Cross-BorderM&A Due Diligence
William N. Hulsey III, Esq.
Of Counsel, Intellectual Property
September 30, 2009
Second International SummitSchloβ Reinhartshausen, Eltville-Frankfurt, Germany
29th September – 1st October 2009
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
• Company Status & Pedigree Information
• National Security Compliance Issues
• Cross-Border Issues & Examples
• Use of Due Diligence Information
Cross-Border M&A Due Diligence
It’s agreed then: dogs, cats, gerbils and parakeets will merge, forming an entity which will be called a Unipet”
“Due Diligence”:A Product of the Great Depression
•Institution of U.S. Securities Act of 1933
•1933 Securities Act included a defense known as the “Due Diligence” defense
•Used by broker-dealers when accuses of inadequate disclosure of material information to investors
•As long as broker-dealers conducted their “Due Diligence” disclosing results to investors, they were not liable for non-disclosure of information not uncovered during the investigation
•Broker-dealer community soon embraced the practices conducting “Due Diligence” of a stock offering
Mergers & Acquisitions Process:Pre-Due Diligence Activities
Market Considers Target: Using public information and general knowledge of Target, Buyer considers if Target might represent a good fit. Factors include (among others):
•Size / Lines of Business / Geographic Mix
•Distribution Channel(s)
•Historic Profitability, including Cost Structure
•Market Perception / Target’s Reputation & Brand
•Technology / Competitive Advantages
Valuation: Interested Buyers approach Seller for non-public information about Target. In addition to Target’s intrinsic value, Buyers look for potential enhancements, synergies, +/or diversification to existing operations to estimate value addedupon acquiring Target.
• Product
• Distribution
• Production
• Service
Mergers & Acquisitions Process:Pre-Due Diligence Activities
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
Initial Due Diligence Mindset & Objectives
Don’t anybody move, this is a merger
Fundamental M&A Due Diligence
Due Diligence: A process of examination by the prospective buyers to validate the assumptions underlying their conditional bids.
• Business strategies and operating models
• Historic results
• Perceived competitive advantages
• Cash Flow Projections
• Look for overstatements and sugar coatings
Due Diligence Process
• Start early, to help shape the deal value, terms, protections
• Know what is being sought, limit surprises• Due Diligence is an iterative process
• Get context through business unit discussions and Target officer interviews
• Review documents• Ask follow-up questions• Consider solutions
Disclosure schedule modifies Reps unless limited for “informational purposes only”
“New” issues and documents disclosed in schedules need to be “diligenced”
Due Diligence Process
Acq’n Agreement Reps & Warranties
“Special” Indemnities
Target’s DisclosureSchedule
Diligence Should Be of Appropriate Scope
• Determined for each transaction in light of the size of the transaction, the perceived risks and budgetary constraints
• Asset purchases versus stock purchases or mergers
• Very important to be thorough in a stock purchase
• Document vs. Interview Due Diligence
Fundamentals of Due Diligence
• Get copies of everything (to extent possible) in your department. If you think you will not need a document later in the life of the deal, someone else may.
• All writing should be directed to corporate legal counsel, and bear the legend:
“Privileged and Confidential Attorney-Client Communication”
Due Diligence: More Than Debits And Credits
•“Technical due diligence is critical.
•You need to look product-by-product, margin-by-margin to understand the value of an acquisition.
•Once you have looked at the numbers rational people will usually reach the same conclusion.”
M&A in Silicon Valley - A Roundtable, PriceWaterhouseCoopers
• A recent survey showed that 85 percent of corporate respondents said a target company’s intellectual property assets had importance equal to or greater than other corporate assets when M&A deals were on the table.
• Most corporate respondents cited inadequate due diligence as the primary reason dealmakers fail to identify intellectual property risks like future litigation. Among corporate respondents that cited deficient due diligence, 56 percent cited lack of time as the main due diligence roadblock and 46 percent cited lack of resources.
Source: Megamarket Group: M&A Insights: Spotlight on Intellectual Property Rights, 2008
Intellectual Property Due Diligence
• Lack of Planning
• Inadequate Team Organization
– Is there an effective team leader?
– Who to report to?
– Communications/sharing problems
– Lack of clear reporting format
• Insufficient Time
• Insufficient Expertise
• Buyer Already Determined to Do Deal
Due Diligence Failures
• “Zeitgeist” the general cultural, intellectual, ethical, spiritual, and/or political climate within a group, along with the general ambience, morals, and sociocultural direction or mood of an era—Here the era of transactional due diligence
• Work in close cooperation with the company you’re acquiring – an adversarial posture will always backfire
• The due diligence process may seem excessively intrusive, but it builds relationships and provides the opportunity for the acquire to better understand his own company while at the same time pleasing the acquiring company
• Hesitancy or hostility during due diligence is often a sign that a deal’s value will be more difficult to realize than originally expected
Due Diligence Zeitgeist?
Be Patient – Don’t be Disappointed if the Decision is Made to “No Go”
The seller (or intermediary) should establish a virtual collaboration environment / data warehouse
• Populate it with all contractual documentation
• Contracts and modifications
• Non-disclosure agreements
• Current proposal efforts
• Allows for “virtual” due diligence from the comfort of your own office
• Availability of documentation is critical!
• Each folder in the collaboration environment should contain a 1-2 page synopsis describing the documents that are housed in that folder
• e.g.: contract, period of performance, value, type, deliverables, and status
• The collaboration environment should be constantly updated with all new modifications, RFPs, etc
Establish the RightDue Diligence Environment
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
• Company Status & Pedigree Information
Company Status & Pedigree Information
“Are you thinking what I’m thinking?”
Corporate Law Due Diligence
• Articles of incorporation, bylaws and shareholder agreements
• Directors, officers, shareholders, and holders of other equity rights such as options
• Minutes of shareholders, board of directors and board committee meetings
• Jurisdictions in which qualified to do business.
• Governmental and regulatory permits, consents and licenses
• Investments or ownership in other business enterprises
• SEC/Securities regulatory materials, regular and periodic reports, etc.
Corporate EntityDue Diligence
• Preferred Stock rights, esp. those triggered by M&A
• Authorized and outstanding stock, options, etc.
• The Board approvals, issuances, transfers and cancellations to capitalization and financial statements
• Confirm that contracts or Board approvals to issue shares or rights to shares are reflected in cap table
• Understand terms of option plan and any non-plan options
• Are options bound by acquisition terms?
• Equity claims by former employees
• Vesting
• Acceleration on M&A event
• Accounting issues
• Retention Issues
Financial Due Diligence
• Financial statements
• Inventories and valuations
• Aging of accounts receivable and payable
• Independent accountants' "management letters"
• Loss contingencies or related reserves
• Audit letters provided to accountants by attorneys
• Indebtedness other than trade payables incurred in the ordinary course of business
• U.S. federal, state and local and foreign income tax returns
• Estimated tax payments to be made during the current fiscal year
Human Resources Due Diligence
• Organization charts
• Cultural issues and concerns to address at integration
• Schedule of employees setting forth names, functions and compensation
• Personnel policies, employee manuals or handbooks and codes of conduct
• Job codes and position descriptions
• Employment agreements
• Severance plans or agreements
• Employee benefit, deferred compensation, bonus, or commission plans
• List of all consultants and their agreements
• Review key employees and potential retention bonus agreements
Intellectual Property Due Diligence
• To determine deal possibility
• To determine deal value
– Worth less / more?
– Does target own relevant IP?
– Are target’s products/services covered by IP?
• To determine deal risk
– Can/will you uncover issues that increase (decrease) risk of deal and therefore valuation?
• Deal Risks
• Does third party IP present a risk?
• Is Target in litigation with respect to the IP?
• Relevant litigation in industry with respect to the IP?
• Are there service agreements, representations and warranties, indemnification obligations, and third party IP that create potential liabilities or risks that need to be factored into the risk assessment of the deal?
• Open Source Code involved?
Intellectual Property Due Diligence
• Types of IP Assets
– Patents
• Domestic, PCT, Foreign, Patent Applications
• Invention Disclosures for which no patent applications filed
• Assessment of R&D for which patents may be filed.
– Trade Secrets/Know-how
• How well documented?
• How secret?
– (Material) Copyrights
• Registered?
Intellectual Property Due Diligence
– Trademarks – Domestic and Foreign; Domain Names
– Licenses, Assignments and IP Agreements
– Medical Devices
– Source Code
– Employee agreements – invention assignment, confidentiality, and non-compete provisions
– Lawsuits: asserted and potential claims involving IP
Intellectual Property Due Diligence
Employees Due Diligence
• Ensure employees and independent contractors who participate in R&D have signed Confidentiality and Invention Assignment Agreements.
• Ensure non-compete agreements for key employees are assignable and enforceable (e.g., not possible in Calif. unless selling shareholder)
• Did key employee and independent contractors:
– Work for or provide services to a competitor prior to working for Target?
• If so, has employee honored all nondisclosure obligations due prior employer, and was work related to that of Target?
– Does employee have a personal interest in what could cover a product, production, method, or service of Target?
Employees Due Diligence
Licenses and Agreements
• Ensure sufficient rights have been granted on both in-bound licenses and out-bound licenses
– Does license grant all rights covered by patent, trademark, copyright, trade secret or just particular products?
– Does Target have sufficient rights for applicable properties and products for territory in which they are being sold?
• Verify each license/agreement is in effect and material provisions have been/are being/can be met, i.e., double check that Target is not/will not be in breach.
Legal Disputes Due Diligence
• Litigation, regulatory or administrative proceedings and alternate dispute resolutions
• Threats of litigation and claims
• Consent decrees, judgments, writs, orders and injunctions
• Active or threatened investigations
• Disclosures
• Export/import issues
• False statements and false claims issues
Indemnities and Limitations of Liability
• What are limitations to indemnities Target gave/gets?
– E.g., repair or replace OR repair, replace or refund/termination?
– Any IP indemnification damages left out of agreements?
– Other limitations: geographical, eligible third party, vague language
• When does license expire? What are renewal terms?
– How important is license to Target’s business model, either inbound or outbound?
• Verify transferability/assignability of license/agreement.
– IP licenses are “personal” and usually not transferable without consent. PPG Indus., Inc. v. Guardian Indus. Corp., 597 F.2d 1090 (6th Cir. 1979) (No transfer by merger of patent license; California requires specific assignment provision (silence doesn’t work).
Licenses and Agreements
Insurance Due Diligence
• Insurance policies in effect
• Insurance claims made
• Information concerning any termination or cancellation of insurance policies
• Determine if “tail” coverage is needed
AntitrustDue Diligence
Key areas that may be covered include:
• Relations with competitors (e.g., trade associations, joint ventures)
• Bidding practices
• Distribution, marketing, pricing practices
• Business lines involving high market shares
• Prior history of antitrust investigations
• Recent acquisitions
• Existing compliance procedures
Other Items forDue Diligence
• Business plans and studies describing current or expected business
• External and internal analysis and research regarding competitors
• Reports and studies related to business operations
• Reports concerning environmental conditions, risks or exposure
• Disclosure Schedule process
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
• Company Status & Pedigree Information
• National Security Compliance Issues
We’re from the Department of Homeland Security. You left your damn door unlocked”.
National Security
Compliance Issues
Foreign Ownership, Control and Influence (FOCI)
• FOCI occurs with foreign entity buying (or investing in) the business or having some other control or influence (i.e., BAE, QinetiQ, Rolls Royce, former Getronics)
• FOCI company not eligible for security clearance (FCL or PCL) unless FOCI is “mitigated” pursuant to the NISPOM
• Review of classified contracts generally usually require clearance plus agency approval under “need to know” standard
• Any outstanding or ongoing export licensing, export jurisdiction or other export control issues
• Non-routine issues correspondence with one or more government agencies
• International Traffic in Arms Regulations (ITAR) violations
• Any person in the company who has been or is the subject of an indictment
Export/ImportDue Diligence
• Any commodities, technical data, software or services the company has exported within the last 5 years
• Products subject to Commerce Department jurisdiction
Export/ImportDue Diligence
• Business activities involving items on the U.S. Munitions List in any of the countries proscribed by section 126.1 of the ITAR
• Import tariff classifications for all imported products
• Contact information for freight forwarders used within the past 5 years that facilitated these exports
• Empowered Officials
Export/ImportDue Diligence
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•Determine if target company is subject to Foreign Corrupt Practices Act (“FCPA”), or if continuation of target’s business could violate FCPA post-acquisition
• Assessment of the risk profile of countries where target operates
• Analysis of the risk profile of the industry/business activity involved
FCPADue Diligence
• Any person in the company who has been convicted ofviolations of any of the U.S. Criminal Statutes enumeratedin
• Section 120.27 of the ITAR
• The Export Administration Regulations (EAR)
• Customs regulations
• EU trade controls and customs requirements, or
• Any foreign country trade control and customsregulations
Export/ImportDue Diligence
• Any person in the company who is ineligible to
• contract with, or
• receive a license or other approval to import articlesor defense services from or
• receive an export license or other approval from anyagency of the
• US Government,
• the E.U. or
• foreign government
Export/ImportDue Diligence
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• Due diligence should address the use of
• agents and other third parties
• commercial dealings with state-owned customers
• any joint venture, teaming or consortium arrangements
• customs, immigration, tax, licensing and permit matters
FCPADue Diligence
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• Review of the internal audit reports and internal investigations
• Interviewing employees of target/seller who have contact with officials
• Review of the records/reports prepared by target’s/seller’s auditors
• Review JV agreements and material contracts that will continue post-acquisition
• Sample past contracts and third-party agreements to identify red flags
FCPADue Diligence
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
• Company Status & Pedigree Information
• National Security Compliance Issues
• Cross-Border Issues & Examples
ChinaM&A
Transactions
Great Wall Sprawl
• Investor’s first line of protection – thorough business andlegal due diligence
• Professional due diligence in China presents peculiar challenges:
– Less reliable information than foreign investors are used to
– Obscure and volatile state of China’s legal system
– Chinese companies’ lack of familiarity (and patience!) with corporate formalities and record keeping
– Great breadth of authority afforded China’s bureaucracy
Due Diligence forChina M&A
Due Diligence forChina M&A
•Land use rights and related real property matters
•Improper payments—FCPA and other anti-corruption compliance issues
•Government permits, licenses and approvals
•Labor and employment matters
•Contract enforceability
•Environmental issues
•Reputational risks
•Tax matters
Due Diligence forChina M&A
Order No. 10•Effective September 8, 2006, replacing 2003 interim rules
•Substantive and procedural inbound China M&A rules
•New reporting and disclosure obligations
•Among other requirements, an acquisition must be reported to Ministry of Commerce (MOFCOM) if:
• The foreign investor will obtain control of the PRC domestic enterprise as a result of the acquisition; and
• Such acquisition relates to a key industry, or involves any element that will affect or potentially affect national economic security, or will result in the transfer of the actual controlling power over any domestic enterprise owning any well-known trademark or China time-honored brand
•MOFCOM has power to order termination of the acquisition or take other measures to mitigate adverse impact
IP Rights Violations Remain a Serious Threat• IP violations are widespread in China
– Infringing/counterfeiting (20%+ of all consumer products)– Piracy (90%+ of movies, software, games, books)– Imitation of product designs– IP theft by employees/partners
• In the US, Canada, Japan and EU, China is the No. 1 source of seizures of infringing goods
• Chinese government entities may acquiesce in infringing/counterfeiting activities– Local governments (sole source of revenue and salaries for local
courts and judges) protect local taxpayers and employers– National government determined to advanced China’s
technological progress by whatever means
Due Diligence forChina M&A
• Market Access – Restrictions and Investment Vehicles• Order No. 10• Intellectual Property Protection• Legal System/Dispute Resolution/Corruption• Foreign Exchange/Taxation• Guanxi 关系 = Connections• Dealing with State-owned Enterprises• Financial Transparency/Hidden Liabilities• Employees and Employment Law Matters• Land/Real Estate• Corporate Governance and Corporate Culture• Local v. National Issues (local protectionism)
Due Diligence forChina M&A
Then, we’re in agreement. There’s nothing rotten here in Denmark. Something is rotten everywhere else.
European Union M&A
Transactions
European Union Mergers
• European Community Merger Regulations (ECMR): Regulations 139/2004
• A major cross-border deal (“A Concentration”) requires notification to the European Commission, if
• It has a “Community Dimension” where turnover thresholds are met
European Union: Meaning of “Concentration”
A “concentration” includes:• A merger of two or more previously independent•Undertakings; or• Acquisition of control of an undertaking by anotherundertaking or persons controlling that undertaking; and• Includes full and partial mergers and certain joint ventures, as well as the acquisition of control of an undertaking.• Acquisition of control need not be 100 percent
European Union Mergers
Relationship between European Commissionand Member States
•Where transaction falls below ECMR thresholds, may still be caught by national thresholds – cooperation through European Competition Network
•A national competition authority (NCA) may request transfer of a case from EC Commission where merger affects market within a Member State
•Conversely, NCA can ask EU to take over a case
European Union Mergers
Cross-Border M&A Due Diligence
• Origins & Purpose of Due Diligence
• Initial Due Diligence Mindset & Objectives
• Company Status & Pedigree Information
• National Security Compliance Issues
• Cross-Border Issues & Examples
• Use of Due Diligence Information
We must never take for granted the precious gift of hindsight
Use of Due Diligence Information
Due DiligenceReporting Checklist
Weekly report to the due diligence lead summarizing progress and flagging issues and recurring themes
• Summary of Diligence Scope
•Key findings
•Outstanding Issues / concerns (intellectual property, export, OCI, Safety Act issues)
•Mitigation Plans
•Financial Impact
•Integration Concerns
•Outstanding Data Items
•Recommendations
Disclosure schedule modifies Reps unless limited for “informational purposes only”
“New” issues and documents disclosed in schedules need to be “diligenced”
Due Diligence Process
Acq’n Agreement Reps & Warranties
“Special” Indemnities
Target’s DisclosureSchedule
“I’m feeling absolutely marvelous, I think I’ll acquire another company.”
Cross-BorderM&A Due Diligence
William N. Hulsey III, Esq.
Of Counsel, Intellectual Property
September 30, 2009
Second International SummitSchloβ Reinhartshausen, Eltville-Frankfurt, Germany
29th September – 1st October 2009
Thank You!