There is often confusion between the functions of “diligence” and “disclosure” in a mergers and acquisitions transaction. Diligence and disclosure have a lot of conceptual and substantive crossover, but serve very different roles in a transaction, and both deserve the full attention of parties and counsel. In fact, disclosure (on the behalf of a seller), and understanding the seller’s disclosures (on the behalf of a buyer) are arguably one of the most important parts of any M&A transaction.
Diligence
Diligence often started prior to a Letter of Intent, and then continues throughout the transaction in some form or fashion. By definition, “Diligence” is the process by which the party on the buy side of a M&A transaction investigates the assets, liabilities, and other circumstances of the target company. The goal is to give stakeholders on the buy-side the comfort of understanding the assets or equities that they are purchasing, as well as the attendant risks; to justify the expense of carrying out the transaction. In this process, the buyer will typically rely on information provided by the seller, and often hires advisors to help the buyer evaluate that information.
There is no required set or formal process for due diligence, and it is typically administered by the parties as a cooperative effort. Sometimes aspects of the diligence process may be governed by a letter of intent or confidentiality agreement, but by large it is a process that is voluntary and non-contractual. This means that no party is obligated to participate and neither party has any liabilities resulting from the omission or commission of the diligence process. The diligence process can take weeks or months, depending on the size and complexity of the transaction and the level of organization of the parties.
So, does this mean that the seller can skip the process or send the buyer a bunch of nonsense? Not quite. Even though it’s voluntary and non-contractual, the buyer’s role in the transaction is also voluntary. Therefore, if the seller isn’t willing to provide the buyer with the information needed to evaluate the company, the buyer is probably going to walk away from the deal. False or misleading information is also not going to work out well. That’s because the information supplied in diligence is going to be incorporated into the transaction documents, such that the seller will ultimately be legally responsible for the accuracy and completeness of that information should the transaction close.
Disclosure
This is where the second of the seller’s tasks comes in – the disclosure schedules. The vast majority of the disclosure schedules are a product of the representations and warranties section in any purchase agreement (more to come on this concept later in this paragraph). Disclosure schedules are a legal tool through which the purchase agreement reference the information supplied in diligence (things like contracts, financial statements, customer lists, insurance, potential litigation, and other important documents and information of the company) and make them an official part of the purchase agreement. The information needed for the disclosure schedules usually crosses over significantly with the items provided in diligence. So, part of the additional work here is organizing the documents supplied in diligence in a manner that corresponds with the provisions of the purchase agreement that require disclosure schedules. The legal hook here is that when the purchase agreement references items in the disclosure schedules, the seller represents that the information contained in the disclosure schedules is true and correct, and those warranties can last months or years after the transaction closes. This is a formal way of saying that the seller is promising that this information is true. Representations are usually accompanied by a warranty, which is a mechanism by which the seller can become liable for damages incurred by the buyer in the event the seller’s representations are not true.
TLDR? In summary, by the time parties get to the closing stage of the transaction, many of the diligence documents will be referenced in the purchase agreement and the seller promises that those documents are accurate, true, and complete, and will be liable if not.
Another very important feature of disclosure schedules is one that can work to the advantage of the seller. Purchase agreements will often contain statements that the seller is representing to be true with an allowance for exceptions that are included in the disclosure schedules. For example, a representation might state, “except as stated in section one of the disclosure schedules, there has been no litigation, pending or threatened, against the company within the past three years.” This clause is an opportunity for the seller to list anything that might appear to be threatened litigation, such as angry customers who said offhand that they were going to call a lawyer. This provides a powerful protection for the seller if anyone was to end up pursuing one of those claims in the future. In turn, since the potential litigation was disclosed in the purchase agreement, the risk will typically shift to the buyer. The buyer may or may not accept the transaction with this risk, but if they do, they do it knowingly and bearing that risk. If the seller fails to disclose, and the seller was aware that the threatened litigation was out there, the seller could be liable for any losses the buyer incurs from that risk.
Bottom line: Serious sellers want to work with serious buyers, and serious buyers are going to want the opportunity to carefully review the fundamentals of the company, and then use the transaction documents to ensure that the information that has been provided is accurate and complete. Review of the diligence documents and incorporation of those documents into the transaction structure are two distinct parts of an M&A transaction that need to be managed with care. Representations and warranties relating to the diligence documents will often last long after the transaction has closed and money has changed hands, so it’s worth it to get these steps right.