Due Diligence Prepared For: Legal Education Society of Alberta Buying and Selling a Business Prepared by: Peter I. Inglis, Nicholas Jeanes and Mark P. Kortbeek Bennett Jones LLP Edmonton, Alberta For Presentation In: Edmonton April 9, 2015 Calgary April 23, 2015
DUE DILIGENCE I. INTRODUCTION This paper provides an overview of the due diligence process involved i n the buying and selling of an Alberta-based business. The paper seeks to highlight best practices, common issues, and emerging trends. As with the other modules of the Legal Education Society of Alberta (LESA) "Buying and Selling a Business" program, the default framework for considering due diligence in this paper is based on the acquisition of a mid-market energy services firm. The paper focuses primarily on the due diligence to be conducted on the "buy-side" (i.e. by the "Buyer" or its agents, including legal counsel ("Buyer's Counsel")) of a share purchase transaction (i.e. buying all of the shares ("Share Purchase") of a target corporation (i.e. "TargetCo")), however, the paper also addresses considerations for the due diligence to be conducted on the "sell-side" (i.e. by the "Seller" or its agents, including legal counsel ("Seller's Counsel")) as well as other structures for transactions such as buying all or substantially all the assets ("Purchased Assets") of a business ("Asset Purchase"). The context of focus here (i.e. buying and selling a business) is sometimes generically referred to in this paper as "M&A" (i.e. mergers and acquisitions). By way of disclaimer, we note that the information provided in this presentation is for general information purposes only and does not constitute professional legal advice. The paper presents an overview of certain matters relating to its subject matter and is not intended to be complete or exhaustive. Every transaction where lawyers or law firms are engaged to perform due diligence is different and the ultimate due diligence process, results, reporting and use depends on a number of circumstances, some of which are transaction specific. Your experience may differ in some or indeed many instances. We note further that there are a number of sources available to practitioners regarding conducting due diligence, some of which are referenced herein, and parties to any M&A transaction are encouraged to review and consider them all. II. WHY DUE DILIGENCE? A. What is it/why do it There are multiple definitions of due diligence, whether related directly to the buying and selling of a business or otherwise, most of which incorporate core elements of the following: 1
"The diligence reasonably expected from, and ordinarily exercised by a person who seeks to satisfy a legal requirement or to discharge an obligation." 1 " an investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to a sale. Generally, due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party." 2 Due diligence in the M&A context is typically focused on verifying the existence and ownership of the targeted assets (whether that is all the shares of a corporation owning and operating a business (a Share Purchase) or all or substantially all the assets comprising a business (an Asset Purchase), along with attempts to uncover any issues, claims or defects which could devalue the targeted assets and thus equip the party performing the due diligence (or the party for whom it is being performed) with the ability to evaluate and potentially mitigate the risks that could result based on such issues, claims or defects. It is tempting to view due diligence as a standardized set of procedures and checklists, proceeding in a linear process one step after the other. Indeed, a stable of internal processes, action lists and an overall structured approach are vital to effectively performing due diligence. However it is important to remember that due diligence is not an end in and of itself. An emerging trend in the U.S. M&A market in particular is to speak of "value creation" due diligence which explores the full complement of opportunities available in a transaction. Legal counsel are generally not mandated to develop commercial opportunities within the transaction, but it is possible to obtain value from them by effectively performing due diligence, beyond merely identifying risks. As will be discussed later in this paper, due diligence effectively performed not only identifies risks associated with acquiring the targeted assets, but also serves a decision making function, a negotiating function and as an important component with the closing, as well as post-closing transition and integration. B. Professional Responsibility A sound due diligence process related to business transactions and M&A in particular is also an important component of any lawyer's or law firm's risk management strategy and should be approached with that perspective in mind. If a lawyer or a law firm has been engaged to assist with the buying or selling of a business, then the lawyer or law firm must take steps to comply with his/her/their professional obligations. Whether acting for the Buyer or the Seller, legal counsel will 1 Black's Law Dictionary, Third Pocket Edition, Bryan A. Garner, Editor in Chief, Thompson West: 2006. 2 "Mitigating Risk and Creating Value: A Focused Approach to Due Diligence" in Best Practices of the Best Deal Makers M&A Series, Merrill DataSite and The M&A Advisor. 2
be expected to identify issues and perform the due diligence process, or at least the aspects of it that are assigned to them, competently and professionally. Amongst other relevant provisions of the Code of Conduct, Chapter 2.01(2) provides that "[a] lawyer must perform all legal services undertaken on a client's behalf to the standard of a competent lawyer." 3 A 2003 decision of the Prince Edward Island Supreme Court highlights this point. In Gillis v Schurman, 2003 PESCTD 55, the defendant solicitor (previously cast as Buyer's Counsel) provided legal advice to the plaintiff (the Buyers) during the purchase of a business. Following the closing of the transaction the Canada Revenue Agency (CRA) contacted the plaintiff/buyer in pursuit of unpaid GST. In performing due diligence during the relevant transaction, the defendant/buyer's Counsel had allowed the transaction to close without receiving confirmation from the CRA that no outstanding taxes were owing and had not explained the risks of not receiving such confirmation to the plaintiff/buyer. The court found: "It is common ground that the defendant failed to complete the GST search that would have been completed by the "reasonably competent and diligent solicitor" in PEI. The defendant was aware of the need for the search to be completed but through administrative error, allowed the transaction to close without having completed the search. This failure in and of itself constitutes a breach of the duty of care owed to his clients." 4 Ultimately, the defendant solicitor was not liable for any losses suffered by the plaintiff/buyer as a comfort letter received from the CRA following the closing of the transaction stated that no taxes were actually outstanding at the time of the closing. Nevertheless, the case serves to emphasize that certain due diligence procedures are clearly considered standard in M&A transactions and failing to address them (i.e. by either conducting the relevant search/evaluation or clearly addressing the risks of not doing so with the client) will attract liability if not competently performed. C. Another cautionary tale regarding the importance of M&A due diligence Moving beyond the more basic M&A "checklist" failure identified above, there are numerous cases where it would seem clear with the benefit of hindsight that at some point in the course of the relevant M&A transaction something significant was "missed" in due diligence to the detriment of either Buyer or Seller. The 1998 acquisition of Rolls-Royce Motors by Volkswagen is one of the classics of the genre. After having suffered substantial losses for many years as a 3 Law Society of Alberta, Code of Conduct (version 2013_V2), Chapter 2.01(2), available at www.lawsociety.ab.ca/lawyers/regulation/code. 4 2003 PESCTD 55 at para 10. Referenced in "Effective Due Diligence" 7 th Annual M&A Skills Boot Camp April 1-2, 2014, by Jason Bullen of Cassels Brock & Blackwell LLP ("Bullen") 3
result of recessionary economies throughout the 1990s, Rolls Royce Motors was caught in the position of having to "explore strategic alternatives" including putting itself up for sale. That led to BMW making a friendly offer to purchase the financially troubled automaker for 340 million (US $563.5 million). The BMW bid made plenty of strategic sense since at that point BMW was exclusively supplying engines and other key components to Rolls-Royce Motors for both their Rolls-Royce and Bentley branded cars. However, Volkswagen, ostensibly seeking to move into the higher margin up-market spectrum of the industry and scoop its bitter German rival BMW, jumped in big to the tune of 126% of the BMW bid with a 430 million (US $712.7 million) offer. The Seller, which was then Vickers, plc., could not pass on the financially superior bid, and BMW appeared to be shut out. However, based on a number of key elements of the Rolls-Royce Motors business that in hindsight, Volkswagen ought to have identified through due diligence, it did not take much additional time for BMW to eventually still acquire the Rolls-Royce Motors business, and for substantially less than what it had originally offered. 5 So what did Volkswagen and/or their legal counsel and other advisors miss? It would appear probably a few things - but the most damaging element was that Rolls-Royce Motors did not own its own name ("Rolls-Royce") or its distinctive "RR" logo. Those elements of its business were being used under a license from Rolls-Royce, plc. a totally separate LSE-listed public company focused on aviation and aerospace businesses 6 and Volkswagen did nothing to specifically preserve or renew the license on closing. The Volkswagen acquisition resulted in the historical license being terminated in accordance with its terms based on a change of control provision (i.e. a change of control was deemed to be an assignment of the contract and no assignments of the license were permitted without the prior written consent of the licensor). Shortly afterwards, BMW, who also had various joint aerospace businesses with Rolls-Royce, plc, secured a new license for the name and logo for use with automobiles for 40 million. BMW quickly used this as leverage against Volkswagen along with another significant item that ought to have been uncovered and carefully considered in due diligence. BMW's exclusive engine supply arrangements could be unilaterally terminated by BMW on 12 month's notice, which it relied 5 "BMW Wrests Rolls-Royce Name Away from VW" by Tom Buerkle, New York Times, July 29, 1998, http://www.nytimes.com/1998/07/29/news/29iht-rolls.t.html. 6 The auto business came first with the original company founded in 1906 as "Rolls-Royce Limited". Aircraft engineering was initiated with the outbreak of World War I. In 1971, the company was bankrupted based on the development of the RB211 jet engine for Lockheed. The British government stepped in and nationalized the business as "Rolls-Royce (1971) Limited". In 1973, the government spun out (or in the language of the day "de-merged") and sold the auto business as "Rolls Royce Motors", which transaction would have included some licensing of the "Rolls-Royce" name and logo. The remaining aviation/aerospace company was privatized in 1987. See "Rolls-Royce Limited", online: Wikipedia http://en.wikipedia.org/wiki/rolls-royce_limited (last modified: 4 March 2015) 4