Due Diligence – What You Don’t Know Can Hurt You
Proper due diligence can prevent catastrophe
The common thread is a failure to perform sufficient due diligence. In our experience as attorneys, the major contributing factors are haste to consummate a transaction, the assumption that a superficial examination is “enough,” and/or a reluctance to undertake the effort and expense of reasonable due diligence.
A spectacular example of the danger of a superficial examination is the 1963 salad oil scandal, in which a company obtained a series of bank loans collateralized by its purported inventory of salad oil stored in huge tanks in New Jersey. Since oil floats on water, examinations consisting of looking into the tanks did not reveal that the tanks were filled with water topped by a layer of salad oil. When a careful inspector used a dipstick, the scam was quickly discovered. The avoidable result was loss of money for many major lenders and jail time for the main scam artist.
A fact of life for attorneys is that clients may come to us late in a negotiation process when time is pressing. Experience teaches that due diligence is important, no matter how “great” the deal and how imminent the deadline.
A number of years ago, an officer of a client called me, enthusiastic about pursuing a joint venture with a construction company. Our client, an energy solutions company, would provide financing together with managing the interface with the utility, and the construction company would install energy conservation measures under a utility demand-side management program; a filing deadline was imminent. The company officer had met the president of the company, “a great guy,” and wanted me to prepare the necessary papers as soon as possible. But when we performed a check, the construction company president had a history of financial mismanagement and had spent five years in jail for fraud. The client passed on the opportunity.
Due diligence, in essence, is an investigation for any of a number of purposes that can include business, governmental, institutional, or personal matters. The objectives of due diligence include but are not limited to:
• Confirming the correctness of the facts presented
• Discovering any serious “portal” problems that would preclude the potential transaction or arrangement
• Assessing the value of any involved asserts (real, intangible, and personal)
• Gaining information for negotiation purposes
• Identifying potential or actual legal and financial issues.
One cause of incomplete due diligence is that due diligence and the extent to which it is performed is generally voluntarily. Some types of due diligence, however, are legally required, and it can be dictated by fiduciary responsibility. Even if not a legal requirement, failing to conduct due diligence using a reasonable standard of care prior to a transaction, whether purchase of a business, equipment leasing, or hiring an employee can result in an exposure to liability, to commercial risks, and to damage to the company’s reputation. Liability can arise when a problem surfaces that could have been identified by due diligence or was identified but incorrectly assessed. Ironically, the flood of information that is obtainable electronically can be a serious issue in due diligence. How do you identify the “needle in the haystack?”
Preliminary agreements, such as non-disclosure and confidentiality agreements permit information to be exchanged. Other preliminary documents include option agreements, letters of intent, or a memorandum of understanding evidencing that the parties have reached a preliminary understanding on the terms of a proposed contract prior to signing a binding contract and typically allowing exchange of information.
An increasingly common vehicle for due diligence is to use secure file sharing, in which files are stored in a virtual data room for which code entrance is required. I have used this storage approach for recent transactions and am using it now. I expect virtual data rooms will be used for due diligence and other purposes like storing documents used for a transaction.
Over the years, I have found site visits to be particularly helpful and sometimes crucial. One client had a property tax dispute with a city regarding an oil tank “farm.” The client showed me a copy of an old site map filed in the city’s records that showed four medium-sized oil tanks and one large tank. As part of my review, I asked to visit the tank farm. When I visited the site, I found only four medium-sized tanks. The new property manager did not realize that the large tank had been demolished until we were standing together on the site. Filing a revised site map resulted in a reduced assessment.
Another client, a large retailer, was in a hurry to close a deal to build a very large distribution warehouse on meadowland fill owned by a developer. As part of my due diligence, I took the time to drive out to visit the intended site. I discovered a small bridge over tidal water. When I checked with the property owning developer, they had state permissions and local permits but no Corps of Engineer approval, despite the presence of tidal water. It was a serious oversight that took a year to rectify.
And, speaking of prime examples, we have only to review the recent sub-prime mortgage fiasco, in which lenders gave mortgages⎯most of them adjustable⎯to borrowers without sufficient means to pay back the loan especially when the interest rate was adjusted upwards after the initial term. The financial community securitized these risky mortgages in tiers, which resulted in some of these being re-rated as Triple A without basis. The causes of the resulting crises were many and included widespread lack of due diligence.
Conducting due diligence is a mission critical part of any significant transaction. It can be tempting to give it short shrift⎯very tempting in these days of hurried processes and short attention spans. At times I have to remind my clients of the ancient adage “act in haste and repent at leisure.”