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Careful What You Wish For: Limiting or Waiving Due Diligence in Private Mergers and Acquisitions
What area(s) of law does this episode consider? | Due diligence in private M&A. |
Why is this topic relevant? | Due diligence is a vital commercial step in the process of a merger or acquisition. The process allows the parties to discover information about each other which may not otherwise be readily available. A particularly notorious M&A transaction occurred at the end of 2022, Elon Musk’s acquisition of Twitter. In that transaction, Musk offered to buy the platform and waived due diligence. Musk then faced litigation when seeking to renege on the deal over what he said was an unsatisfactory amount of bots on the platform – something that he would have discovered had he done due diligence. Legal practitioners undertaking due diligence are entrusted with identifying legal risks. Understanding how those legal risks interact with the structure of a deal – and when to drill down into or let something go – is vital for any practitioner. |
What are the main points? |
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What are the practical takeaways? |
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Show notes: | The Big Idea: The New M&A Playbook (Harvard Business Review 2011) |
David Turner:
1:00 | Hello and welcome to Hearsay the Legal Podcast, a CPD podcast that allows Australian lawyers to earn their CPD points on the go and at a time that suits them. I’m your host David Turner. Hearsay the Legal Podcast is proudly supported by Lext Australia. Lext’s mission is to improve user experiences in the law and legal services and Hearsay the Legal Podcast is how we’re improving the experience of CPD. Now for most people, even most lawyers, the words due diligence might not get the blood pumping. It’s not exactly the most exciting of legal processes but it’s having its moment in the spotlight. With quite a bit of deal activity last year and early in 2022, due diligence has been at the heart of some of the largest business news stories of the year. And as one particularly notorious international transaction has demonstrated, due diligence is an absolutely vital step in the process of a merger or acquisition, allowing the parties to discover information about each other, which may not otherwise be readily or even publicly available. Of course, the transaction that we’re talking about is Elon Musk’s acquisition and privatisation of Twitter, a deal that was offered and announced on the Twitter platform itself, in which Musk offered to buy the platform without due diligence and then faced some litigation when seeking to renege on the deal over what he said was an unsatisfactory number of bots on the platform. The deal ended up going through, after all, and to say it hasn’t been smooth sailing since would be a bit of an understatement, all of which might have been avoided with a bit of due diligence. So; what is it? How does it work in practice? What can you and can’t you find out? And why on earth would you think about waving it? Joining me today on Hearsay to answer these questions is a good friend, the co-founder of Assured Legal Solutions, Chris Cruikshank. Chris, welcome to Hearsay. |
Chris Cruikshank: | Thank you, David. It’s wonderful to be here. |
DT: 2:00 | Wonderful to be here, finally. |
CC: | Yes. I’ve been waiting for my invitation for a long while, but I’m very pleased to be here to talk about this exciting topic. |
DT: | Yeah. Well seventy episodes in we’ve run out of other guests, and we thought we’d better extend the invitation to you! |
CC: | Yep. My time in the sun. |
DT: | Now, of course we know each other quite well, but listeners might not know you quite as well, although your reputation may precede you. But tell us a little bit about the sorts of matters that you work on day to day and where you might see due diligence. |
CC: | Sure. At Assured Legal, we are proudly a mid-market firm, but we come to that position having been the insolvency and restructuring team at a much larger international firm. So we see due diligence in two contexts. We see it in the solvent M&A context and we also see it in the insolvent context. So situations of distress and the sorts of due diligence you do, the sorts of risk that you look for can be very different in those different situations. So we see it broadly in those two categories. |
DT: 3:00 | Yeah, absolutely. And as we’ll come on to talk about later in the show, there’s a whole range of differences between those distressed and non-distressed situations, both in terms of what might be driving due diligence and also what kind of protection it might give you. Now, we talked about the Twitter acquisition at the top of the episode. Fascinating story to be following, but probably not an enviable one to be working on or living. That’s really an example of due diligence gone wrong, isn’t it? |
CC:
4:00
5:00 | Yes is the short answer. It’s an example of lots of things gone wrong, I think, with a transaction. But certainly due diligence is one of them. Elon famously waived due diligence and as a result was locked into the transaction. As I said, there was lots of things that were wrong with the transaction, he’d obviously mistimed his run at the market. I think every market has their ups and downs and there will be a notorious top of the market deal or a famous bottom of the market deal for each cycle. I suspect we might be watching in real time the notorious top of the market deal for this particular cycle. For the interest in tech stocks coming off over the last six months, increasing interest rates. The moment that he made his offer – Tesla stocks flying – he felt like, and was, the richest man in the world. Made his bid, waived his due diligence, and it went wrong from there, really. TIP: Now, in April 2022, Elon Musk made an offer to purchase Twitter – a then-public company – at $54.20 a share or around US$43billion for the lot. This offer was unanimously accepted by Twitter’s board. Musk, notoriously, chose to waive his right to due diligence. Around May of 2022, Elon claimed that he would put the deal on hold while he requested details of the numbers of spam or fake or bot accounts on the platform. In June, Twitter provided a stream of data to validate its numbers. In July, Musk famously decided to call it quits with the excuse that Twitter never provided him with the requested data about bot accounts and that same month Twitter’s board determined it would pursue legal action to enforce Musk’s closure on the deal – resulting in the infamous “oh the irony” tweet from Musk and some amazing pleadings filed by Twitter’s legal team. Twitter took Elon to the Delaware Court of Chancery – which is the delightfully quaint name of Delaware’s corporations court – demanding he fulfill his side of the deal and after the filing, Elon ultimately agreed to go through with the deal after all in October of 2022. Judge Kathaleen McCormick noted that the whole thing could have been avoided if due diligence was performed and not waived by Elon Musk. If he hadn’t waived his due diligence, obviously would’ve been in a process and had lots of opportunities to look at the underlying business and work out an exit route when the market turned against him, when the economy turned against him. The style of the man is not to take a step back. He famously backs himself and he currently owns Twitter as a private company. And is belting it into what he regards as much better shape. |
DT: 6:00 | Yeah, the $8 blue checkmark seems to be going really well. |
CC: | The $8 blue checkmark. I think currently it doesn’t have a CEO, doesn’t it? I think he put that up on a poll recently and was voted out. |
DT: | Yeah, as he famously says, “vox populi, vox dei“. But the voice of God hasn’t really fallen in his favour on that last poll. Speaking of which, I think I saw the Jesus Christ parody account had a blue verified check mark, so… Anyway, we’re not here to lampoon Elon Musk, although it is fun, we’re here to talk about due diligence now. Have you ever seen a transaction where a party has completely waived due diligence? |
CC:
7:00
8:00
9:00 | In our experience sometimes doing distressed transactions we do see that occasionally. Let me explain that, because that might sound strange having just lampooned Elon for exactly that. Your typical M&A transaction involves someone outside the business or target looking to acquire the business – the economic benefit of that business. And in those circumstances it’s really uncommon for bidders to waive their right to conduct some due diligence. As a very basic proposition, due diligence is just looking for and understanding risk. And if you’re outside a business, it’s eminently sensible to look for and identify risk in the business before you buy it. So in those circumstances we definitely don’t see people waiving their due diligence – their right to conduct due diligence – often at all. However, in situations of distress, we do see a version of that quite commonly. Insolvency practitioners will have to sell businesses quite quickly with accelerated timeframes because of a short runway of cash available to keep the business afloat. They’ve got a short time to realise the value that is left in the business for creditors. And so not so much a circumstance of a third party waiving the right to do due diligence, but certainly a circumstance of a vendor saying, “ordinarily you might take a month to look at all elements of this business, but we really only have three days.” And so do your best in the time that you’ve got. And in those circumstances the elevated risk that those bidders consider that they’re taking on, is factored into the price. And so, coming back to Elon, part of his problem is he paid top of the market dollar for assets that he felt he knew about by watching them perform on the platform itself rather than from inside the tent. Whereas in the distressed situation you might have that dynamic of not truly understanding, but factored into price. And then I guess the last situation, or the most extreme version of that, we very regularly see founders, owners, and shareholders who may have had to tip their business into a formal insolvency process. The underlying business may be strong or solid, but trapped in a distressed financial structure. And so if they’ve had to put the business into an insolvency process, there are often circumstances where the insolvency practitioner runs a quick process and the owner or the former owner and shareholders buy the business back. And so in those circumstances, you’ll see people waiving due diligence rights all of the time but quite common sensical. If the idea of due diligence is to understand the business, identify and quantify the risk, someone who’s lived the business understands it day in day out, has had to hand it over to an insolvency practitioner and picks it back up quite quickly can waive those rights because they still do truly understand the business. |
DT: | And they’ve already accepted those risks. |
CC: | Exactly. They’ve lived with them for a number of years while they traded it. |
DT:
10:00 | And I suppose the other perspective on those distressed transactions and the limited due diligence or even no due diligence that might be available there is, as we might come on to discuss a bit later, due diligence isn’t just a process of finding out about the asset, it’s also a process of delineating the limits of the warranties that a seller is giving about the assets you’re acquiring. The back of any sale agreement has – depending on the complexity of the transaction – between 2 and 200 pages of legal, tax and other warranties. Would that be fair to say? And those warranties typically apply except in so far as they are contradicted by something disclosed in the process of due diligence and where a insolvency practitioner is conducting that transaction, as you say, very quickly over a condensed period of time and not having had an opportunity to exhaustively investigate the affairs of the business, there might be very little to disclose to define those warranties and there might be very few warranties that the administrator or liquidator is in fact prepared to give. |
CC: | Absolutely. Usually none. |
DT: | If you’re lucky, you might get title. |
CC:
11:00 | Yeah. If you’re very lucky. Insolvency practitioners who are appointed to a business and don’t know it are very, very, very reluctant, in my experience, to give any form of warranty. So yes, if you view the due diligence process as a way of minimising or reducing the risk you’re otherwise giving in the warranties, absolutely it makes sense that in an insolvency context where you get almost no warranties anyway, there’s going to be limited due diligence. I think the real perspective is the inverse. In a solvent transaction, you certainly do have vendors, particularly private equity owned vendors, who will want to ensure that the data room and the due diligence offered to purchasers is very comprehensive from exactly that perspective. They understand that they’ll be asked to give a bunch of warranties in the transaction docs, and they minimise that risk or mitigate that risk to a large extent by the extent of the due diligence that they can provide. They use that tool alongside warranty and indemnity insurance but probably a topic for another day, but certainly that interplay between the extent of the due diligence and warranties is a common feature in M&A transactions. |
DT: 12:00 | And without going too far into it, I suppose a policy of warranty indemnity insurance can often govern where most of the time on due diligence is spent because it might not cover certain kinds of warranties, warranties as to title, for example, and so that might then take up much more of the investigative time if the risk is otherwise mitigated by that insurance policy. But would it be fair to say in summary then we often see that sort of waiver of due diligence as a process in distress transactions, but very rare in non-distressed transactions? |
CC: | Absolutely, yeah. You look at the transaction in the context in which it’s being done. If you have a bidder unfamiliar with the target bidding for the asset, it is very uncommon for them to waive their rights to learn about the asset. If you have a bidder that is very familiar with the asset or a vendor that has not a lot of time to tell the bidder about the asset, in those two situations, you see much more limited due diligence or sometimes none at all. |
DT: 13:00 | And I suppose even in a non-distressed situation, you could imagine a minority but substantial shareholder in a business acquiring a majority stake might also be prepared to forego some due diligence if they have representation on the board. They’ve been aware of the operations of the business and had access to the books and records for a long time. |
CC: | Absolutely. Yes, absolutely. |
DT:
14:00 | Now, in saying all of that, there’s an example that comes to mind for me, having worked on a few M&A transactions and one that I’m sure must be coming up in some conversations perhaps at BHP and OZMinerals over the last couple of days, now I’m not sure when this episode will release, but at the time of recording, it’s the 22nd of December. Yesterday it was announced to the market that BHP’s exclusive access to the books and records of OZMinerals had been extended to the 27th of December. So Merry Christmas to the advisors working on that transaction. At this time of year everyone wants to clock off, start their holidays. On the 23rd or the 24th of December, you get that pressure; “look, there’s 50 items on the due diligence checklist. 49 of them have been ticked off. Can’t the lawyers just give it a rest and let us complete?” There’s sometimes pressure to waive individual items in a request for information or in a due diligence process. Would you say that’s fairly common? |
CC:
15:00 | Undoubtedly, yes. I think often in a deal there’s a fundamental tension between what the lawyers are setting out to do and what the business people are setting out to do. The business people are driving the transaction, see synergies between two particular businesses and wish to pick the two businesses up and put them together. The lawyer’s perspective, particularly on due diligence, is to identify, quantify risk for their clients so they understand what they’re getting themselves in for. And so there’s this fundamental tension often between getting the deal done and the legal due diligence process that is designed to ensure that people understand what they’re getting themselves in for, and that tension becomes more and more pronounced as you get closer and closer to the finish line – to closing the deal. If you’re in the happy situation as the lawyer leading it, and you’ve closed off all of the due diligence items, well done. That in my experience is relatively uncommon. Mostly there’s always some things hanging over and usually, particularly with accelerated deals, there’s often some bigger ticket stuff that is still open. And so you certainly are under that pressure as the deal is getting closer to completion, particularly if you have a situation where the stakeholders or founders wish to announce the deal to the market. |
DT: | There’s all sorts of pressures at any level of the market. At the one hand you might have a very large transaction where announcing the deal to the market is important. There might be some obligations around announcing the deal to the market. |
CC: | Yep. |
DT: | But even in SME businesses that are being acquired, you have some very different pressures. I can think of one that business brokers are sometimes quite keen to get deals signed and might be driving the signing process perhaps at the expense of completing some of those inquiries. |
CC: 16:00 | Exactly. I’m yet to see someone who has a success kicker fee arrangement that kicks in on completion, be particularly concerned about the four or five, pretty esoteric legal risks that you might have hanging over a deal. They’re usually far more excited about the fee that they’ll get for closing the deal and often justifiably so, they’ve worked very hard to get the deal, to that point and the last thing they want is lawyers with a fastidious focus on risk getting in the way of that. |
DT: | Very diplomatic, Chris. |
CC:
17:00
18:00 | But often, what you see is just the mid-market moves very quickly. And so if you have owner operators in the mid-market who have decided to buy a business, engaged lawyers and in their mind almost completed that process, really what’s driving their timing is just wanting to start the plan that they have in their mind or that they have written down in their business plan and get on with things. And things like a couple of outstanding consents to act, for example, on a couple of smaller but not too important leases that are holding up the broader transaction, often you’re under pressure to take a view on or you’re under pressure to put some advice into context so that they can achieve the commercial outcome that they wish. And we do, as lawyers, need to remember that our role is to identify the legal risk, but there are a number of components to due diligence. There’ll be the advisors looking at the business from a financial perspective. Everyone will be looking at it from a regulatory and governance perspective. There’s just the fundamental threshold business perspective. There’s difference in risk in a business that manufactures aprons, for example, compared to a business that manufactures some sort of food product that people eat, all the way through to the much more risky end of manufacturing products that may be used in the military or things like that. In the underlying business itself, there’ll be varying elements of risk and someone will have done that due diligence on the business from all of those perspectives. So as we get to close we as lawyers do need to remember that all of those things are done. The proponents of the deal wish it to occur and so we need to view our role in perspective. |
DT:
19:00 | Yeah, absolutely. And it is an interdisciplinary process, often the material that we are pouring through is being poured through by the tax accountants, by the management accountants, by the investment bankers, by the management consultants, the McKinseys, etc. But I think our listeners would be really interested in maybe how you handle that situation where there’s an item in the due diligence checklist that you think is pretty important that you’d really think you’d rather find out about before closing or signing – we’ll talk a little bit about the situations in which you might be conducting this process, pre-signing or pre-closing – but the client really just wants to get it over the line. It’s the 23rd or 24th of December, time to clock off for the year. Of course, we have to act on our instructions. We aren’t the owners of the process. We are there to assist the people who want to get the deal done, as you said. But how do you tactfully manage that process? How do you, without being difficult, without getting in the way, try to make sure that those inquiries get closed out? |
CC:
20:00
21:00
22:00
23:00 | Yeah, that’s a great question and I think you’re exactly right in the sense that we’re not the owners of the process, we are not the principals. Our role is to support the transaction and help it to occur if it is to occur. From the due diligence perspective, our role is just to make sure people understand. It really is as simple as that. Due diligence is identifying elements of legal risk, seeing them for what they truly are in the real world and quantifying that risk so that our clients who aren’t legally trained can understand. And so looking at it from that perspective that really is our role. And so if the underlying problem is that we understand the issue but it’s not closed off to our satisfaction, then that’s one category of problem. So things like identifying that some third party consents are required and we can’t see that those third party consents have been obtained, that’s an example of a problem in this category. And I think all you do in that category is make sure that your underlying client understands what the risk is involved in proceeding without those third party consents. And I’d suggest to all lawyers out there to really try to do that in the context of the transaction and in the context of the real world because we often understandably focus on legal risk that is our role in these transactions, it’s our role in life, but we don’t practice law in a vacuum. We practice law in the real world, and our role is to make sure that people understand that risk in the real world but then there’s a second category of risk, which is a much more difficult problem. If we understand that there is an issue or we suspect that there might be an issue there, but we don’t know the full extent of it, or we understand the problem, but we can’t quantify how big a problem that might be, that is much more difficult because human nature is you’re a bit scared of the uncertain, lawyers are particularly focused and trained to identify those areas and bring light to those areas so that we do understand it. And fundamentally that’s what we’re trying to do for due diligence. So, that one is a much bigger problem. Again, it does come back to practicing law in the real world. So if the deal transaction is such and the timetable is such that you can’t do anything else, the transaction’s occurring around you and you do have no further time, you just need to flag in your due diligence report that you sense that there is an issue here, and in the time that you haven’t been able to drill into it, quantify it appropriately or to your satisfaction and just put that issue up in headlights. If you do have some influence on the transaction timetable, certainly in the mid-market you often do, if it’s a big enough issue, you may be able to go to the founders, the advisors and say, “look, we’ve got this particular problem.” We dealt with one recently in the medical context. Performing, functional, very profitable medical business, obviously in the medical industry, quite highly regulated, a number of regulatory permissions required to conduct the business and through the course of the due diligence we identified that there was one relatively important one. Not the most important one, but one relatively important one, that we hadn’t been provided with yet. Exactly as you said, David, the transaction closing around us and under pressure to sign off on the transaction so that it could close but in those circumstances, that was a sufficiently important issue that we brought that to the attention of the key stakeholders, they understood what that meant. We adopted a slightly revised timetable to drill into it a bit further, understand that there was the regulatory approval, it just hadn’t yet been provided. We took another couple of days to drill into that regulatory approval, all was in order and the transaction closed I think about 7 or 8 days later than originally contemplated but from the perspective of the original timetable not disaster stations. |
DT:
24:00 | I think that point about risk, we are focused on risk, usually legal risks, and I think often our preference is to eliminate them, follow that rabbit down the hole so far that we can close out that issue completely but of course, as we’ve said a few times on this show, there’s a number of ways to approach a risk. You don’t necessarily have to eliminate it, you can mitigate it, you can transfer it with insurance, you can accept a risk and I think sometimes our clients are much more willing to accept a risk than we are. Now, we’ve talked about waiver of due diligence now let’s take it back a step and talk about the process itself. So far throughout this episode, we’ve been using completion and signing almost interchangeably. We’ve been talking about pre-completion due diligence, we’ve been talking about pre-signing due diligence, but really they’re very different things. Sometimes you might conduct due diligence before signing your sale agreement, sometimes you might conduct it before completing, often you’ll do both. Chris, tell us a little bit about why you might be completing due diligence before exchange and why you might be completing due diligence before completion and what those processes might look like. |
CC:
25:00 | Yeah, sure. Your usual transaction involves roughly four phases, I would say. Roughly first phase, term sheet. At that point, you’ve got an interested vendor and an interested purchaser. For larger transactions, you might have a very motivated vendor running a sale process with a bunch of prospective purchasers. And then the second phase is really your due diligence phase. A phase where before there is any binding legal commitment, although that’s not always the case but usually before there’s a binding legal commitment parties can jump into a data room and understand a little bit about the business and the asset before they sign their life away and acquire it. The third phase is the transaction documents phase. So that’s the signing phase that you’ve spoken about David. And the fourth phase is completion. So satisfying the conditions precedent in the binding legal agreement and getting to completion. A transaction that involves really good due diligence really involves some form of the due diligence process going almost all the way through that process, completing simultaneously with completing. There’s usually not much processing, continuing to understand a business or an asset that you already own, although again, that’s not always the case. There may be particular circumstances where for particular reasons you wish to complete that understanding. |
DT: | And then you’ve got the loathsome situation of completion subject to the post completion deliverables. |
CC: 26:00
27:00 | Yes, exactly. And what you’re looking for in those situations is different. A term sheet sort of phase and prior to signing you often have buyers who don’t know the business or underlying asset learning about it in detail, getting themselves up to the level of an understanding of the business so that they can be confident in the price they’re putting forward and confident in their terms. So at that phase of the due diligence, it’s really a very steep learning curve, understanding really what the business is, what it does how it works, how it makes money, hopefully, and each purchaser or prospective buyer will be looking at it from the perspective of the little or big things that they can do to take that business and make it even more profitable in their hands. Whereas at the later stage in a transaction – certainly post-signing legal docs and in the lead up to completion – you might be just making sure that nothing has changed in the business that you’ve understood from an earlier phase of your due diligence, making sure that nothing has changed before you complete the transaction. |
DT:
28:00 | Yes, absolutely because I suppose at each of those stages, the relevance of that information is changing, isn’t it? At that term sheet level, it’s really about pricing information. You can’t make a sensible bid, especially in a competitive process like you described, without some of that due diligence being completed. The traditional conception of M&A pricing is, it’s the value of the enterprise plus some share of the synergies you expect to gain from buying it. How do you know what those synergies are or what the underlying value of the business is unless you learn a bit about it? And then as we continue through, we’re looking at issues like the one you described with that medical business, regulatory risks, things that might have to be done in order to complete and further and further on and that leads me onto my next question for you, Chris, which is, what kind of factors are we considering in due diligence, legal due diligence, that is the kind that our listeners might be conducting. Some of them are more obvious than others; the underlying financials of the business, its tax affairs, intellectual property’s a common one, especially with the deal activity in the tech market that we were describing earlier, but there’s some other factors that you might look at in due diligence as well, isn’t there? |
CC:
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32:00 | There are, yes. You’re looking all up and down the business for legal risk, but you’re looking from two particular perspectives, really. From the first and most important perspective, you’re looking to understand what it is that you’re acquiring. So how does this business operate? How does it make money? Does it need leases to do that? Does it need people to do that? How many leases does it have to do that? How many people does it have to do that? And then dropping down a level, what are the lease terms? What are the employment terms? What does all of that mean for the cost of this business in its ordinary operations? You’ll be looking for traditional legal risks, so litigation. You’ll run a bunch of searches on the company to understand that it’s been in business for 20 years and has not been involved in any disputes, or it’s been in business for 6 months and is currently in 14 different disputes in every court in the land. Obviously two very different risk profiles in those two different circumstances. But the other category that you’re looking at is the transaction element. So if we were to acquire these assets in the way contemplated – either a share sale or an asset sale – what do we need to do to validly pick those assets up and transfer them across? And that’s a very different and much more specific set of searching and due diligence. In those circumstances, you’re looking for particular provisions in particular well known agreements to achieve those outcomes. So, obviously, leases will involve assignment provisions. So before a lessee can assign a lease what the lessee needs to do will be written into the lease, usually obtain landlord’s consent to any assignment and most leases will contain a provision that says if there’s a change in control of the lessee that’s a breach of the lease. The landlord likes to know who they are dealing with when they grant their leases and so if there’s a change in who they’re dealing with that’s technically a breach of the lease. And so if the transaction is a share sale, you will need landlord consent in order to achieve what you wish which is an assignment of those shares from the vendor to the purchaser. And so you’re looking for two different things all the way through the due diligence process. So usually the way that comes about is you start with a due diligence checklist that from a legal perspective, commences with the assets that you’re looking at. So what are the assets? Are they shares? Are they the underlying business? If they’re shares; who has title to them? You drill into that. ASIC searches on the company itself. Cross-checking the corporate register against the ASIC register to identify discrepancies to make sure that when you buy the 1,400,000 shares that you think are issued by the vendor company, that you’re actually getting 100% of the vendor company. But that due diligence checklist will then roll through all of the different areas that you ordinarily look at in a business. So it will range from leases, as we’ve discussed, it will cover employees, it will cover regulatory issues or problems, if you’re in a highly regulated industry it will often cover tax, even in the legal due diligence, just to make sure that there are no outstanding legal problems arising from the company’s tax affairs. Often in the mid-market, you’ve got very busy proponents, very busy business owners, and you often find that the company is well run, well managed and completely up to date with all of its tax affairs but occasionally you might find a business that is well run, well managed but has a few outstanding filings and you certainly wish to know that before you acquire that business. But continuing on with our list. You then are looking at things like litigation, intellectual property is a big one, particularly with tech companies. |
DT:
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34:00 | Yeah, I think we’ve talked on the show before about intellectual property due diligence in tech, especially in software companies, and how to manage open source software because traditionally the due diligence process for intellectual property has been to ensure that the company owns everything that it’s developed, that it has the ability to deliver title but of course open source modules open source software is a essential part of really any modern software development and increasingly lawyers have to be aware of the MIT and other open source licenses that govern that open source software to be satisfied that, yes, the intellectual property that’s being transferred or that the company that’s being sold owns has some open source elements, but it’s subject to a license that allows that to be transferred on commercial terms. Now there’s something interesting about your answer there, Chris, about the kinds of things that you look at which really jumped out at me. One was that the risks that you might expect to identify from a particular search or a particular category of questions might be relevant to another category in the sense that we do litigation searches, we do court searches to identify if a company’s subject to any pending litigation. And of course, that’s a pretty obvious risk if a company’s subject to a live damages claim. There might be a pretty big liability on the horizon. But even if it’s been the subject of historical litigation as you were describing, if a company’s been in business for a couple of years and has a dozen adverse action proceedings in the Fair Work Commission, that might suggest that there are cultural issues in the business that you might want to address or might want to be satisfied by being addressed before you proceed with the transaction. And that really leads me to people risks, the kind of due diligence issues that come up with individuals especially in an industry like professional services, where the whole business really is the individuals and the relationships between them and between their customers. We’ve worked on some notable professional services transactions. How do you do due diligence on people? |
CC:
35:00
36:00 | Yeah, that’s another great question. And I think it really draws out the two ways that lawyers and non-lawyers would look at due diligence. So starting proposition, most business owners would say the real value in their business sits with their people. And if you take that by extension, the real value in two businesses together sits with those two groups of people working and operating together. From a legal due diligence perspective, traditionally you would look at all of the employment contracts in the target company, look at their employment terms again, from the perspective of understanding what it is that you are acquiring. How much do those employees get paid? What are their leave arrangements? What are the super arrangements? Where does the super get paid? All of those sorts of things. And then from the perspective of in most transactions, most bidders wish to make an employment offer to all employees on terms no less favourable than the ones they currently enjoy. And so making sure that you – from a bidder’s perspective – can actually do that to achieve happy employees coming across into the new structure. Traditional due diligence in non-labour intensive industries might stop there, but that probably leaves a hell of a lot of value on the table. It really would make sense to have a bit more due diligence on the sort of people who are involved in the target company, what their culture is, and how that is going to interplay, or how that will translate, and how that will succeed in the culture of the new organisation. The figures around M&A historically aren’t necessarily great in terms of successful M&A deals. On their original definitions of success, most M&A deals fail. |
DT: | I think the Harvard Business Review says most M&A deals erode rather than create value. |
CC:
37:00
38:00
39:00
40:00 | Exactly. TIP: Now, to borrow a turn of phrase from Chris, this is an idea worth drilling into. In 2011, the Harvard Business Review published an article titled “The Big Idea: The New M&A Playbook”. It proposed a unified theory designed to address the causes of success and failure in merger and acquisition activity. The authors of the article had this to say to explain why most research typically puts the failure rate of M&A deals repeatedly puts the failure rate of a merger or a acquisition at between 70% to a staggering 90%, and I quote: “So many acquisitions fall short of expectations because executives incorrectly match candidates to the strategic purpose of the deal, failing to distinguish between deals that might improve current operations and those that could dramatically transform the company’s growth prospects. As a result, companies too often pay the wrong price and integrate the acquisition in the wrong way.” In other words, acquiring companies tend to overvalue the companies that they’re acquiring. They believe that the target company will have a dramatic effect on the growth prospects of the company and not merely the attractive but far more modest impact on current operations. As a consequence, they pay a higher price for synergies that they’re ultimately not going to realise. Chris is going to jump back onto this point in just a moment. And I think my perspective on having watched this occur for 20 odd years and really never quite understood how the single biggest valuable asset that most people see in a business is the people and how they interact with each other to produce value is really left to a post-transaction integration issue. And so you pick these two disparate groups of people up pop them down into a room together and say, “now get on and work towards this new common goal.” And you can start to see why in those circumstances that any reasonable sized business takes 2-3 years for synergies to be seen, realised and exploited and, as that Harvard Review that you just referenced found, most businesses erode value, but most CEOs then explain the success of the business or the merger by slightly different criteria or criteria that move over time is probably the politest way to put it. And we see in professional services when you move two professional services businesses together, people focused on that culture and integration very early on, we definitely do see that. We definitely see advisors engage to assist the two businesses, understand what their strengths are on their own, what their weaknesses are on their own, and what their strengths and weaknesses might be together as a starting rule to generate some goodwill for the deal and then having things like select working groups or committees of people from one side of the ledger and the other working together to define what the common set of values, what the common approach to business might be, and starting to do that well before execution and certainly well before completion, but that is the exception. You don’t commonly see that in your roll up of vet clinics. You don’t commonly see that in your roll up of medical centers. You don’t commonly see that in an acquisition of a tech company. What you more commonly see in those situations is focus on the legal elements of the employment relationship, dropping two groups of people together, and then the business owners then from that point, making a genuine effort at working out how we can get these people to cooperate really well productively and valuably but that often is a missed opportunity. |
DT: | Yeah, absolutely. You don’t often see it, but it is a great tip that you’ve described there that I think we’ve seen in some professional services firms merging or one acquiring the other, of having the people who will be affected by the issue manage the issue. Creating those working groups as you described and working through those issues. The people who are most affected by the decision making it, but it’s rare to see. |
CC:
41:00 | Yeah, it’s human psychology, but it’s also relatively uncommon. In most things in life, if you’re told what you have to do, you might do it, but do it a bit more reluctantly than if you are invited towards a course of action and you choose it willingly and then once you’ve chosen it willingly, you might champion that cause of action and that really is, particularly for bigger integrations, that really is important. You need those champions of the combination out there amongst all the employees talking very strongly and favourably. And if you’ve got that dynamic, you’ve got a really good chance of exploiting the synergies in the business far more quickly. |
DT: | The IKEA effect, if you help to build something, you tend to have a more positive disposition towards it. |
CC: | IKEA… |
DT: | That’s why I love the furniture in our office so much. |
CC: | A business at the source of your heart. |
DT:
42:00 | Yes. Listeners might have heard before, I don’t know, I love building flat pack furniture, and I do feel a real warmth towards the furniture once I’ve built it. I love all of the desk rises on all of our desks but I digress. Something in your answer really jumped out at me because we know, we hear these stats from publications like the Harvard Business Review, from august institutions like the Stern Business School, that far too much time is spent on the financials of mergers and acquisitions – on the theory of how the businesses might integrate – and then far too little time is spent on implementation and integration and indeed, often the estimates of how long it might take for that implementation and integration to take place are woefully underestimated. Now, in terms of the documentation we’re using to conduct due diligence, I imagine a lot of us – I have to say, on occasion, myself included – when we get out our request for information, which is really that first document to kick off the process, we get out our RFI checklist for legal due diligence, we tend to dust off a precedent, send that off, maybe tweak it a little bit. But this is really a reminder for us to think not just about the risks that we might want to identify, but the implementation issues that we might want to identify through that process as well because as advisors, we can really assist with that implementation if we can identify those issues through legal due diligence. |
CC: 43:00 | Yeah, absolutely. It’s an opportunity for a significant value add for us as lawyers. If we view our role as one to identify risks so that the expected transaction can happen, we sit at a certain level of value. If we identify our role as that plus ensuring that the expected transaction flourishes, you are inevitably going to be seen to be more valuable. |
DT: | Yeah. See that lost opportunity is a risk as well as just the concrete financial risks. |
CC
44:00 | Absolutely. In the RFI that you indicated – your request for information – the cornerstone of your due diligence process, you’re unlikely to be requesting information that gets to that combination point. How do these two businesses combine most effectively? But you can request some information about how the vendor sees itself. What is your culture? What is your set of values? How do your people see themselves and the value that they provide? And then you can assist the purchaser, if you’re representing the purchaser, to follow a similar process from their perspective. I would certainly be encouraging them to do it earlier rather than later and start to think about how you might integrate those two businesses successfully. And then I think you’re still going to run through your standard due diligence process. You’re still going to produce your due diligence report. You’re still going to identify the two categories that we spoke about – the categories of risk in understanding the business, and then the categories of how we transfer this business over to the purchaser – but you’ve then helped your client get a head start on that business flourishing and succeeding in the hands of your client. |
DT:
45:00 | Now, we talked about the Twitter acquisition at the top of the episode. There was a brief and exciting twist in that story where Elon Musk wanted to back out of the deal. There was some litigation, the pleadings in that litigation made for great reading with embedded tweets and emojis and all sorts of things, it was great reading. Where a party has waived due diligence or has conducted due diligence and on the basis of it signed the transaction documents but now wants to back out of the deal. What can be done? Is due diligence ever a basis on which a transaction party can seek to back out of a deal or once that due diligence is complete and the documents signed are they bound to go through with it? |
CC:
46:00
47:00
48:00
49:00 | Yeah, that’s a really interesting question. And the answer sits in the shades of gray. So starting point; once you’ve got your deal signed is what does the agreement say? There’ll be a bunch of conditions precedent to the agreement and, once those conditions precedent are satisfied, one party will be obliged to complete, or both parties often will be obliged to complete, but from the perspective of your question, you’ll have one party obliged to complete but may be not as keen to complete as they’d like. So the starting point is what does the agreement say, but certainly that interplay between the conditions that need to be satisfied before the deal completes and what has been disclosed in the data room is the answer to your question. So if there is an out for the party who wishes to have an out, it will be found there. I think part of Elon’s problem was there was a bunch of things in that category. There was also some financing problem, I think he put together his financing package about a week before he actually settled, having delayed completion for so long and having produced some litigation before then. So coming back to your question, we often see that situation emerge, but usually it’s much better acting for the purchaser to pick those issues up before you’ve exchanged. So we often see a situation where parties will jump into a data room, jump into a process, have a look, find something that they don’t like, and exit the process. That is very common. We have been involved in situations where parties have exchanged and then there is an argument about the extent to which one party’s obliged to complete, or the extent to which one party carries the risk of delivering something that is in third party control. You often see that with FIRB. You often see that with ACCC approval. FIRB traditionally and currently possibly is relatively slow to make decisions. FIRB can only make decisions based on the quality of information and the speed with which it’s provided with that information. So, if you’ve got a bidder who needs FIRB approval and that bidder provides information more slowly to FIRB than the vendor might like, FIRB moves more slowly, might make a decision later than the parties originally contemplated. TIP: Now, if you don’t know, FIRB is the Foreign Investment Review Board. It’s an advisory body that provides advice to the Federal Treasurer and the Australian government on matters related to Australia’s foreign investment policy – including reviewing proposed foreign investments in Australian assets. Now, being an advisory-only body, any determination by FIRB on the merit of a transaction comes in the form of a recommendation; it’s the Treasurer himself who ultimately has the decision making authority. Now, infamously, during the COVID-19 pandemic from about March 2020, the monetary review threshold for foreign investment was dropped to zero for all acquisitions. This meant that pretty much any investment into an Australian asset by a foreign entity had to be the subject of a recommendation by FIRB and a decision by the Treasurer before it could take place and this rule was brought in out of a fear of foreign investors swooping in to acquire distressed Australian assets during the downturn caused by the pandemic. Pre-COVID thresholds were reinstated for certain types of notifiable and significant actions in January 2021, but the $0 threshold still remains in other categories of investment assets and that means, as you might imagine, it’s created a bit of a backlog over at FIRB – one that our critical minerals sector has been making noises about as recently as December of last year. There often is a sunset clause in the agreement. So if CPs aren’t satisfied by a particular date, both parties may have a right to walk away from the agreement and so by slowing down the process with FIRB or another third party, that in itself may give a counterparty an opportunity to extract itself from a deal that it’s decided it no longer wishes to do. But the best advice for lawyers – if we at all can, remembering that we’re not principal, we can’t always do this – but try not to let yourselves or your clients get into those situations. Best to avoid a problem rather than need to confront it head on. |
DT: | Prevention is better than a cure. You do sometimes see, in those mid-market deals, certainly not at the top of the market where there’s a competitive process, you sometimes see the purchaser having completed satisfactory due diligence as a condition precedent to completion but of course acting for the vendor, that’s the sort of thing that you’d want to get rid of before exchange. It’s a bit of a carte blanche opportunity to renege on the deal at the last minute. |
CC: | It’s a get out of jail free card. |
DT: | Yeah, that’s right. |
CC: | The non-Elon card. |
DT:
50:00 | Now, as we’ve been saying, the purpose of due diligence is really to identify risk and this year, 2022, we’ve seen some extraordinary news of cyber breaches. The Optus cybersecurity breach really took everyone by surprise, the sheer scope and scale of that, given the number of Australian customers Optus has but very quickly it was eclipsed, I think, by the Medibank and AHM cybersecurity breach where we’re dealing with incredibly sensitive records – private health information, really about as sensitive a category of personal information you can describe. For deal makers, for deals lawyers, cybersecurity and cyber risk is probably right up there in terms of the risks that they’re most concerned about. How do we identify, how do we manage cyber risk from a due diligence and M&A perspective? |
CC:
51:00 | Yeah, David, great question. Again, due diligence is about identifying risk. Cyber and data is probably the biggest issue around in Australian corporate boards at the moment. A huge part of what most Australian companies are doing right now as a result of those breaches is reviewing their own systems, processes, understanding where the data that they hold on behalf of their customers sits, how secure it is and how comfortable they are with that. And so certainly over the last 5 years, you’ve seen an increase in cyber and data security as a due diligence point that is being looked at through the course of a transaction. It already was an important point that was being reviewed, but I suspect through 2023 and beyond, it will be right up there for legal due diligence on transaction structures. So for target companies, you will be looking at what data do they collect through their ordinary processes? With one eye on owning the business, you might have a think about whether that data is necessary because I suspect what the Optus hack taught us is that a lot of the data that Optus held wasn’t strictly necessary for their business. |
DT: | Absolutely. |
CC: 52:00 | Like they, they ended up with the data, they had it, but they didn’t really need it. They didn’t use it for much through their processes and that cataloging of data that they didn’t need proved to be a very risky element of their business. |
DT: | Yeah. And I think to digress a little bit, after these really eye-catching extraordinary breaches. I think we’re seeing a bit of a, I hate to use the term, but a paradigm shift in terms of how data is collected. If you looked at a privacy policy from 5 years ago, you’d see the most extensive catchall description of the personal information that we’re collecting. We’re collecting everything about you. We’re collecting your name, your date of birth, your dog’s date of birth, your dog’s favourite treat. All the information we can use because data’s useful. It’s such a valuable asset we want to collect it all. |
CC: | The Mark Zuckerberg approach to life. |
DT:
53:00 | Exactly. All of these tech companies are collecting data, data seems really valuable, we should collect some data. Today, we see that data creates some real risks, some real potential liabilities, and we’re now moving towards a principle of lease data. How little data can you collect about your customers in order to provide a quality service? And you’re absolutely right, why Optus needed to keep my driver’s license number on file after they had verified my identity to set up my account, I don’t know. That’s the sort of thing that you might think you would sight and dispose of rather than keeping it on file. But from a due diligence perspective, you’re absolutely right, there might be an opportunity, and we’ve been talking about how due diligence is an opportunity, not just to identify risk, but to identify implementation risk. What sort of data don’t we want? What sort of data don’t we want to acquire that we might want to leave behind or dispose of? |
CC: | Oh, absolutely. And data might be valuable, but it comes with the cost. It comes with all of the cost that Optus and Medibank are learning about now, but also it comes with a cost – the cost of storing data… |
DT: | Yeah. |
CC:
54:00
55:00 | … is one for the business people to consider. So absolutely, we should look at that. What data does the target company collect through the course of their normal business processes? And therefore, what data is there if we buy that company? But also we need to look at what I mean by ‘is there’. Where is that data held? Who owns it? Is it stored on site on a physical server by the company? Or is it stored in the cloud under a contracted arrangement between the company and a third party provider? And if the latter you’ve just got to follow that rabbit down the hole. Who is that third party provider? What does that contract provide? What does the tech that company uses in terms of safety and security? With one eye on how much data is there and how secure is it? And then again, coming back to your integration perspective, how does that sit into the way that we, as the bidder, own, hold and manage our own data because often there are, particularly with bigger M&A transactions, there are several years worth of IT work in exploiting the synergies that might exist in that data. You’ve got to get that data from the vendor and data from the purchaser to be talking to each other to be particularly valuable if there’s a synergy there and there often are a number of technological problems to be solved before those two pools of data can speak to each other. |
DT: | Absolutely. Now we’re nearly out of time, but before we finish up, I wanted to ask you a bit about what due diligence looks like in the office because look, I haven’t been practicing that long, but even I remember a time when due diligence was a lot of paralegals, 1-2 year graduates gathered around a table in a meeting room somewhere going through archive boxes of hard copy documents but due diligence doesn’t really look like that anymore, does it? There’s a whole range of tools that we can use to do the process a bit more efficiently. |
CC: 56:00
57:00 | Absolutely, yes. I think there are as many tools as your mind is open, really. And again, look, lawyers are excellent at following a process and repeating what we’ve done before, as we’ve spoken about earlier, due diligence usually involves you dusting off a checklist from the most recent deal that you did or your most recent deal that you’ve done in that industry, identifying the areas that you wish to look and going from there but it doesn’t have to be that way. And it certainly is the case that we as practitioners always should be looking at tools that can help us practice more effectively and help us practice law, as I said earlier, in the real world. And so the two categories of risk that you’re looking for, there are different tools that you can use to assist. If the advisor’s looking through financial statements, the traditional view is that they need to look at all those financial statements, truly understand the business. There are some tools that they can use that plug those financial statements through platforms that will provide some insights for them. Similarly, for lawyers, particularly in that second category, we are looking for the specific clauses that we know might be there in specific agreements that we know we need to look at to make sure that we can pick those assets up or pick that business up and transfer it over to the purchaser. That’s a very specific request and there is certainly tech and tools that we can use that will allow us to do that and do it far more effectively than maybe the traditional way of having graduates and law clerks sitting in a room picking up a hard copy version of a lease employment contract or whatever it may be, and flicking through the pages to find the right clause. |
DT:
58:00 | Yeah, there are a number of natural language models, I think especially of change of control clauses, that we were discussing earlier, there are a number of natural language processing models that can read through due diligence documents whether they’re OCR PDFs or something else that can identify change of control clauses for us. Now sometimes we think what’s the margin of error on that software that’s automating the identification of change of control clauses. Of course, as people, we have margins of error too so we have to weigh that up. |
CC: | We just tend to underestimate our margins of error. |
DT: | Yeah, that’s right. I think even if there is some reticence on the part of some practitioners to pick up these AI tools, in the deal space we move pretty quickly to adopt these technologies. I think one that’s just become an essential, as a matter of course, that no one would ever question using is the electronic deal room. That’s a essential tech tool of any M&A transaction. We would never think of doing due diligence without one today. |
CC:
59:00
1:00:00 | Oh, absolutely. Absolutely. And at the risk of showing my age I can recall a time where companies were such that when platforms like Ansarada first emerged, most of the work for vendors using those platforms were taking their hard copy documents that only existed in hard copy and putting them up on the electronic database with a whole range of concerns and queries around how that would be and privacy risk and cyber risk and all that kind of stuff. But we’ve moved well beyond that into a space now where most serious M&A advisors, practitioners will either have a preferred relationship with a platform or even have their own platform, relatively good margins in deploying their own platform for use during transactions. And so yeah, look, I think we’re well beyond that stage, but there are a whole range of other tools as well, ranging from those litigation searching tools to using public data brokers to extract your information, a whole range of different tools available to people. Obviously for the practitioners out there, there will be limitations in what your particular firm can do, you need to have a look at that. No sense investigating all of these tools and understand that they may not work at all in the confines of the security settings of your particular firm. So certainly have a look at that. But there are a whole range of tools out there that can help make our lives easier, even the output that we produce from this process is thankfully changing. The traditional 40 odd page written Word doc as your legal due diligence report has changed. Lawyers much more comfortable using slide decks now, using the tools of business. PowerPoint really became the tool of business 10 years ago, lawyers probably only caught up 5, 4, couple of years ago. |
DT: | Getting there… |
CC:
1:01:00 | Maybe… And traditionally, you might produce your all singing, all dancing, written, legal due diligence report in Word but then summarise it with a slide deck that sits across the top but even the way people work these days in a post-COVID world is very different. Due diligence, as you said, may traditionally have been a bunch of people, more junior practitioners sitting in a room together, working their way through particular elements of a transaction. Quite a dry subject matter to be doing. Absolutely necessary and really important grounding for junior lawyers. You’re looking at key commercial documents and understanding their effect in the real world. That’s very valuable grounding. But you’re doing that in a really fun environment with other lawyers around working to a timetable that was inevitably tight. Coming back to your reference to BHP and OZMinerals there’d be teams of, traditionally if that deal was 10 years ago, there’d be teams of lawyers sitting in a room together working away, a bit frustrated at the time of year, but possibly enjoying each other’s company. Whereas these days most due diligence will be done remotely using the tech tools all law firms and their clients will have put in place to view documents securely, but remotely from wherever it is that they tend to be practicing. |
DT: 1:02:00 | If there is a risk of some of the tech tools that we’re describing in conducting due diligence, it’s that maybe that’s a missed opportunity for some of that foundational learning, that those early building blocks for very junior lawyers or graduates to learn their craft. But I suppose one could also say our craft is changing and learning to use those tools is probably a much more relevant set of skills than learning to go through the archive box in a room with your colleagues? |
CC:
1:03:00 | Oh, absolutely. I think, undoubtedly, it’s really important to embrace technology and use it well. As I’ve said a few times we practice law in the real world, we deliver great outcomes for clients when we realise that. And so as the world embraces new technology and uses it, it’s just trite to say that lawyers need to do the same. But that key component of due diligence, which is looking at an underlying element of risk and watching it translate into the deal, into the transaction document for the deal, and then manage that risk to the extent it still exists in the real world post the deal, it’s that bit that’s the great foundational training for the lawyers. That bit won’t change. That is really important stuff because whether you’re in transactional practice or disputes practice, where that dynamic of a legal issue, problem or approach that needs to be translated into the real world using your written communication skills or your verbal communication skills, that is just what we do all day, every day and so learning that at an early stage in your career is incredibly important. |
DT:
1:04:00 | And the more efficiently we do each step of that process, the more complete a junior lawyer’s experience of that process and learning of it is. I think we’re in furious agreement that due diligence tech tools are good. Although such a shame that the lawyers coming up today won’t have that character building experience of standing by a photocopier for 2 weeks. Chris, thanks so much for being on Hearsay the Legal Podcast, we’ll have you back on before we’ve released another 70 episodes. |
CC: | Thank you very much, David. It’s a pleasure. |
DT:
1:05:00 | As always, you’ve been listening to Hearsay the Legal Podcast. I’d like to thank our very special guest Chris Cruikshank for coming on the show. Now, we talked a little bit about distressed asset acquisitions during this episode, if you want to hear more about distressed assets, why not check out episode 78 with the CEO of the Australian Restructuring Insolvency and Turnaround Association John Winter? It provides us with an in-depth update on the insolvency market. As you well know, if you’re an Australian legal practitioner, you can claim one Continuing Professional Development point for listening to this episode. Whether an activity entitles you to claim a CPD unit is self-assessed, but we suggest this episode entitles you to claim a substantive law or a professional skills point, take your pick. More information on claiming and tracking your points on Hearsay can be found on our website. Hearsay the Legal Podcast is, as always, brought to you by Lext Australia, a legal innovation company that makes the law easier to access and easier to practice, and that includes your CPD. Finally, before you go, I’d like to ask you a favour. If you like this episode and the other episodes you’ve listened to, please leave us a Google Review. It helps other listeners find us and that means that we can keep making the great content that you love. Thanks for listening and we’ll see you on the next episode of Hearsay. |
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