A Common Benchmark but Differing Legal Standard
Unlike securities underwriters—who conduct due diligence into the material accuracy of disclosure documents to, among other things, meet regulatory requirements and to support the assertion of statutory affirmative due diligence defenses—corporate officers and directors evaluating a negotiated transaction conduct due diligence to inform their independent, context-specific business judgments regarding the transaction including whether to proceed with it and, if so, on what economic, contractual, and other terms.
In the context of a securities offering, the legal standard by which a defendant’s due diligence is measured is “reasonableness” as set forth in the Securities Act of 1933 (the “Securities Act”). Section 11(c) of the Securities Act defines reasonableness as what a “prudent man” (or person) in a similar context would have done in the management of his own property. While there is no statutory analog in the context of a negotiated transaction, shareholders and other constituents have an understandable and appropriate expectation that corporate officers and directors will conduct contextually reasonable and prudent due diligence. However, the lens through which negotiated transaction due diligence is viewed is the duty of care as opposed to compliance with statutes, SEC rules and regulations, or FINRA guidance. Thus, attempting to apply regulatory or judicial interpretations of what is reasonable or prudent in the securities offering context to the negotiated transaction context is deeply flawed given both the profound differences in the regulatory regime and applicable legal standard as well as the essential role contextual business judgment plays in a negotiated transaction.
The American Law Institute’s Principles of Corporate Governance define the duty of care of a corporate director or officer as performing their functions in good faith and in a manner that they reasonably deem to be in the best interests of the corporation and with the care that an ordinarily prudent person would reasonably be expected to exercise in a similar context. Moreover, the treatise notes that courts generally analyze the duty of care by applying the business judgment rule and examining the standard processes and frameworks by which the directors and officers made decisions. Thus, whether a buyer has fulfilled its duty of care is not assessed on the basis of regulatory mandates or guidance regarding any particular scope or character of due diligence, as would be the case in a securities offering context. Rather, the focus is whether their business judgments, made in context and in real time, were reached on an informed and unbiased basis.
The National Association of Corporate Directors has explained that the duty of care in this context “has a rather specialized meaning” that is “not synonymous with ‘caution’” because “taking risks is an essential part of doing business and, by definition, not all risks turn out positively”.
Directors must be afforded considerable latitude in deciding which business risks are reasonable. The courts have, by and large, been sensitive to this need. In interpreting the duty of care, courts have generally focused on the behavior and thought processes of the directors at the time a decisive action was taken and have placed less weight on the actual outcome of the decision. By refusing to equate disappointing outcomes with director carelessness, the courts have preserved the board’s ability to innovate and take risks.
Therefore, because each transaction and buyer are unique, what is “reasonable” or “prudent” in the realm of negotiated transaction due diligence is largely a matter of subjective business judgment driven by context-specific factors and is assessed through the lens of the duty of care. This stands in stark contrast to securities offerings.
Customary Practices
Unlike in the context of securities offerings, there is a broad range of custom and practice in negotiated transaction due diligence, and no one custom and practice is applicable to all parties in all contexts.
As the ABA Committee on Negotiated Transactions (now known as the Committee on Mergers & Acquisitions) has explained, what is important to a given party “varies from deal to deal and from buyer to buyer” and “[e]ven similarly situated buyers may react in an entirely different manner, some being cautious and risk averse (implying extensive due diligence), while others, believing themselves intuitive, may engage in only the most basic due diligence.” This commentary reflects the fact that, unlike in securities offerings, there are no mandates, beyond compliance with the duty of care, regarding the proper scope and character of buyside due diligence in a negotiated transaction.
As a result, a buyer’s business judgment plays an essential role in negotiated transaction due diligence. While any or all of these judgments may be challenged, especially through the lens of hindsight, numerous sources of guidance have explained that a buyer’s due diligence cannot be judged through that lens. Indeed, a buyer’s due diligence, regardless of the business judgments made regarding its scope and character, is not a guarantee of any particular outcome, nor is the outcome, whatever it ultimately might be, relevant to an assessment of the buyer’s due diligence and fulfillment of its duty of care. This is because no buyer has a crystal ball to confirm that the business judgments made throughout the due diligence process will manifest given that such outcomes are definitionally future, unknowable events.
Thus, the economic or other results of a given transaction are not appropriate considerations in assessing a buyer’s negotiated transaction due diligence. Ignoring this fundamental tenet can lead to various perceptual biases, including “outcome bias” (judging due diligence based on the outcome of the transaction) and “hindsight bias” (applying future knowledge to a prior timeframe as if the information had been known at that prior point in time). These and other perceptual biases can lead to unsound analysis and faulty conclusions.
Given both this guidance and the realities of the commercial marketplace, buyers exercise substantial context-specific discretion in evaluating how much and what kinds of due diligence to conduct. These judgments are based on a variety of contextual factors including, for example, industry knowledge and experience, strategic goals, investment objectives, competitive pressures, and confidence in the acquiror’s ability to address any areas of identified or contingent risk after closing. This means that in a negotiated transaction, buyers must make many ongoing, organic, and contextually specific business judgments including regarding the scope and character of due diligence to be conducted. These kinds of decisions, which must be made in real time, have been described as profoundly discretionary in nature and specific to a particular context.
Red Flags
Finally, like securities offerings, negotiated transactions can involve red flags. However, here too, one must take care not to conflate the concept, or the guidance, as applied to securities offerings with that applied to negotiated transactions.
In the context of a negotiated transaction, a red flag has been described as information that would prompt a prudent person with the same risk tolerance, investment objectives, and other contextual attributes to take further investigatory or other action. Or stated differently, a red flag in a negotiated transaction is an indication of special elements of risk that may not be consistent with the buyer’s risk profile.
However, just as buyer risk appetites, return goals, and other considerations can vary markedly, so too can a buyer’s sensitivity to negotiated transaction red flags (or even its individual views regarding what constitutes a red flag).
As a result, what constitutes a negotiated transaction red flag for one buyer might be considered a desirable attribute of the investment by another. For example, evidence of poor management, strained customer or supplier relations, regulatory issues, or other factors may be considered a positive factor for a buyer in the context of its skillsets, risk tolerance, and investment objectives. For other buyers, such as those desiring a lower risk profile or lacking industry-specific knowledge and expertise, the same factors may be red flags indicating that the investment is not appropriate or requires preclosing corrective actions to bring it into alignment with the buyer’s profile. And, as explained earlier, the ABA Committee on Negotiated Acquisitions has stressed that “[w]hat is important to a buyer varies from deal to deal and from buyer to buyer” and “[e]ven similarly situated buyers may react in an entirely different manner, some being cautious and risk averse (implying extensive due diligence), while others...may engage in only the most basic due diligence.”
Thus, in negotiated transactions, what constitutes a red flag (vs. merely a manifestation of a contextually desirable risk-reward relationship as determined in the exercise of business judgment) is buyer-defined.
Conclusion
In summary, in a negotiated transaction, as opposed to a securities offering, the scope and character of due diligence is contextual and judgment-based and does not involve mandates or mandatory conduct. Instead, customary due diligence in negotiated transactions encompasses a broad spectrum of practices, with diligence in any specific transaction dictated by a buyer’s exercise of discretion, considering, among other things, the entirety of the context. And the legal standard is not compliance with statutes, SEC rules and regulations, or FINRA guidance but rather the duty of care. Thus, attempting to apply regulatory or judicial interpretations of what is reasonable or prudent in the securities offering context to the negotiated transaction context ignores the profound differences in the regulatory regime and applicable legal standard as well as the essential role contextual business judgment plays in negotiated transaction due diligence.
