Best practices for conducting a complete due diligence search (and pitfalls to avoid)

In this article, we explore best practices for conducting a thorough due diligence search using collected data and observations from the legal community – and the perils of failing to conduct an adequate investigation before entering into a transaction.

The five-part search: The starting point of due diligence

There are several types of due diligence searches that apply to all entities and individuals, and they are a useful starting point for a comprehensive search. They include the following five areas:

• UCC lien search
• State and federal liens
• Fixture filing liens
• Judgment liens
• Bankruptcy

Limiting a search to just UCC might create the false impression that the collateral is unencumbered, which can lead to serious consequences. Also, unlike UCC search, tax and judgment liens are not consensual, so they can be on file without the debtor’s knowledge of their existence. For that reason, for many firms the five-part search is a useful template.

Get the full picture: search litigation

Litigation is also a critical part of the due diligence puzzle and can be a red flag, possibly exposing the buyer to liability and an obligation for legal fees.

We spoke to Neil Shelton, a partner at Katten Muchin Rosenman — a full-service law firm with nearly 700 attorneys across the United States, London, and Shanghai — about where litigation searching falls in their due diligence process, and the response was unequivocal: “We order litigation on every deal regardless of business”. When drilling down further, Mr. Shelton indicated that “[E]xisting material litigation is a big diligence focus”.

At CT Corporation, we’ve also found that litigation with a five-part search is critical. Over the last decade, this has been our fastest-growing search type, far outpacing any mix without litigation. Our findings suggest that more firms are now including this as part of a more thorough due diligence review.

New search types

As the economy changes so do our asset types. When asked what “new” factors exist in due diligence, Mr. Shelton responded that globalization has led to “more foreign searches than we handled in the past”. He also added that “the increased number of tech and software deals that we handle has resulted in more IP-focused diligence. So, even if we have coalesced around the importance of litigation as being part of a complete search, we may now have new areas and factors that will continue to shift the norm”.

While the focus of this article is litigation as an established component of due diligence strategy, there are other factors that cannot be overlooked. A firm conducting due diligence clearly needs to look at areas such as EPA, ERISA, OFAC and of course mechanic liens to get the complete picture in today’s market, says Neil Shelton. Such OFAC reviews were a growing concern even before the proposed changes by the Financial Crimes Enforcement Network (FinCEN) were issued in response to the passage of the Corporate Transparency Act (CTA). These searches reduce the risk of some type of “undiscovered” lien or claim creating a significant impediment to a deal getting closed. These topics may merit further discussions to further flush out your complete due diligence strategy.   

The imperative of a complete due diligence investigation

Failure to conduct an adequate due diligence investigation can have consequences for a corporation, its directors, and others across many transaction types.

Statutory merger

For instance, in a statutory merger, the liabilities of the merged company vest in the survivor. A failure to learn of any existing judgments or pending litigation against the non-survivor can result in a risky transaction or the survivor paying too much.

It can also mean that the survivor and the board of directors that approved the merger could be sued by the survivor’s shareholders for breach of their fiduciary duties in failing to conduct adequate due diligence, failing to disclose important information about the target acquiring, or wasting corporate assets by paying too much. The corporation might also blame any law firms that it engaged to perform due diligence.

Acquisition

Similarly, in any acquisition, whether accomplished by merger, asset purchase, or otherwise, due diligence is required to learn all relevant information about the proposed target. If the acquisition is made, and it later turns out the assets acquired were encumbered and there was a failure to conduct proper searches, this could also lead to shareholder litigation.

Public corporation

In the case of public corporations, securities laws that protect shareholders could be implicated. For example, the SEC actively monitors SPAC and de-SPAC mergers. The SEC stresses the importance of SPAC directors and sponsors conducting due diligence before choosing their de-SPAC target.

Furthermore, shareholders whose shares lost value after the de-SPAC can allege that due diligence failures led to material misstatements in the disclosure materials, and thus claim breaches of fiduciary duty.

Conclusion

While each client matter will stand on its own foundation of facts around what due diligence is required, there does appear to be market consensus regarding the importance of litigation being included in modern due diligence/risk analysis.

In addition to the standard five-part search, litigation searches are no longer considered an “add-on” but a mainstay for a complete due diligence picture that can help protect a corporation, its director, and others from legal consequences.