Due diligence - doing what needs to be done

Topic: Due Diligence - Doing What Needs To Be Done

This paper was prepared for the first annual business acquisition law conference on 5 and 6 June 2014 organised by Television Education Network Pty Ltd. Practitioners and purchasers should conduct their own due diligence in relation to the subject of this paper, rather than relying on the paper. Liability limited by a scheme approved under Professional Standards Legislation

1. Why do due diligence Every purchaser wants to know that they will get what they are paying for. To try and achieve this, well advised purchasers will seek to obtain comfort through one or more of the following:

   Vendor warranties; Personal inspection/trial periods; and Due diligence. Purchasers are also generally aware that despite the provisions of the Competition and Consumer Act and other laws, the basic principle remains caveat emptor (let the buyer beware). The principle received strong judicial support from the 2004 High Court decision in Woolcock Street Investment Pty Limited v CDG Pty Limited [2004] HCA 16; (2004) 216 CLR 515.

   Woolcock purchased a commercial building and offices in Townville (Complex) from the trustee of a property trust some years after the complex was built. There was no warranty in the sale contract that the complex was free of defects and there was no assignment of the trustee's right against those responsible for any such defects. About a year after the purchase, the Complex showed signs of structural distress due to subsidence either of the foundations or the soil upon which they were built. CDG was the structural engineer employed by the trustee in 1987 to assist with design of the Complex. There was evidence that CDG had recommended to the trustee that a geotechnical report be obtained as to the load bearing capacity of the structure and the trustee had refused to incur the expense. It was likely that the subsidence was unlikely to cause any physical harm to anyone and that the only loss was economic. The High Court by a majority found that CDG did not owe a duty to Woolcock. Woolcock's vulnerability to risk and its ability to protect itself from that risk was a key factor in determining whether CDG owed it a duty of care to avoid economic loss. The court found that Woolcock as a commercial investor was able to protect itself from the risk of subsidence. It could for example have obtained an expert's report before purchase or negotiated appropriate terms into the sale contract. It did neither and this was sufficient to negate any liability. The decision makes the point that a failure to conduct due diligence or obtain suitable warranties may deny access to other relief. When taken with the provisions of the Competition and Consumer Act 2010 which give effect to proportional liability (and reductions for loss due to a claimant's failure to take reasonable care), it is clear that a buyer who cuts corners with their due diligence, largely does so at their own risk.

   In the Woolcock case, the purchaser neither obtained a warranty from the vendor on the issue nor performed due diligence on the geotechnical condition. However is the availability of suitable warranties from a creditworthy vendor sufficient to avoid a suggestion of purchaser negligence or failure to take reasonable care?

   I suspect the answer is that unqualified warranties if obtained from a suitably solvent vendor may materially reduce the extent of required due diligence, but even with the best of warranties and vendors a purchaser should at least test some of the critical assumptions behind their decision to buy, to determine whether or not further enquiry is necessary.

2. What precisely is due diligence The expression "due diligence" seems to derive from a 1933 US Securities law which provided a defence of "due diligence" to those who made reasonable investigation into the contents of a prospectus before its issue.

   Whilst the term has gained other meanings and uses, it is still part of the process by which those participating in the issue of a prospectus in Australia may obtain a defence to claims of errors (see section 731 of the Corporations Act 2001). I will return later to experience gained from that context.

   "Due diligence" has been described as "the converse of negligence": Lord Diplock in Tesco Supermarkets Ltd v Natrass [1972] AC 153 - that's still not very useful in saying what exactly one is meant to do.

   In the negligence case of Wyong Shire Council v Shirt [1980] HCA 12; (1980) 146 CLR 40, Mason J at [14] held that:

   "In deciding whether there has been a breach of the duty of care the tribunal of fact must first ask itself whether a reasonable man in the defendant's position would have foreseen that his conduct involved a risk of injury to the plaintiff or to a class of persons including the plaintiff. If the answer be in the affirmative, it is then for the tribunal of fact to determine what a reasonable man would do by way of response to the risk. The perception of the reasonable man's response calls for a consideration of the magnitude of the risk and the degree of the probability of its occurrence, along with the expense, difficulty and inconvenience of taking alleviating action and any other conflicting responsibilities which the defendant may have. It is only when these matters are balanced out that the tribunal of fact can confidently assert what is the standard of response to be ascribed to the reasonable man placed in the defendant's position." This concept of balancing the magnitude and probability of a risk with the expense, difficulty and inconvenience of the necessary enquiry, as hypothetically carried out by persons professing the relevant skill, will determine what is required by "due diligence" (before any contractual additions and limitations). It appears a similar concept will apply to directors in performing their general statutory duties of care: ASIC v Vines [2005] NSWSC 738. In the same case Austin J noted that not every mistake will constitute negligence.

   However, purchasers may like to think that a due diligence report is like a guarantee or insurance against any problems with their purchase.

   To avoid any misunderstanding and manage risk, it is clear that it is up to the consultants participating in a due diligence exercise to clearly agree in writing with the client as to what exactly the exercise will, and will not, involve. Advice, followed up by a written agreement as to the scope and steps involved in (and to be omitted from) the exercise is critical in allowing prospective purchasers to make informed choices, and for consultants to know what they are expected to do.

3. Checking against what Any exercise which simply involves wandering around looking for a problem to turn up, or which is confined to a review of the material provided by means of vendor disclosures or a vendor initiated due diligence bundle, misses the point.

   The starting point for any proper due diligence exercise should be to ask the prospective purchaser for:

   a copy of any marketing material including offering documents, advertisements, communications from the agent etc., which have induced the purchaser to put in an offer (Marketing Material); a written list of those features which the purchaser regards as important in their decision to proceed (Assumptions List); and details of any proposals the purchaser has in mind for the business (Proposals). Accordingly, and subject to special circumstances and the limitations mentioned below, the due diligence exercise then becomes a task in testing out whether:

   the key statements and representations in the Marketing Material are reasonably based; the Assumptions are reasonably based; and there are any business or regulatory impediments to achieving the Proposals, as these may be an integral part in the decision to buy. This really goes back to something like the original concept of due diligence, which involved checking a prospectus - i.e. are the written representations and the Assumptions soundly based?

   By having the Marketing Material, Assumptions List and Proposals, the business purchase due diligence exercise becomes a question of determining whether the basis on which the purchaser proposes to proceed (as demonstrated by those documents), is soundly based.

   It follows for example that purchasers with different proposals for the business, may require different areas to be covered in the due diligence exercise. The exercise should be tailored for the particular purchaser.

4. What can be disclosed by vendor for due diligence purposes A vendor will generally need to disclose sufficient information to achieve the following commercial and legal outcomes:

   Entice a purchaser to enter a contract and to proceed to completion by allowing the purchaser to determine whether their expectations, understanding, and valuation of the business are likely to be matched by reality; Avoid a breach of contract or warranty; and Comply with any legal disclosure requirements. In practice, the information a vendor will need to disclose varies depending on:

   what has lead the purchaser to consider the transaction (the Marketing Material, Assumptions List and Proposals); the type of transaction (purchase of business assets or purchase of shares); the nature and size of the business and its assets; the reputation of the vendor; the risks; whether or not the deal is fully priced; and the stage of the transaction (pre-exchange, pre-completion or post- completion). A vendor will often hesitate to disclose confidential information to prospective buyers as they fear the ramifications of the transaction not completing. If the transaction does not go ahead the purchaser may use the information disclosed for their own benefit for example by:

   going into competition with the vendor; providing information to a competitor; or being in a better bargaining position with parties who had relationships with the vendor (for example, customers or suppliers). I have a matter at...