U.S. and global regulators are turning up the heat on businesses, and the risk of large civil penalties or even criminal sanctions adds a layer of complexity to many merger and acquisition deals. Business due diligence should be top-of-mind for any corporate legal department, but especially those that are considering buying or selling. While the risk of regulatory action might not prevent a deal from closing, the financial repercussions should be modeled into any merger or acquisition agreement. And in some cases, resolving an issue discovered during due diligence can make a target even more attractive.
In a recent Jones Day memo on global business due diligence shared with the Practising Law Institute's Securities Center, the authors highlighted the need for effective business due diligence during an acquisition or merger. The Department of Justice and referring agency Securities Exchange Commission have both been ramping up enforcement efforts, and unwitting buyers can get dragged into enforcement actions involving an acquisition well after a deal takes place.
Simply stated, "caveat emptor" is the first rule for any buyer on the lookout for acquisitions or a lucrative merger. That's because the liability for any misconduct or improprieties doesn't die with a merger. Rather, a regulator like the Securities Exchange Commission, a tribunal or other governing body will make sure that a successor is on the hook to settle up and pay after violations of the law or other adverse findings against the seller.
Many buyers have come to rue the day they ever contemplated an acquisition after regulatory action turned a good deal sour. Examples of what can happen when business due diligence does not go far or deep enough into an acquisition target's business practices, dealings and conduct fill the classrooms and hallways of B-schools across the globe. On the other hand, proper business due diligence can uncover problems, which, if corrected by the seller pre-sale, can make the acquisition target an even better deal for the buyer.
Jones Day's memo highlights DOJ guidance on how any entity that is a focus of a DOJ inquiry can lessen the damage, so to speak. And based on that opinion procedure, the law firm recommended that buyers should complete the following due diligence steps to avoid being drawn into a regulator's inquiry involving an acquisition target:
If a company decides to proceed with an acquisition after discovering improprieties, the buyer should be prepared to fully cooperate with the DOJ and SEC and take steps to isolate problem players and remedy misconduct. Of course, these risks should also be modeled into any offer price for the target company.
But companies looking to be acquired can also vet themselves to be a more attractive acquisition target, or to sanitize improprieties or outright misconduct through voluntary disclosure to regulators.
Here's how that worked for an Illinois-based medical center in 2008. The medical center was apparently under some financial distress: Fitch had issued a negative rating watch on about $130 million of the medical center's bonds, and a balloon payment loomed at the end of 2008. In May 2008, a rival health care network swooped in with a plan to acquire the medical center and expand it. The parties entered into a definitive agreement at the end of May 2008 on a deal that would close in about five months.
But during the course of its own due diligence before the acquisition, the medical center discovered several improprieties including improper Medicare and Medicaid payments, loans and leases made to the medical center's doctors. Because some of these actions were violations of the federal False Claims Act, the medical center or its buyer could have been on the hook for triple damages for every false claim it submitted, with civil damages of between $5,500 and $11,000 for each violation. But, under the law, if the medical center voluntarily disclosed the violations, it would only be liable for double damages.
The medical center, perhaps between the Scylla of the False Claims Act and the Charybdis of its suitor, chose to voluntarily disclose the violations and settle up with the Department of Justice. It paid roughly $33 million to the United States Treasury and almost $2 million to the State of Illinois from cash reserves. The acquisition was finalized with the buyer in a much safer position than it had been at the time it agreed to acquire the medical center.
That is just one example of the value of thorough business due diligence. Whether it is mitigating future risk, or even leveraging information discovered by the buyer or seller to sweeten the deal, business due diligence is essential in today's regulatory environment.
Mary Grams markets Thomson Reuters transactional and regulatory products, including Westlaw® Drafting Assistant – Transactional, to legal and business professionals within corporate legal departments. She writes about trends in the practice and business of law. After graduating from the University of Minnesota Law School, she clerked on the Minnesota Court of Appeals, and has practiced and consulted on trial and appeals brief-writing projects.