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.
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.
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
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 inventors 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 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.
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.
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 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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