Due Diligence and Other Preclosing Matters
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Chapter 3: Due Diligence and Other Preclosing Matters
Nicholas J. Jones, Honigman LLP; Andrew C. Khouri, Honigman LLP

Financial Statements
Tax Matters
Title to and Condition of Assets
Contracts and Commitments
Products and Services
Environmental Matters
Permits and Licenses
Litigation and Claims
Labor and Employment Matters
Export Control Violations
Special Considerations When Buying a Division
Special Considerations Under the Sarbanes-Oxley Act of 2002
Other Preclosing Activities, Notices, and Filings
Paycheck Protection Program Loan Considerations

I.   Overview

§3.1   Due diligence is the investigation and analysis of a target entity performed in connection with the proposed acquisition of, potential investment in, or other proposed transaction with the entity. This chapter focuses on due diligence conducted in connection with the purchase of a privately held Michigan business by a private company. Transactions involving publicly held companies necessitate due diligence inquiries in addition to those discussed in this chapter and are not covered here. This chapter also discusses certain other preclosing requirements.

The purpose of due diligence is to confirm the legal status, financial condition, and assets and liabilities of an entity, which is important to structuring, negotiating, and consummating the proposed acquisition. After completion of due diligence, the buyer should have the information required to value the seller’s assets and assess its liabilities. Due diligence should also confirm (or disprove) the rationale for undertaking the transaction. That is, upon completion of its due diligence review, does the buyer continue to believe that the transaction will further its strategic goals or that the buyer will realize anticipated synergies? The process can also serve to identify disputes in valuation that may be resolved through a postclosing purchase price adjustment (if, for instance, there is an inventory valuation issue) or an earnout (in the case of a disagreement regarding the value of contracts yet to be performed or awarded). In addition, through the due diligence process, the buyer will identify actions that are required to be taken (such as obtaining third-party consents and making necessary governmental filings), or that the buyer desires to be taken (such as satisfying indebtedness, terminating contracts, and updating corporate records), before closing.

In several cases, buyers have sought to be relieved from their obligations to close under definitive documents on the basis of a material adverse effect or a failure of the seller to disclose certain financial or key business due diligence information (see, e.g., Valassis Commc’ns, Inc v Advo, Inc, CA No 2383 (Del Ch Aug 30, 2006), available at https://media.corporate-ir.ne... ; Complaint, Project Gamma Acquisition Corp v PPG Indus, Inc, No 604224/2007 (NY Sup Ct 2007)). Courts have sometimes taken the position that the onus was on the buyer to more vigorously investigate the target company; thus, the due diligence investigation in advance of execution of definitive agreements is essential. See, e.g., RAA Mgmt, LLC v Savage Sports Holdings, Inc, 45 A3d 107 (Del 2012) (rejecting potential buyer’s claim for due diligence costs incurred before discovering three significant unrecorded liabilities that caused potential buyer to end negotiations with seller—after seller had orally disclosed to potential buyer that there were no such liabilities—because, among other things, seller expressly disclaimed all representations not in definitive documents in preclosing nondisclosure agreement between parties).

Due diligence is primarily directed at the seller’s business; however, the seller will also conduct some investigation of the buyer. Depending on the structure of the transaction, the seller’s due diligence investigation can range from limited to comprehensive. In a cash sale, the seller’s investigation will be limited to ensuring that the buyer is, or will be, able to finance the acquisition and is properly authorized to enter into and consummate the acquisition. The availability of financing becomes more complicated if the buyer requires new bank financing or a combination of mezzanine financing and new equity. The seller should seek specific information about the financing sources and evidence of term sheets or debt and/or equity commitment letters from each financing source. These documents will, however, likely be preliminary or contain their own due diligence conditions. In addition, the seller, who knows the business, should be able to evaluate whether the proposed leverage can be supported by the business being sold; otherwise, the buyer will become aware of this problem later in the process after time and money have been invested by both parties.

The seller’s due diligence investigation should be conducted as early in the process as possible to confirm that the buyer is a viable purchaser, particularly in the context of an auction or other circumstance involving multiple bidders. This information can be obtained from public filings, industry reports, word of mouth, or financial information requested as part of the bidding or early negotiation process. Where some or all of the consideration for the seller’s business consists of the buyer’s equity, if part of the purchase price will be paid over time, or if the buyer will indemnify the seller in any significant respect, the seller’s investigation of the buyer will be more comprehensive.

Depending on the nature and size of the proposed transaction, due diligence by the buyer can consist of an exhaustive review or be more restricted in scope. In an asset sale, where the buyer acquires only specified assets and assumes only specified liabilities, due diligence may focus primarily on the assets to be acquired and liabilities to be assumed. However, even in a limited asset acquisition, the buyer should be sensitive to liabilities of the seller for which the buyer may have successor liability to third parties regardless of whether the buyer contractually assumed such liabilities. In a sale of equity or a merger, where the buyer generally succeeds the seller as to all assets and liabilities, due diligence should consist of a comprehensive investigation of the seller’s entire business.

A due diligence planning session should occur near the beginning of the inquiry between the client and the various advisors to discuss and agree on the scope of the diligence to be performed. The timing, the size of the transaction, the complexity of the business, and its inherent risks, as well as cost issues, may lead the client to limit or expand the scope of the diligence investigations.

Often, financial due diligence is conducted by the buyer’s financial advisors contemporaneously with legal due diligence. In addition, the buyer may have sought assistance from, for example, an insurance broker, an environmental consultant, or local counsel (in the case of a seller with foreign subsidiaries). It is helpful if the buyer’s advisors conducting legal due diligence coordinate with those conducting financial due diligence and any other advisors or consultants to streamline the due diligence process. It is also critical to understand the scope of the investigation required by the client, including the extent to which internal experts will be involved in the human resources, intellectual property, environmental, or other areas, and the format in which the results of the due diligence investigation are to be presented. To this end, the buyer’s legal team often designates one person to handle due diligence requests and monitor the flow of information to and from the legal team’s specialists as well as outside consultants. One frustration encountered in the due diligence process is repetitious requests for information, which often results in increased legal and consulting fees. This can be curbed by designating a due diligence point person for each consultant and each legal team. It can also be curbed by having one person maintain a comprehensive log of information that has been provided, the status of the review, and the remaining outstanding requests and issues.

Due diligence report sessions should be scheduled, with all necessary parties, if possible, at the inception, midpoint, and conclusion of the diligence process. At these sessions, identified problems should be discussed with the principal drafter of the documents and the key business person on the deal. The failure to appropriately identify and communicate the significant issues in the due diligence inquiry is a common downfall in the process. Any potential issues should be identified in a summary fashion that allows the draftsperson and business person to quickly grasp the potential consequences and ask for additional information or investigation, if warranted. This summary is often presented effectively at the beginning of a comprehensive due diligence memorandum (as a general rule, no more than 10 pages), with cross references to detailed explanations of the issues within the memorandum. Such an executive summary allows the reader to absorb the salient issues quickly and to refer to an exhaustive review of the issues as necessary.

Due diligence is typically conducted after the letter of intent has been signed but before the signing of the definitive purchase agreement. However, due diligence may begin before the letter of intent stage and continue following the execution of the purchase agreement. At a minimum, prior to executing a letter of intent, the buyer should review the seller’s financial statements (and notes thereto) and any offering memorandum or similar materials provided by the seller or its financial advisors. This should provide a high-level overview of significant liabilities and insight into past financial performance to juxtapose against the seller’s predictions of future financial performance, potentially affecting valuation. If due diligence is to continue after the purchase agreement has been signed, the buyer may wish to negotiate a so-called “due diligence out” in the purchase agreement providing, as a condition to closing, for the buyer’s satisfaction with its due diligence investigation. A seller should resist such a clause as it creates an option in favor of the potential buyer if, as generally occurs, the buyer has required exclusivity through a “no shop” clause from the seller. Further, if the buyer terminates the agreement after a public announcement following the execution of the documents, the seller will be viewed as damaged goods in the marketplace. Parties often reach a compromise by limiting the scope of the postsigning diligence to matters not reasonably accomplished earlier in the process, such as customer visits, further environmental investigation, or other specifically identified issues (e.g., patent claims).

Due diligence will proceed only after the execution of a nondisclosure or confidentiality agreement. To commence the process, the buyer will typically provide the seller with a checklist setting forth the documents and information the buyer seeks to review in connection with its due diligence investigation. The buyer may also request copies of particular documents relating to the seller’s business. Occasionally, the checklist will be provided by the seller, in which case the buyer should review and revise it to include any materials and information that were not addressed. The checklist should be broad enough in scope to cover information regarding the seller and all its subsidiaries.

A good checklist is critical to the due diligence process. The model checklist (form 3.1) included at the end of this chapter contains a list of items that should be reviewed in a typical transaction; however, not all such items will be relevant to every transaction. Depending on the structure of the transaction, the business of the seller, the industry in which the seller operates, and the assets and liabilities of the seller, some items listed in the model checklist will not be applicable. For example, the seller may not own any real property or may not be subject to substantial governmental regulation. Similarly, the model checklist should be adapted if the seller owns a significant asset or is subject to a significant liability that warrants further investigation. For example, if the seller is party to a significant legal proceeding, the buyer may wish to expand its checklist to request copies of pleadings and other court papers. Tailoring the list will engender goodwill and enhance the likelihood of a focused and appropriate response.

In connection with drafting the due diligence request, buyer’s counsel should obtain from their client the financial statements (with notes) and offering memorandum or similar material received from the seller or its advisors. In addition, buyer’s counsel should conduct Internet searches of the target company (including its website and industry websites). The Business Wire, PR Newswire (press releases), and Google (links to industry-related websites) websites contain useful information. Of particular interest for the due diligence request list are the notes to the financial statements, which usually summarize debt obligations, liabilities such as material pending litigation and regulatory actions, material lease obligations, and related party transactions. Such background knowledge allows the drafter to make the request list more efficient and meaningful for the seller.

Because the due diligence process can be burdensome to the seller and is often responded to by employees who also must continue to operate the business in an uncertain environment, it is important to tailor the checklist appropriately. For the sake of completion, the seller should be instructed to answer “none” or “n/a” in response to any item for which no materials exist (e.g., “describe any pending litigation”). Typically, the seller acts as gatekeeper of its documents and information. The seller, working with its attorneys and financial advisors, compiles all materials in response to the buyer’s checklist. Due diligence materials are most often uploaded to an online data or virtual data site. Different levels of access can be afforded to different parties in a virtual data site. For example, basic information may be made available early in the process with employee or customer information shared only after there is a greater assurance that the transaction will proceed on mutually acceptable terms. Since the virtual data site is prepared by the seller, often by reference to an index that is presented by the host of the site, the buyer will have to adapt to the organization of materials on the site. The buyer should compare the information included on the virtual data site with its standard due diligence request to confirm that all diligence it wishes to review is made available. In a smaller transaction, the seller may provide copies of the due diligence materials directly to the buyer. The seller should maintain a list of all materials provided to the buyer and the buyer should maintain a list of all materials reviewed. The seller should appoint a key contact (generally, an employee of the seller or its attorney or financial advisor) to coordinate its response to any supplementary questions. Use of a key contact will ensure consistency of responses, control data flow, protect confidentiality, and generally prevent excessive distraction of the seller’s employees. From a buyer’s perspective, it is important to have access to the seller’s officers with specific knowledge and expertise (e.g., human resources manager, environmental safety officer, etc.).

Often, to the frustration of the seller, the due diligence process is evolutionary, in that answers to certain questions generate follow-up questions that are reflected in supplemental due diligence questionnaires. Further, information is likely to be provided over a period of time by the seller, thus causing an iterative (or repetitive) process. In addition, some of the most insightful due diligence will occur in face-to-face meetings or site tours by the buyer at which the lawyer is usually not present. What is discussed in those interactions may, in fact, differ from what the documents state; any discrepancy will need to be managed as part of negotiating the transaction. Finally, the diligence inquiry, in one form or another, continues until the transaction closes! The parties should be aware of any provisions in the letter of intent, purchase agreement, and any other operative preclosing agreements calling for the return of due diligence materials if the proposed acquisition is not consummated.

The seller may be hesitant to disclose proprietary information to a buyer who is also a competitor. Moreover, the seller should be sensitive to issues that may arise as a result of its disclosure of certain information. For example, the disclosure of pricing information may raise antitrust concerns. In a sale to a competitor, the seller may wish to divide the due diligence process into stages. Proprietary or sensitive information (including supplier and customer lists) would be disclosed at a later stage in the process (such as following execution of the documents), at which point the buyer has demonstrated its commitment to consummating the proposed transaction. Alternatively, the seller may initially disclose documents with the sensitive information redacted and then disclose such sensitive information at a later date. This alternative allows buyer’s counsel to review the documents for legal issues such as assignability, change of control, liens, and termination provisions, which, if not addressed early in the acquisition process, can delay the closing.

The seller should be familiar with all due diligence materials provided to the buyer, not only to permit it to respond to follow-up questions from the buyer, but also because the seller will need to prepare the disclosure schedules to the purchase agreement. The disclosure schedules include all information called for by the representations and warranties of the seller contained in the purchase agreement. The diligence process also will allow the seller to be proactive in addressing issues that could impair the ability to close the transaction or may provide the basis for the buyer to argue for a lower purchase price. These issues can include required consents, employee severance issues, supplier claims, environmental issues, and litigation. It will behoove the seller to resolve open issues that may have a greater impact to the business in the eyes of the buyer than in the eyes of the seller. Further, items that are likely to be required by a buyer, such as a Phase I environmental assessment, real or personal property appraisals, or audited financial statements (the buyer, however, may require its own financial information in the form of a quality of earnings report), should be initiated by the seller in advance of the sale process to assure that, once commenced, the sale process can expeditiously move to closure. Otherwise, the seller is exposed to both market and business risk, as well as to the cost and expense of negotiating the transaction, for a longer period of time. Information (other than financial information) should be reviewed by counsel to the seller before such information is provided to the buyer.

The following sections provide detailed information about the types of documents and materials a buyer should review. References to the seller include the seller and its subsidiaries, any joint ventures in which the seller participates, or entities previously merged into the seller.

II.   Background Information

§3.2   The buyer should request all press releases and press clippings concerning the seller or its industry. Depending on how long the seller has been in business, the buyer may wish to limit such requests to items from recent years only. The buyer should also request a list of the seller’s websites and any newsgroups concerning the seller. This background information will provide an overview of the seller’s business and its industry, as well as highlight recent events the seller considers material to its business.

III.   General Legal Entity Matters

A. Organizational Documents

§3.3   The buyer should confirm that the business to be acquired has been formed and maintained as required for that particular type of business entity—sole proprietorship, partnership, limited liability company, or corporation. Uncertified copies of any certificates, articles, or registrations discussed below as being on file with the Michigan Department of Licensing and Regulatory Affairs, Corporations, Securities, and Commercial Licensing Bureau (the Bureau) may be available at the Business Entity Search on the Bureau’s website. Certified copies can be obtained by visiting the Bureau office at 2407 N. Grand River Ave., Lansing, MI 48906-3900; by calling 517-241-6470; by writing the Bureau at P.O. Box 30018, Lansing, Michigan 48909-7518; or by faxing a request to 517-763-0039.

Very few organizational steps need be taken in organizing a sole proprietorship. The sole proprietor should have filed a certificate of assumed name with the county clerk’s office in each county in which the entity does business or maintains an office. MCL 445.1. The buyer of a sole proprietorship should confirm and review such filings.

For a general partnership, the buyer should carefully review the partnership agreement and all amendments and ancillary agreements. If any partners have died or otherwise withdrawn from the partnership, records regarding the settlement of their interests should be carefully reviewed. The partnership should also have a certificate of copartnership on file with the county clerk’s office in the counties in which the partnership business is located. Although providing no liability protection, the certificate does permit the partnership to bring suit, and failure to comply with the requirement carries certain penalties. MCL 449.101 et seq. If the business location changes to another county, the partnership must file in that county. MCL 449.104a. Alternatively, the partnership may file a certificate of assumed name with the appropriate county clerk. MCL 445.1. These certificates must be renewed every five years. MCL 449.101b.

For a limited partnership, the buyer should examine the partnership agreement and a certified copy of the certificate of limited partnership (on file with the Bureau), together with all amendments, restatements and supplements, which will provide information about the names of the limited partners and their contributions to the partnership. The buyer may also want to review the governing documents of the general partner.

For a limited liability partnership, the buyer should examine the partnership agreement and all amendments, as well as a certified copy of the partnership’s registration and all renewals (on file with the Bureau). In addition to the partnership agreement, the buyer should also examine the settlement of any interests of partners who have died or withdrawn from the partnership.

For a limited liability company (LLC), the buyer should review a certified copy of the articles of organization and all amendments thereto (on file with the Bureau). Michigan limited liability companies are required to file an annual statement with the Bureau. MCL 450.4207. A Michigan limited liability company generally has an operating agreement pertaining to the affairs of the LLC and the conduct of its business, although it is not required by law. MCL 450.4102(2)(r). The LLC Act permits single-member LLCs to have operating agreements as well. Id. If the seller has an operating agreement, the buyer should review it, obtain a current list of members and managers, and determine whether the members or managers have the authority to act on behalf of the LLC.

For a corporation, the buyer should review a certified copy of the corporation’s articles of incorporation (on file with the Bureau). The buyer should also review the corporation’s current bylaws and obtain a current list of directors and officers. Generally, the corporation’s articles of incorporation and bylaws should be reviewed to see if they impose special requirements for shareholder approval (such as a supermajority voting requirement or a requirement for shareholder approval in cases where such approval is not statutorily mandated). The articles of incorporation will set forth the rights of any holders of preferred stock, such as special dividend rights, rights of redemption and conversion, liquidation preferences, and, of particular importance, protective voting rights. The articles of incorporation can also give existing shareholders preemptive rights, that is, the right to purchase a proportional amount of newly issued shares of the corporation. Corporations created since January 1, 1973, the effective date of the Michigan Business Corporation Act (MBCA), are presumed not to grant preemptive rights unless those rights are specifically provided for in the articles of incorporation or in an agreement between the corporation and one or more shareholders. MCL 450.1343(1).

For a limited partnership, limited liability company, or corporation, the buyer should also obtain a list of all states in which the seller is qualified to do business; a good-standing certificate, or its equivalent, from each such state; and a description of the seller’s activities in other states to determine whether qualification in those states is necessary. The buyer should also review any certificates of assumed name in Michigan (on file with the Bureau) and each other state in which the seller is qualified to do business to determine all names under which the seller has done or is doing business.

B. Corporate Minute Books

§3.4   The buyer should conduct a detailed review of the seller’s corporate minute books. The buyer should read the minutes of meetings of directors and shareholders, members and managers, or partners, as the case may be, preferably from the date of organization, but certainly from no fewer than five years before the proposed acquisition. The buyer should ascertain whether officers were properly appointed, whether important transactions were properly authorized and documented (including presence of a quorum and compliance with notice and other requirements contained in the bylaws or required by law), and whether there were significant transactions with officers and directors. Minutes of meetings of shareholders or members, as the case may be, should be checked to ensure that the directors or managers were properly elected and the amendments to organizational documents were properly adopted. Generally, the minute book will also give a good indication of whether the seller has adhered to corporate formalities. The minute book may contain unexpected information, including material contracts and transactions or problems that may not have been resolved (such as quality, employee, environmental, and litigation issues). If the minute book records are incomplete, the current directors and shareholders, members and managers, or partners can adopt resolutions (usually more easily done by consent resolutions) ratifying prior actions.

C. Capital Stock

§3.5   In a corporate stock sale, the buyer should examine the current articles of incorporation to determine the number of authorized shares of each class of stock. The buyer should then check the directors’ resolutions authorizing issuance of shares and the seller’s stock transfer records. These should be compared to the current shareholder list. It is important to check whether shares are held by a minor, in trust, and so on, and that the representative intending to sell the shares has the authority to sell and to bind the seller (including the beneficiaries of any trust) to indemnification obligations. If the selling shareholder is uncomfortable with sharing the trust documents, a relevant excerpt from the trust documents usually suffices. The buyer should also check the consideration for the shares and whether it was paid. Similarly, the buyer should analyze any redemptions by the seller of its stock to ensure that they were fully consummated and that there are no lingering or springing voting rights. In addition, corporate redemptions proximate in time to the transaction may raise securities liability issues for the seller as to the redemptions if they occur at a significantly lower price than that proposed in the current transaction. For any cancelled stock, the minute books should include either the cancelled stock certificates or evidence that the certificates were returned to the seller. The buyer should also review any shareholder agreements, as well as the articles of incorporation and bylaws, to identify any existing rights to acquire an equity interest in the seller or rights of the seller or any of its shareholders to purchase another shareholder’s stock. Employment agreements may also provide for rights to acquire an equity interest. The buyer should analyze any such rights and their impact, if any, on the transaction. Finally, the buyer should determine whether any options have been granted or restricted equity awards made and whether any of the selling shareholders have pledged their shares as collateral. In the case of a sale of less than all of a company’s stock, the nonselling shareholders’ rights to purchase will have to be addressed before closing. The purpose of this review is to ensure that the buyer is able to buy, free and clear, the percentage of the seller’s shares that it thinks it is buying.


1 Previous versions of this chapter were written by Barbara A. Kaye, Mary I. Hiniker, Theresa G. Carroll, and Uzma Ahmad.

Forms and Exhibits

Form 3.01 Due Diligence Checklist for Purchase of Business