The importance of compliance diligence and representations in corporate transactions

June 2022 | EXPERT BRIEFING | MERGERS & ACQUISITIONS

financierworldwide.com

Compliance issues present unique risks and challenges to corporate transactions of all structures and magnitudes. As such, parties to commercial transactions should ensure that proper compliance due diligence is undertaken in the context of any transaction, and that appropriate representations and warranties (R&W) are obtained from counterparties to mitigate risk.

Although compliance issues are not always front of mind in the transactional context, companies may face significant liability and organisational risk if they do not take appropriate steps to confirm compliance of counterparties with relevant laws. In particular, in the context of a share purchase transaction, the purchaser may be subject to corporate successor liability by inheriting the liabilities of a target corporation.

This may result in significant monetary fines for the amalgamated company, debarment from public contracting or funding, monitorship over future operations and the potential for costly civil class actions. Even in other deal contexts and in the absence of formal liability, companies that have engaged in corporate transactions without confirming their counterparties’ compliance may face significant business disruptions, regulatory and reputational risk, investigation costs and dilution in the value of the investment.

The compliance diligence process

While the scope of the compliance diligence process will vary depending on the specific transaction, we believe that compliance issues should still form part of the diligence process in all corporate transactions. By undertaking appropriate diligence into the target company’s compliance with relevant laws – including corruption, sanctions, fraud and money laundering – parties to the transaction can proactively identify any existing risks that will be material to proceeding with the deal, which may include the actions listed below.

Reviewing policies and procedures. Acquiring companies should verify whether the target company has policies and procedures in place to guard against illicit activity. These may include policies and procedures regarding compliance issues such as conflict of interest, corruption, sanctions, fraud and money laundering, as well as having a code of conduct incorporating each policy and appropriate training for all employees and representatives. These policies should be commensurate with the risk profile of the company, having regard to factors such as the industry and jurisdictions within which it operates, and should reflect a tone at the top of compliance throughout the organisation.

Reviewing accounting controls. The acquiring company should verify whether the target company has a consistent system of internal accounting controls designed to maintain fair and accurate books, records and accounts. As proper keeping of books and records is required under various anti-corruption legislation and improper accounting can be used for the purpose of concealing bribery, confirming the target company has appropriate internal controls in place is an important aspect to mitigating risk. In certain circumstances, review of certain books and records may be appropriate as part of the diligence process.

Conducting third party due diligence. Companies should verify whether counterparties to the transaction have sufficient controls in respect of their third-party dealings, past or present, including from an enhanced due diligence or know your customer (KYC) perspective. Policies and procedures should reasonably apply to third-party representatives such as suppliers and contractors, and the target company’s commercial agreements should contain R&W regarding compliance from their third-party representatives. Scrutiny should also be undertaken to ensure relationships are properly documented and that third parties are retained based on merit or a fair bidding process (where appropriate) to ensure no impropriety or favouritism.

Reviewing publicly available information. When appropriate, the target company’s name and any affiliates, as well as those of the company’s principals, officers and directors, should be searched in publicly accessible sources to ensure there are no outstanding convictions or allegations against them. This may include adverse media searches as well as searches of consolidated databases showing sanctions and other outstanding compliance issues including convictions, debarments, delistings from exchanges and other issues. Any material issues identified should be carefully considered by the acquiring company, investors and any other parties with an interest in the compliance of the target company. By keeping these key items in mind, parties to corporate transactions can be alert to potential vulnerabilities and risks related to the transaction. While minor issues may invariably arise, they should be noted so that they can be fully considered in determining whether to proceed with the transaction and remediated upon closing.

Compliance R&W. Like the diligence process, the R&W that will be necessary and appropriate in any given transaction will depend on the circumstances and should be commensurate with the risks associated with the transaction. We note that such representations may be requested by any party including the purchaser, vendor, financers, insurers or other parties.

Some of the most common R&W in contemplated transactions are outlined below.

Compliance with relevant laws. First, representations that other parties to the transaction – and, to the best of their knowledge, any affiliates or representatives thereof – have been in material compliance with relevant laws including conflict of interest, corruption, fraud, sanctions and money laundering. Second, their counterparties are not aware of any conduct that may constitute a violation of such laws, or of any outstanding investigations, allegations or enforcement proceedings.

Policies and procedures. Representations that counterparties maintain policies and procedures sufficient to reasonably guard against compliance issues, as well as sufficient accounting controls.

Sanctions. Representations that counterparties have taken reasonable measures to ensure they have not done business with sanctioned entities or in sanctioned jurisdictions, and that neither the company nor any of its affiliates or representatives is subject to applicable sanctions.

Anti-money laundering and proceeds of crime. In certain circumstances, R&W that funds used in respect of the transaction do not constitute proceeds of crime, or that proceeding with the transaction will not constitute a violation of any applicable law. Conversely, parties should only agree to R&W that are true and feasible to comply with, having regard to the scope of their business, applicable laws and those matters that they have actual knowledge over.

Common issues that parties should turn their minds to when crafting R&W include the following. First, knowledge. Parties should be careful to ensure they are actually in a position to give the representations requested of them. For example, a large corporation with thousands of current and former employees may not be in a position to warrant that no individual has engaged in any conduct that may constitute a violation of law. Instead, this corporation could generally warrant that, to the best of its knowledge, no such conduct has occurred, and that it has taken appropriate measures to prevent it (including maintaining policies and procedures with appropriate training).

Second, scope. Parties should ensure representations are not overly broad. For instance, representations regarding the conduct of a party should align with its legal obligations under applicable laws, rather than placing a higher onus on the organisation that may prevent it from properly doing business in the normal course.

Third, jurisdiction. R&W should cover the laws of jurisdictions in which parties to the transaction do business, but it is often not appropriate that they extend to irrelevant jurisdictions which may cause conflicts of law or other issues. For instance, sanctions representations should be crafted to capture all applicable listings without unduly limiting the scope of the company’s business by engaging listings that do not apply to the parties in question (for instance, retaliatory sanctions of certain jurisdictions).

Such R&W – particularly where they overlap with subject matter of the diligence process – are an important aspect of mitigating risk and should go hand in hand with the diligence performed on counterparties. However, they should supplement rather than replace the diligence process, and parties to commercial transactions should not rely solely on R&W in place of proper diligence.

Key takeaways

It is important to note that the level of diligence and the scope of R&W should be commensurate with the risks involved in the transaction in question. The due diligence appropriate for a large transaction involving a multinational company in a high-risk industry, for example, will be higher than that for a smaller transaction with a lower risk profile.

However, companies to all transactions should turn their mind to the appropriate diligence and R&W in the circumstances of the deal. Even where risks that are identified are not sufficiently material to prevent the deal from proceeding, identifying them will be important to the parties walking into the transaction with open eyes.

Ensuring that these matters are appropriately considered at the outset will allow commercial actors to properly evaluate any potential risks associated with a transaction, which can save significant financial, regulatory and reputational costs.

Malcolm Aboud is counsel, Frédéric Plamondon is a partner and Jayne Cooke is an associate at Osler, Hoskin & Harcourt LLP. Mr Aboud can be contacted on +1 (416) 862 4207 or by email: maboud@osler.com. Mr Plamondon can be contacted on +1 (514) 904 8109 or by email: fplamondon@osler.com. Ms Cooke can be contacted on +1 (416) 862 5944 or by email: jcooke@osler.com.

Malcolm Aboud, Frédéric Plamondon and Jayne Cooke

Osler, Hoskin & Harcourt LLP