Private Equity 2015

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ICLG
The International Comparative Legal Guide to:
Private Equity 2015
1st Edition
A practical cross-border insight into private equity
Published by Global Legal Group, with contributions from:
Aabø-Evensen & Co
Ali Budiardjo, Nugroho, Reksodiputro
Angola Capital Partners
Anjarwalla & Khanna
Ashurst LLP
Bär & Karrer AG
Bentsi-Enchill, Letsa & Ankomah
British Private Equity & Venture Capital Association
Chiomenti Studio Legale
Clifford Chance
Elvinger, Hoss & Prussen
Garrigues
Goltsblat BLP
Greenberg Traurig, LLP
Hajji & Associés
Houthoff Buruma
Milbank, Tweed, Hadley & McCloy LLP
Morais Leitão, Galvão Teles, Soares da Silva
& Associados
Schindler Rechtsanwälte GmbH
Schulte Roth & Zabel LLP
Shearman & Sterling LLP
Simont Braun
Skadden, Arps, Slate, Meagher & Flom (UK) LLP
Țuca Zbârcea & Asociații
Veirano Advogados
Vieira de Almeida & Associados,
Sociedade de Advogados, RL
Zhong Lun Law Firm
The International Comparative Legal Guide to: Private Equity 2015
General Chapters:
1
Vendor Due Diligence Reports: A Tale of Two Markets – Jeremy W. Dickens, Shearman & Sterling LLP
1
2
Enforcing Investors’ Rights in Latin America: The Basics – Emilio J. Alvarez-Farré & Juan Delgado,
Greenberg Traurig, LLP
7
Contributing Editor
Shaun Lascelles,
Skadden, Arps, Slate,
Meagher & Flom (UK) LLP
3
Unitranche Facilities – A Real Debt Funding Alternative for Private Equity – Paul Stewart & Ewen Scott, Ashurst LLP
12
Head of Business
Development
Dror Levy
4
The Development of EU Regulation since the Financial Crisis and the Future of the Capital Markets Union – Simon Burns, British Private Equity & Venture Capital Association
16
Sales Director
Florjan Osmani
Commercial Director
Antony Dine
Country Question and Answer Chapters:
5
Angola
Vieira de Almeida & Associados – Sociedade de Advogados, R.L. and Angola Capital Partners: Hugo Moredo Santos & Rui Madeira
20
6
Austria
Schindler Rechtsanwälte GmbH: Florian Philipp Cvak & Clemens Philipp Schindler
26
7
Belgium
Simont Braun: David Ryckaert & Koen Van Cauter
33
8
Brazil
Veirano Advogados: Ricardo C. Veirano & Gustavo Moraes Stolagli
41
9
China
Zhong Lun Law Firm: Lefan Gong & David Xu (Xu Shiduo)
47
10 Germany
Milbank, Tweed, Hadley & McCloy LLP: Dr. Peter Memminger 55
11 Ghana
Bentsi-Enchill, Letsa & Ankomah: Seth Asante & Frank Nimako Akowuah
61
12 Indonesia
Ali Budiardjo, Nugroho, Reksodiputro: Oene J. Marseille & Emir Nurmansyah
68
13 Italy
Chiomenti Studio Legale: Franco Agopyan
75
14 Kenya
Anjarwalla & Khanna: Roddy McKean & Dominic Rebelo
83
15 Luxembourg Elvinger, Hoss & Prussen: Toinon Hoss & Jean-Luc Fisch
89
16 Morocco Hajji & Associés: Amin Hajji & Houda Boudlali
97
Printed by
Ashford Colour Press Ltd
July 2015
17 Netherlands
Houthoff Buruma: Alexander J. Kaarls & Johan Kasper
102
Copyright © 2015
Global Legal Group Ltd.
All rights reserved
No photocopying
18 Norway
Aabø-Evensen & Co: Ole Kristian Aabø-Evensen & Harald Blaauw
110
19 Poland
Clifford Chance: Marcin Bartnicki & Wojciech Polz
129
20 Portugal
Morais Leitão, Galvão Teles, Soares da Silva & Associados:
Ricardo Andrade Amaro & Pedro Capitão Barbosa
137
21 Romania
Țuca Zbârcea & Asociații: Ștefan Damian & Silvana Ivan
143
22 Russia
Goltsblat BLP: Anton Sitnikov & Vera Gorbacheva
150
23 Spain
Garrigues: María Fernández-Picazo & Ferran Escayola
158
24 Switzerland
Bär & Karrer AG: Dr. Christoph Neeracher & Dr. Luca Jagmetti
165
25 United Kingdom
Skadden, Arps, Slate, Meagher & Flom (UK) LLP: Shaun Lascelles
171
26 USA
Schulte Roth & Zabel LLP: Peter Jonathan Halasz & Richard A. Presutti
179
Account Directors
Oliver Smith, Rory Smith
Senior Account Manager
Maria Lopez
Sales Support Manager
Toni Hayward
Editor
Rachel Williams
Senior Editor
Suzie Levy
Group Consulting Editor
Alan Falach
Group Publisher
Richard Firth
Published by
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Tel: +44 20 7367 0720
Fax: +44 20 7407 5255
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ISBN 978-1-910083-53-6
ISSN 2058-1823
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Disclaimer
This publication is for general information purposes only. It does not purport to provide comprehensive full legal or other advice.
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This publication is intended to give an indication of legal issues upon which you may need advice. Full legal advice should be taken from a qualified
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EDITORIAL
Welcome to the first edition of The International Comparative Legal Guide
to: Private Equity.
This guide provides the international practitioner and in-house counsel
with a comprehensive worldwide legal analysis of the laws and regulations
of private equity.
It is divided into two main sections:
Four general chapters. These are designed to provide readers with a
comprehensive overview of key private equity issues, particularly from the
perspective of a multi-jurisdictional transaction.
Country question and answer chapters. These provide a broad overview of
common issues in private equity laws and regulations in 22 jurisdictions.
All chapters are written by leading private equity lawyers and industry
specialists and we are extremely grateful for their excellent contributions.
Special thanks are reserved for the contributing editor, Shaun Lascelles
of Skadden, Arps, Slate, Meagher & Flom (UK) LLP, for his invaluable
assistance.
Global Legal Group hopes that you find this guide practical and interesting.
The International Comparative Legal Guide series is also available
online at www.iclg.co.uk.
Alan Falach LL.M.
Group Consulting Editor
Global Legal Group
[email protected]
Chapter 1
Vendor Due
Diligence Reports: A Tale
of Two Markets
Shearman & Sterling LLP
Jeremy W. Dickens
legal requirements related to shareholder approval of mergers
and consolidations or the sale of all or substantially all the
assets, class voting rights, or the availability of appraisal
(sometimes called dissenters’) rights;
Introduction
Over the past 20 years or so, a peculiar (at least in the author’s opinion)
difference has grown between the European and American manner of
conducting auction sales processes for private equity transactions.1 In
the European style of practice, the development of which first began
in England, it is routinely the case that before a seller (the vendor, in
European parlance) commences a formal sales process, it commissions
legal, accounting and often other advisors to prepare comprehensive
due diligence reports related to the target business. Those “vendor
due diligence reports” (or VDDRs) are not only made available to
prospective purchasers of the target, but the experts who prepare them
are expected to, and customarily do, permit the successful bidder to
rely on those reports as though prepared for them in the first instance.
In the United States, sellers only occasionally ask their advisors to
prepare VDDRs and more rarely are those reports made to successful
bidders on a “reliance” basis.
This article evaluates the difference in market practice and concludes
twofold: (i) there is no compelling reason for the difference; and (ii)
participants in U.S.-based private equity transactions would benefit
materially if American practitioners were to adopt the European
model.
What is Vendor Due Diligence?
As it sounds, vendor due diligence is the process by which a private
company contemplating a sales process commissions lawyers,
accountants and other relevant experts to prepare comprehensive
reports addressing those legal, accounting2 and other substantive
topics3 almost any buyer would otherwise investigate for itself in
deciding whether to bid for a particular business.4
■
material contracts affecting the sales process itself, such as
those under which shareholders or other investors may have
contractual (as distinct from legal) approval or other rights,
such as drag-along or tag-along rights, rights of first offer or
first refusal, specific board approval rights or supermajority
consents, etc. Other types of contracts that one might consider
relevant to the sales process are those related to executive
compensation plans, such as equity plans, employment
agreements, retention agreements, severance plans, etc., all of
which must be evaluated and taken into consideration as part of
the overall economics of the transaction to the buyer. Similarly,
the target’s existing financing arrangements5 may have an
impact on the sales process (for example, many financing
arrangements require repayment with specified premiums upon
a change of control; in other cases, there may be financing
arrangements a buyer considers unfavourable that cannot be
prepaid and which, therefore, may require negotiations with
lenders and the payment of make-whole amounts);
■
material contracts related to the target’s business, such as those
with key customers or suppliers, or licensors or licensees, or
franchisors or franchisees, lessors or lessees, etc. Each type of
company will have its own set of material contracts;
■
intellectual property, including not only the status of
patent applications (pending, provisional, or issued) or
the registration of trademarks, but also the existence of
confidentiality or work-for-hire agreements intended to
safeguard trade secrets or otherwise ensure the validity of the
target’s claim to key IP assets;
■
pending and threatened litigation, which may run the gamut
from employment practice-related claims, to infringement
of intellectual property, to commercial and product liability
claims, to shareholder or securities fraud lawsuits, or
governmental investigations (formal or informal) or actual
cases brought by governmental authorities related to
antitrust matters, alleged violations of the Foreign Corrupt
Practices Act or many other types of alleged violations of law
(including cases that may raise criminal liability as well as
civil liability).6 Litigation diligence also covers both cases
where the target is or may be a defendant, as well as those
cases where the target is a plaintiff; and
■
pensions-related matters, such as the funding status of
plans governed by ERISA,7 potential claims by the PBGC,8
and labour-related matters, such as the status of collective
bargaining agreements or union organising efforts or cases
proceeding before the United States National Labor Relations
Board.
Legal due diligence (which is the central area of focus for this
article) typically addresses key areas such as the following:
■
general corporate matters, such as the due organisation, valid
existence and capitalisation of the target, as well as formal
legal requirements related to the proposed sale transaction.
Relevant areas of interest range from the mundane, such as
confirmation that the target company and its subsidiaries
in fact legally exist under the laws of their jurisdictions of
organisation and possess legal authority to conduct business
in other jurisdictions in which they operate, to the important,
such as confirmation of the capitalisation and ownership of
the target and its subsidiaries, including the existence of any
rights, such as options or warrants or other securities, giving
third parties the ability to acquire an ownership interest in the
target and/or its subsidiaries, to the critical, such as formal
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1
Shearman & Sterling LLP
As should be obvious from the foregoing list and the related
endnotes, the categories of information covered by legal due
diligence are well understood, but the specific due diligence for
individual companies is likely to vary widely from one company to
the next depending on its industry and its unique concerns.
How did the Practice of Vendor Due
Diligence Come About?
At the risk of being facetious, it seems likely that the concept of
vendor due diligence arose out of a conversation among exhausted
executives at a private equity firm complaining about various sales
processes they had endured recently and inefficiencies such as:
■
repetitive and seemingly endless management presentations
to prospective buyers;9
■
significant time and effort spent responding to multiple due
diligence request lists and follow-up questions from sponsors
and their financing sources;
■
time “wasted” coming up to speed with and crafting solutions
to specific problems – typically (and a little embarrassingly)
identified by one or more bidders during diligence – that, in
hindsight, could have been addressed up-front had the seller
and sponsor focused on them;
■
suspicion that they might have negotiated more favourable
indemnity provisions (i.e., higher baskets/deductibles, lower
caps, shorter duration) or, potentially, a more favourable
purchase price, had they better controlled the diligence
process;10 and
■
suspicion that a more efficient sales process presents the
opportunity to better control the legal and other advisory
costs associated with the transaction.
The benefits of vendor due diligence to the seller seem self-evident.
There are also corresponding benefits to a prospective buyer. For
example:
2
■
A properly prepared VDDR provides bidders with a
“road map” to likely issues of material interest to them.11
Therefore, bidders are more able to assess rapidly whether
there are “red flags” that either are “deal breakers” or
simply issues for which the buyer will require specific
accommodation (whether via the purchase price, specific
structuring solutions, indemnity, or a combination). The
ability to make a quick “go-no go” decision obviously
reduces costs to those parties electing to withdraw from a
sales process. The seller, of course, obtains a corresponding
benefit to the extent that it has been able to determine more
accurately and more quickly which bidders are likely to be
the most serious in their interest in the target. Moreover,
having received VDDRs in advance, it may be more difficult
for a bidder to submit a high bid simply to obtain exclusivity
with the objective of using a later due diligence process as a
means of negotiating a lower ultimate price.
■
The VDDR enables bidders to direct their advisors more
effectively in terms of prioritising the issues of most
concern to them. A targeted approach to diligence should
enable bidders to better control their own costs because their
advisors are able to engage in “confirmatory” rather than
“comprehensive” diligence.
■
In many vendor-controlled diligence processes, the bidders
submit follow up questions in writing and, in some cases,
are subject to limits on the number of those questions. The
seller then catalogues the follow up questions and prepares
a single response shared with all bidders. From the bidder’s
perspective, there is comfort obtained from knowing that
there is a level playing field among the parties when it comes
to developing an understanding of the target business.
Vendor Due Diligence Reports
■
In a similar vein, it is not uncommon for seller’s to host
group meetings with management and/or advisors to deliver
presentations about the business and the contents of the
VDDRs. While it may be slightly inconvenient for bidders to
participate in these group briefings, particularly those hosted
by phone where there may be limited or no ability to ask
questions, each bidder at least knows that the playing field
remains level.
■
Finally, having been afforded the opportunity to participate
in a thoughtful, well-organised and fair diligence process, the
bidder may acquire sufficient comfort with its understanding
of the business to be encouraged to put forward its best offer
for the target company relatively secure in the knowledge that
the disclosure schedules to the definitive purchase agreement
are unlikely to contain surprises.
Downside to Vendor Due Diligence
There are, of course, potential negatives inherent in vendor due
diligence.12 For example, from the seller’s perspective, potential
disadvantages largely consist of (i) increased upfront time and
associated (and potentially significant) cost involved in having
outside advisors prepare the VDDRs, (ii) the prospect that the
items disclosed will affect negatively the sales price, (iii) potential
concerns, in the case of disclosures about pending or threatened
litigation and/or governmental investigations and proceedings,
of waivers of attorney-client privilege, (iv) the prospect that
notwithstanding the seller’s best efforts, it will still be forced to
respond to multiple, conflicting and time-consuming requests for
follow up diligence and meetings, and (v) the risk that there will not
be any tangible benefit to it in terms of an increased sales price and/
or more favourable indemnification terms than it would otherwise
have achieved had it simply left each bidder to its own device in
carrying out diligence.
In the author’s view, none of the potential negatives to the seller
are sufficiently onerous as to tip the scale in favour of opting for
the traditional approach. Time invested by sellers up front often
substantially limits the time required from launch to completion of
a sales process. The cost of VDDRs is something that a seller can
require the successful bidder to share in as part of the transaction.
Worries that disclosure may affect the sales price is a red herring
– in the author’s view, if an item of disclosure is so material as to
have an actual (or perceived) effect on the sales price, it is precisely
the sort of information the seller should (indeed, one might argue,
must) disclose to the bidder.13 Concerns about losing the benefits
of attorney-client privilege in the context of litigation-related
disclosure is another red herring. Whether the vendor sponsors the
due diligence process or bidders are left to fend for themselves, the
seller’s general counsel and, frequently, external counsel handling
material litigation or governmental investigations or proceedings,
will invariably be called upon to brief bidders and their counsel
about those matters. Custom and practice in avoiding disclosure that
jeopardises the attorney-client privilege is well-developed and the
process of vendor due diligence should have no bearing on how this
disclosure is handled. The risk of the due diligence process running
amok, notwithstanding the seller’s attempt to control it, seems to
be one well within the seller’s ability to control (and if the issues
are such that the seller cannot control the process, it suggests those
issues have considerable substance to them). Finally, as to whether
or not vendor due diligence will provide the hoped-for benefit of
an improved sales price and/or more favourable indemnification
provisions, the author leaves it to economists and others to study the
issue and reach an objective conclusion. However, given the widely
accepted wisdom of the efficient market hypothesis as applied to
publicly listed companies, it is not much of a leap to hypothesise that
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the more a bidder knows about the company, the more the price paid
and terms offered will reflect that information. Put another way, the
less a bidder knows (or fears that it does not know) about a company,
the more likely it will be to discount its purchase price or otherwise
seek to shift the consequences of unknown risks to the seller.14
From a bidder’s perspective, there seems to be little reason to reject
VDDRs out of hand. It may be the case that a bidder is unfamiliar
with the vendor’s advisors, and therefore may place less inherent
trust in the quality of their work than had those reports been by
its own advisors. It may also be the case that a particular bidder
has a different view as to materiality from that taken by the advisor
preparing the VDDR or prefers a different reporting format from
that used in the VDDR. However, those sorts of objections are
not particularly compelling. Indeed, so long as a seller works with
reputable advisors with experience in private equity transactions,
it seems unlikely there is much actual risk that a VDDR would be
so shoddy, or so flawed in the materiality judgments it makes, or
presented in such a confusing format, as to make the report of no
or little value to a bidder. In the author’s experience, most bidders
will be content to have their own advisors conduct confirmatory
diligence of the matters covered in the VDDRs, at least unless and
until they discover a substantive problem with those reports.15
European Vendor Due Diligence in Practice
Over the past 20 years or so, European market practice has evolved
to the point where VDDR is a routine and expected part of the
private equity sales process. At the outset, the vendor, as it begins
to prepare for the sales process, engages accounting, legal and other
relevant advisors to prepare draft VDDRs. Those draft reports
are made available to prospective bidders on a “non-reliance”
basis. At the conclusion of the sales process, when the successful
bidder enters into a definitive purchase agreement for the target, the
various advisors deliver their definitive VDDRs to the buyer subject
to the terms of a “reliance” letter, which often contains a cap on
the advisor’s liability16 to the recipient for any deficiencies in the
report other than those arising out the preparer’s gross negligence,
recklessness or fraud.
A non-reliance letter, in the context of a legal due diligence report,
serves primarily to record the recipient’s acknowledgment that
delivery of the report does not establish an attorney-client relationship
between the law firm and the recipient of the report. It also contains
disclaimers – largely self-evident – to the effect that the preparing
firm has not consulted with the recipient in connection with defining
the scope of the report and, as a result, it is possible that the recipient
may have different interests and views of materiality from those
expressed by the preparer of the report. Finally, the non-reliance
letter contains a waiver and release by the recipient of any and all
claims it may have against the preparing firm with respect to the
report. Although different law firms use different language in their
non-reliance letters, the gist of the letter is the same – the recipient
uses the report at its own risk and the provider takes no responsibility
for its contents and disclaims any responsibility to update the report.
The reliance letter, however, is a more substantive document and
its tone and content is very much like that of a legal opinion letter,
taking great pains to tell the recipient what it is within the scope of
the opinion letter and to spell out any limitations and qualifications
applicable to the covered matters. The typical reliance letter covers:
(1) a careful definition of the “Report” being delivered; (2) a
description of the scope of work encompassed by the report and a
disclaimer of liability or responsibility for any matters outside the
scope of the report; (3) consent to the recipient’s review and reliance
upon the report solely for the purpose specified in the reliance
Vendor Due Diligence Reports
letter, subject to a number of important disclaimers and limitations
with respect to the report; (4) specific acknowledgments by the
recipient, such as its agreement to the terms of the reliance letter
and its understanding that the provider makes no representations or
warranties as to the sufficiency or appropriateness of the information
in the report for the purposes for which the recipient intends to use
it; (5) confidentiality undertakings of the recipient with respect to
the report; (6) a cap on the liability of the provider to the recipient,
which (to the extent permitted by law) is only available in the case
of the provider’s gross negligence, recklessness, or fraud;17 and (7)
the governing law and the forum in which any disputes related to the
report will be heard.18
Why Hasn’t Vendor Due Diligence Caught
on in the United States?
The author frankly admits to being stumped by the question just
posed. There is no adequate explanation. Vendor due diligence
offers sellers the same advantages, and delivers buyers the same
head-start in understanding a target’s business, regardless of
whether the transaction is European or American. There is no
greater reason to discount the reliability of VDDRs because they
are prepared by the seller’s U.S. law firm (or the U.S. office of
an international law firm) than there is to discount the reliability
of reports prepared by an English law firm or the London office
of an U.S.-based international law firm. Moreover, U.S. law firms
routinely deliver legal opinions to third parties when requested to do
so by their clients (e.g., opinions delivered by a borrower’s counsel
to lenders in a senior debt transaction, or opinions delivered by an
issuer’s counsel to underwriters and/or initial purchasers in capital
markets transactions). Indeed, it is quite common for U.S. law firms
representing buyers in acquisition transactions to share their due
diligence memoranda (most often, but not only, on a non-reliance
basis) with prospective co-investors, other financing sources and
even providers of “rep and warranty” insurance.
The only substantive reason that the author has seen offered to explain
the absence of vendor due diligence in American transactions is that:
“[E]thics rules applicable to lawyers in the United States
disallow them from capping or otherwise limiting the
amount of their liability for malpractice. A U.S. law firm that
contractually permitted a buyer to rely on its due diligence
report therefore would be liable, without any limitation, for
any losses incurred by the buyer that result from mistakes or
omissions contained in its report.”19
Unfortunately, the prohibition on lawyers limiting their liability for
malpractice is not as absolute as the commentator, quoted above,
suggests. For example, Rule 1.8(h)(1) of the New York Rules of
Professional Conduct states that “[a] lawyer shall not … make an
agreement prospectively limiting the lawyer’s liability to a client
for malpractice” (emphasis added).20 By its terms, Rule 1.8(h) only
prohibits liability caps if (1) they are entered into prospectively, and
(2) with a client.21 Accordingly, there is no ethical prohibition on
a law firm asking a non-client to agree to a cap on the law firm’s
liability for malpractice.22
There is likewise no ethical rule that prohibits a law firm from
permitting a third party from relying on its due diligence report.
Indeed, Rule 2.3(a) of the New York Rules of Professional Conduct
specifically provides “[a] lawyer may provide an evaluation of
a matter affecting a client for the use of someone other than the
client if the lawyer reasonably believes that making the evaluation
is compatible with other aspects of the lawyer’s relationship with
the client”. Moreover, Rule 2.3(b) provides that, with the client’s
informed consent, “a lawyer may provide the evaluation to a third
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Shearman & Sterling LLP
party even if the lawyer knows or reasonably should know that the
evaluation is likely to affect the client’s interests materially and
adversely”. In short, there is nothing in the New York Rules of
Professional Conduct that explain why vendor due diligence has not
been adopted more widely in the United States.
Vendor Due Diligence Reports
arrangements may be treated as capital leases, while others
may be operating leases). Off balance sheet financings and
contingent liabilities are also likely fall into the category of
contracts relevant to the sales process.
6.
Different industries have their own specific regulatory profiles.
For example, both the Board of Governors of the Federal
Reserve System and the Office of the Comptroller of the
Currency oversee national banking associations. In certain
circumstances, the Federal Deposit Insurance Corporation
may also be a relevant regulatory body. A state chartered
bank may be overseen by both a state banking department
and the Federal Reserve. Insurance holding companies may
be subject to regulation in a variety of states. Pharmaceutical
companies are subject to the jurisdiction of the Federal Drug
Administration, as are manufacturers of medical devices. The
list of potential regulatory concerns for various industries is,
unfortunately, endless.
7.
The United States Employee Retirement Income Security Act
of 1974, as amended.
8.
The United States Pension Benefit Guaranty Corporation.
9.
The benefits of a focused sales process that minimises the
demands on management time cannot be underestimated.
In the author’s experience, it is not uncommon for business
performance to lag during the sales process because
management becomes distracted. This is certainly the case
when critical operating executives are essential presenters
during management meetings. The less time management
spends on these meetings, the more time it has to focus on
running the business.
Conclusion
In the author’s view, there is no principled reason why vendor due
diligence should not be the norm of practice in the United States as
well as in Europe. There is much to recommend the practice and
very little to say against it. At best, the arguments against it are
parochial and lazy. That said, until one or more significant private
equity firms decide to adopt vendor due diligence as a core part of
their process when selling their portfolio companies, there is very
little practical incentive for the U.S. market to change. The only
thing that prevents vendor due diligence from being used more
in the U.S. is the indifference of sellers, a strange state of affairs
given that many private equity firms also operate overseas and use
the practice extensively and routinely when selling their non-US
portfolio companies.
Endnotes
1.
2.
3.
4
This article considers only sales processes affecting nonlisted companies (that is, companies that do not have a class
of securities, whether equity, debt or hybrid, as to which the
company has an obligation to file periodic, publicly available
reports with the United States Securities and Exchange
Commission, comparable authorities in other jurisdictions or
foreign securities exchanges exercising similar supervisory
functions). Sales processes in “take private” transactions
have separate considerations and practitioners conduct
them pursuant to the requirements of specific regulatory and
market practices.
The specifics of accounting due diligence are outside the
scope of this article. Speaking from practical experience,
however, relevant areas of accounting due diligence are
likely to include the quality of earnings, the cash-generating
capabilities of the company, and material risk areas such as
inventory accruals, bad debt experience, litigation and other
reserves, such as for product warranty claims or similar
contingent liabilities, as well as those accounting areas most
subject to significant estimates and judgments.
Examples include environmental, actuarial, engineering and/
or other technical areas relevant to the target company’s
business. Tax due diligence is generally not reflected in
vendor due diligence because tax optimisation strategies are
generally driven by the particular needs of each prospective
purchaser. For example, a private equity sponsor may
consider preserving the net operating losses or other tax
assets of the target to be critical to achieving its targeted
investment returns, yet a strategic buyer may put very little
value on those assets.
4.
The author is a U.S. lawyer with only a passing familiarity
with the terminology and requirements of the laws of other
jurisdictions. For the sake of simplicity, then, this article tends
to use U.S. terminology and legal concepts with the hope that a
reader qualified in another jurisdiction will accept his apologies
and identify the appropriate analogies for themselves.
5.
By the term “financing arrangements”, the author
intends to encompass not only traditional bank financing
arrangements but also debt or preferred securities, saleleaseback arrangements, equipment leases and other types
of similar arrangements, whether or not accounted for
on a balance sheet as a liability (e.g., some material lease
10. By this observation, the author refers to the negative
consequences to transactions when a buyer discovers a material
issue during diligence that had not been flagged previously by
the seller. When this happens, the most favourable inference
drawn by a buyer is that the seller is sloppy and does not have
its arms fully around its own business; the worst interpretation
is that the seller is dissembling. In either case, the buyer tends
to lose confidence in the seller and fears that there may be
other undisclosed and undiscovered significant issues. Any
buyer worried about the integrity of the due diligence process
is likely to seek more protective indemnification terms than it
might otherwise had the due diligence process been managed
better by the seller.
11.
While particular bidders may have concerns about issues of
unique interest to them given their individual circumstances
(which therefore are issues that a seller may not necessarily
be able to anticipate), it is almost certainly the case that if
the vendor and its advisors highlight a due diligence issue
as being material from their perspective, it will be an issue
worthy of study and understanding by all bidders.
12.
In the case of European transactions, the potential negatives
of vendor due diligence were long ago evaluated and
discounted. There seems no prospect that market practice
will revert to the older model. Market participants have
become used to the process. In the United States, however,
market practice has moved only glacially toward vendor due
diligence, which suggests to the author that there is still a
debate as to the merits of the process.
13.
A seller that affirmatively decides not to disclose materially
negative information to a bidder, or that hopes to bury the
disclosure amid an avalanche of other information to obscure
its significance, risks post-closing litigation, potentially for
fraud, breach of contract, or negligent misrepresentation. In
the case of the seller that simply takes the view that it will
populate a data room and leave it to the buyer to discover
items of significance, it risks losing credibility in the eyes
of the buyer, which in turn is likely to motivate the buyer to
take a more hard-line position in negotiating the acquisition
agreement than it might if it had a more positive view of the
seller’s integrity.
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14. VDDRs tend to be either (i) “long form” reports that
summarise and analyse the contents of a (now almost
always electronic, or virtual) data room established by the
target, or (ii) “exceptions” reports that focus on only the
most significant matters. In both cases, the reports typically
consist of an executive summary and a more detailed report
on those matters within the described scope of the report.
15.
16.
In discussing VDDRs with various colleagues, the author has
heard concerns expressed about the wisdom of clients who
are prospective purchasers relying on reports commissioned
and paid for by the seller. While VDDRs may not contain
the same recommendations and “colour commentary” that
a bidder might receive from its own advisors, it is hardly
likely that a well-regarded advisor working for a seller would
jeopardise its professional standing (and risk a lawsuit, more
on which later) by intentionally misleading (by misstatement
or omission) bidders about known due diligence issues.
Certainly it is possible that the seller may keep its advisors in
the dark about worrisome issues and therefore a VDDR may
not contain all the information a bidder considers important.
However, if a seller were willing to keep relevant facts away
from its advisors, surely it would keep those same facts from
a bidder’s advisors engaged in comprehensive diligence.
Finally, even if a VDDR does lack the same gloss a bidder’s
own advisors would provide, so what? Having received the
VDDR, the bidder’s advisors will have ample opportunity to
take a view on the report and to discuss with its client the
identified risks and possible solutions.
Vendor Due Diligence Reports
industry were likely to be comfortable with the approach
taken in the Memorandum of Understanding. The lesson to
be drawn – and which, in fact, was drawn by the English legal
profession – is that third parties who receive VDDRs will agree
to reasonable liability caps.
17.
18. In reviewing internal Shearman & Sterling precedent, the
author came across reliance letters governed by New York
law as well as letters governed by English law.
19.
Lee J. Potter, Jr., “Vendor Due Diligence: Could it Catch on
Here” (https://apps.americanbarorg/buslaw/blt/content/2011/07/
article-potter.shtml).
20.
The author is a member of the New York Bar and therefore
has focused on its rules of ethics. While the ethical rules of
other states may lead to a different conclusion, the author’s
cursory research suggests that is not likely in the context of
the specific questions considered.
21.
In this regard, it may be important to consider the definition
of the “client” for whom the report has been prepared. In the
context of a parent’s sale of a subsidiary, a report focused on
the subsidiary but issued to the parent and relied on by the
buyer clearly would be a report delivered to a non-client. A
similar result seems likely in the context of a sale of all or
substantially all the target’s assets (i.e., the report is not an
asset the target company can transfer to the eventual buyer
and, therefore, the buyer is not even arguably a client of the
preparing law firm). In the context of a merger transaction,
however, where the buyer will acquire the entity for which
the report was prepared in the first instance, there may be
slightly greater grounds for concern that the buyer and the
client become one and the same after the merger. However,
even if this were to be the case (something that would be
fact specific), any concerns about the validity of the liability
cap as a matter of legal ethics could be addressed by having
the report commissioned by the private equity house rather
than the actual target company. It would be a strange result,
however, if the form of the transaction drove the analysis of
the ethical propriety of a liability cap. Moreover, Rule 1.8(h)
of the New York Rules of Professional Conduct only prohibits
prospective waivers of liability for malpractice. In the context
of a merger, one might argue that the waiver was not made
prospectively, it was made after the buyer had the opportunity,
with the assistance of independent counsel, to review the due
diligence report and consider whether the liability cap was
reasonable under those known circumstances.
In February 1998, the British Private Equity & Venture Capital
Association (the “BVCA”) and the-then Big 6 Accounting
Firms entered into a Memorandum of Understanding with
respect to limitation of liability provisions in due diligence
engagement terms applicable to private equity transactions.
Although not legally binding, the Big 6 and the BVCA
agreed that:
■ in smaller transactions (those having a transaction value
of less than £10 million), the accountant’s liability will be
capped at the transaction value;
■ in mid-market transactions (those having a transaction
value between £10 million and £55 million), the
accountant’s liability will be equal to £10 million plus onethird of the amount by which the transaction value exceeds
£10 million subject to a maximum of £25 million; and
■ in larger transactions (those having a transaction value
greater than £55 million), the amount of liability generally
will be limited to £25 million although, in exceptional
circumstances unrelated to the size of the transaction, an
amount either less than or in excess of £25 million may be
agreed.
Further, the BVCA and the Big 6 agreed that in the case
of larger transactions (but not otherwise), accounting
engagement letters could contain “proportionality” wording
to address the principle under English law that says when two
or more advisors could be jointly liable to a third party, and
that party has agreed a cap on liability of one of those advisors,
the right of the uncapped advisor to seek contribution from
the capped advisor is limited to the amount the third party
could claim against its capped advisor. Proportionality
therefore could result in a greater claim against an uncapped
advisor than against a capped advisor.
The BVCA publication of its report with respect to the
Memorandum of Understanding is instructive in two
other respects: (i) first, the BVCA consulted in advance
with its member firms, which, the report stated, it broadly
expected would adhere to the terms of the Memorandum of
Understanding; and (ii) second, the BVCA consulted with
representatives of senior lenders and mezzanine providers who,
after discussion, indicated that their constituents in the banking
One reliance letter prepared by an English law firm and
reviewed by the author required the recipient to agree “that
any legal or other proceedings in respect of the Report must
be formally commenced and relevant originating application,
writ or other process served on [the preparing law firm] within
two years from the date of the Report”. Given the informal
nature of the author’s survey of precedent transactions, it
is likely the case that other law firms require comparable
undertakings in their reliance letters.
22. See “Contractual Limitations of Liability to Clients and
Others”, Committee on Professional Responsibility of the
American Bar Association (http://apps.americanbarorg/buslaw/
newsletter/0065/materials/pp8.pdf); see also “Working Group
on Legal Opinions, Fall 2007 Seminar Series” (http://apps.
americanbarorg/buslaw/newsletter/0067/materials/pp.6.pdf)
(“Rule 1.8(h) is applicable to agreements with clients, but
doesn’t seem to apply to those with non-clients”).
Note
The views expressed in this article are solely those of Mr. Dickens
and not of Shearman & Sterling LLP.
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Shearman & Sterling LLP
Vendor Due Diligence Reports
Jeremy W. Dickens
Shearman & Sterling LLP
599 Lexington Avenue
New York
NY 10022-6069
USA
Tel: +1 212 848 4504
Fax: +1 646 848 4504
Email:[email protected]
URL:www.shearman.com
Jeremy Dickens is co-head of the firm’s Private Equity Group. Mr.
Dickens has a broad background as a lawyer, having spent 18 years
with another leading international law firm where he was a member of
the private equity practice and co-founder and co-head of its Global
Capital Markets practice. In addition, he spent nearly six years as a
corporate executive, entrepreneur and board member before joining
the firm in 2013. He is an experienced private equity, leveraged finance,
IPO and restructuring attorney and has advised boards of directors on
a variety of complex matters including corporate governance, M&A,
restructurings, shareholder litigation and governmental and internal
investigations.
As one of the first law firms to establish a presence in key international markets, Shearman & Sterling has led the way in serving
clients wherever they do business. This innovative spirit and the experience the firm has developed for more than 140 years make
it the “go-to” law firm for seamless service. From major financial centres to emerging markets, the firm has the reach, depth and
global perspective necessary to advise clients on their most complex worldwide business needs.
6
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