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Aabø-Evensen & CoAli Budiardjo, Nugroho, ReksodiputroAngola Capital PartnersAnjarwalla & KhannaAshurst LLPBär & Karrer AGBentsi-Enchill, Letsa & AnkomahBritish Private Equity & Venture Capital AssociationChiomenti Studio LegaleClifford ChanceElvinger, Hoss & PrussenGarriguesGoltsblat BLPGreenberg Traurig, LLPHajji & Associés

Houthoff BurumaMilbank, Tweed, Hadley & McCloy LLPMorais Leitão, Galvão Teles, Soares da Silva & AssociadosSchindler Rechtsanwälte GmbHSchulte Roth & Zabel LLPShearman & Sterling LLPSimont BraunSkadden, Arps, Slate, Meagher & Flom (UK) LLPȚuca Zbârcea & AsociațiiVeirano AdvogadosVieira de Almeida & Associados, Sociedade de Advogados, RLZhong Lun Law Firm

The International Comparative Legal Guide to:

A practical cross-border insight into private equity

1st Edition

Private Equity 2015

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General Chapters:

The International Comparative Legal Guide to: Private Equity 2015

Country Question and Answer Chapters:

1 Vendor Due Diligence Reports: A Tale of Two Markets – Jeremy W. Dickens, Shearman & Sterling LLP 1

2 Enforcing Investors’ Rights in Latin America: The Basics – Emilio J. Alvarez-Farré & Juan Delgado, Greenberg Traurig, LLP 7

3 Unitranche Facilities – A Real Debt Funding Alternative for Private Equity – Paul Stewart & Ewen Scott, Ashurst LLP 12

4 The Development of EU Regulation since the Financial Crisis and the Future of the Capital Markets Union – Simon Burns, British Private Equity & Venture Capital Association 16

5 Angola Vieira de Almeida & Associados – Sociedade de Advogados, R.L. and Angola Capital Partners: Hugo Moredo Santos & Rui Madeira 20

6 Austria Schindler Rechtsanwälte GmbH: Florian Philipp Cvak & Clemens Philipp Schindler 26

7 Belgium Simont Braun: David Ryckaert & Koen Van Cauter 33

8 Brazil Veirano Advogados: Ricardo C. Veirano & Gustavo Moraes Stolagli 41

9 China Zhong Lun Law Firm: Lefan Gong & David Xu (Xu Shiduo) 47

10 Germany Milbank, Tweed, Hadley & McCloy LLP: Dr. Peter Memminger 55

11 Ghana Bentsi-Enchill, Letsa & Ankomah: Seth Asante & Frank Nimako Akowuah 61

12 Indonesia Ali Budiardjo, Nugroho, Reksodiputro: Oene J. Marseille & Emir Nurmansyah 68

13 Italy Chiomenti Studio Legale: Franco Agopyan 75

14 Kenya Anjarwalla & Khanna: Roddy McKean & Dominic Rebelo 83

15 Luxembourg Elvinger, Hoss & Prussen: Toinon Hoss & Jean-Luc Fisch 89

16 Morocco Hajji & Associés: Amin Hajji & Houda Boudlali 97

17 Netherlands Houthoff Buruma: Alexander J. Kaarls & Johan Kasper 102

18 Norway Aabø-Evensen & Co: Ole Kristian Aabø-Evensen & Harald Blaauw 110

19 Poland Clifford Chance: Marcin Bartnicki & Wojciech Polz 129

20 Portugal Morais Leitão, Galvão Teles, Soares da Silva & Associados: Ricardo Andrade Amaro & Pedro Capitão Barbosa 137

21 Romania Țuca Zbârcea & Asociații: Ștefan Damian & Silvana Ivan 143

22 Russia Goltsblat BLP: Anton Sitnikov & Vera Gorbacheva 150

23 Spain Garrigues: María Fernández-Picazo & Ferran Escayola 158

24 Switzerland Bär & Karrer AG: Dr. Christoph Neeracher & Dr. Luca Jagmetti 165

25 United Kingdom Skadden, Arps, Slate, Meagher & Flom (UK) LLP: Shaun Lascelles 171

26 USA Schulte Roth & Zabel LLP: Peter Jonathan Halasz & Richard A. Presutti 179

Contributing EditorShaun Lascelles, Skadden, Arps, Slate, Meagher & Flom (UK) LLP

Head of Business DevelopmentDror Levy

Sales DirectorFlorjan Osmani

Commercial DirectorAntony Dine

Account DirectorsOliver Smith, Rory Smith

Senior Account ManagerMaria Lopez

Sales Support ManagerToni Hayward

EditorRachel Williams

Senior EditorSuzie Levy

Group Consulting EditorAlan Falach

Group PublisherRichard Firth

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DisclaimerThis publication is for general information purposes only. It does not purport to provide comprehensive full legal or other advice.Global Legal Group Ltd. and the contributors accept no responsibility for losses that may arise from reliance upon information contained in this publication.This publication is intended to give an indication of legal issues upon which you may need advice. Full legal advice should be taken from a qualified professional when dealing with specific situations.

EDITORIAL

Welcome to the first edition of The International Comparative Legal Guide to: Private Equity.This guide provides the international practitioner and in-house counsel with a comprehensive worldwide legal analysis of the laws and regulations of private equity.It is divided into two main sections: Four general chapters. These are designed to provide readers with a comprehensive overview of key private equity issues, particularly from the perspective of a multi-jurisdictional transaction.Country question and answer chapters. These provide a broad overview of common issues in private equity laws and regulations in 22 jurisdictions.All chapters are written by leading private equity lawyers and industry specialists and we are extremely grateful for their excellent contributions.Special thanks are reserved for the contributing editor, Shaun Lascelles of Skadden, Arps, Slate, Meagher & Flom (UK) LLP, for his invaluable assistance.Global Legal Group hopes that you find this guide practical and interesting.The International Comparative Legal Guide series is also available online at www.iclg.co.uk.

Alan Falach LL.M. Group Consulting Editor Global Legal Group [email protected]

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Chapter 1

Shearman & Sterling LLP Jeremy W. Dickens

Vendor Due Diligence Reports: A Tale of Two Markets

legal requirements related to shareholder approval of mergers and consolidations or the sale of all or substantially all the assets, class voting rights, or the availability of appraisal (sometimes called dissenters’) rights;

■ material contracts affecting the sales process itself, such as those under which shareholders or other investors may have contractual (as distinct from legal) approval or other rights, such as drag-along or tag-along rights, rights of first offer or first refusal, specific board approval rights or supermajority consents, etc. Other types of contracts that one might consider relevant to the sales process are those related to executive compensation plans, such as equity plans, employment agreements, retention agreements, severance plans, etc., all of which must be evaluated and taken into consideration as part of the overall economics of the transaction to the buyer. Similarly, the target’s existing financing arrangements5 may have an impact on the sales process (for example, many financing arrangements require repayment with specified premiums upon a change of control; in other cases, there may be financing arrangements a buyer considers unfavourable that cannot be prepaid and which, therefore, may require negotiations with lenders and the payment of make-whole amounts);

■ material contracts related to the target’s business, such as those with key customers or suppliers, or licensors or licensees, or franchisors or franchisees, lessors or lessees, etc. Each type of company will have its own set of material contracts;

■ intellectual property, including not only the status of patent applications (pending, provisional, or issued) or the registration of trademarks, but also the existence of confidentiality or work-for-hire agreements intended to safeguard trade secrets or otherwise ensure the validity of the target’s claim to key IP assets;

■ pending and threatened litigation, which may run the gamut from employment practice-related claims, to infringement of intellectual property, to commercial and product liability claims, to shareholder or securities fraud lawsuits, or governmental investigations (formal or informal) or actual cases brought by governmental authorities related to antitrust matters, alleged violations of the Foreign Corrupt Practices Act or many other types of alleged violations of law (including cases that may raise criminal liability as well as civil liability).6 Litigation diligence also covers both cases where the target is or may be a defendant, as well as those cases where the target is a plaintiff; and

■ pensions-related matters, such as the funding status of plans governed by ERISA,7 potential claims by the PBGC,8 and labour-related matters, such as the status of collective bargaining agreements or union organising efforts or cases proceeding before the United States National Labor Relations Board.

Introduction

Over the past 20 years or so, a peculiar (at least in the author’s opinion) difference has grown between the European and American manner of conducting auction sales processes for private equity transactions.1 In the European style of practice, the development of which first began in England, it is routinely the case that before a seller (the vendor, in European parlance) commences a formal sales process, it commissions legal, accounting and often other advisors to prepare comprehensive due diligence reports related to the target business. Those “vendor due diligence reports” (or VDDRs) are not only made available to prospective purchasers of the target, but the experts who prepare them are expected to, and customarily do, permit the successful bidder to rely on those reports as though prepared for them in the first instance. In the United States, sellers only occasionally ask their advisors to prepare VDDRs and more rarely are those reports made to successful bidders on a “reliance” basis.This article evaluates the difference in market practice and concludes twofold: (i) there is no compelling reason for the difference; and (ii) participants in U.S.-based private equity transactions would benefit materially if American practitioners were to adopt the European model.

What is Vendor Due Diligence?

As it sounds, vendor due diligence is the process by which a private company contemplating a sales process commissions lawyers, accountants and other relevant experts to prepare comprehensive reports addressing those legal, accounting2 and other substantive topics3 almost any buyer would otherwise investigate for itself in deciding whether to bid for a particular business.4

Legal due diligence (which is the central area of focus for this article) typically addresses key areas such as the following:■ general corporate matters, such as the due organisation, valid

existence and capitalisation of the target, as well as formal legal requirements related to the proposed sale transaction. Relevant areas of interest range from the mundane, such as confirmation that the target company and its subsidiaries in fact legally exist under the laws of their jurisdictions of organisation and possess legal authority to conduct business in other jurisdictions in which they operate, to the important, such as confirmation of the capitalisation and ownership of the target and its subsidiaries, including the existence of any rights, such as options or warrants or other securities, giving third parties the ability to acquire an ownership interest in the target and/or its subsidiaries, to the critical, such as formal

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■ In a similar vein, it is not uncommon for seller’s to host group meetings with management and/or advisors to deliver presentations about the business and the contents of the VDDRs. While it may be slightly inconvenient for bidders to participate in these group briefings, particularly those hosted by phone where there may be limited or no ability to ask questions, each bidder at least knows that the playing field remains level.

■ Finally, having been afforded the opportunity to participate in a thoughtful, well-organised and fair diligence process, the bidder may acquire sufficient comfort with its understanding of the business to be encouraged to put forward its best offer for the target company relatively secure in the knowledge that the disclosure schedules to the definitive purchase agreement are unlikely to contain surprises.

Downside to Vendor Due Diligence

There are, of course, potential negatives inherent in vendor due diligence.12 For example, from the seller’s perspective, potential disadvantages largely consist of (i) increased upfront time and associated (and potentially significant) cost involved in having outside advisors prepare the VDDRs, (ii) the prospect that the items disclosed will affect negatively the sales price, (iii) potential concerns, in the case of disclosures about pending or threatened litigation and/or governmental investigations and proceedings, of waivers of attorney-client privilege, (iv) the prospect that notwithstanding the seller’s best efforts, it will still be forced to respond to multiple, conflicting and time-consuming requests for follow up diligence and meetings, and (v) the risk that there will not be any tangible benefit to it in terms of an increased sales price and/or more favourable indemnification terms than it would otherwise have achieved had it simply left each bidder to its own device in carrying out diligence.In the author’s view, none of the potential negatives to the seller are sufficiently onerous as to tip the scale in favour of opting for the traditional approach. Time invested by sellers up front often substantially limits the time required from launch to completion of a sales process. The cost of VDDRs is something that a seller can require the successful bidder to share in as part of the transaction. Worries that disclosure may affect the sales price is a red herring – in the author’s view, if an item of disclosure is so material as to have an actual (or perceived) effect on the sales price, it is precisely the sort of information the seller should (indeed, one might argue, must) disclose to the bidder.13 Concerns about losing the benefits of attorney-client privilege in the context of litigation-related disclosure is another red herring. Whether the vendor sponsors the due diligence process or bidders are left to fend for themselves, the seller’s general counsel and, frequently, external counsel handling material litigation or governmental investigations or proceedings, will invariably be called upon to brief bidders and their counsel about those matters. Custom and practice in avoiding disclosure that jeopardises the attorney-client privilege is well-developed and the process of vendor due diligence should have no bearing on how this disclosure is handled. The risk of the due diligence process running amok, notwithstanding the seller’s attempt to control it, seems to be one well within the seller’s ability to control (and if the issues are such that the seller cannot control the process, it suggests those issues have considerable substance to them). Finally, as to whether or not vendor due diligence will provide the hoped-for benefit of an improved sales price and/or more favourable indemnification provisions, the author leaves it to economists and others to study the issue and reach an objective conclusion. However, given the widely accepted wisdom of the efficient market hypothesis as applied to publicly listed companies, it is not much of a leap to hypothesise that

As should be obvious from the foregoing list and the related endnotes, the categories of information covered by legal due diligence are well understood, but the specific due diligence for individual companies is likely to vary widely from one company to the next depending on its industry and its unique concerns.

How did the Practice of Vendor Due Diligence Come About?

At the risk of being facetious, it seems likely that the concept of vendor due diligence arose out of a conversation among exhausted executives at a private equity firm complaining about various sales processes they had endured recently and inefficiencies such as:■ repetitive and seemingly endless management presentations

to prospective buyers;9

■ significant time and effort spent responding to multiple due diligence request lists and follow-up questions from sponsors and their financing sources;

■ time “wasted” coming up to speed with and crafting solutions to specific problems – typically (and a little embarrassingly) identified by one or more bidders during diligence – that, in hindsight, could have been addressed up-front had the seller and sponsor focused on them;

■ suspicion that they might have negotiated more favourable indemnity provisions (i.e., higher baskets/deductibles, lower caps, shorter duration) or, potentially, a more favourable purchase price, had they better controlled the diligence process;10 and

■ suspicion that a more efficient sales process presents the opportunity to better control the legal and other advisory costs associated with the transaction.

The benefits of vendor due diligence to the seller seem self-evident. There are also corresponding benefits to a prospective buyer. For example:■ A properly prepared VDDR provides bidders with a

“road map” to likely issues of material interest to them.11 Therefore, bidders are more able to assess rapidly whether there are “red flags” that either are “deal breakers” or simply issues for which the buyer will require specific accommodation (whether via the purchase price, specific structuring solutions, indemnity, or a combination). The ability to make a quick “go-no go” decision obviously reduces costs to those parties electing to withdraw from a sales process. The seller, of course, obtains a corresponding benefit to the extent that it has been able to determine more accurately and more quickly which bidders are likely to be the most serious in their interest in the target. Moreover, having received VDDRs in advance, it may be more difficult for a bidder to submit a high bid simply to obtain exclusivity with the objective of using a later due diligence process as a means of negotiating a lower ultimate price.

■ The VDDR enables bidders to direct their advisors more effectively in terms of prioritising the issues of most concern to them. A targeted approach to diligence should enable bidders to better control their own costs because their advisors are able to engage in “confirmatory” rather than “comprehensive” diligence.

■ In many vendor-controlled diligence processes, the bidders submit follow up questions in writing and, in some cases, are subject to limits on the number of those questions. The seller then catalogues the follow up questions and prepares a single response shared with all bidders. From the bidder’s perspective, there is comfort obtained from knowing that there is a level playing field among the parties when it comes to developing an understanding of the target business.

Shearman & Sterling LLP Vendor Due Diligence Reports


letter, subject to a number of important disclaimers and limitations with respect to the report; (4) specific acknowledgments by the recipient, such as its agreement to the terms of the reliance letter and its understanding that the provider makes no representations or warranties as to the sufficiency or appropriateness of the information in the report for the purposes for which the recipient intends to use it; (5) confidentiality undertakings of the recipient with respect to the report; (6) a cap on the liability of the provider to the recipient, which (to the extent permitted by law) is only available in the case of the provider’s gross negligence, recklessness, or fraud;17 and (7) the governing law and the forum in which any disputes related to the report will be heard.18

Why Hasn’t Vendor Due Diligence Caught on in the United States?

The author frankly admits to being stumped by the question just posed. There is no adequate explanation. Vendor due diligence offers sellers the same advantages, and delivers buyers the same head-start in understanding a target’s business, regardless of whether the transaction is European or American. There is no greater reason to discount the reliability of VDDRs because they are prepared by the seller’s U.S. law firm (or the U.S. office of an international law firm) than there is to discount the reliability of reports prepared by an English law firm or the London office of an U.S.-based international law firm. Moreover, U.S. law firms routinely deliver legal opinions to third parties when requested to do so by their clients (e.g., opinions delivered by a borrower’s counsel to lenders in a senior debt transaction, or opinions delivered by an issuer’s counsel to underwriters and/or initial purchasers in capital markets transactions). Indeed, it is quite common for U.S. law firms representing buyers in acquisition transactions to share their due diligence memoranda (most often, but not only, on a non-reliance basis) with prospective co-investors, other financing sources and even providers of “rep and warranty” insurance.The only substantive reason that the author has seen offered to explain the absence of vendor due diligence in American transactions is that: “[E]thics rules applicable to lawyers in the United States

disallow them from capping or otherwise limiting the amount of their liability for malpractice. A U.S. law firm that contractually permitted a buyer to rely on its due diligence report therefore would be liable, without any limitation, for any losses incurred by the buyer that result from mistakes or omissions contained in its report.”19

Unfortunately, the prohibition on lawyers limiting their liability for malpractice is not as absolute as the commentator, quoted above, suggests. For example, Rule 1.8(h)(1) of the New York Rules of Professional Conduct states that “[a] lawyer shall not … make an agreement prospectively limiting the lawyer’s liability to a client for malpractice” (emphasis added).20 By its terms, Rule 1.8(h) only prohibits liability caps if (1) they are entered into prospectively, and (2) with a client.21 Accordingly, there is no ethical prohibition on a law firm asking a non-client to agree to a cap on the law firm’s liability for malpractice.22 There is likewise no ethical rule that prohibits a law firm from permitting a third party from relying on its due diligence report. Indeed, Rule 2.3(a) of the New York Rules of Professional Conduct specifically provides “[a] lawyer may provide an evaluation of a matter affecting a client for the use of someone other than the client if the lawyer reasonably believes that making the evaluation is compatible with other aspects of the lawyer’s relationship with the client”. Moreover, Rule 2.3(b) provides that, with the client’s informed consent, “a lawyer may provide the evaluation to a third

the more a bidder knows about the company, the more the price paid and terms offered will reflect that information. Put another way, the less a bidder knows (or fears that it does not know) about a company, the more likely it will be to discount its purchase price or otherwise seek to shift the consequences of unknown risks to the seller.14

From a bidder’s perspective, there seems to be little reason to reject VDDRs out of hand. It may be the case that a bidder is unfamiliar with the vendor’s advisors, and therefore may place less inherent trust in the quality of their work than had those reports been by its own advisors. It may also be the case that a particular bidder has a different view as to materiality from that taken by the advisor preparing the VDDR or prefers a different reporting format from that used in the VDDR. However, those sorts of objections are not particularly compelling. Indeed, so long as a seller works with reputable advisors with experience in private equity transactions, it seems unlikely there is much actual risk that a VDDR would be so shoddy, or so flawed in the materiality judgments it makes, or presented in such a confusing format, as to make the report of no or little value to a bidder. In the author’s experience, most bidders will be content to have their own advisors conduct confirmatory diligence of the matters covered in the VDDRs, at least unless and until they discover a substantive problem with those reports.15

European Vendor Due Diligence in Practice

Over the past 20 years or so, European market practice has evolved to the point where VDDR is a routine and expected part of the private equity sales process. At the outset, the vendor, as it begins to prepare for the sales process, engages accounting, legal and other relevant advisors to prepare draft VDDRs. Those draft reports are made available to prospective bidders on a “non-reliance” basis. At the conclusion of the sales process, when the successful bidder enters into a definitive purchase agreement for the target, the various advisors deliver their definitive VDDRs to the buyer subject to the terms of a “reliance” letter, which often contains a cap on the advisor’s liability16 to the recipient for any deficiencies in the report other than those arising out the preparer’s gross negligence, recklessness or fraud.A non-reliance letter, in the context of a legal due diligence report, serves primarily to record the recipient’s acknowledgment that delivery of the report does not establish an attorney-client relationship between the law firm and the recipient of the report. It also contains disclaimers – largely self-evident – to the effect that the preparing firm has not consulted with the recipient in connection with defining the scope of the report and, as a result, it is possible that the recipient may have different interests and views of materiality from those expressed by the preparer of the report. Finally, the non-reliance letter contains a waiver and release by the recipient of any and all claims it may have against the preparing firm with respect to the report. Although different law firms use different language in their non-reliance letters, the gist of the letter is the same – the recipient uses the report at its own risk and the provider takes no responsibility for its contents and disclaims any responsibility to update the report.The reliance letter, however, is a more substantive document and its tone and content is very much like that of a legal opinion letter, taking great pains to tell the recipient what it is within the scope of the opinion letter and to spell out any limitations and qualifications applicable to the covered matters. The typical reliance letter covers: (1) a careful definition of the “Report” being delivered; (2) a description of the scope of work encompassed by the report and a disclaimer of liability or responsibility for any matters outside the scope of the report; (3) consent to the recipient’s review and reliance upon the report solely for the purpose specified in the reliance



arrangements may be treated as capital leases, while others may be operating leases). Off balance sheet financings and contingent liabilities are also likely fall into the category of contracts relevant to the sales process.

6. Different industries have their own specific regulatory profiles. For example, both the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency oversee national banking associations. In certain circumstances, the Federal Deposit Insurance Corporation may also be a relevant regulatory body. A state chartered bank may be overseen by both a state banking department and the Federal Reserve. Insurance holding companies may be subject to regulation in a variety of states. Pharmaceutical companies are subject to the jurisdiction of the Federal Drug Administration, as are manufacturers of medical devices. The list of potential regulatory concerns for various industries is, unfortunately, endless.

7. The United States Employee Retirement Income Security Act of 1974, as amended.

8. The United States Pension Benefit Guaranty Corporation.9. The benefits of a focused sales process that minimises the

demands on management time cannot be underestimated. In the author’s experience, it is not uncommon for business performance to lag during the sales process because management becomes distracted. This is certainly the case when critical operating executives are essential presenters during management meetings. The less time management spends on these meetings, the more time it has to focus on running the business.

10. By this observation, the author refers to the negative consequences to transactions when a buyer discovers a material issue during diligence that had not been flagged previously by the seller. When this happens, the most favourable inference drawn by a buyer is that the seller is sloppy and does not have its arms fully around its own business; the worst interpretation is that the seller is dissembling. In either case, the buyer tends to lose confidence in the seller and fears that there may be other undisclosed and undiscovered significant issues. Any buyer worried about the integrity of the due diligence process is likely to seek more protective indemnification terms than it might otherwise had the due diligence process been managed better by the seller.

11. While particular bidders may have concerns about issues of unique interest to them given their individual circumstances (which therefore are issues that a seller may not necessarily be able to anticipate), it is almost certainly the case that if the vendor and its advisors highlight a due diligence issue as being material from their perspective, it will be an issue worthy of study and understanding by all bidders.

12. In the case of European transactions, the potential negatives of vendor due diligence were long ago evaluated and discounted. There seems no prospect that market practice will revert to the older model. Market participants have become used to the process. In the United States, however, market practice has moved only glacially toward vendor due diligence, which suggests to the author that there is still a debate as to the merits of the process.

13. A seller that affirmatively decides not to disclose materially negative information to a bidder, or that hopes to bury the disclosure amid an avalanche of other information to obscure its significance, risks post-closing litigation, potentially for fraud, breach of contract, or negligent misrepresentation. In the case of the seller that simply takes the view that it will populate a data room and leave it to the buyer to discover items of significance, it risks losing credibility in the eyes of the buyer, which in turn is likely to motivate the buyer to take a more hard-line position in negotiating the acquisition agreement than it might if it had a more positive view of the seller’s integrity.

party even if the lawyer knows or reasonably should know that the evaluation is likely to affect the client’s interests materially and adversely”. In short, there is nothing in the New York Rules of Professional Conduct that explain why vendor due diligence has not been adopted more widely in the United States.

Conclusion

In the author’s view, there is no principled reason why vendor due diligence should not be the norm of practice in the United States as well as in Europe. There is much to recommend the practice and very little to say against it. At best, the arguments against it are parochial and lazy. That said, until one or more significant private equity firms decide to adopt vendor due diligence as a core part of their process when selling their portfolio companies, there is very little practical incentive for the U.S. market to change. The only thing that prevents vendor due diligence from being used more in the U.S. is the indifference of sellers, a strange state of affairs given that many private equity firms also operate overseas and use the practice extensively and routinely when selling their non-US portfolio companies.

Endnotes

1. This article considers only sales processes affecting non-listed companies (that is, companies that do not have a class of securities, whether equity, debt or hybrid, as to which the company has an obligation to file periodic, publicly available reports with the United States Securities and Exchange Commission, comparable authorities in other jurisdictions or foreign securities exchanges exercising similar supervisory functions). Sales processes in “take private” transactions have separate considerations and practitioners conduct them pursuant to the requirements of specific regulatory and market practices.

2. The specifics of accounting due diligence are outside the scope of this article. Speaking from practical experience, however, relevant areas of accounting due diligence are likely to include the quality of earnings, the cash-generating capabilities of the company, and material risk areas such as inventory accruals, bad debt experience, litigation and other reserves, such as for product warranty claims or similar contingent liabilities, as well as those accounting areas most subject to significant estimates and judgments.

3. Examples include environmental, actuarial, engineering and/or other technical areas relevant to the target company’s business. Tax due diligence is generally not reflected in vendor due diligence because tax optimisation strategies are generally driven by the particular needs of each prospective purchaser. For example, a private equity sponsor may consider preserving the net operating losses or other tax assets of the target to be critical to achieving its targeted investment returns, yet a strategic buyer may put very little value on those assets.

4. The author is a U.S. lawyer with only a passing familiarity with the terminology and requirements of the laws of other jurisdictions. For the sake of simplicity, then, this article tends to use U.S. terminology and legal concepts with the hope that a reader qualified in another jurisdiction will accept his apologies and identify the appropriate analogies for themselves.

5. By the term “financing arrangements”, the author intends to encompass not only traditional bank financing arrangements but also debt or preferred securities, sale-leaseback arrangements, equipment leases and other types of similar arrangements, whether or not accounted for on a balance sheet as a liability (e.g., some material lease



industry were likely to be comfortable with the approach taken in the Memorandum of Understanding. The lesson to be drawn – and which, in fact, was drawn by the English legal profession – is that third parties who receive VDDRs will agree to reasonable liability caps.

17. One reliance letter prepared by an English law firm and reviewed by the author required the recipient to agree “that any legal or other proceedings in respect of the Report must be formally commenced and relevant originating application, writ or other process served on [the preparing law firm] within two years from the date of the Report”. Given the informal nature of the author’s survey of precedent transactions, it is likely the case that other law firms require comparable undertakings in their reliance letters.

18. In reviewing internal Shearman & Sterling precedent, the author came across reliance letters governed by New York law as well as letters governed by English law.

19. Lee J. Potter, Jr., “Vendor Due Diligence: Could it Catch on Here” (https://apps.americanbarorg/buslaw/blt/content/2011/07/article-potter.shtml).

20. The author is a member of the New York Bar and therefore has focused on its rules of ethics. While the ethical rules of other states may lead to a different conclusion, the author’s cursory research suggests that is not likely in the context of the specific questions considered.

21. In this regard, it may be important to consider the definition of the “client” for whom the report has been prepared. In the context of a parent’s sale of a subsidiary, a report focused on the subsidiary but issued to the parent and relied on by the buyer clearly would be a report delivered to a non-client. A similar result seems likely in the context of a sale of all or substantially all the target’s assets (i.e., the report is not an asset the target company can transfer to the eventual buyer and, therefore, the buyer is not even arguably a client of the preparing law firm). In the context of a merger transaction, however, where the buyer will acquire the entity for which the report was prepared in the first instance, there may be slightly greater grounds for concern that the buyer and the client become one and the same after the merger. However, even if this were to be the case (something that would be fact specific), any concerns about the validity of the liability cap as a matter of legal ethics could be addressed by having the report commissioned by the private equity house rather than the actual target company. It would be a strange result, however, if the form of the transaction drove the analysis of the ethical propriety of a liability cap. Moreover, Rule 1.8(h) of the New York Rules of Professional Conduct only prohibits prospective waivers of liability for malpractice. In the context of a merger, one might argue that the waiver was not made prospectively, it was made after the buyer had the opportunity, with the assistance of independent counsel, to review the due diligence report and consider whether the liability cap was reasonable under those known circumstances.

22. See “Contractual Limitations of Liability to Clients and Others”, Committee on Professional Responsibility of the American Bar Association (http://apps.americanbarorg/buslaw/newsletter/0065/materials/pp8.pdf); see also “Working Group on Legal Opinions, Fall 2007 Seminar Series” (http://apps.americanbarorg/buslaw/newsletter/0067/materials/pp.6.pdf) (“Rule 1.8(h) is applicable to agreements with clients, but doesn’t seem to apply to those with non-clients”).

NoteThe views expressed in this article are solely those of Mr. Dickens and not of Shearman & Sterling LLP.

14. VDDRs tend to be either (i) “long form” reports that summarise and analyse the contents of a (now almost always electronic, or virtual) data room established by the target, or (ii) “exceptions” reports that focus on only the most significant matters. In both cases, the reports typically consist of an executive summary and a more detailed report on those matters within the described scope of the report.

15. In discussing VDDRs with various colleagues, the author has heard concerns expressed about the wisdom of clients who are prospective purchasers relying on reports commissioned and paid for by the seller. While VDDRs may not contain the same recommendations and “colour commentary” that a bidder might receive from its own advisors, it is hardly likely that a well-regarded advisor working for a seller would jeopardise its professional standing (and risk a lawsuit, more on which later) by intentionally misleading (by misstatement or omission) bidders about known due diligence issues. Certainly it is possible that the seller may keep its advisors in the dark about worrisome issues and therefore a VDDR may not contain all the information a bidder considers important. However, if a seller were willing to keep relevant facts away from its advisors, surely it would keep those same facts from a bidder’s advisors engaged in comprehensive diligence. Finally, even if a VDDR does lack the same gloss a bidder’s own advisors would provide, so what? Having received the VDDR, the bidder’s advisors will have ample opportunity to take a view on the report and to discuss with its client the identified risks and possible solutions.

16. In February 1998, the British Private Equity & Venture Capital Association (the “BVCA”) and the-then Big 6 Accounting Firms entered into a Memorandum of Understanding with respect to limitation of liability provisions in due diligence engagement terms applicable to private equity transactions. Although not legally binding, the Big 6 and the BVCA agreed that:■ in smaller transactions (those having a transaction value

of less than £10 million), the accountant’s liability will be capped at the transaction value;

■ in mid-market transactions (those having a transaction value between £10 million and £55 million), the accountant’s liability will be equal to £10 million plus one-third of the amount by which the transaction value exceeds £10 million subject to a maximum of £25 million; and

■ in larger transactions (those having a transaction value greater than £55 million), the amount of liability generally will be limited to £25 million although, in exceptional circumstances unrelated to the size of the transaction, an amount either less than or in excess of £25 million may be agreed.

Further, the BVCA and the Big 6 agreed that in the case of larger transactions (but not otherwise), accounting engagement letters could contain “proportionality” wording to address the principle under English law that says when two or more advisors could be jointly liable to a third party, and that party has agreed a cap on liability of one of those advisors, the right of the uncapped advisor to seek contribution from the capped advisor is limited to the amount the third party could claim against its capped advisor. Proportionality therefore could result in a greater claim against an uncapped advisor than against a capped advisor.

The BVCA publication of its report with respect to the Memorandum of Understanding is instructive in two other respects: (i) first, the BVCA consulted in advance with its member firms, which, the report stated, it broadly expected would adhere to the terms of the Memorandum of Understanding; and (ii) second, the BVCA consulted with representatives of senior lenders and mezzanine providers who, after discussion, indicated that their constituents in the banking



Jeremy W. DickensShearman & Sterling LLP599 Lexington AvenueNew York NY 10022-6069USA

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As one of the first law firms to establish a presence in key international markets, Shearman & Sterling has led the way in serving clients wherever they do business. This innovative spirit and the experience the firm has developed for more than 140 years make it the “go-to” law firm for seamless service. From major financial centres to emerging markets, the firm has the reach, depth and global perspective necessary to advise clients on their most complex worldwide business needs.

Jeremy Dickens is co-head of the firm’s Private Equity Group. Mr. Dickens has a broad background as a lawyer, having spent 18 years with another leading international law firm where he was a member of the private equity practice and co-founder and co-head of its Global Capital Markets practice. In addition, he spent nearly six years as a corporate executive, entrepreneur and board member before joining the firm in 2013. He is an experienced private equity, leveraged finance, IPO and restructuring attorney and has advised boards of directors on a variety of complex matters including corporate governance, M&A, restructurings, shareholder litigation and governmental and internal investigations.


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