Due Diligence and The Disclosure Letter

Key Aspects of the Due Diligence Process and the Importance of a Comprehensive Disclosure Letter.

A buyer uses due diligence to investigate ownership, liabilities, contracts and other risks before committing to a purchase. The scope depends on the business and whether shares or assets are being acquired.

A solicitor will help streamline the due diligence process, which can help in hitting a completion date. If acting for the sellers or the target, a solicitor will respond to the due diligence enquiries. Where acting for the buyer, a due diligence report will follow, which will flag up any areas of concern. A purchase price can be subject to the results of any due diligence.

Key Aspects of Due Diligence

Due diligence is broadly split into financial due diligence, i.e. the target’s outstanding liabilities and liquid assets, and legal due diligence, i.e. employees and intellectual property.

With regards to legal due diligence, the enquiries to raise will depend on the target’s market. However, broadly speaking, the following seven enquiries should always be raised:

1. Contracts: Review key terms, liabilities and compliance with applicable law. Check consent, assignment and change-of-control provisions rather than assuming contracts transfer unchanged.
2. Employment: Review employment terms, disputes and policies. TUPE may apply to a qualifying business or asset transfer; assess information and consultation duties before completion.
3. Disputes:is the target subject to any ongoing dispute with a supplier, client, or customer? If so, will completion be conditional on the resolution of any dispute subject to the satisfaction of the buyer? The seller should take steps to resolve disputes out of court, as litigated matters in the courts can become protracted.
4. Intellectual property:from a seller’s perspective, it always pays to have the business’s intellectual property rights adequately protected. If the target has a revenue stream through a licensing model, then a review of the licence agreement can help address any areas of concern.
5. Assets: Verify title, security interests, leases and required consents. EBITDA is an earnings measure, not a guarantee that asset values are preserved; valuation should reflect cash flows, capital needs and the agreed transaction structure.
6. Compliance: Review applicable data protection duties, lawful processing, security and international-transfer safeguards. Transfers outside the UK can require additional safeguards; an EEA-only test is not sufficient.
7. Ownership:bespoke articles and/or shareholders’ agreement will usually contain provisions relating to share transfers. Do the majority shareholders have the right to “drag” the minority into a sale? Likewise, do the minority shareholders have the right for their shares to be bought out by the buyer? This will depend on how the purchase is structured.

The Importance of the Disclosure Letter

The buyer may seek warranties about the business and specific indemnities for identified risks. Data protection compliance requires a substantive review; registration or payment of an ICO fee alone does not establish compliance.

A seller will then have to fully fairly and accurately disclose against any warranties that the buyer requests. For example, the buyer may request that the seller warrants that “there have never been any employment claims against the target company”. The seller then discloses against this warranty in the disclosure letter, similar to “the target has had a claim from one employee for constructive dismissal in 2010, which was dismissed by an employment tribunal”. The seller would then disclose the tribunal’s judgment as an annexed document.

The disclosure letter qualifies warranties only to the extent permitted by the sale agreement and the agreed disclosure standard. Identify exceptions clearly and provide supporting documents; general data-room access may not be sufficient. Indemnities and fraud provisions require separate legal review.

Protecting Sellers in the Purchase Documents

A seller should look to cap liability for warranty breach within the purchase documents.

The usual way to do this is to cap the seller’s liability to the buyer in the event of a warranty claim at an amount equal to, or a percentage of, the purchase price. The actual level of liability cap will depend on negotiations, due diligence, the seller’s exposure, and the buyer’s assessment of the target’s risk.