What buyers need to know about your company’s legal rights, commitments, and other exposures

You may have found a buyer who thinks your business is exactly what they are looking for–a sound investment thesis, a sustainable business model, profitable operations, strong growth prospects, and a plethora of synergy opportunities. But buyers can’t finalize a transaction without taking prudent measures to find out about the contractual entanglements they will inherit. The purchase of your company could encumber their assets or operations, or it might saddle their shareholders with potential legal liability. These problems could materially impact the target’s value. That is why buyers undertake legal due diligence (LDD).

LDD is a process not only of developing findings that are the primary focus of the LDD work stream, but also of synthesizing them with the findings of all other diligence work streams and refining the legal terms of the deal in parallel. Your role and that of your legal advisor is to aid in this process of discovery, and to adopt a prudent stance in response to the buyer’s iterative contract language changes aimed at stacking the deal in their favor as they incorporate due diligence findings. For the seller, LDD is therefore a blend of cooperation, candor, and negotiation.

Objectives of LDD

The buyer will have several important goals when conducting LDD:

Uncovering potential liabilities

In stock transactions, the buyer must identify three kinds of unrecorded impacts:

• Actual. The company may have already incurred legal obligations. These should be recorded on the balance sheet–and they likely are if the company’s financial statements have been audited. But LDD will seek to ensure no material obligations have been missed.

• Future. There can be multiple reasons the buyer should be concerned about the transaction generating an economic loss, but some can be directly related to legal structure. When an entity leaves a controlled group, it can incur liabilities. One obvious example would be the triggering of capital gains tax owed by the target for assets previously transferred to affiliates, so the LDD team needs to coordinate with the tax due diligence (TDD) advisor to ensure the tax implications of any such activity have been properly identified and considered in the buyer’s price calculation. There may also be change-of-control clauses in licensing and distribution agreements. The target’s profit margins may also suffer in the transaction if, for instance, it can no longer benefit from the parent’s group purchasing discounts. The LDD team needs to ensure legal provisions don’t cause value to evaporate with the stroke of a pen at closing.

• Contingent. The LDD team must catch change-of-control clauses in contracts with counterparties, and ensure legal certainty is obtained before a transaction is consummated. These provisions are usually introduced into contracts as fail-safes, but they may create the potential for the target’s counterparties to take advantage of the situation by renegotiating the economics of the original contract.

Even in asset sales, the buyer can become responsible even for liabilities not expressly assumed in the deal. Tax liabilities, tort and product liabilities, and environmental liabilities follow the assets that generated them. Buyers will seek tax clearance certificates from governments to ensure tax obligations are paid off or held back at closing. Buyers will also add indemnification for breaches of reps and warranties and hold harmless language to the contract to address specific liabilities.

Contingencies also include contingent litigation. This is more than just a list of pending and threatened litigation identified by the company’s lawyers. The lawyers on the buyer’s LDD team earn their pay by bringing their insight and experience to bear in spotting risks and assessing their magnitude and likelihood. Depending on the circumstances, this can include legal counsel in multiple jurisdictions where the target is subject to local legal or regulatory oversight.

Ideally, contingencies will be identified in the working draft of the seller’s disclosure letter and associated schedules. A good source for legal investigators looking for contingencies is the company’s financial statements. Even if audited, the LDD team won’t take for granted the financial statements disclose all potential legal contingencies. But the financial statements can be a helpful starting point nonetheless. Also, the auditor’s work papers may provide additional insight into matters the seller was able to keep out of the financial statements, and these should have been surfaced by financial due diligence (FDD) and shared with the LDD team. Other contingencies are contractual issues that can be identified by digging into loan agreements for debt on the balance sheet. Charges reflected on the income statement can be the harbinger of contingent losses. And guarantees and indemnities disclosed in the financial statements’ notes can be other productive avenues for the LDD team to follow.

The buyer and seller will negotiate over certain contingencies, possibly resulting in indemnification for reps and warranties. To maintain a degree of control over collection on indemnifications, sellers will often negotiate for a certain portion of the deal proceeds to be retained in escrow until the first audit under the buyer’s watch is completed, releasing any excess of the holdback beyond what the buyer isn’t entitled to keep based on indemnifications triggered up to that point.

Finding legal or contractual obstacles

A stock transaction means the buyer purchases the company’s equity from the seller. So the LDD team needs to ensure the owners have good title, and no encumbrances are attached to those shares because of agreements entered into by the seller(s).

This may involve inspecting the documents relating to the allocation, issuance, and transfer of shares, the approval of transfers at BOD meetings, and the registration of various transfer documents, as well as ensuring former shareholders have returned their certificates and that the current shareholders selling their shares hold certificates. But it will also involve verifying the ownership interests to be sold are not subject to liens or encumbrances.

The legal team must also ensure that the target company holds title, free of encumbrances and liens, to real property and other major assets. Tainted title is a major concern, as it impacts future marketability of assets and possibly right of use.

The LDD team will also look for evidence of breaches of leases or other contract covenants and their consequences.

Insofar as the target’s branding is important post transaction, the LDD team will focus on the worthwhile domain names. They will check that the target has taken steps to register names important to protecting the brand, and those which could be useful in the future.

Identifying required consents and releases

Deals are often held up because of third parties. Identifying the hurdles that stand between you and a closed deal is important, and the buyer’s LDD team will ensure you are working to remove these obstacles.

When the target company is a subsidiary of a controlled group, the buyer must determine affiliate contracts to which the company may be a party. For example, the target may need to be released from a parent company debenture.

There may also be shareholder pre-emption rights, employee stock options, union consents, joint venture partner consents, or landlord consents. Informal representations to employees promising them an ownership interest for past performance can also present an obstacle. Seemingly small issues rooted in forgotten emails years earlier can be a show stopper until remedied, so it is better for the seller to handle them proactively with some finesse early in the process than to risk them surfacing at the last minute to block the deal.

Antitrust regulation may also present hoops for you to jump through. To avoid antitrust violations, the Hart-Scott-Rodino Act requires the parties to notify the FTC and DOJ before consummating a proposed acquisition and imposes a 30-day waiting period if the transaction size exceeds a certain threshold, or if a combination of transaction size and participant size thresholds are met. If antitrust pre-clearance regulation applies, the buyer will work to ensure the required notification is initiated early so that it does not delay closing.

There are numerous potential roadblocks to a buyer legally consummating the transaction. LDD will consider them and ensure any prerequisites are addressed.

Identifying and evaluating regulatory issues

The LDD team will need to identify all licenses, permissions, and registrations necessary to operate the target’s business.

For the licenses the company has, LDD will verify that they are active and that there are no violations that have jeopardized them, The LDD team will also identify any that are missing.

The LDD advisor will prioritize license issues, since dealing with licensing authorities can involve long delays. The process may even reveal to the buyer that the legal structure of the target is unworkable in its industry, stopping the deal from moving forward or requiring an overhaul of the legal structure.

In some cases, the acquirer will need to hold a license to operate the target’s business after the transaction. When this is necessary, the LDD team must ensure the license is transferable, or that steps to obtain a new license for the buyer are underway. This obviously becomes an issue in an asset purchase, but it can also be an issue in the stock purchase if the target is a subsidiary operating under the aegis of a license held by its parent entity or another member of the controlled group instead of its own license.

From a practical perspective, the LDD team must also be alert to the need for membership in important industry or trade groups. While not strictly a legal matter, this can be critical to maintaining the credibility and prestige of the business.

Developing findings that form the basis of the disclosure letter and the final purchase agreement

LDD culminates in two documents, the disclosure letter and the definitive sale and purchase agreement (SPA), which play a central role in negotiating and memorializing the final terms of the deal and consummating the transaction:

• The disclosure letter. The disclosure letter is a formal document provided by the seller to the buyer, accompanied by disclosure schedules that qualify those disclosures. The disclosure schedules are critical for the protection of the seller. But the exceptions they document also provide the buyer with a clear picture of the risks in the deal, thus aiding the buyer in negotiating the SPA. The disclosure letter is a critical convergence of findings not only by the LDD team, but all other due diligence work streams as well. This is why best practice for the buyer is often to have their internal counsel coordinate LDD, and to organize the LDD function to serve as a central clearinghouse for risk issues.

• The purchase agreement. The SPA binds both parties to execute the transaction. It lays out exhaustively the terms of the deal, and it ensures the seller does not change the company in any significant way prior to closing. Importantly, the SPA includes all the seller’s representations and warranties, and it specifies what happens in the event problems arise that should have been disclosed but were not. Much of the negotiations around the contract often pertains to who will pay for defects that come to light after closing.

Legal Advisors

The buyer will have one lead legal advisor that coordinates the entire team of outside legal resources and issues the LDD report.

But, depending on how complicated the target is, the buyer may need to engage multiple lawyers with different specializations to conduct thorough LDD. To address the full spectrum of risks, specialization in certain industries, assets, or countries may be required. Just as due diligence involves some natural overlap between work streams, there is likely to be overlap within the LDD work stream, with different lawyers working on the same issues from different angles. Local (country or state/province) counsel will often be needed.

• The law of the jurisdiction under which the target is incorporated governs the constitution of the target, and the rules about ownership and transfer of its shares.

• The law of the jurisdiction in which property is located will determine legal matters regarding that property.

• The law of the jurisdiction in which employees are located will determine employment issues.

The more complex and geographically dispersed the target is, the less likely the lead LDD firm will have all the necessary capabilities in-house. In these cases, the buyer will engage unaffiliated specialists. The lead LDD advisor must liaise closely with outside counsel since their findings could be important to elements of the SPA.

The quality of LDD depends largely on the buyer’s management of the process. In particular, the buyer’s briefing of the lawyers is the bedrock for LDD, and a prime determinant of the value the buyer gets from it. The lawyers are central to the deal, and thus need to know everything the buyer can tell them about it, including their biggest concerns. This gives them essential context necessary to focus their attention and efforts in meaningful ways as they wade through the mountain of material they will receive.

The LDD Process

LDD is a dynamic process. Although it culminates in a formal written report, the lead lawyer will liaise with the buyer on an ongoing basis throughout the process, bubbling up new information on issues as it becomes clearer, and providing their opinions about how to proceed. The seller’s reactions to LDD findings, as well as the findings of other diligence work streams, become central to the drafting and redrafting of the SPA. This continues between the parties’ legal teams until final agreement is reached on these matters and the deal can be brought to closing.

The buyer’s LDD advisors will review requested information as it arrives, often mechanically by staffers—a cost-effective and practical way of getting through everything while leaving senior personnel able to supervise and investigate the most important and challenging matters. The more complex the deal, the more likely the buyer will have underestimated the time required to follow up on all important matters. Particularly in international transactions, dealing with regulators, time differences, language barriers, and cultural differences can all cause delays.

Much of what the LDD team needs may already be in the seller’s data room. But it is imperative for them to get their request for information to the seller as soon as possible. This starts out as a boilerplate, comprehensive list; the lead LDD advisor deletes irrelevant questions and adds new questions that are specific to the nature of the business or the transaction. The team also adds questions that are needed to address initial findings, such as those that emerged from commercial due diligence (CDD) conducted thus far. The buyer’s team will aim to make these questions focused enough to be relevant, but sufficiently broad to elicit all germane information in the response. As information is received and digested, follow-up questions are sent to the seller’s team.

The LDD team will collect information from many sources during the process, including:

• The seller. The seller’s lawyers will coordinate preparation of responses, collection and distribution of information, and tracking when and to whom it has been provided. The buyer’s side will also have someone on the LDD team keeping careful track of what information has been received and when, as well as to whom it has been circulated. The buyer’s lead LDD advisor will remain wary of the common seller tactic of delivering the disclosure letter at the last minute in an effort to get their R&W exceptions in under the wire while also providing the buyer the least possible time to comb through and use them in SPA negotiations. To counter this, the buyer’s legal advisor will ask for an early version of the disclosure letter, and they will manage it as a succession of drafts that includes additional disclosures prompted by the buyer as more due diligence is completed.

• Other due diligence advisors. The LDD function cuts across all other areas, so the lead LDD advisor needs to coordinate with the broader due diligence team to ensure they remain aware about findings as they arise. Other due diligence advisors need to communicate risks as they are discovered so that any incremental legal diligence can be conducted, and further disclosure can be sought from the seller. The lead LDD advisor will be the last due diligence advisor actively involved in the deal process. So as due diligence winds down into the final stretch of the deal, the buyer’s attorney/lead LDD advisor will act as a hub for information gathering/processing with the other due diligence providers and the seller. As open issues get whittled down, this process continues until the purchaser is satisfied, the seller insists it is time for the buyer to bring due diligence to a conclusion and make a decision, or the parties simply tire of the diminishing returns from the effort.

• Public information. While waiting for requested information and a first draft of the disclosure letter, the LDD advisor will use public sources to build out their profile of the target in order to refine their efforts. They may consult the internet, subscription databases, and credit reference agencies. As LDD progresses, the team may need to use public information to confirm a number of issues related to real property, including clean title, adverse easements, mortgages, liens, restrictive covenants, boundaries, and determination of any environmental issues associated with land, such as brownfield sites. Extensive public information related to the company itself will be available if the company is an SEC registrant, but for private companies, only limited state registration information will be available. The LDD team will also determine if any owners or directors have bankruptcy proceedings outstanding or pending, and it will check to see if the sellers have the authority to sell the company. Court records will be consulted to verify the status of any ongoing or pending litigation, and that no steps have been taken to put the company into receivership or dissolve it.

The LDD Report

The lead LDD advisor’s report will document detailed commentary on the issues discovered in the process in a report to the buyer.

The LDD report will be prefaced by an executive summary, which will memorialize the opinions they have reached and those obtained from hired specialists. It will identify the major issues, and it will provide counsel’s opinions on how they should be addressed in the deal.

The lead LDD advisor will also present its findings to the buyer, ensuring the buyer understands the conclusions reached and the recommendations for dealing with them.

But the work of incorporating LDD findings into the working draft of the SPA does not wait for preparation of the LDD report. Due diligence from all work streams, channeled to the LDD team, will inform contract negotiation and proposed language. The buyer’s lead LDD advisor and in-house counsel will remain involved in the negotiation process until the final draft of the SPA is completed.

Emerging from LDD with a Solid Deal Intact

LDD is a central component of buyer due diligence. As a seller, you can expect to devote extensive attention to the LDD team’s requests and inquiries, repeatedly revisit and adapt your disclosures based on the buyer’s findings, and face additional negotiation challenges and possibly repricing implications. But if you are aware of how this due diligence stream works and what it will uncover about your business, you can work with your transaction advisor and M&A lawyer to get in front of problems and ensure discovery goes as smoothly as possible.

The process of negating contract language can begin before the buyer’s advisors even surface their first due diligence finding. The buyer will typically provide the first draft of the SPA with the representations and warranties they expect the seller to make, as well as the majority of documents associated with most deals. Your attorney’s role will be to drive the following efforts:

• Narrow reps and warranties. The buyer typically takes a kitchen sink approach, asking for extensive reps and warranties. Oftentimes, boilerplate items are included that address implausible or minimal risks based on the seller’s industry. Taken to the extreme, they can saddle the seller with risks that are beyond their actual knowledge. Your lawyer will help you understand the breadth of these representations and assumptions of responsibility, and they will look for opportunities to reduce the number and limit the scope of reps and warranties to those necessary to the deal. Managing reps and warranties also requires a clear delineation between those deemed “fundamental” and those that are not. This key distinction matters because caps and baskets (mechanisms for limiting the seller’s exposure on indemnifications) only apply to non-fundamental reps and warranties; for fundamental reps and warranties, the seller’s assumption of risk is unlimited. Your lawyer will negotiate to raise the basket and lower the cap on your indemnification for non-fundamental reps and warranties based on current averages in your industry.

• Limit indemnification. The buyer will seek indemnification from you on every risk they can. These go hand in hand with reps and warranties. Your attorney will take a coordinated approach to controlling the risk you assume.

• Appropriately allocate risk to the buyer. To support your attorney’s efforts, it is important to present your concerns about disclosures you are being asked to make in the disclosure letter. The lawyer’s next step is often to add a disclosure schedule to the letter, limiting the responsibility you assume. This also surfaces the issue to the buyer’s attorney, allowing legal counsel on both sides to negotiate the language. Although typical buyer-drafted contracts include numerous reps and warranties they want the seller to make, they only include and handful being made by the buyer. Your attorney will identify opportunities to ensure the buyer is asked to make additional representations and warranties that mirror yours. Such buyer reps and warranties can reduce the risk of liability (e.g., tax liabilities, litigation liabilities, and closing expenses) attaching to cash received by the seller.

• Find solutions to close the deal. Negotiating contract language requires finesse, and it is important for counsel on both sides to avoid myopia that can jeopardize the deal. Compromises can often be reached that minimize the parties’ collective level of concern. Aside from allocating risk, due diligence may find issues that have serious adverse effects on the marketability of the company. Your lawyer will analyze the facts and apprise you of your options and a roadmap to curing problems.

It is important to understand that broader due diligence process is the means by which the buyer learns many of the finer details about the risks in your business, and the process naturally leads to the buyer’s demand for language in the SPA tailored to address these findings. This is expected, and the redrafting of legal language by both side’s legal teams is an undercurrent that runs contemporaneously with all diligence work streams throughout the deal process. It should also be expected that the buyer will take the liberty of drafting language that addresses these findings in a manner that is most favorable to them. Your attorney will help you navigate the give-and-take needed to take a balanced response to the buyer’s attempts to shift all risk to you.

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