Download pdf - Due Diligence - What You Don’t Find Out Will Hurt You

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Due Diligence What You Don’t Find Out Will Hurt You

Presented by: Brian AbrahamMay 17, 2010

http://www.fmc-law.com/People/AbrahamBrian.aspx

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Acknowledgments

• Bill Gilliland, Partner – FMC Calgary

• Sarah Sidhu, Associate – FMC Vancouver

• Pia Webster, Summer Student ‐ FMC Vancouver

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1. What is legal due diligence?

2. How does a business deal focus and guide the due diligence process?

3. The importance of legal due diligence being coordinated with business due diligence.

4. How legal due diligence provides essential information to the business transaction.

Overview

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What is due diligence?

• Due diligence is an important step toward the acquisition of a business – assets, property interests, shares, and/or mixed elements

• It is a process by which clients, lawyers and other advisors tryto learn as much as possible about a target business or property before committing funds to enter into an option; joint venture lease

• Legal due diligence is just one element of due diligence process

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CREATING A DUE DILIGENCE FRAMEWORK

Why due diligence?

• Lawyer’s role in due diligence is to ensure achievement of client objectives

• Why does the client want to acquire the ‘target’property or interest?

• Will the client’s acquisition of target business help them achieve their end objectives?

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Different purposes for due diligence

• Some due diligence is “target” focused, this type of investigation attempts to address the risks and or issues regarding what is being acquired– e.g. existence of underlying agreements,i.e. royalties

• Transactional due diligence addresses the risks and or issues concerned with getting the deal done– e.g. loan agreement requires consent of third parties for transaction, original owner

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Why due diligence?

• According to the B.C. CLE Due Diligence Deskbook, legal due diligence consists of:

1. Document review

2. Regulatory approval

3. Statutory searches

4. Other steps dictated by transaction circumstances

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Why due diligence?

• Time, cost, and transaction constraints are important to consider

• Due diligence expectations and processes should be set out in writing for both counsel and client and should be re‐assessed as new information is learned and evaluated throughout the process

• Regularly scheduled meetings for updating purposes

• The creation of a due diligence framework, frequent status reporting and a simple easy to update format can help make the process go more smoothly

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Legal Due Diligence ChecklistBasic Corporate Documents

Searches

Property Records

Securities Regulation and Issuances

Shareholder Information

Material Contracts

Underlying Contracts

Financial Information

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Legal Due Diligence Checklist

Employee Compensation/Benefits Plans

Patent, Trademark and Copyright Matters

Proprietary Information

Tangible Property

Litigation and Audits

Environmental

Management

Local Customs and Practices

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Basic Corporate Documents• Bylaws, including all amendments.• Articles of Incorporation, including all amendments.• Minutes of all meetings of directors, committees of directors and

shareholders, including copies of any written notices (if given) or waivers thereof and any written consent to action without a meeting within the past five years.

• List of all provinces, states and countries where property is owned or leased or where employees are located, indicating in which provinces, states and countries the Company is qualified to do business.

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Basic Corporate Documents• Copies of any voting trust, shareholder or other similar agreement

covering any portion of the Company’s shares.• Copies of all agreements relating to repurchases, redemptions,

exchanges, conversions or similar transactions.• Copies of all agreements containing registration rights or assigning

such rights.• Copies of all agreements containing pre‐emptive rights or assigning

such rights.• All quarterly and annual reports, proxy materials and any other

communications to the Company’s shareholders within the past five years.

• List of all subsidiaries.

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Searches• Applicable registries/names/jurisdictions• Local advice is critical – even in Canada!• Mining Recorder or equivalent• Land Offices e.g. BLM, County

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Securities Regulation and Issuances• All securities filings, including exhibits, within the past five years.• Agreements relating to sales of securities by the Company including

any private placement memoranda or other offering circulars within the past five years.

• Stock option or purchase plans and forms of option or purchase agreements which have been or may be used.

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Securities Regulation and Issuances• Stock option or purchase plans and forms of option or purchase

agreements which have been or may be used.• All securities permits, registrations, notices of exemption and consents

for issuance or transfer of Company’s securities and evidence of qualification or exemption under other applicable securities laws.

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Shareholder Information• Records setting for all issuances or grants of stock, options and

warrants by the Company, listing the names of the issuees or grantees, the amounts issued or granted, the dates of the issuances or grants, the number of shares presently exercisable (if applicable) and the consideration received (or to be received) by the Company in each case.

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• Material Contracts• Property agreements, areas of interest, consents, royalties, clawback

rights, right to market product• Confidentiality agreements• Strategic alliance agreements• Bank line of credit agreements, including any amendments, renewal

letters, notices, waivers, correspondences, etc.• Other material agreements evidencing outstanding loans to or

guarantees by the Company, including correspondences.• Material contracts with suppliers, manufacturers or customers. Please

indicate which suppliers are sole source.

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• Material Contracts• Agreements for loans to and any other agreements (including

consulting and employment contracts) with officers, directors oremployees, whether or not now outstanding.

• Schedule of all insurance policies in force covering property of the Company and any other insurance policies such as "key person" policies, director indemnification policies or product liability policies.

• Partnership, lease, option or joint venture agreements.• Any other material contracts outstanding.

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Financial Information• All management letters or special reports by auditors and any

responses thereto.• Federal, provincial and foreign returns (together with exhibits and

schedules thereto) filed by the Company. Also, a schedule describing any ongoing tax disputes together with copies of reports, correspondence, etc., relating to pending federal and provincial tax proceedings, assessments, or investigations, etc. with regard to open years or items.

• Copies of any tax agreements relating to the Company or any of its Subsidiaries.

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Financial Information• SEDAR, EDGAR, quarterly, MD &A, AIF’s, Annual Reports, News

Releases• All audited and unaudited financial statements of the Company,

including balance sheets, income statements and statements of changes in financial position.

• Balance sheet with information concerning the tax basis of assets.• Any accounting manuals or memoranda that would be helpful in

reviewing any of the requested documents.• All letters from accountants of the Company regarding the Company’s

control systems, methods of accounting, etc.

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Financial Information• Recent analyses of the Company or its industries prepared by

investment bankers. engineers, management consultants, accountants or others, including marketing studies, credit reports and other types of reports, financial or otherwise. Company projections for future periods.

• Company projections for future periods.• Any special reports by auditors (e.g., as to control procedures).• Letters of counsel in reply to auditors’ letters for the past 5 years.

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Financial Information• List of all fixed assets of the Company and its Subsidiaries together

with depreciation schedule if available.• Bank letters or agreements regarding lines of credit.• All documents and agreements that are evidence of other material

financing arrangements, including sale and lease back arrangements, instalment purchase, securitisation arrangements, etc.

• Correspondence with lenders (including entities committed to lend) including all compliance reports submitted by the Company, its Subsidiaries and its accountants.

• Computations demonstrating compliance with covenants in existingfinancing documents

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Employee Compensation/Benefits Plans• Copies of all domestic and foreign employee benefit plans including

(without limitation):- equity compensation plans and forms of agreements executed pursuant thereto.

- employee stock purchase plans.

- all Board resolutions adopting each equity compensation plan andevidence of shareholders approval, where such approval was obtained, of the equity compensation plans.

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Employee Compensation/Benefits Plans- all pension and deferred compensation plans, including qualifiedpension plans of all entities acquired, even if such plans were frozen or merged into other plans.

- form of promissory note used in connection with plan loans, as well as any other administrative documents related to plan loans.

- form of election completed by participants to request a plan distribution or hardship withdrawal, and any other administrative form used in connection with the plans.

- employment agreements or severance agreements with officers or key personnel.

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Employee Compensation/Benefits Plans- all plans, agreements or arrangements providing benefits contingent upon a change in control.

- list of outstanding equity compensation awards, showing exerciseprice and vesting.

- any material sales compensation plans or arrangements.- fringe benefit and perquisite arrangements.

• List of existing and potential workers’ compensation claims.• Description of any significant labour problems or union activities the

Company has experienced including any collective bargaining agreements.

• Be cautious of foreign jurisdictions.

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Patent, Trademark and Copyright Matters• List of all foreign and domestic patents and patent licenses held by the

Company.• List of any trademarks, trade names or service marks.• List of any copyrights.• Copies of all material agreements for licensing of Company technology

to third parties.• Copies of all material agreements for licensing of technology from

third parties.• Any correspondence from third parties regarding potential

infringement of intellectual property right of others.• Proprietary data.• Any pending patents or trademarks.

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Tangible Property• List of real and material personal property owned by the Company.• Documents of title, mortgages, deeds of trust and security agreements

pertaining to the properties listed in (a) above.• List of any security interests in personal property.• Documentation of significant acquisitions or dispositions of assets.• Claims, concessions, permits, licences, leases (examine terms and

conditions).

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Litigation and Audits• All letters which have been sent to auditors in connection with year

end and current interim audits, including "litigation letters".• Descriptions of (and reasons for) any change in accounting methods in

the past three years.• Active litigation files, including letters asserting claims, complaints,

answers, etc.

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Litigation and Audits• Any material litigation settlement documents.• Any decrees, orders or judgements of courts or governmental

agencies.• Information regarding any material litigation to which the Company is

a party or in which it may become involved.• Property expenditures, write‐offs.

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Environmental• Schedule of all instances in the past in which the Company has

corrected unsafe working conditions.• Schedule of all permits, certificates, registrations or approvals

obtained from any governmental body responsible for environmental or health regulation.

• Any notices of violation or requests for information that have been received or threatened at any time for alleged failure of any facility to comply with applicable environmental laws, permits, certificates, registrations or approval.

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Environmental• Schedule of any environmental problems, conditions or issues known

to the Company concerning the Company’s business or any known violations or potential violations of applicable environmental laws.

• Schedule of any discharges or releases of Hazardous Materials into the environment by the Company.

• Schedule of the location, size and contents of any underground or aboveground storage tanks or PCB transformers owned or used by the Company.

• Description of all hazardous wastes that are disposed of on and off site by the Company and a description of the procedures for disposal of such wastes (including a list of all disposal sites and transporters).

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Environmental• Description and status statement of all completed, pending or

threatened regulatory, judicial or administrative actions relating to the Company.

• Description and status statement of any investigation, remediation, removal or monitoring actions relating to any of the Company’s facilities.

• Environmental assessments, reports or audits performed by the Company or any other party relating to any of the Company’s facilities or operations.

• Schedule of Hazardous Materials management plans, emergency response plans, inventory reports, and other environmental reports, policies and notices required by environmental law to be filed by the Company with any governmental body.

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Management• Founders agreements, management employment agreements,

indemnification agreements, and "golden parachute" agreements, if any.

• Schedule of all compensation paid in the most recent fiscal year to officers, directors and key employees showing separately salary,bonuses and non‐cash compensation (e.g. use of cars, property, etc.).

• Bonus plans, option agreements, retirement plans, pension plans,deferred compensation plans, profit sharing and management incentive agreements.

• Agreements for loans to and any other agreements (including consulting and employment contracts) with officers or directors,whether or not now outstanding.

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Management• Organizational chart.• Extensive, broad scope.• Starting point for planning legal investigation.• Cost limitations.• Effective use of time available.• Legal investigation needs to be focused.

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Local Customs and Practices• Critical on foreign transactions.• Unwritten laws.• Community consultation.• Aboriginal claims.

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Where does Legal Due Diligence get their information?1

• Site visits• Written questionnaires• Data room visits• Disclosure letter• Certificates of title• Commissioning specialist reports• Collection of public information

1Rankine, Denzil. “Chapter 5-Investigating the Target”, Acquisition Essentials: A step-by-step guide to smarter deals, E-Book Accessible through the Carleton University Library website: Harlow, Prentice Hall, 2005, p. 110

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How a does a business deal focus and guide the due diligence process?How is the Transaction structured?

Objectives:• staged due diligence• threshold issues

What should you look at to assess risks?

Value drivers

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How a does a business deal focus and guide the due diligence process?All the members of due diligence team need a basic understanding of the particular transaction structure, risks, value drivers, and objectives.• Plan regular due diligence team meetings, need to know basis• Team

• Management

• Engineering, geology, metallurgy

• Accounting

• Legal

• Environmental

• Country experts

• Tax advice

• Political risk

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Transaction Structure

Is it an Asset purchase, a share purchase or a transaction with mixed elements?• This information helps to determine scope and extent of due diligenceWhat type of business is the “target” involved in?• This information helps assess risk

Key elements of the business

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Transaction Structure

Assets/liabilities

Pre‐closing transactions/conditions• Transactional due diligence

Transaction structure• Transactional due diligence

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Key Due Diligence Points

Due diligence is a responsive multi‐stage process

This investigation must be as thorough as possible to accurately assess the ‘‘target’’ acquisition or transaction within the particular timeframe, cost, and client constraints

Due diligence is a value driven process because it serves to further inform both the acquirer and the “target” of the appropriate “target’’ value

Comprehensive due diligence exposes unexpected or unknown liabilities before the deal is closed and offers an opportunity for both sides to re‐assess the preliminary agreement terms

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Key Due Diligence Points

Preliminary review of certain issues

Threshold review to identify key issues

Auction process can drive access and economics of due diligence

Thorough due diligence review

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Identification and Assessment of Key RisksNeed background to business being acquired

Public disclosure – securities filings on SEDAR/stock exchange

Websites

Media search

Financial statements

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Identification and Assessment of Key RisksNotes to financial statements – contingencies/commitments/subsequent events

Management’s discussion and analysis – trends, uncertainties, liquidity

Risk factor disclosure in public documents

Assessment of risks – identify key risks

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Due Diligence as a Value Driven Process

Further refinement and focus to legal due diligence exercise

Where is the value that will be paid for?• Due diligence will help assess the real underpinnings of value of

acquisition targetWhat assumptions regarding value are being made by acquirer?• Assess reliability of assumptions/information e.g. bull boards

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Due Diligence as a Value Driven Process

Asset type – determines relevant issues regarding actual value• e.g. Functioning plant/enforceable contracts

Liability type – determines relevant issues regarding actual value• e.g. Tax issues regarding structure

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Types of Due Diligence – Functional Types

Legal due diligence

Financial due diligence

Accounting due diligence

Operational due diligence

Technical due diligence

Environmental due diligence

Tax due diligence

Regulatory due diligence

Legal element to all types of due diligence

Country risk

Political risk

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Business & Legal Due Diligence Done in ParallelCoordination

Constant reassessment of findings in light of other findings – consistency of results, red flags, re‐interpretationImportance of a legal issue depends on business issues• Loan covenants more important where company in default?

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Business & Legal Due Diligence Done in Parallel

Regular communication and sharing of results/findings

Work sharing – intranet/portals

War rooms

Issue‐based due diligence rather than functional• e.g. sales agreement team rather than legal/business/financial teams

Contract review can be confirmed against the due diligence searches that have been performed

Agreements can relate to one another e.g. areas of interest, overlapping royalties

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Using Due Diligence Results Effectively

Agreement schedules

Due diligence identifies risks

Risks identified can be covered off with representations and warranties• Risk allocation• Especially risks relating to key value assumptions

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Using Due Diligence Results Effectively

Risks impact indemnity limitations

Transactional due diligence identifies conditions precedent/transaction timing issues

Due diligence team needs to review transactional documentation

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What is not covered by due diligence?

Due diligence impacts the ability to negotiate transaction terms

Representations and warranties are a risk allocation mechanism

Due diligence allows risk assessment and impacts "requirement" for representations and warranties• Areas of non‐risk

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What is not covered by due diligence?

Due diligence can be a substitute for representations and warranties• Competitive bid/auction situations• Allows assessment of need for representations and warranties• Representations and warranties can be important in the assessment of

non‐financial risk of a transaction• As Is Where Is deals

Effective due diligence can help get the deal

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Mining Considerations

Confidentiality agreements

Proprietary data

Professional obligations to disclose

Overlapping agreements

Technical matters need experts

Access to key people

Material undisclosed information

Cultural differences

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Mining Considerations (continued)

Fraudulent activities

Tenure system

Agreement requirements

Foreign entities, operations

Political risk

Country risk

Aboriginal matters

Local customs and practices, cultural matters

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Who do you talk too

Confidentiality

Technical questions

Site visits

Detailed checklists

Due diligence questionnaire

Data rooms

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Due diligence request listcorporate structurearticles, by‐lawsindebtednessproperty interestsmineral projects

ownership

contracts

company rights

access

infrastructure

rights of mineral owner and third parties

third party consents

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Due diligence request list (con’t)employment mattersenvironmental matterslitigationrelated party transactionsintellectual propertyassets and businessgovernment reportsinsurancemiscellaneous

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Denzil Rankine’s Insight into the Due Diligence Process

“Due diligence. . .involves a lot of people digging up a lot of often incomplete and conflicting information in a very short time. Thechallenge for the person who commissions due diligence is to stay on top of all this by not getting lost in the detail, having the insight and experience to spot what is important and what is not...” – Denzil Rankine, author of Acquisition Essentials: A step‐by‐step guide to smarter deals2

2 Rankine, Denzil. “Chapter 5-Investigating the Target”, Acquisition Essentials: A step-by-step guide to smarter deals, E-Book Accessible through the Carleton University Library website: Harlow, Prentice Hall, 2005, p. 112

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Sources

• B.C. CLE, Due Diligence Deskbook, 2009

• RMMLF, Due Diligence, 1993

Brian E. Abrahambrian.abraham@fmc‐law.com

+1 604 443 7134

http://www.fmc-law.com/People/AbrahamBrian.aspx

mailto:[email protected]

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