Due Diligence & Disclosure - Why must vendors endure both?

Twice in the last couple of weeks I have been asked -rather tetchily - by my clients why they need to go through a disclosure exercise when the proposed buyer of their business has already taken them through a full “drains up” due diligence and they have spent weeks answering detailed questions and providing swathes of information into a data room.?

It is true that at the tail end of a transaction, the process of disclosing against warranties and indemnities can feel like Ground Hog Day and a final attempt by the buyer to drive the seller into a frenzy of frustration by asking them all the same questions again, and again.

In fact, due diligence and disclosure do sit logically side by side and the disclosure exercise fulfils a meaningful purpose in the overall jigsaw of the transaction, which I thought I would try to explain (please forgive me any lawyers reading this.....)

Due Diligence

As the name suggests, the Due Diligence exercise is designed to address the principle of caveat emptor (or Buyer Beware) in English law. The buyer or investor is diligently checking that they fully understand the business they are taking on and that it is as they understand it to be.

Usually, most of the Due Diligence work is delegated to professional advisers who are domain experts in financial information, the law and/or the commercial context in which the business operates. Sometimes an investor or acquirer will also engage experts in HR, Marketing, Insurance, or other specialist areas.

The teams appointed to do the due diligence work ask all the questions they feel they need to in order to be in a position to report back to the would-be buyer or investor that their understanding of the business and its performance is correct and to highlight any areas that might represent potential risks in the future. Those advisers will report their findings formally in writing to their clients (the would-be acquirer or investor) and if they have materially missed or misunderstood something which later indicates that the price paid for the business was too high, they will have to stand behind their written conclusions, potentially in court and certainly with their professional indemnity insurance. This surely explains their relentless persistence in the pursuit of data and occasional tendency to get distracted by (in a vendor’s view) meaningless lines of enquiry.

The level of detail into which due diligence professionals will go can be eye-watering and it is therefore understandable that at the end of the process a vendor will feel that there is nothing that the buyer cannot now be aware of.

Disclosure

Disclosure in the context of an acquisition or investment means disclosure of information in relation to the warranties in the sale and purchase or investment agreement.

Due diligence provides a buyer or investor with a huge amount of information, but it does not/cannot give absolute comfort that the information provided by the vendor is either accurate or complete. For example, as far as due diligence has identified, at the date of completion the historic financial information is complete and accurate and in line with the valuation. ?However, a week before completion a major client has called the vendor to say that they are giving notice on their contract with a written notification to follow in due course. At the date of doing the deal, that information would fall outside the scope of the due diligence (even due diligence providers don't have second sight!) and would not be known to anyone but the vendor who took the call.

In addition, the due diligence fieldwork typically ends some weeks before legal completion of a transaction. This gives time for the due diligence teams to draw the threads of their work together, write their reports, discuss them with their clients and finalise them. There is therefore a “gap” in time during which the business will have moved on and during which things could have happened which the buyer would only know of if the vendor was minded to tell them.

Warranties, and disclosure against those warranties, are therefore the mechanism by which a buyer or investor “flushes out” the information that they could never obtain from due diligence and covers the gap between the period covered by due diligence and completion day.

Warranties cover all aspects of the business and are simply statements of fact or “promises” that the seller is making to the buyer or investor. ?If the statement, or promise, later turns out not to be true and the impact of the untruth has a financial impact on the business, and if the seller knew or should have known (being reasonably diligent) that it was untrue at the date of signing the legal documents, then subject to a de minimis amount, the buyer can sue for damages under the legal agreement and against that warranty.

Warranties are necessarily broadly drawn because they are designed to cover risks which due diligence couldn’t find and to flush out anything that due diligence might have missed or misinterpreted. For this reason, they do, frustratingly, cover the same ground as due diligence.?For example, financial due diligence will cover the business’s historic experience with debtors, measuring debtor days, looking at late payers and generally evaluating the debtor book. But there will also be a warranty which says something along the lines of “There are no debts on the debtor book which at the date of completion the vendors believe are irrecoverable or will be paid outside terms”.

This is where disclosure comes in. It is very unlikely that at the date of completion there are absolutely no slow payers or disputed invoices. This doesn’t mean it is a problem for the business, or that the buyer is going to be concerned about it, but it is not possible for the vendor to make the promise inherent in the warranty without caveating it.

The disclosure process is a process of caveating the promises that the warranties represent. In response to the debtor warranty, for example, the vendors may respond that the warranty is true but with the proviso that there are certain (named) customers who pay late every month, a disputed invoice (chapter and verse provided) on an account and perhaps that a new contract with potentially different payment terms is under discussion on another. Provided all information pertinent to the warranty is provided as far as a vendor is aware (or should be aware having asked the right people in his team) then disclosure protects them from any warranty claim in the future.

Disclosure is painful but it is helpful to see it as an insurance policy for buyer and seller that everyone has fully understood where the business is at and are going into the transaction with their eyes wide open and no risk of recrimination or comeback.

Conclusion

There is no doubt at all that at the end of a long transaction process, disclosure is a boring and frustrating exercise for a deal-weary vendor team. Information required for disclosure will in some cases have been provided already as part of the due diligence process; which is why there is often a debate about whether the data room, or elements of the data room can simply be cross referenced as disclosure against certain warranties. Sometimes this is permitted but cross referencing usually has to be very specific as the data room isn’t closed until completion and there is nothing to stop a vendor pushing new information into it without drawing it to the acquirer or investors attention once due diligence is complete and then claiming it has been disclosed. ?

All of that frustration and time commitment fully acknowledged, I hope that this brief explanation sheds light on the relative roles of due diligence and disclosure in creating a full information set for the buyer. Warranty claims are, in practice, unusual because the disclosure exercise should fill any gaps or updates left after due diligence is complete and proper disclosure means that any issues are dealt with before and not after completion. Most warranty claims are indeed where a vendor has wilfully withheld information.

None of this makes it any more fun for a vendor to weather either due diligence or the disclosure exercise, but at least they can be reassured that there is a point to the apparent information "double-dip"?