Compliance due diligence – a clear advantage with corporate acquisitions

Due di­li­gence is now a stan­dard com­po­nent of the re­se­arch that pre­ce­des cor­po­rate ac­qui­si­ti­ons, and it is im­pos­si­ble to ima­gine any M&A prac­tice wi­thout it. In ad­di­tion to per­for­ming clas­sic due di­li­gence, com­pa­nies, banks and fi­nan­cial in­ves­tors are in­cre­asin­gly ex­pan­ding the fo­cus of their ex­ami­na­ti­ons and con­duc­ting com­pli­ance due di­li­gence.

Com­pli­ance due di­li­gence is re­ally no dif­fe­rent than re­gu­lar due di­li­gence. It just has a slightly dif­fe­rent ob­jec­tive and the­re­fore em­ploys a dif­fe­rent me­tho­do­logy. Mo­re­over, com­pli­ance due di­li­gence is both re­tro­spec­tive and pro­spec­tive in na­ture and thus ex­tends beyond le­gal due di­li­gence. The pri­mary goal of com­pli­ance due di­li­gence is to as­cer­tain whe­ther the spe­ci­fic le­gal and eco­no­mic risks that are ma­te­rial to a com­pany have been iden­ti­fied and whe­ther a com­pli­ance ma­nage­ment sys­tem with in­for­ma­tio­nal, trai­ning and con­trol com­pon­ents has been es­ta­blis­hed to ap­pro­pria­tely re­spond to these risks. In other words, le­ga­lity is not the sole fo­cal point. The ethi­cal be­ha­vior of em­ployees and ma­nage­ment also mat­ters, which safe­guards an en­tity’s re­pu­ta­tion, a cor­po­rate va­lue with gro­wing si­gni­fi­cance, and helps to avoid or at least re­duce lia­bi­lity risks.

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Com­pli­ance due di­li­gence al­ways be­gins with iden­ti­fy­ing the le­gal and eco­no­mic risks that are ma­te­rial to the tar­get com­pany. The sec­tor in which a spe­ci­fic com­pany ope­ra­tes and its in­di­vi­dual cir­cum­stan­ces are im­port fac­tors in this re­gard. Is the com­pany ac­tive in a re­gu­la­ted sec­tor like phar­maceuti­cals, waste ma­nage­ment or ban­king? Is it a ma­nu­fac­tu­ring en­ter­prise and the­re­fore ex­po­sed to pro­duct lia­bi­lity risks? Is it mostly in­vol­ved in ex­ports? Are there any in­ter­nal po­li­cies on is­sues the com­pany de­eply va­lues, such as en­viron­men­tal pro­tec­tion and so­cial justice, that im­pose stric­ter re­qui­re­ments on its ope­ra­ti­ons than exis­ting laws pre­scribe?

Ex­pe­ri­ence shows that the purchasing, sa­les and ac­coun­ting de­part­ments are the main areas of fo­cus in com­pli­ance due di­li­gence, since lia­bi­lity risks and even cri­mi­nal risks like cor­rup­tion, an­ti­trust vio­la­ti­ons, fraud and em­bez­zle­ment that could jeo­par­dize the con­ti­nued exis­tence of the com­pany can be grea­test there. Howe­ver, staff in­vol­ve­ment in these de­part­ments is key, so as not to give the im­pres­sion that all of the em­ployees in these de­part­ments are un­der su­spi­cion. Com­pany and in­dus­try-spe­ci­fic risks like en­viron­men­tal lia­bi­lity or pro­duct lia­bi­lity must not be pus­hed into the back­ground. In ad­di­tion, many com­pa­nies to­day of­ten un­de­re­sti­mate the IT risks as­so­cia­ted with their com­pu­ter and In­ter­net usage.

Be­si­des sub­stan­tive re­views, func­tio­nal re­views of an ac­qui­ree’s com­pli­ance ma­nage­ment sys­tem, as­su­ming it has one that is, are also part of com­pli­ance due di­li­gence. Com­pli­ance ma­nage­ment sys­tems should be strin­gent, in­ter­nally con­sis­tent and cap­ture all im­port­ant di­vi­si­ons and de­part­ments. Other items to cla­rify in­clude what kind of in­for­ma­tion and con­trol struc­tures there are and whe­ther em­ployees are re­gu­larly and ap­pro­pria­tely trai­ned. Of great re­le­vance to buy­ers is ex­ami­ning the sys­tem for weak­nes­ses that could pro­duce pre­viously uniden­ti­fied lia­bi­lity risks. Au­diting Stan­dard 980 of the Ger­man In­sti­tute of Pu­blic Au­di­tors (IDW) pro­vi­des gui­dance for per­for­ming com­pli­ance au­dits. If an in­ves­tee has not yet es­ta­blis­hed a com­pli­ance ma­nage­ment sys­tem, there may be con­cerns about its com­pli­ance cul­ture and lia­bi­lity risks that need to be ad­dres­sed in the purchase price or th­rough gua­ran­tees.

The re­sults of com­pli­ance due di­li­gence have a large bea­ring on the fur­ther pro­gress of con­tract ne­go­tia­ti­ons and may, in the worst case sce­na­rio, e.g., with se­rious an­ti­trust vio­la­ti­ons, cor­rup­tion or pro­duct lia­bi­lity risks, cause the ne­go­tia­ti­ons to be bro­ken off. Even if ne­go­tia­ti­ons con­ti­nue, the re­sults will be in­cor­po­ra­ted into the con­tract, say in the list of gua­ran­tees and war­ran­ties pro­vi­ded or in in­dem­ni­fi­ca­tion clau­ses. The price will also be af­fec­ted.

In prac­tice, the trend away from due di­li­gence fo­cu­sed so­lely on le­gal, tax or fi­nan­cial is­sues in fa­vor of a com­pli­ance-ba­sed due di­li­gence has pro­ven ef­fec­tive. Buy­ers get a more com­pre­hen­sive look at their tar­get com­pa­nies, re­du­cing the risk of bad in­vest­ments and fa­ci­li­ta­ting the tar­get com­pany’s in­te­gra­tion into the buy­ers’ cor­po­rate or­ga­niza­tion. Thus, the ad­ded time and ex­pense as­so­cia­ted with com­pli­ance due di­li­gence is time and mo­ney well spent.

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