademark registrations may also be filed at the state level. Most importantly, trademark rights arise from the use of the mark, in "common law" and not from registration of any kind. Therefore, simply checking the USPTO listing of registered trademarks does not guarantee a trademark is free from potential infringement. The best possible search is a "full trademark search" that can be conducted using a trademark search company. The results of a full trademark search will provide a plethora of information including common law usage for legal analysis. Additional information regarding trademark and service mark issues may be found at LeapLaw's Intellectual Property Connection.

Copyrights
Copyright protection begins automatically when a copyrightable work comes into fixed, tangible form. A copyrightable document may or may not be registered with the Library of Congress; and assignments of a copyright may or may not be registered. When registered, the work will be assigned a registration number and title.

Works should be closely scrutinized in order to determine the manner in which ownership has been acquired. For instance, if an employee made the work, is it considered a "work for hire"? If there is no written agreement stating that an employee owns the work, the employer is generally deemed to own the work as a work product made in the scope of employment.

If a consultant developed the work, it may be considered to be work developed outside the scope of employment and therefore owned by the consultant and not the target company. Software development is a special cause for concern and scrutiny since developers may start as employees and continue work as consultants. Look for assignments or agreements that would preempt the consultant from claiming a copyright.

Licensing
Certain rights to intellectual property may be obtained through a third party. In these instances, it is important to determine that the target company has the rights it purports to have and that those rights, exclusive or nonexclusive, are transferable post-closing. Generally licensing agreements are considered to be personal services contracts and therefore, unless rights and obligations are specified to be transferable, they will generally not be transferable.

Additionally, licensing agreements generally specify licensing rights and obligations are not transferable and terminate upon change of control. If the licensing agreement is critical to the transaction, options may be to:

• Re-negotiate for assignable rights;
  
  
• Obtain necessary third party consents;
  
  
• Restructure the transaction. Restructuring the transaction may or may not be a possibility. For instance, an acquisition may be restructured to a stock purchase, since the stock purchase may not affect licensing rights.

Environmental Issues

Environmental issues can be extremely material, particularly if the target company is involved in any environmental litigation or has any involvement in Superfund sites. Pay careful attention to real estate leases and chain of title, waste management agreements, Environmental Protection Agency notices and correspondence and any other documents connected with environmental matters. Depending on the nature of the business, the likelihood of environmental issues can vary, for example, a company that owns no real estate and isn't involved in manufacturing or chemical use of any kind is considerably less likely to encounter such issues. Determine risks early as the review could become lengthy and costly when dealing with environmental concerns.

Litigation

Pending or potential litigation can also kill a deal. The diligence review will seek to identify threatened litigation through interviews with company counsel and document review and pending litigation by ordering court docket searches in the appropriate federal and state courts.

Need assistance? Virtual Paralegal Services provides cost-effective paralegal services including litigation searches in all 50 states and all counties. For more information contact us at [email protected].

Legal Opinions

Legal opinions are an important part of every transaction. The parties rely on these to provide a level of comfort when sealing the deal. Counsel will usually be asked to opine as to due organization and corporate good standing, validity of stock, power and authority to enter into agreements and operate its business and other issues. The diligence review assists in backing up the legal opinion. In addition to diligence efforts, a certificate from a company officer will often be requested to certify certain conditions such as certification of the stock ledger and other internal matters that are included in the opinion, but may be difficult for counsel to verify in addition to any officer's certificates required by the transaction documents.

The Work Product

After the review is complete, organizing the information to track and follow up on issues is extremely important. Some like to organize notebooks for follow-up items such as information collected that needs to be verified or a list of issues that need to either be cleared or brought into negotiations. The final work product for distribution is usually in the form of a memorandum.

Due Diligence Memorandum
Due diligence results are provided to the client and deal team in a detailed memorandum setting forth the findings of the diligence efforts. It is best to prepare the memo as you sift through diligence using a Dictaphone, noting any missing documents. Always follow up on missing documents or outstanding questions. They may be important. As part of the memorandum, the drafter may wish to:

• Prepare a schedule of potential liabilities and/or extraordinary material risks;
  
  
• Prepare a schedule of necessary third-party consents and approvals (i.e. landlords, service contracts or government agencies) to the transaction;
  
  
• Review Change of Control provisions that would prohibit the lease or agreement from being valid post-closing;
  
  
• Ensure accurate disclosure of information and representations outlined in the transaction document;
  
  
• Gather necessary information to support legal opinions.

Due Diligence Checklist

A due diligence checklist needs to be tapered for each transaction and will list each document that is requested or will be produced, with columns for easy tracking. The columns on the checklist should include:

• List of Documents
  
  
• Status and Outstanding Issues: Notes can be kept in this column. Notes may include whether or not the document has been requested, received or is being copied.
• Copies Requested By: This column can provide information on the requestor of the copies (i.e. attorney on the other side).
  
  
• Copies Delivered

Sample due diligence checklist

Summation

Due diligence is an investigative effort and as such, the best rule of thumb is to keep your ears and eyes open and most importantly ASSUME NOTHING!

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