Due diligence – to have or have not?

July 2018 | EXPERT BRIEFING | MERGERS & ACQUISITIONS

financierworldwide.com

Due diligence is a common component of any transaction, be it an acquisition of shares, a business or an asset deal. It is also an important part of IPOs and plays a role in intragroup transformations, such as mergers, with the scope of the due diligence usually dependant on the type of transaction.

Regarding acquisitions of shares (or a business, or any part of a business), which this article is focused on, the seller usually wishes to disclose to the purchaser as much information as possible, with the aim of excluding everything that has been disclosed from liability for a possible breach of the representations and warranties made in the share purchase agreement or business transfer agreement. On the other hand, the purchaser usually wishes to find out whether the target company has any deficiencies that would hinder the acquisition or select areas that the purchaser would like to have covered by indemnities in the acquisition agreement, for example issues ‘excluded’ from the seller’s liability on the grounds of the disclosure thereof.

The major downside is that the only documents that can be reviewed during due diligence are ones that the seller discloses and makes available, and the purchaser must rely on them and trust that they include all that is essential for the transaction. The Czech legal system did not recognise due diligence before the country’s new Civil Code came into effect in 2014. Section 1728(3) of the new Code imposes a disclosure duty and requires parties to transactions to inform each other about all circumstances (whether factual or legal) of which they are, or are required to be, aware so that either party has a chance to check whether it would be entering into a valid agreement and so that either party can clearly express its will to enter into the agreement. Such provisions also apply to acquisition agreements and require sellers to inform purchasers about all substantial circumstances (factual or legal). Although legal professionals argue whether the provisions are mandatory or voluntary, the prevailing opinion is that they are mandatory. If a party breaches the disclosure duty, there is a question of what the consequences will be. Typically, there is the duty to pay damages as a result of breaching a statutory duty. However, a mistake could theoretically result in a breach of that obligation as well. If the mistake relates to the essential facts, then the consequence would be the invalidity of the agreement. In the case of a mistake on less substantial facts, the consequence would be the right of the other party to compensation. In an attempt to mitigate the consequences of a breach of the disclosure duty, if any, sellers include a representation by the purchaser in an acquisition agreement to be entered into under Czech law that it has requested all information from the seller which the purchaser considers substantial for executing the agreement.

If a shareholder decides to sell its stake in a company, it will want the company to provide the potential purchaser with as much information as possible, by, for example, setting up a detailed data room. However, setting up a data room requires effort. The company’s board (if the company is a joint-stock company) should first decide whether it allows the disclosure to occur and then determine the scope of the data room. Moreover, the decision should impose a duty on the company to enter into a confidentiality agreement with the potential purchaser. Should the party wishing to acquire the company be a competing undertaking (as the term is understood by competition law), information that is sensitive in terms of competition law should not be disclosed in the data room. If such information is disclosed, the competition authority could impose a penalty. After all, it is not always the case that all shareholders wish to sell their stakes at once. If, for example, only the majority shareholder decides to sell its stake, then the governing body should, in making its ‘due diligence’ decision, honour the principle of shareholder equality. If the board did not allow a minority shareholder who wanted to sell its stake in the past to open a data room or allowed it but with a restriction, or demanded a fee to reimburse the costs, the board should do the same in the case of the ‘new’ due diligence requested by the majority shareholder.

Finally, Czech law, like a number of other legal systems, enshrines the opportunity of positive prescription of a stake, including stakes in limited liability companies and shares in joint-stock companies. However, this process is based on good faith. It is quite common that purchasers, in carrying out due diligence, discover a number of discrepancies regarding the shares. Not all inconsistencies are easy to remove, especially those relating to historical transfers. The purchaser is then faced with the dilemma of whether to buy the shareholding if there are such inconsistencies. If it had not carried out due diligence, it would probably not have discovered the inconsistencies and could have acquired the shareholding and be protected by good faith. Knowledge acquired through due diligence, however, cannot uphold good faith. So the real question is whether due diligence helps or hinders.

Dagmar Dubecká is a partner at Kocián Šolc Balaštík, advokátní kancelář, s.r.o. She can be contacted on +420 224 103 316 or by email: ddubecka@ksb.cz.

Dagmar Dubecká

Kocián Šolc Balaštík, advokátní kancelář, s.r.o.