M&a Due Diligence in the New Age of Corporate Governance
Lajoux, Alexandra Reed, Ivey Business Journal Online
Due diligence cannot always be perfect. However, from a legal perspective, the point is to make a good faith effort to conduct due diligence, within the limits of time and funding, and in consideration of what matters most-the long-term financial health of the surviving company and its stakeholders. This author has written a comprehensive primer on the subject.
In a bestselling book published a generation ago, sociologist Alvin Toffler coined the term "future shock" to describe "too much change in too short a period of time." This phrase certainly applies to due diligence today. In this new millennium, significant regulatory changes have affected due diligence in each of its four core areas: financial statements review, management and operations review, legal compliance review, and document and transactions review. Despite these changes, the timeless fundamentals of risk management apply.
The basic function of due diligence in any merger or acquisition is to assess the potential risks of a proposed transaction by inquiring into all relevant aspects of the past, present, and predictable future of the business to be purchased. The term is also used in securities law to describe the duty of care and review to be exercised by officers, directors, underwriters, and others in connection with public offerings of securities.
The due diligence effort in a merger transaction should include basic activities to meet diligence standards of common law and best practices. These activities include the following:
* Financial statements review, to confirm the existence of assets, liabilities, and equity in the balance sheet, and to determine the financial health of the company based on the income statement.
* Management and operations review, to determine quality and reliability of financial statements, and to gain a sense of contingencies beyond the financial statements.
* Legal compliance review, to check for potential future legal problems stemming from the target's past.
* Document and transaction review, to ensure that the paperwork of the deal is in order and that the structure of the transaction is appropriate.
All of these areas have been affected by recent changes in law and accounting. Recent regulatory and accounting reforms in the United States, in the aftermath of Sarbanes-Oxley, make M&A due diligence somewhat easier. Now, based on rules promulgated under Section 404 of Sarbanes-Oxley, corporate leaders have greater accountability for the oversight of internal accounting controls, so company financials will tend to be cleaner. On the other hand, these same reforms, coupled with some recent, influential court decisions in Delaware, suggest heightened standards for the results of due diligence.
Requirements for due diligence
As mentioned, due diligence is found in securities laws. The two fundamental federal securities laws in the United States are the Securities Act of 1933 and the Securities Exchange Act of 1934. Both mandate a certain level of diligence with respect to securities, although neither mentions the term "due diligence" per se.
The Securities Act of 1933
This Act applies primarily to disclosures made when registering securities (debt or equity) for sale to the public. But it has broader implications. Some concepts in the 1933 Act, and in rules promulgated under it, have had far-reaching influence in court decisions. Therefore, mastering the disclosure principles in the 1933 act can help companies, both public and private, maintain good business practices.
Directors who are sued for violation of the 1933 Act can use proof of their "due diligence" as a legal defense. Section 11 of the Act requires accurate and complete disclosure of material facts in a securities offering registration statement. If a registration document contains misstatements or omissions of material facts, shareholders can sue the underwriters, accountants, and/or directors-and may prevail even without any proof of intentional wrongdoing. …