What is the purpose of a due diligence in the acquisition of companies Is it worth the investment

A due diligence is an investigation process of one or more assets, which may well be of a company or a group of companies. However, before entering into this “indirect” acquisition process (decision to acquire the company as means of acquiring the assets and liabilities contained therein), we should ask ourselves whether it is more favourable, in this case, to acquire the assets and liabilities encapsulated in the company one by one (asset deal or “direct” acquisition), since in this case the process and its guarantees would be different.

The peculiarity of the due diligence process in the sale and purchase of companies – or any M&A operation (mergers and acquisitions) – lies in the fact that there is no express regulation of this process beyond the Insolvency Law (arts. 215 and following.). That is to say, outside the insolvency proceedings, in Spanish legislation there is not a specific regulation governing the acquisition process, but rather a set of articles scattered between the Insolvency Law itself (by analogy) and the Civil Code must be compiled.

Before due diligence processes, brought over from Anglo-Saxon law, began to gain popularity in Spain and the rest of the countries governed by civil law, the traditional system based the buyer’s guarantees on the delivery of the company’s deeds, with an updated balance sheet. The problems presented by this system are obvious, since not all the relevant information is contained in a balance sheet and this does not prevent the buyer from being subrogated to all the possible debts that the company may have (labour debts, tax debts, legal proceedings, contracts with suppliers, etc.).

To avoid this lack of protection, the due diligence process is set up, which seeks to ensure that the means being acquired (the company) to achieve an objective (the business) are clear of unknown liabilities. At this point, Article 1.484 of the Civil Code is of particular relevance, which states the following:

Principle form. The seller shall be obliged to rectify any hidden defects in the sold goods, if they render them unfit for the use for which they are intended, or if they reduce its use, that if the buyer had been aware, it would not have acquired them or would have paid a lower price. On the contrary it shall not be liable for manifested defects or those which are visible, nor for those which are not visible, if the buyer is an expert who, by reason of its trade or profession, ought easily to have known them.”

Therefore, before acquiring a business in operation through the acquisition of the company that owns it, it becomes particularly relevant to carry out a prior investigation that can reveal what of these hidden defects are, not only because an entrepreneur could be considered as an “expert” in the sense of Article 1. 484 of the Civil Code, but also because (i) these procedural remedies do not contemplate the economic content of the business, since what is acquired are only shares or stocks; and (ii) the action to claim the seller liable for these defects expires six months after the completion of the acquisition transaction (Art. 1.490 of the Civil Code); a very short period if the objective is to ascertain the inexistence of hidden defects due to the passage of time (for example, tax debts expire after 4 years).

Accordingly, we always recommend our clients to carry out a due diligence prior to the acquisition of a company, as this is the only process that guarantees the balance of services, achieving price adjustments in the event of contingencies or, in certain cases, the complete cancellation of the operation without losses.

Unlike an audit, in which it is the party itself that hires a professional to give an opinion on its internal situation, in the due diligence of a buyer there is an element of alterity: there are two distinct parties with the advisors of the buying party reviewing the data provided by the selling party (who may also have its own advisors, for the purposes of equality of arms).

Before the completion of the process, we will already obtain certain guarantees:

  1. Representations and warranties, which are the seller’s prior declarations, which function as a guarantee and will reflect the seller’s margin of liability for the purposes of articles 1.091 and 1.124 of the Civil Code.

  2. Indemnities, which consist in liabilities (present or future) declared in advance by the seller and which, therefore, will already be known to the buyer and will not be claimable at a later stage. In other words, their manifestation will become a contractual promise to bear certain liabilities, costs or expenses, so that, if they are of such significance that they frustrate the subject matter of the transaction, the transaction must be abandoned at the time they become known. An example of such liabilities may be litigation in process or tax audits with contingencies.

After the process has been completed, the buyer will receive a full report, which will focus on whether the representations and warrants are true and whether there are any other undisclosed matters of particular relevance. Based on these contingencies, other guarantees may be negotiated, such as deferred payment of the price, notarial or bank guarantees, and obtention of any type of warrant. Furthermore, if the non-fulfilment of any manifestation cannot be proven at this initial moment, the buyer will have a period of 5 years to claim it, should it appear (via art. 1.964 of the Civil Code); a much more effective period than the 6 months imposed by art. 1.490 of the Civil Code.

Bearing in mind all of the above and making special emphasis on the risks that this type of operations may present for the buyer, we hope that no reader of this article will decide to venture into any M&A operation without the appropriate advice; although an exception can be made for those vehicles whose creation has been so recent that they may not entail the acquisition of any hidden defects.

María Roldán

Legal Department at Devesa & Calvo Abogados

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