In business transfers, the due diligence process is crucial in order to ensure that there are no unpleasant surprises for the seller or purchaser after the transaction has been completed. There are several different types of due diligence audits, such as legal due diligence, financial due diligence, commercial due diligence, etc. This article explains what legal due diligence actually is and why its performance is important for both the purchaser and the seller.
What is legal due diligence?
Due diligence is a generic expression for the process in which the purchaser audits the target company in order to obtain the fullest possible picture of the target company. The purpose of legal due diligence is to identify and minimise any legal risks that could have major consequences for both the purchaser and the seller. Legal due diligence includes an audit of several different areas such as an audit of the target company’s agreements (customer and subcontractor agreements, for example) and circumstances regarding properties and employees. The target company’s corporate formalities, intellectual property rights, insurance policies, information technology, data protection, compliance with regulations and disputes are also normally audited.
How does a legal due diligence process work?
A legal due diligence process often begins with the seller preparing and structuring all relevant information on the target company in a virtual data room. This data room is a secure digital platform where both the purchaser’s and seller’s advisors are able to access necessary documentation. One important feature of the data room is the Q&A function, which helps bring about direct structured communication between the purchaser and the seller. The purchaser’s advisors can ask specific questions concerning individual documents or areas that require clarification. The Q&A function enables questions to be answered quickly and efficiently by the seller or the target company. A virtual data room is normally also used for other types of due diligence audits, which means that all information to be audited in the various types of due diligence is normally located in the same data room.
After the legal due diligence audit has been completed, the purchaser’s advisors often compile the results in a report delivered to the purchaser. That report contains an overview of the areas audited, including identified risks and potential problems that may affect the business transfer. The report may therefore also affect how the terms of the share purchase agreement are formulated, for example by recommending that certain guarantees or indemnity undertakings (see more on this below) be included in the share purchase agreement in order to manage the risks identified during the audit.
When the entire due diligence process has been completed, all relevant documentation and communication from the process is normally attached to the share purchase agreement, often in the form of a USB memory stick. This enables the parties to subsequently go back and verify what was included in the audit. It also creates transparency and reduces the risk of disputes over what information was actually available at the time of the transfer.
Why is it important to carry out legal due diligence?
One common misconception is that legal due diligence only benefits the purchaser because, through the audit, the purchaser gains greater insight into the company to be acquired and can thus make informed and more risk-aware decisions regarding the acquisition. However, legal due diligence is also of great importance to the seller. By carefully preparing and presenting all relevant information in the virtual data room, the seller is able to protect itself against future guarantee claims from the purchaser. If the purchaser has or should have discovered certain risks during the legal due diligence process, the purchaser cannot subsequently file a claim on the basis of those risks after the transaction has been completed. That means that, in principle, the seller can only be held liable for two things: (i) circumstances of which the seller was not actually aware and which were not evident from the data room, and (ii) if the information in the data room is incorrect. Furthermore, the purchaser cannot, generally speaking, file a guarantee claim relating to a circumstance of which it was already aware at the moment when it entered into the share purchase agreement.
Example – legal due diligence from the purchaser's point of view
The purchaser plans to acquire Target Company AB from the seller and engages a legal representative to carry out legal due diligence on Target Company AB. During the audit, it is discovered that Target Company AB is facing a potential dispute with one of its customers. The customer has cancelled a contract and claimed a refund of the purchase price for the purchased goods. The customer’s claim for repayment amounts to several million SEK. Even though the customer has not yet brought any legal action, there is a risk that such action may be brought in future. Since the purchaser has identified a risk that Target Company AB may need to repay the purchase price of several million SEK to the customer, the purchaser is able to adopt protective measures in conjunction with the agreement negotiations. In order to protect itself against any future costs and claims that may arise as a result of this dispute, the purchaser may request that a so-called “indemnity undertaking” be included in the share purchase agreement. Such an undertaking means that the seller assumes liability for any damage that may arise for Target Company AB in connection with the dispute. This protects the purchaser from any need to bear the costs and ensures that the risks relating to the potential dispute are managed by the seller.
Example – legal due diligence from the seller’s point of view
The seller is preparing the sale of Target Company AB to the purchaser and has carefully compiled a virtual data room containing all relevant information on the company. This data room contains information on Target Company AB’s agreements, assets, employees and intellectual property rights, among other things. The purchaser chooses to carry out limited legal due diligence and does not examine all the documents uploaded to the data room. After the share purchase agreement has been signed and the transaction has been completed, the purchaser discovers that Target Company AB’s most valuable trade mark is not owned by the company itself. Instead, Target Company AB had a non-transferable license to use the trade mark and a competitor of Target Company AB has already acquired the trade mark rights and terminated the license. When the purchaser points this problem out and files a guarantee claim against the seller, the seller is able to protect itself by citing the fact that all relevant information on the trade mark was available in the data room. Because the purchaser had access to this information but chose not to fully investigate it, the seller can claim that the liability lies with the purchaser. Thus, the purchaser assumes the risk for the problem that has arisen, not the seller.
The examples presented above are of course simplified and, in the last example, also presuppose that the share purchase agreement is drafted in a particular way. However, the examples highlight the importance of carrying out a thorough and well-organised legal due diligence process, for both the purchaser and the seller. Properly implemented legal due diligence is essential for identifying and dealing with potential risks and for avoiding future disputes.
How can inadequate legal due diligence affect the parties?
As the above two examples illustrate, inadequate or insufficient legal due diligence can have serious consequences for both the purchaser and the seller. For the purchaser, an inadequate audit may lead it to acquire a company with hidden liabilities, potential disputes or unresolved regulatory issues that were not apparent at the time of acquisition. In a worst case scenario, it can result in significant financial losses and unforeseen expenses for dealing with these risks. For the seller, a carelessly implemented legal due diligence process can lead to the purchaser subsequently filing guarantee claims against the seller. If the seller has failed to ensure that all relevant information was available or presented correctly, there may be a risk that the seller may face expensive disputes and may need to repay part of the purchase price.
Summary
To sum up, the legal due diligence process is a decisive tool in business transfers to enable both parties to make informed decisions and minimise legal risks. For the purchaser, it is a way of ensuring that the company is in the state it is claimed to be in, whereas for the seller it means protection against future guarantee claims. A well-executed legal due diligence process lays the foundations for a smoother transaction and reduces the risk of unwanted surprises after the transfer.
Finally, it should be stated that the above is only an overall summary of certain key aspects of legal due diligence. The article aims to provide a general understanding of the process, its purpose and how it can affect both purchasers and sellers in business transfers. This article is not intended to replace legal advice and must not be used as a basis for decisions in an individual case.
About the author of the article
Jannica Stefansson is a member of the Lindahl Corporate M&A team. Questions about business transfers? Contact Jannica.
