From Analysis to Certainty: The Importance of Thorough Due Diligence in M&A Transactions

A vendor due diligence essentially means that a transferor or seller, before the actual sale process is initiated, even before the company is brought to market, conducts an internal review of the company in order to identify potential issues or deal breakers (matters that could affect the purchase price or result in extensive warranty obligations) and, where possible, resolve them in advance. At the same time, all information that may be relevant to a potential buyer is collected and structured. In essence, the company is made “sale-ready” so that the actual sale process can proceed more quickly and efficiently, likely with fewer discussions.

However, when due diligence is discussed in business circles, it generally refers to buyer due diligence: the preliminary investigation carried out, or at least that should be carried out (see below), by a prospective purchaser or acquirer. In an asset deal, where specific assets rather than shares are acquired, the buyer knows exactly what is being purchased: which machinery, which parts of the stock, the intellectual property rights and customer portfolio, which receivables and potentially which contracts and liabilities, etc.. In a share deal, on the other hand, the buyer acquires, through the shares, an entire company or a proportional interest in a company, including in principle the company’s entire history: financial and accounting matters, tax matters, potentially real estate-related aspects, in which case issues such as title deeds, permits and soil conditions become relevant. The buyer also assumes all rights, but above all obligations relating to employees, contracts in general, all receivables and liabilities, potential or pending disputes, ongoing legal proceedings, and so forth. To avoid unpleasant surprises afterwards, it is important to identify and analyse such matters in advance, so that they can, where appropriate, form part of the further negotiations with the seller.

It is up to the buyer to verify whether the picture presented by the seller corresponds with reality, based on deeds, minutes and other documents, the accounts, tax returns, and so on. Matters that are visibly incorrect, or which the buyer cannot reasonably argue afterwards were concealed, cannot subsequently be invoked against the seller. This falls within the buyer’s duty to investigate. Should disputes later arise in this respect, the buyer’s own (professional) background and/or the extent to which the buyer was assisted by professional advisers will moreover be taken into account. The more professional the prospective buyer is and/or the more professional the assistance obtained, the less convincing it will be to argue that certain matters were hidden.

In principle, the seller is under no statutory obligation to provide information to a prospective buyer. The seller, as it were, places the business in the shop window and may choose to present it solely in its best light, without informing a potential buyer of its negative aspects. Under Belgian law, the seller is merely obliged to deliver what is being offered (Article 1604 of the former Belgian Civil Code). Moreover, the seller’s statutory liability is limited to the warranty against eviction (claims of ownership by third parties) and hidden defects (Articles 1626 et seq. of the former Belgian Civil Code). That being said, the seller may however not engage in fraud (Article 5.35 of the Belgian Civil Code). If a prospective buyer and/or its advisers ask specific questions regarding certain matters, the seller may therefore not simply lie. Nor may the seller freely conceal information.

Indeed, a seller cannot simply adopt a completely passive position. Based on the general obligation that one always has to act (and negotiate) in good faith, the seller is subject to a certain duty of disclosure. Belgian case law has repeatedly confirmed in recent years that a seller must proactively disclose information which the seller knows, or should reasonably know, may influence the buyer’s decision. This applies all the more where such matters cannot easily be derived from documents or other records, and/or where the buyer cannot readily be considered an experienced professional and is not professionally advised either. The seller’s duty of disclosure begins where the buyer’s duty to investigate reaches its limits and therefore ends. A seller who fails to comply with this obligation exposes itself to pre-contractual liability (culpa in contrahendo) and may therefore be held liable for damages. Certainly something worth bearing in mind.

In other words, due diligence is a comprehensive analysis of the company’s existence and history, in all its aspects and components, with the aim of drawing conclusions that may serve as a basis for further discussions with the seller and for obtaining appropriate safeguards or guarantees where necessary. This may be achieved, for example, by including conditions precedent or conditions subsequent (although this is often not straightforward in practice), by providing for deferred payment mechanisms, potentially through an escrow account, or by introducing earn-out mechanisms based on future performances, and at the very least by including a number of Representations and Warranties for matters that are not otherwise fully covered.

Representations and warranties in an acquisition agreement partly consist of providing additional information (regarding matters that cannot readily be inferred from documents), and partly of providing guarantees regarding certain (latent) risks. Their importance lies in the fact that, even after a thorough due diligence investigation, a buyer can never obtain complete certainty regarding every aspect of the business. By including such provisions in the agreement, the buyer obtains additional protection against hidden risks. At the same time, they provide clarity as to who bears responsibility if certain information subsequently proves to be incorrect. Representations are primarily factual confirmations. For example, the seller confirms that the annual accounts present a true and fair view of reality, that there are no ongoing legal proceedings and that all taxes have been duly paid. Warranties or guarantees go a step further. They imply that the seller guarantees that these representations are effectively correct. If it later appears that one of these statements was inaccurate, the buyer may hold the seller liable and claim compensation for damages. In this way, the risk associated with incorrect or incomplete information is contractually allocated to the seller.

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If you require support, have questions regarding due diligence or contract drafting, Andersen’s M&A team is ready to advise you.
Dirk Clarysse & Charlotte Romaen (Senior Counsel)