What is the difference between due diligence and disclosure?

Due diligence

Due diligence is typically the first step in the information-gathering process during an acquisition and is generally led by the buyer.  It involves a comprehensive review of the target company’s legal, financial, and commercial affairs through a Q&A process.  The purpose is to enable the buyer to assess the risks and opportunities associated with the transaction and to decide whether to proceed.  Due diligence should ordinarily seek to establish, among other things:

• that the seller has the legal right to sell the shares;
• the value of the target company;
• any factors that may negatively affect that value (for example, litigation or charges over the shares);
• whether the business operates in line with the buyer’s assumptions and applicable laws;
• any specific issues relevant to the transaction; and
• any post-completion steps needed to ensure the business’s future profitability and operational stability.

This list is not exhaustive.  Once due diligence is complete, the buyer will be in a better position to evaluate the transaction.  If they choose to proceed, they may seek contractual protections, such as warranties or indemnities, to mitigate any identified risks.

Disclosure

In the acquisition agreement, a seller will give certain warranties (statements of fact) about the target company at completion.  Warranties are designed not only to provide recourse in the event of a breach but to encourage the seller to be transparent about any issues that could trigger a claim.  Such warranties are typically only enforceable to the extent that the matters giving rise to potential breaches of those warranties have not been ‘Disclosed’ in the disclosure letter.

A disclosure letter is a letter from the seller to the buyer containing formal statements (disclosures) in which the seller reveals known issues that may give rise to potential breaches of the warranties in the acquisition agreement.  Such disclosures need to be in accordance with the disclosure standard set out in the acquisition agreement.  A buyer-friendly definition of Disclosed is “fairly, fully, clearly and accurately disclosed (with sufficient details to identify the nature and scope of the matter disclosed) in or under the Disclosure Letter”.  An article on the definition of Disclosed is the next in our M&A series.

Find out more about warranties and disclosure letters in our article here.

Comment

Due diligence and disclosure are complementary but distinct methods of information exchange.  Parties should understand the distinction to allocate risk and make informed decisions.

Due diligence is intended to identify any material issues that may affect the transaction.  Once this initial review is complete, the parties generally proceed to negotiate warranties/indemnities in the acquisition document and conduct the seller-led disclosure process, during which known issues are formally disclosed.

Disclosure, by limiting the scope of warranties in favour of the seller, incentivises the seller to reveal additional information that the buyer’s due diligence may not have uncovered. 

If material issues are uncovered (either during due diligence or through disclosure), the buyer may seek to renegotiate the purchase price, request specific indemnities, or, in some cases, withdraw from the transaction.

Contact our Corporate & Commercial team if you would like advice and assistance with navigating a share or asset sale/acquisition.