1 ADVANCE PRAISE FOR 2 Due Diligence for Global Deal Making 3 EDITED BY ARTHUR H. ROSENBLOOM 4 5 6 7 “Thoughtful due diligence has never been more important in deal 8 making, and this book gives you all the tools to get the job done. 9 It also goes beyond diligence to clarify strategy and long-term objectives. 10 It’s a critical business reference.” 11 RICK RICKERTSEN 12 Chief Operating Officer 13 Thayer Capital Partners 14 Author, Buyout: The Insider’s Guide to 15 Buying Your Own Company 16 17 18 “Arthur Rosenbloom has succeeded in compiling, distilling, and explain- 19 ing the many complex issues related to performing due diligence for 20 global opportunities. This excellent book provides valuable insights 21 for private equity principals, investment bankers, CEOs, CFOs, and 22 anyone else who participates in such transactions.”

23 PETER E. BERGER 24 Managing Director 25 Ripplewood Holdings LLC 26 27 “A nice primer on the importance and multidimensional facets of due 28 diligence in cross-border transactions. The due diligence checklists 29 included are 30 great reference tools for either the practitioner or the ” 31 student. 32 THOMAS A. MASTRELLI 33 Chief Operating Officer 34 VNU Inc. 35 36 37

1 “This is a timely book that brings back the commonsense, in addition to 2 the applied forensics, approach to due diligence. In light of recent dra- 3 matic due diligence failures, deal participants need to make sure they 4 fully understand the company that is undergoing a corporate transaction. 5 Due diligence issues are often exacerbated in cross-border deals, 6 making this book’s global focus very relevant.” 7 8 JAMES H. ZUKIN 9 Senior Managing Director 10 Houlihan Lokey Howard & Zukin Capital 11 12 “It’s hard to find a book more timely than Due Diligence for Global 13 Deal Making. The rapid growth of global markets in the last decade of 14 the twentieth century increased the risk of fraud and problems in under- 15 standing legal and financial documents and assessing operations. Arthur 16 Rosenbloom, a top authority on due diligence, has correctly diagnosed 17 the situation and edited a useful and strategically important book. Many 18 of the recent financial scandals to which we are witness might 19 have been avoided had the lessons appearing in this work been 20 heeded.” 21 VLADIMIR KVINT, PH.D. 22 Professor of Management Systems and International Business 23 Fordham University 24 Author, The Global Emerging Market in Transition 25 Contributing Editor, Forbes Global magazine 26 27 28 “The fact of globalization makes reading Due Diligence for Global Deal 29 Making a must for those contemplating cross-border transactions. 30 The work offers a much needed discussion of the strategic planning, 31 human relations, and critical operational components of the due diligence 32 process.” 33 MARK LOWENTHAL 34 Former President 35 Revlon Europe and the Middle East 36 37 1 2 3 4 5 6 7 8 Due Diligence 9 10 11 FOR 12 Global 13 14 15 Deal Making 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

1 2 3 4 5 6 7 8 9 ATTENTION CORPORATIONS 10 11 Bloomberg Press books are available at quantity discounts with bulk 12 purchase for sales promotional use and for corporate education or other 13 business uses. Special editions or book excerpts can also be created. For information, please call 609-750-5070 or write to: Special Sales Dept., 14 Bloomberg Press, P.O. Box 888, Princeton, NJ 08542. 15 16 17 18 19 A complete list of our titles is available at 20 www.bloomberg.com/books 21 22 23 BLOOMBERG MARKETS ™ is for and about professional investors, 24 the places they work, and the companies they invest in. It is specially 25 edited for the BLOOMBERG PROFESSIONAL™ service subscriber who needs to be constantly informed on new functions, trends, and 26 strategies that can help tilt the financial playing field in their favor. See 27 www.bloomberg.com for subscription information. 28 29 30 31 32 33 34 35 36 37 1 BLOOMBERG PROFESSIONAL LIBRARY 2 3 4 5 6 7 8 Due Diligence 9 10 11 FOR Global 12 13 14 15 Deal Making 16 17 18 19 20 THE DEFINITIVE GUIDE TO 21 Cross-Border Mergers and Acquisitions, 22 23 Joint Ventures, Financings, AND 24 Strategic Alliances 25 26 27 28 29 EDITED BY 30 31 ARTHUR H. ROSENBLOOM 32 33 34 35 BLOOMBERG PRESS 36 Princeton 37

1 2 3 Copyright © 2002 Arthur H. Rosenbloom. All rights reserved. Protected under the Berne Con- 4 vention. Printed in the United States of America. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photo- 5 copying, recording, or otherwise, without the prior written permission of the publisher except in 6 the case of brief quotations embodied in critical articles and reviews. For information, please write: 7 Permissions Department, Bloomberg Press, 100 Business Park Drive, P.O. Box 888, Princeton, NJ 08542-0888 U.S.A. 8 9 Books are available for bulk purchases at special discounts. Special editions or book excerpts can also be created to specifications. For information, please write: Special Markets Department, 10 Bloomberg Press. 11 12 BLOOMBERG, BLOOMBERG NEWS, BLOOMBERG FINANCIAL MARKETS, OPEN BLOOMBERG, BLOOMBERG PERSONAL, THE BLOOMBERG FORUM, COMPANY 13 CONNECTION, COMPANY CONNEX, BLOOMBERG PRESS, BLOOMBERG PROFES- 14 SIONAL LIBRARY, BLOOMBERG PERSONAL BOOKSHELF, and BLOOMBERG SMALL BUSINESS are trademarks and service marks of Bloomberg L.P. All rights reserved. 15 16 This publication contains the authors’ opinions and is designed to provide accurate and authori- 17 tative information. It is sold with the understanding that the editor, authors, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other 18 professional advice. The reader should seek the services of a qualified professional for such advice; 19 the editor, authors, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader. 20 21 First edition published 2002 22 1 3 5 7 9 10 8 6 4 2 23 Library of Congress Cataloging-in-Publication Data 24 Due diligence for global deal making : the definitive guide to cross-border mergers and acquisi- 25 tions, joint ventures, financings, and strategic alliances / edited by Arthur H. Rosenbloom. 26 p. cm. 27 Includes bibliographical references and index. ISBN 1-57660-092-0 28 1. Consolidation and merger of corporations--Handbooks, manuals, etc. 29 2. International business enterprises. 3. Joint ventures. 4. Strategic alliances (Business) I. Rosenbloom, Arthur H. 30 31 HD2746.5 .D84 2002 32 658.1’6--dc21 2002008649 33 Acquired and edited by Kathleen A. Peterson 34 35 36 37 1 2 Preface 3 4 5 6 7 8 9 10 FFECTIVE DUE DILIGENCE in all transactions—but especially 11 those involving parties across national borders—is a critical com- 12 E ponent of the deal process. This is an absolute if parties are to be 13 spared the enormous loss of time, money, and reputation (not to mention 14 personal anguish) of deals that fail to meet expectations. Cross-border 15 due diligence encompasses all of the elements found in purely domestic 16 transactions, overlain with an extra level of complexity due to its inter- 17 national character. (Thus, a double-barreled benefit for readers of this 18 book!) 19 Paradoxically, the transactions in which strategic, operational, finan- 20 cial, tax, legal and people/organizational due diligence is practiced effec- 21 tively often don’t make the headlines but are observable only dimly in 22 the accreted earnings of the acquirer. However with failed or aborted 23 transactions, the story is otherwise. Daimler-Chrysler’s shrunken market 24 capitalization evidences a corporate marriage flawed in many cultural, 25 financial, and operational ways. Better due diligence might have made a 26 difference. 27 Could better legal due diligence have more effectively anticipated the 28 European Union’s anti-monopoly response, now on appeal, in General 29 Electric-Honeywell? Perhaps. Had Enron, Global Crossing, Sunbeam, 30 Adelphia, or WorldCom been the subject of cross-border deal offers, 31 would the many issues surrounding these companies that later surfaced 32 have been unearthed by means of effective due diligence? Unprovable, 33 of course, but reasonably likely, we assert. 34 In many respects, twenty-first century cross-border due diligence 35 resembles the classic due diligence of prior periods, but in two distinct 36 ways it does not. One is the specter of international terrorism, whose 37

v VI DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 implications for cross-border due diligence are the subject of the 2 Appendix to this book. A second is the proliferation of intellectual 3 property-driven transactions in fields like biotech, software, and com- 4 munications. These sorts of deals require new levels of due diligence 5 resourcefulness, and we have more than a little guidance for you in this 6 regard in the pages that follow. 7 To the corporate executives, attorneys, accountants, consultants, and 8 the graduate students and others who aspire to become skilled in any of 9 these areas, and to those who teach these aspirants, we hope and believe 10 that you’ll find in this volume a wealth of practical advice on how to 11 become more effective professionals in cross-border due diligence. Good 12 luck and good deals to you all. 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 1 2 Acknowledgments 3 4 5 6 7 8 9 10 UTTING TOGETHER a book like this is a work of the heart as well 11 as the mind. All of the contributors to this volume either advise 12 P clients in cross-border deals, have been corporate executives 13 engaged in the process of doing deals, or teach graduate students in this 14 field. (Some of us do more than one of these.) From professional experi- 15 ence, we know how integral a role effective due diligence plays in the 16 cross-border transactional process. As practitioners, we’re pleased to share 17 our insights with you because we believe that better due diligence means 18 making better deals that result in greater increase in shareholder wealth. 19 Such due diligence also may result in deals that, for good reason, should 20 be aborted—an outcome that also serves shareholder interests. 21 Thanks are due to many staff persons at each of our places of work 22 through whose efforts our chapters have emerged. Special thanks are due 23 to Orietta Ramirez of CFC Capital LLC, who coordinated the general 24 production of the manuscript, and Kathleen Peterson, Senior Acquisitions 25 Editor at Bloomberg Press, for her valuable advice at every step of the way 26 from conceptualization to manuscript production. 27 28 29 30 31 32 33 34 35 36 37

vii 1 2 3 Contents 4 5 6 7 8 9 10 ABOUT THE CONTRIBUTORS xiv 11 12 13 1 Due Diligence in the Global Economy 1 14 ARTHUR H. ROSENBLOOM 15 What Is Due Diligence? 3 16 Types of Due Diligence 4 17 Who Is Involved in Due Diligence? 4 18 What Constitutes Legal Due Diligence? 6 19 What Constitutes Financial Due Diligence? 7 20 What Constitutes Operational Due Diligence? 9 21 Integrating Due Diligence Efforts 11 22 23 24 Strategic Due Diligence 13 25 2 GEOFF CULLINAN AND TOM HOLLAND 26 27 Strategy Precedes Due Diligence 14 28 Reviewing Your Strategy 15 29 Costs 15 30 Customers 16 31 Competitors 16 32 Capabilities 17 33 Achieving Value 18 34 Factoring in Cross-Border Complexities 22 35 Identifying Your Strategic Rationale 23 36 Active Investing 23 37 Scale 24 1 2 3 4 Adjacency 24 5 Scope 25 6 Transformation 25 7 Undertaking Thorough Due Diligence 28 8 Market Definition 29 9 Industry Dynamics and Trends 29 10 Competitor Market Map 31 11 Competitor Dynamics 31 12 Competitor Benchmarking 31 13 Customer Analysis, Input Costs, and Price Elasticity 32 14 Growth Opportunities 33 15 Cross-Border Complications 35 16 Key Factors in Evaluating Strategic Rationales 36 17 Due Diligence for Scale-Driven Transactions 37 18 Due Diligence for Adjacency-Driven Transactions 41 19 Due Diligence for Scope-Driven Transactions 43 20 Due Diligence for Transformation-Driven Transactions 44 21 Assessing Your Findings 45 22 Checklist: Cross-Border Strategic Due Diligence 48 23 24 25 Operational Due Diligence 51 3 26 LINDA D. ARRINGTON, NELSON M. FRAIMAN, 27 CAROLYN E.C. PARIS, AND MICHAEL L. PINEDO 28 Operational Due Diligence in the Cross-Border Context 52 29 Designing Due Diligence from a Strategic Perspective 53 30 Validating and Integrating Other Due Diligence Efforts 54 31 Serving as the Foundation for the Integration Plan 55 32 Serving in Support of Deal Strategy and Pricing 55 33 What Should Operational Due Diligence Cover? 57 34 Mapping the Value-Creation Process 58 35 Products and Services, Market Positioning and Brand, Sales and 36 Distribution, and Customers 58 37

1 Manufacturing or Other Production of Goods/Services 61 2 Procurement of Supplies and Supply-Chain Management: 3 Possible Related Reconfiguration of Distribution Processes, 4 External Infrastructure Requirements, and System Cash Needs 62 5 Systems and Know-How Support of the Value-Creation Process 63 6 People, Training, and Corporate Culture 65 7 What Can Go Wrong 68 8 Deals That Got It Right 72 9 Checklist: Cross-Border Operational Due Diligence 75 10 11 12 Financial and Accounting Due Diligence 101 13 4 JORGE M. DIAZ 14 15 Addressing All Aspects—Whether Large or Small 103 16 Financial Due Diligence Procedures 104 17 How to Verify the Numbers 106 18 Inbound Transactions 109 19 Outbound Transactions in Developed Countries 110 20 Outbound Transactions in Emerging Markets 113 21 Accounting Due Diligence Procedures 114 22 Integrity and Qualifications of Company Personnel, 23 Their Practices, and Ethical Standards 119 24 Relationship with Independent Certified Public Accountants 120 25 Considerations in Evaluating Key Accounting Issues 122 26 Statutory, Regulatory, and Legal Requirements 127 27 Industry Accepted and Generally Accepted Accounting Principles 128 28 Industry Practices 129 29 Income Tax Laws and Regulations 130 30 Data Processing Systems 131 31 Political Environment in the Target’s Country 132 32 Checklist: Cross-Border Financial and Accounting Due Diligence 134 33 34 35 36 37

1 Legal Due Diligence 149 5 2 NORMAN J. RESNICOW, ESQ. AND 3 CLIFFORD A. RATHKOPF, ESQ. 4 “Legalese” across Borders 150 5 The Purpose of Legal Due Diligence: 6 Insurance against the Unknown 151 7 A Good Deal Is Vastly Better Than a Good Lawsuit 152 8 Defensive Due Diligence in U.S. Public Securities Issuance 9 Transactions: Proving Enough Was Done 154 10 Forces Working to Limit Due Diligence: 11 Quick Decision Makers versus Slow Scriveners 155 12 Avoiding Ruffled Feathers and Missed Opportunities 157 13 Fitting Due Diligence into the Structure and Timing of the Deal: 14 Sooner Is Better 158 15 Organizing and Executing Legal Due Diligence: 16 The Buck Stops at the Top 160 17 Assigning Qualified Personnel 160 18 Organizing and Delegating Duties 164 19 Ensuring a Searching Investigation 165 20 Communicating Results Effectively 167 21 Certain Key Risk Exposure Areas in Legal Due Diligence 169 22 Environmental 169 23 Antitrust 173 24 Intellectual Property 177 25 National Security Implications 182 26 Litigation 183 27 Security Interests of Creditors 186 28 Terminating Employment and Marketing Relationships 29 without Liability 188 30 The Preferred Result of Legal Due Diligence: 31 No News Is Good News 190 32 Checklist: Cross-Border Legal Due Diligence 191 33 34 35 36 37 1 2 6 Tax Due Diligence 209 3 ROBERT T. BOSSART, ESQ. 4 Compliance versus Planning 209 5 Due Diligence Coordination 210 6 Local, National, and International Perspective 211 7 A Word about Joint Ventures 211 8 Taxable Purchase of Assets 212 9 Understanding the Target’s Operations and Structure 212 10 International Federal Tax Compliance Due Diligence 216 11 Foreign Subsidiary Shares as Part of the Target’s Assets 220 12 Transfer Pricing 222 13 Nonfederal Tax Due Diligence in an Asset Acquisition 224 14 Asset Acquisition Planning Opportunities: Overview 229 15 Taxable Share Purchases 232 16 Tax Compliance 233 17 Transactions and Tax Reserves 233 18 Consolidated Returns, Attributes, and Accounting Methods 235 19 Withholding Taxes 235 20 Employee Benefits 236 21 Foreign Tax Credits and Exemptions 237 22 Tax Attributes 238 23 Structuring the Share Acquisition 238 24 Tax-Free Exchanges 239 25 Checklist: Cross-Border Tax Due Diligence 241 26 27 28 People and Organizational Due Diligence 253 29 7 CYNTHIA N. WOOD, PH.D. 30 AND RICHARD C. PORTER 31 32 General Considerations 254 33 Strategic Objectives 254 34 Type of Deal 255 35 Composition of the Organizational Due Diligence Team 256 36 Impact of Organizational Experience and Cultural Milieu 257 37 Negotiations 258 Key Components of Organizational Due Diligence 259 1 Organizational Performance Measures 259 2 Cultural Factors 261 3 Mission, Vision, and Values 265 4 Communications Patterns and Processes 267 5 People Issues 270 6 Overall Organizational Structure 275 7 Functional Areas 278 8 Checklist: Cross-Border Organizational Due Diligence Process 295 9 10 11 8 Due Diligence Investigative Technology 12 and Know-How 303 13 JAMES B. MINTZ 14 15 How Investors Use Private Investigators 303 16 How Investigative Technology Can Help 304 17 The International Public Record 304 18 The Hometown Newspaper 305 19 The Backgrounds of Key Executives 307 20 Prime Questions Investigators Must Explore 307 21 Resolution through Follow-up Investigation 311 22 The Business Practices of the Target Company 311 23 Regulatory Issues 312 24 Concerns about Intellectual Property 315 25 Business Disputes 316 26 Increased Pressure on Due Diligence Professionals 318 27 Checklist: Due Diligence Investigative Technology and Know-How 320 28 29 30 APPENDIX: Cross-Border Due Diligence 31 in an Age of International Terrorism 323 32 33 INDEX 333 34 35 36 37 1 2 3 About the Contributors 4 5 6 7 8 9 10 11 Linda D. Arrington has spent nine years in banking at Chase Securities 12 (and its predecessor institutions). Her investment banking experience has 13 covered corporate finance activities in the retail industry group, media 14 and telecommunications group, mergers and acquisitions group, private 15 equity group, debt capital markets, and cross-border M&A analysis while 16 covering clients in Johannesburg, South Africa. Ms. Arrington holds an 17 M.B.A. from Columbia Business School and a B.S. degree from William 18 Smith College. (Chapter 3) 19 20 Robert T. Bossart is of counsel in the New York office of Greenberg 21 Traurig, LLP and chair of the firm’s corporate international tax group. 22 Formerly an international tax partner with the New York office of a Big 23 Five CPA firm, he specializes in corporate and international tax matters. 24 Mr. Bossart’s client responsibilities include U.S. multinationals as well as 25 non-U.S. multinationals investing in the United States. With more than 26 twenty-five years of experience advising multinational manufacturing 27 and service corporations, Mr. Bossart has frequently been involved in 28 helping companies develop global tax strategies, including funding and 29 movement of intellectual property, cross-border structuring and financ- 30 ing, mergers and acquisitions, transfer pricing issues, manufacturing/ 31 distribution/Internet reengineering, revenue agent examinations, and 32 strategic repatriation planning. In addition to an LL.M. in taxation from 33 New York University’s Graduate School of Law, Mr. Bossart holds a B.S. 34 from the Wharton School of the University of Pennsylvania, an M.B.A. 35 from Cornell University’s Johnson Graduate School of Management; 36 and a J.D. from Fordham Law School. (Chapter 6) 37

xiv ABOUT THE CONTRIBUTORS XV

Geoff Cullinan is a director in Bain & Company’s London office, where 1 he leads the European private equity practice and the London M&A 2 practice. Mr. Cullinan has more than twenty-five years of general man- 3 agement, strategy consulting, and investor experience in a wide range of 4 industries, including consumer products, retail, automotive, chemicals, 5 engineering, and financial services. Prior to joining Bain, Mr. Cullinan 6 was chief executive officer of Hamleys Plc, a retail business in the toys 7 and games industry. Previous to this, Mr. Cullinan was the founder and 8 managing director of OC&C Strategy Consultants and the head of the 9 European consumer goods practice for Booz Allen & Hamilton Inc. He 10 has a B.A. degree from the University of Essex and earned an M.B.A. 11 with highest distinction from IMEDE, Lausanne. (Chapter 2) 12 13 Jorge M. Diaz is a partner at Ernest & Young LLP with more than 14 twenty-eight years of experience working with organizations in various 15 industries including telecommunications, international banking, do- 16 mestic banking, investment funds, fresh produce, professional sports, 17 real estate, airlines, manufacturing, and distribution. He has provided 18 audit and business advisory services to many international public and 19 privately held companies, and has expertise in initial and secondary 20 public offerings, capital formation, and mergers and acquisitions. 21 Mr. Diaz is actively involved in the international business community 22 and has assisted numerous clients in accomplishing financial and opera- 23 tional objectives, including privatizations. He is a member of the Florida 24 Institute of Certified Public Accountants, the California Society of 25 Certified Public Accountants, the Florida International Bankers Asso- 26 ciation, the Florida International University Council of 100, and the 27 Greater Miami Chamber of Commerce. Mr. Diaz has a Bachelor of 28 Accounting degree from the University of Southern California. 29 (Chapter 4) 30 31 Nelson M. Fraiman is codirector of the W. Edwards Deming Center for 32 Quality, Productivity and Competitiveness and professor in the Division 33 of Decision, Risk and Operations at Columbia Business School. 34 Professor Fraiman joined the business school faculty after a seventeen- 35 year career at International Paper Company, where he was chief tech- 36 nology officer for eight manufacturing divisions. He specializes in the 37 XVI DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 retailing, consulting, and process industries and studies general areas of 2 operations management and technology. Professor Fraiman holds B.S., 3 M.S., M.B.A., and Ph.D. degrees, all from Columbia University. 4 (Chapter 3) 5 6 Tom Holland is a director in Bain & Company’s San Francisco office, 7 where he heads the global business consulting firm’s worldwide private 8 equity practice. For nearly twenty years, Mr. Holland has worked with 9 companies in a variety of industries, including technology, telecommuni- 10 cations, transportation, consumer goods, and manufacturing. He has 11 advised clients on growth strategies, cost and asset restructuring, reengi- 12 neering, and mergers and acquisitions. He has also helped clients facing 13 major turnarounds or repositionings in turbulent industries, such as 14 telecommunications, transportation, and aerospace. Prior to joining Bain, 15 Mr. Holland held positions with Clorox and Bain Capital. He earned his 16 M.B.A. with distinction from Stanford University and holds a B.S. degree 17 in engineering from the University of California at Berkeley. (Chapter 2) 18 19 James B. Mintz, president of James Mintz Group, Inc., has spent the 20 past twenty-five years conducting investigations worldwide, primarily 21 for law firms and general counsel. Mr. Mintz helped pioneer the use of 22 sophisticated resources by law firms in the late 1970s, as an in-house 23 investigator at the Washington, D.C., law firm of Wald, Harkarader & 24 Ross. He cofounded Investigative Group, Inc. in 1984, serving as its 25 president for a decade, and founded the James Mintz Group in 1994. 26 Mr. Mintz has participated in seminars on corporate investigations, 27 including the Practicing Law Institute’s “Conducting Complex Fact 28 Investigations—Techniques and Issues for Lawyers.” His articles have 29 appeared in the Wall Street Journal, the Conference Board’s Across the 30 Board magazine, Directors & Boards, and Corporate Legal Times. Mr. 31 Mintz can be reached at [email protected]. (Chapter 8) 32 33 Carolyn E.C. Paris is a fellow at the W. Edwards Deming Center for 34 Quality, Productivity and Competitiveness at Columbia Business School. 35 She was previously a partner at the law firm of Davis Polk & Wardwell 36 in New York City, specializing in corporate finance, including domestic 37 and international acquisition finance, structured finance, and bankruptcy/ ABOUT THE CONTRIBUTORS XVII workouts. Ms. Paris was also director of practice information and profes- 1 sional development at Davis Polk, working in intranet-based knowledge 2 management. She is the author of How to Draft for Corporate Finance 3 (Practicing Law Institute, 2000). She has a B.A. degree from the 4 University of Illinois, an M.A. degree from the University of Texas, a J.D. 5 from Stanford University, and an M.B.A. from Columbia University. 6 (Chapter 3) 7 8 Michael L. Pinedo is the Julius Schlesinger Professor of Operations 9 Management and deputy chair of the department of information, opera- 10 tions, and management sciences at the Stern School of Business, New 11 York University. He has previously taught at Columbia University, 12 Instituto Venezolano de Investigaciones Cientificas (Caracas), and the 13 Georgia Institute of Technology. Mr. Pinedo has worked extensively in 14 industrial systems development, with a focus on planning and scheduling 15 of production and service systems, for clients such as Philips Electronics, 16 Siemens, and Merck. He is the author or coauthor/editor of several 17 books on operations scheduling, queueing networks, and value creation 18 in financial services, as well as editor of the Journal of Scheduling. He 19 holds an Ir degree from the Delft University of Technology and M.S. and 20 Ph.D. degrees from the University of California at Berkeley. (Chapter 3) 21 22 Richard C. Porter is a human resources consultant specializing in advising 23 global companies on organizational issues. Experienced working with 24 industry leaders in North America, Europe, Asia, South America, and 25 Africa, he possesses particular expertise in multinational mergers, acquisi- 26 tions, divestitures, and joint ventures. Most recently he was the global 27 head of human resources for Young & Rubicam Advertising, an agency 28 with operations in more than eighty countries. Previously Mr. Porter 29 served in a number of international human resource appointments for 30 Guinness and United Distillers Inc., part of the Diageo Group. He is an 31 economics graduate of the University of Strathclyde and holds a master’s 32 qualification from the CIPD in London. Mr. Porter is an International 33 Fellow at Tulane University’s AB Freeman School of Business, regularly 34 lectures at New York University’s Stern School of Business, and has 35 lectured at universities in Beijing and Cairo. He serves as human 36 resources adviser to the National Foreign Trade Council. (Chapter 7) 37 XVIII DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Clifford A. Rathkopf, a partner at the Greenwich, Connecticut, law firm 2 of Gilbride Tusa Last & Spellane, began his career as an antitrust litigator 3 and has since concentrated in corporate, hi-tech, and intellectual and 4 industrial property matters. He has represented the commercial interests 5 of numerous clients from Europe and the Far East as well as a wide range 6 of domestic clients, with much of his work focusing on acquisitions, 7 licensing, and contract negotiations. Other areas of his practice include 8 leasing, purchase and sale of real estate; creditor’s rights in bankruptcy 9 and distress situations, and commercial dispute resolution. Mr. Rathkopf 10 graduated cum laude from Colgate University and received his J.D. cum 11 laude from Columbia University Law School, where he was coeditor in 12 chief of the Journal of Transnational Law. He studied at the 13 International Court of Justice in the Hague and received his LL.M. 14 degree in International Trade Law from Georgetown University, which 15 included studies at Goethe Universität in Frankfurt am Main, Germany. 16 (Chapter 5) 17 18 Norman J. Resnicow, a partner at the New York law firm of Fox Horan 19 & Camerini, has many years of cross-border transactional experience. 20 He counsels inbound (non-U.S.) clients, primarily from Europe and 21 Asia, on establishing and expanding their U.S. operations. His work 22 encompasses a broad range of corporate and commercial transactions, 23 including mergers and acquisitions; joint ventures and partnerships; dis- 24 tribution/marketing/licensing arrangements and disputes; executive 25 employment and terminations; and real estate purchases, sales, and leas- 26 es. A graduate of Yale College and Yale Law School, Mr. Resnicow was 27 for nineteen years a partner at the world’s largest international law firm. 28 He now serves on the Committee on International Employment Law 29 of the New York State Bar Association, previously was on its Committee 30 on International Law, and is a member of its International Law section. 31 Also a member of the International Law and Practice and Business Law 32 sections of the American Bar Association, he has been a term member 33 of the Council on Foreign Relations. Mr. Resnicow has lectured on 34 international legal topics at New York University’s Stern School of 35 Business, the American Management Association, and the World Trade 36 Institute. (Chapter 5) 37 ABOUT THE CONTRIBUTORS XIX

Arthur H. Rosenbloom, managing director of CFC Capital Corp. in 1 New York, is a thirty plus-year veteran of the domestic and cross-border 2 M&A marketplace, with client representations that include Continental 3 Airlines, Hyatt Corp., and American Express. His contributions on 4 investment banking topics have appeared in The Harvard Business 5 Review, Forbes, Business Week, Mergers and Acquisitions magazine, and 6 the National Law Journal. The coauthor of several books on interna- 7 tional mergers and acquisitions, he is an adjunct professor of finance at 8 the Stern School of Business at New York University. Mr. Rosenbloom 9 holds B.A., M.A., and J.D. degrees from Bucknell University, Columbia 10 University, and Cornell Law School, respectively. (Chapter 1) 11 12 Cynthia N. Wood is a principal in Wood Associates, a consulting firm 13 specializing in change management, organizational development, inter- 14 national mergers and acquisitions, and executive training. Her clients 15 have included international food and beverage companies, automobile 16 manufacturers, paper bag manufacturers, institutions of higher educa- 17 tion, and software companies. Dr. Wood has assisted clients in profiling 18 their organizational cultures and understanding the implications for the 19 successful acquisition of new business units. She has also developed 20 plans for the post-merger integration of global businesses and assisted 21 with the implementation of those plans. Dr. Wood has published exten- 22 sively in the journals of the International Academy of Business Disci- 23 plines and the Society for the Advancement of Management. She 24 received a Ph.D. from the University of Virginia and completed post- 25 doctoral work at the Johns Hopkins University. She also studied at the 26 University of Salamanca in Spain. (Chapter 7) 27 28 29 30 31 32 33 34 35 36 37 This page is intentionally blank 1

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15 1 2 Due Diligence in the 3 4 1 Global Economy 5 6 7 ARTHUR H. ROSENBLOOM 8 9 10 11 12 13 14 15 ROSS-BORDER TRANSACTIONS are an integral feature of 16 business in the twenty-first century. Expansion in the Asia-Pacific 17 Cregion as well as in North America, with NAFTA-incentivized 18 trade by and among the United States, Canada, and Mexico, continues 19 apace. Much the same may be said for the salutary effects of the eco- 20 nomic cooperation among countries in the European Union. Latin 21 American cross-border transactions abound, and U.S. investors await the 22 emergence of a post-Castro era and opportunities to join the Canadian 23 and European companies already transforming Cuba’s trade. The trend 24 is less pronounced in most of Africa, whose time for significant cross- 25 border transactions is yet to come. On the whole, however, increasing 26 numbers of cross-border transactions are likely to occur going forward. 27 The purpose of this chapter and of the book itself is to suggest how 28 effective due diligence can result in more thoughtfully planned and bet- 29 ter executed transactions in an ever shrinking world. 30 These days, even small and middle-market firms regularly engage in 31 cross-border transactions. As capital and technology move more frequent- 32 ly across borders and international trade agreements expand, cross-border 33 deals are no longer the sole domain of corporate behemoths. Yet it’s a sad 34 fact of life that many deals fail to live up to the parties’ expectations. 35 Mergerstat reports that in the period 1992–2000, outbound mergers and 36 acquisitions (those involving a U.S. buyer and a non-U.S. target) went 37

1 2DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 from 403 to 1,400, a 247 percent jump, and their total dollar value (where 2 reported) rose from $14.05 billion to $136.75 billion, an 872 percent 3 increase. In that same period, inbound M&A transactions (those involving 4 a non-U.S. buyer and a U.S. target) soared from 167 to 1,248, a 647 per- 5 cent rise, and their total value (where reported) went from $9.3 billion to 6 $299.2 billion, an unprecedented 2,217 percent increase. While the num- 7 ber of such transactions decreased in 2001 and 2002 (but only to about 8 1997 levels), one may confidently predict a rebound in such transactions 9 when economies and capital markets turn upward. 10 Given the huge increase in the number of cross-border M&A transac- 11 tions that has characterized much of the past ten years, one might expect 12 to hear of boardroom bliss and satisfied stockholders. Quite the contrary 13 has been the case. A 1995 Business Week/Mercer Management study that 14 echoed the results of many prior and subsequent studies found, in exam- 15 ining 150 M&A transactions worth over $500 million in the period 16 January 1990 to July 1995, only 17 percent resulted in substantial share- 17 holder returns to the investing party, with 30 percent resulting in a sub- 18 stantial erosion of shareholder returns to the investor. Results in cross- 19 border transactions have been especially unattractive. A 1999 KPMG 20 study of the top 700 cross-border M&A deals between 1996 and 1998 21 concluded that over 53 percent diminished the buyer’s shareholder value. 22 Unsuccessful transactions, like dysfunctional families, go sour for 23 many reasons, but high on the list in most surveys is the absence of thor- 24 ough due diligence. Some experts argue that merger failure is not as pro- 25 nounced among middle-market and small companies as in large ones 26 (see the Business Week/Mercer Management study cited above), or, as 27 Peter Peckar of international investment banking firm Houlihan Lokey 28 Howard & Zukin asserts, that strategic alliances or joint ventures are 29 likely to produce more attractive results than mergers.1 What is crystal 30 clear, however, is that good due diligence will cause thoughtful parties 31 to back away from what are likely to be ill-starred unions or to identify, 32 early on, problems in attractive deals so that they can be dealt with 33 before or soon after the closing. 34 Sound transactional due diligence is a prerequisite to successful busi- 35 ness deals in good times of rising expectations and in bad times when 36 success may be more elusive. And it is particularly necessary in this 37 postmillennial deal period, in which cyberspace, biotech, and other kinds DUE DILIGENCE IN THE GLOBAL ECONOMY 3 of technology-driven companies are, more than ever, subjects of the 1 transactional process. Determining the value and use of the intellectual 2 property of postindustrial-era companies is dramatically more difficult 3 than determining the value of the real property and hard assets of indus- 4 trial-era companies. Many of the tried-and-true valuation yardsticks just 5 don’t apply to intellectual property. 6 7 8 What Is Due Diligence? 9 Transactional due diligence is the investigation by an investor or its advis- 10 ers of the accurate and complete character of the target company’s busi- 11 ness. The target may be an acquisition candidate, a joint venture or strate- 12 gic alliance partner, a prospective public offering registrant, or a company 13 the investor is considering for minority interest private placement purpos- 14 es. Due diligence must be linked to the investor’s corporate strategy; in 15 fact, the goal of much of the legal, financial, and operational due diligence 16 is to determine whether a transaction with a given target is in the service 17 of that strategy. Due diligence also includes investigating the target’s legal 18 status, from its proper legal authorization to do business to its actual or 19 contingent liabilities and all points between. In addition, it includes ana- 20 lyzing the target’s historical, current, and projected financial statements. 21 It involves scrutinizing the target as a whole and its corporate, divisional, 22 or subsidiary affiliates. When the investor and the target are in the same 23 industry, transactional due diligence explores financial, operational, or 24 managerial synergies between the investor and the target. 25 Transactional due diligence is not the exclusive province of the 26 investor. Target companies should perform transactional due diligence 27 on the investor, especially if the investor is offering consideration other 28 than cash. Even in an all-cash transaction, a thoughtful target investi- 29 gates the extent to which an alliance with the investor will assist it in 30 growing its business, not to mention the critical question of whether, in 31 an M&A or joint venture situation, corporate cultures can mesh. 32 History’s lesson is that transactions resulting in personality clashes or 33 dramatically different styles of doing business (entrepreneurial versus 34 highly structured companies, centralized versus decentralized, or the 35 special culture wars that sometimes arise in cross-border deals) seldom 36 produce attractive post-transaction outcomes. 37 4DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 No two due diligence efforts are alike, and for the practitioner each 2 transaction presents novel issues. Due diligence may reveal that a Native 3 American tribe claims title to the land under the target’s principal facil- 4 ity, disclose questionable transfer payments between the target and its 5 corporate affiliates, or unearth unfavorable information on the target’s 6 CEO. However, no solution can be provided unless the fundamental 7 facts are discovered in due diligence. 8 9 10 Types of Due Diligence 11 Although due diligence practices are far from uniform around the world, 12 they can be categorized roughly in two forms. What has been character- 13 ized as the “Anglo-Saxon” practice involves comprehensive legal and 14 financial due diligence and significant disclosure before the signing of an 15 agreement. The deal is embodied entirely in the documents, which set 16 out in detail the rules governing the parties’ rights and obligations. 17 Contrast this with the practice in much of the rest of the world, which 18 involves more modest preliminary legal and financial due diligence with 19 correspondingly limited disclosure. 20 The goal among many non-Western transactors, for example, is to 21 build trust between the parties, leading to provisional agreements. These 22 provisional agreements are followed by more intensive due diligence, cul- 23 minating in a final agreement embodying a business relationship in which 24 the contractual documents form one of the constituent parts. Thus, U.S. 25 parties involved in outbound transactions with companies in countries in 26 which Anglo-Saxon-style due diligence is not practiced often must obtain 27 the necessary information and assurances by means other than the highly 28 documented, full-disclosure process to which they are accustomed in 29 their home market. International deal makers must be flexible and sensi- 30 tive to the differences between what is acceptable in a domestic deal and 31 what is acceptable in certain cross-border deals. 32 33 34 Who Is Involved in Due Diligence? 35 The cast of characters in most due diligence efforts is likely to include 36 company employees, the company’s traditional professional advisers, and 37 those hired for their expertise in certain legal, tax, accounting, and oper- DUE DILIGENCE IN THE GLOBAL ECONOMY 5

1 ational issues present in the target’s home country. They include legal, 2 financial, and operational professionals. 3 Legal pros. Because law has become highly specialized, today even 4 midsized deals involve armies of corporate, tax, real estate, environmen- 5 tal, employee benefits, insurance, and other kinds of legal specialists. 6 Although some of the due diligence legal work may be done in-house if 7 the companies have sufficient legal staff, outside counsel is likely to be 8 engaged in larger and more complex transactions. Over the years, busi- 9 ness has been regulated increasingly by local and national governments 10 as well as by treaty-created organizations like the European Union. As a 11 result, regulatory resistance outside the United States can cause prob- 12 lems in what is, at least nominally, a purely domestic deal. These facts 13 make lawyering an increasingly important part of the transactional due 14 diligence scene. 15 Financial pros. In M&A and private placement due diligence, both 16 the investor and the target typically rely on in-house personnel (CFOs 17 and controllers) as well as their outside auditors. The underwriters and 18 registrant in a cross-border public offering also use both in-house CPAs 19 and outside CPA firms. One or both sides may use investment bankers 20 and commercial banks, and other institutional personnel are certain to 21 perform their own due diligence on the issuance of any debt required to 22 fund the transaction. 23 Operational pros. The buyer must evaluate every material aspect of 24 the target’s business. Key operating personnel (in-house managers or 25 outside consultants) must scrutinize the target’s business and report 26 their findings to the decision makers. The target’s prospective ability to 27 help the investor execute its strategy should infuse every aspect of the 28 operational due diligence process. Operational due diligence includes 29 investigating the target’s intellectual property, its production (if a man- 30 ufacturer), its sales and marketing efforts, its human resources, and the 31 other operational issues described below. For financial investors, the 32 problem of valuing these operations is magnified if the transaction rep- 33 resents the investor’s first foray into the target’s industry. Financial 34 investors tend to be especially meticulous in their collection of inde- 35 pendent financial data on the target’s industry. They generate some of it 36 internally and rely on outside advisers for the rest. 37 6DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 What Constitutes Legal Due Diligence? 3 Whether the transaction is domestic or international, due diligence must 4 address certain fundamental legal issues. Among the basic corporate law 5 issues are whether the target’s debt and equity securities identified in the 6 target’s Certificate of Designation have been validly issued and whether 7 the target is in good standing in the places in which it does business. Its 8 tax compliance status in all such jurisdictions and whether it has good 9 title to all of its assets should also be examined. Although the bona fides 10 of all of these will surface as the target’s representations and warranties 11 and covenants in the purchase agreement, the ability to sue for breach of 12 the agreement is cold comfort after the deal is done, when the funds 13 have been expended and when the parties, comfortably or otherwise, 14 must join as one to accomplish the common goals that brought them 15 together in the first place. 16 Tax attorneys and accountants examine the target’s tax practices, 17 undertake the tax planning for the transaction itself, and consider post- 18 deal tax planning. Lawyers also investigate whether the deal will raise 19 antitrust questions. In this respect the cross-border deal may present 20 interesting challenges, such as those the European Union’s anti- 21 monopoly group posed to the GE-Honeywell transaction, a nominally 22 domestic U.S. transaction. 23 Legal due diligence requires careful attention to actual and threatened 24 litigation. Such litigation can come from debt or equity security holders, 25 tax authorities, customers, or suppliers, in the form of breach of con- 26 tract, product liability, or breach of warranty claims, and the liability 27 exposure and damage implications of all such matters should be careful- 28 ly investigated. Due diligence of so-called lawyer’s representation letters 29 that describe such litigation is a must. 30 In this post-Enron age of increasing regulatory and judicial scrutiny, 31 issues like allegations of improper behavior by corporate officers, direc- 32 tors, and employees (as in accusations in 2002 concerning misuse of 33 company funds by executives of Tyco International Ltd., for example); 34 workplace safety matters; employee benefits; potential equal opportunity 35 violations; and increasingly significant, environmental regulations, may 36 loom large. Second perhaps only to environmental concerns, pension 37 and related issues have, over the past three decades, become an item of DUE DILIGENCE IN THE GLOBAL ECONOMY 7 ever greater concern. Thus, ERISA lawyers are inevitably involved in due 1 diligence. The list of legal specialists the above discussion presupposes is 2 far from exhaustive. 3 Lawyering in cross-border due diligence involves considering all of the 4 matters found in purely domestic transactions as well as those that arise 5 from different or conflicting legal regimes operating in the countries in 6 which the parties are domiciled. Selected examples in developed markets 7 include rules that require minimum amounts of capital to be invested, 8 requirements to purchase or manufacture in the target’s country, and 9 restrictions on acquiring assets in certain types of “national interest” 10 industries (such as defense, telecommunications, or broadcasting). Many 11 countries have foreign investment control laws, impose limits on foreign 12 ownership, require restrictions on share transfers, or regulate the prices 13 that companies can charge. Tariffs, duties, required government or work- 14 ers’ counsel approvals, and bilateral or multinational tax treaty implica- 15 tions are but a few of the elements involved in legal due diligence. 16 To this daunting list, add the legal issues that arise when targets are 17 in emerging markets. These issues include questions about the enforce- 18 ability of judgments and creditors’ rights. Indeed, one investor recent- 19 ly abandoned a cross-border transaction because it was not able to 20 obtain a security interest in the target’s assets given the absence of a 21 Uniform Commercial Code–type procedure in the target’s home coun- 22 try. Contradictory laws and regulations as well as new laws (such as 23 environmental ones) might affect how future business is conducted in 24 an emerging market. 25 26 27 What Constitutes Financial Due Diligence? 28 Financial due diligence (leaving aside, for the purposes of this general 29 overview discussion, the important related area of tax due diligence) 30 involves considering a company’s historical, current, and prospective 31 operating results as disclosed in its historical, current, and projected 32 financial statements, tax returns, backlog data, and other information. 33 From these data, an income statement review can establish trends in rev- 34 enues and profits, investor returns, and compound growth rates. 35 Examination of the cost of sales; selling, general, and administrative 36 (SG&A); extraordinary and nonrecurring expenses; interest; and other 37 8DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 fixed charges and taxes can lead to a thoughtful profit margin analysis. 2 Financial due diligence also involves a balance sheet review, from cash 3 to marketable securities, receivables, inventory, prepaid expenses, and 4 other current assets, as well as the value of fixed assets. On the liability 5 side, accounts payable, taxes, and debt obligations must be closely exam- 6 ined. Contingent liabilities such as those from special-purpose partner- 7 ships and the like that are usually “off balance sheet” require particular 8 attention in due diligence. Price redetermination issues in government 9 contracts, warranty or service guarantees, product liability issues, 10 unfunded pension plans, equal opportunity employment issues, and the 11 ubiquitous environmental issues require careful attention. 12 A review of the target firm’s financing and capital structure is de 13 rigueur. Issues to analyze include details of short-term and long-term 14 borrowings, including maturities and acceleration clauses in debt agree- 15 ments, the terms and conditions of equity securities (common and pre- 16 ferred), the percentages of debt and equity in the company’s balance 17 sheet, interest and fixed charges coverage ratios, and so on. 18 In many companies, cash flow is king. Therefore the target’s sources- 19 and-applications statement demands serious review to determine the 20 ability of internally generated cash to finance the company’s future 21 growth. The company’s capital budget and its projections require 22 thoughtful scrutiny as well. 23 On “softer” but no less critical issues, financial due diligence involves 24 examining the quality of the company’s relationships with its lenders and 25 an ultimate opinion concerning the reliability and credibility of its finan- 26 cial statements (such as the effectiveness of its internal controls and the 27 quality of the accountants’ work papers). These efforts are designed to 28 forestall problems of “managed” or “puffed” earnings that could be the 29 product of aggressive accounting practices such as cutbacks in discre- 30 tionary expenses, inadequate compensation of key executives, withhold- 31 ing of payables during recent cutoff periods, and underaccruing for taxes. 32 As in cross-border legal due diligence, cross-border financial due dili- 33 gence carries with it the overlay of different countries’ rules—in this case 34 different accounting and tax regimes. Reconciling the target’s financial 35 statements to U.S. generally accepted accounting principles (GAAP) 36 may be difficult, and tax compliance may be less than punctilious, espe- 37 cially in emerging-market countries. There may be more than one set of DUE DILIGENCE IN THE GLOBAL ECONOMY 9 accounting books. In addition, financial due diligence may need to con- 1 sider the anomalies of financial statements that reflect the policies of for- 2 mer command economies, with their emphasis on asset size rather than 3 bottom line results. In one deal, the investor discovered that the Eastern 4 European target acquired redundant assets like lakeside villas to dampen 5 earnings in order to avoid “upstreaming” profits to state agencies. 6 7 8 What Constitutes Operational Due Diligence? 9 Operational due diligence may involve consulting environmental experts 10 on toxic tort exposure, actuaries on pension and profit-sharing matters, 11 or insurance experts on risk management concerns. 12 Because operational due diligence varies dramatically from target to 13 target, meaningful generalizations are difficult to make, but operational 14 due diligence concerns likely to surface in most transactions include the 15 following: 16 New product or new service creation. Due diligence requires 17 understanding how the target firm creates the new products or services 18 it sells. Is the process organized or random? Is there one “genius,” the 19 loss of whom will be materially adverse to the business, or is there a staff? 20 Has the target skimped on R&D to inflate earnings? Is R&D responsive 21 to customer needs? How good is the target’s intellectual property: Is 22 there real, defensible know-how? Does the target own the rights to the 23 intellectual property it uses? 24 Markets. Is demand basic or created? Who buys the target’s products 25 or services (individuals, companies, governments)? Is the market grow- 26 ing or mature, and what is the target’s market share? What factors affect 27 demand (general business conditions, population changes, new products 28 or services, energy availability, ecological considerations)? Is the market 29 expandable? How is it segmented (for example, by customer type, prod- 30 uct, geography, distribution channels, or pricing)? To what extent is the 31 market seasonal or cyclic? One need look no further than the collapse of 32 many dot-com companies to recognize the mistakes that even savvy 33 financial investors can make if they skimp on market analysis. 34 In cross-border deals it is easy to overestimate market demand. The 35 90 percent market share of an Eastern European company before priva- 36 tization may be sharply eroded in the postprivatization period, when it 37 10 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 must compete against new and tough rivals, many of them from outside 2 the country. Although hindsight is 20/20, one wonders about the 3 assumptions the Daimler-Benz economic gurus made in 1998 about 4 projected U.S. auto sales when they were negotiating the Chrysler deal. 5 Thoughtful due diligence allows companies to avoid costly mistakes 6 in what may prove to be misguided notions of globalization. Thus, an 7 employee benefits consulting firm catering to multinational corpora- 8 tions might think twice about expending time, money, and effort on a 9 globalized acquisition, joint venture, or cross-marketing strategy if it 10 turns out there is no consistency in the legal, tax, and accounting rules 11 of the countries whose companies offer pension, profit sharing, or stock 12 option plans, or if local affiliates of those multinational clients couldn’t 13 care less whether their employee benefits consulting firm was global. In 14 such a situation it might be wisest simply to have offices of the consult- 15 ing firm share leads, perhaps with a financial incentive to the referring 16 office (and perhaps to the individual referrer) providing the lead, 17 payable out of the fees generated by the office to whom the lead was 18 referred. 19 Competition. Due diligence must ferret out the competition. Who 20 are the competitors, and what market share do they have? On what basis 21 is competition waged: price, service, quality, or something else? What is 22 the market size now and prospectively? To what extent is the market sub- 23 ject to significant federal, state, and local regulation? 24 Sales. Who sells the company’s products or services: Employees? 25 Independent agents? The principals themselves? How is the sales force 26 organized: Centrally? Regionally? How are salespeople compensated: 27 salary, commission, or both? 28 People/organizational matters. How many employees are there, 29 and what are their functions? Is there an adequate labor pool in the geo- 30 graphic areas in which the company operates? Are these areas likely to 31 attract a trained workforce (given the transportation network, quality of 32 schools, cultural and recreational opportunities, and so on)? 33 Over the years, human resources professionals have developed tech- 34 niques to determine what sort of workforce an investor is acquiring in a 35 target. They ask, are there unfilled positions in key slots? What’s the 36 morale like? They check for data on Friday/Monday absences, frequency 37 and length of sick leave, worker turnover, poor safety reports, and strikes. DUE DILIGENCE IN THE GLOBAL ECONOMY 11

Due diligence must also address the nuts and bolts of pay. What are 1 the terms of existing collective bargaining agreements? What are the 2 benefit programs (vacation, sick leave, insurance, stock options)? 3 Examine the organization chart. Who are the senior managers, and 4 who are the successors? Is there merit in considering the use of private 5 investigators to uncover what may be embarrassing and costly disclo- 6 sures concerning one or more of the company’s senior managers? What 7 are the career paths, and what is the retention outlook? What is the 8 nature and size of management’s compensation package, and, as in the 9 case of the workforce, how does it compare within the region and with- 10 in the industry? 11 People and organizational matters often are highly sensitive issues in 12 cross-border deals. The cost of laying off redundant workers should 13 be calculated as a component of the purchase price in those countries 14 where terminated employees typically receive large settlements. When 15 acquiring targets in former Soviet bloc countries, for example, investors 16 have typically bid a modest purchase price to accommodate the extraor- 17 dinarily high termination costs. In the final analysis, for both investors 18 and targets, the bedeviling, sleep-depriving questions may be “Can we 19 live with the managers on the other side of the bargaining table?” “Can 20 we trust them?” “Is their corporate culture sufficiently similar to ours 21 so that we can deal with the difficult issues that will necessarily attend 22 our joining forces?” Double the importance of these issues in cross- 23 border transactions. 24 25 26 Integrating Due Diligence Efforts 27 The boundaries dividing legal, financial, and operational due diligence are 28 porous. Say, for example, that a toxic waste disposal problem affects a tar- 29 get firm in China. Due diligence on this issue properly involves the 30 investor’s legal counsel, because the investor must understand the conse- 31 quences of civil or criminal liability, current or prospective, resulting from 32 the problem. Financial professionals also must perform due diligence on 33 this problem in order to measure the present and future economic costs 34 of compliance. Furthermore, operational due diligence should focus on 35 the extent to which environmental issues will impede day-to-day opera- 36 tions. Thus, an environmental issue flagged in legal due diligence, quan- 37 12 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tified in financial due diligence, and evaluated operationally in operational 2 due diligence may affect the price at which the deal is struck, the struc- 3 ture of the transaction, and the contractual character of the representa- 4 tions and warranties, covenants and conditions to closing. 5 As to price, the environmental problem will affect the investment 6 bank’s pricing recommendation. Discounted cash flow analyses of the 7 target will take the form of lower cash flow projections and terminal 8 value computations and higher discount rates. And these factors will 9 result in lower multiples in the banker’s use of comparative company 10 analysis. 11 The environmental risk unearthed in due diligence also will affect how 12 the legal and financial experts structure the terms of the transaction. 13 Faced with a material risk of this sort, the parties are likely to discuss 14 escrows, milestone payments, earn-outs and installment sales with the 15 right of setoff. 16 The same environmental risk also will affect the terms of the agree- 17 ments between the parties. In particular, the scope of the target’s envi- 18 ronmental representations and warranties; covenants the target may be 19 compelled to make as to the commencement of remediation between 20 contract and closing; and an investor’s condition to closing (typically a 21 preliminary environmental investigation—a “Phase I” investigation in 22 U.S. parlance), are all likely. 23 In the pages that follow we take you on a trip through the labyrinth 24 of strategic planning, legal, operational, accounting and financial, tax, 25 and people/organizational cross-border due diligence. We also describe 26 new resources in investigative technology that can assist all professionals 27 involved in the due diligence process. We hope you find the journey 28 instructive and rewarding. 29 30 Chapter Notes 31 32 1. To the contrary, however, see Miller, Glenn, Jaspersen, and Yannis, 33 “International Joint Ventures in Emerging Markets: Happy Marriages?” 34 IFC Discussion Paper No. 29, World Bank/International Finance 35 Corporation, 1999. See also Reuer and Leiblein, “Downside Risk 36 Implications of Multinationality and International Joint Ventures,” 37 Academy of Management Journal, Vol. 43, No. 2, p. 203, 2000. 1 2 Strategic Due Diligence 3 4 2 5 6 GEOFF CULLINAN 7 TOM HOLLAND 8 9 10 11 12 13 14 15 ALUE CREATION, the ultimate aim of a merger, acquisition, joint 16 venture, or related type deal, is anything but certain. One in five 17 V such deals falls through after it’s announced, due to either regula- 18 tory issues or a failure to resolve outstanding disagreements. Of those trans- 19 actions that do close, one-half to three-quarters fail to create shareholder 20 value (their earnings are less than their cost of capital), according to sever- 21 al studies by Harvard Business School and surveys of CFOs by Bain & 22 Company. One of the main reasons is a failure to align strategic goals with 23 the process of generating and executing transactions. 24 Cross-border transactions, involving companies based in different 25 countries, often present mouthwatering opportunities for expansion into 26 new markets. However, these deals also include regulatory and legal 27 issues and complex cultural considerations, such as the need to under- 28 stand foreign market dynamics, employee work styles, and managerial 29 bias to integrate the companies successfully afterward. The merger 30 involving Swedish Asea and Swiss Brown Boveri Inc. was a classic multi- 31 cultural merging of equals. Yet the complexity of integrating these com- 32 panies into engineering giant Asea Brown Boveri (ABB) extended well 33 beyond internal business issues. For instance, ABB had to contend with 34 strong national companies, governments, and striking unionized 35 German workers, plus powerful and culturally different management 36 comprised of five nationalities on the eight-person executive committee 37

13 14 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 and nineteen nationalities among the 170 head-office employees. 2 Transactions that succeed—be they cross-border or within the same 3 country—share a common element: The deals are closely aligned with 4 the buyer’s strategic purpose. 5 British American Tobacco (BAT), the world’s second-largest tobacco 6 company, understood the importance of aligning transactions with strategy 7 when it purchased Toronto-based Rothmans, Canada’s number-two tobac- 8 co company, in 1999. The acquisition involved weathering three major 9 antitrust inquiries and combining operations in more than seventy coun- 10 tries. Despite this complexity, integration was largely completed within a 11 year. BAT chairman Martin Broughton emphasizes, “You need absolute 12 clarity … and you must stick to your strategy, or you’ll lose the troops.” 13 To make sure two companies in a cross-border deal can achieve and 14 maintain strategic alignment, you must conduct exhaustive strategic due 15 diligence. Often called “commercial assessment” or “commercial 16 review,” strategic due diligence begins with a company’s corporate, or 17 strategic, planning. Hence, you must understand the strategic planning 18 process to understand strategic due diligence. 19 20 21 Strategy Precedes Due Diligence 22 Transactions should be made only when they improve the strategic posi- 23 tion of the investor’s existing business or add to its core competencies. 24 To probe the logic of a transaction, ask the following five questions: 25 1 Strategy formulation: Is a transaction (acquisition, joint venture, 26 strategic alliance, minority interest stake) required to fulfill corpo- 27 rate or business unit strategy? 28 2 Transaction target screen: Who is the best candidate based on 29 attractiveness and availability? 30 3 Due diligence: Does this particular deal meet the investor’s strate- 31 gic objectives? 32 4 Target valuation: Can we do the deal at the right price? 33 5 Integration: Can we execute our integration or restructuring plans 34 postdeal to extract the full value? 35 Before trying to incorporate a cross-border deal into your strategy, 36 therefore, you first must have a solid understanding of your current 37 strategic position. STRATEGIC DUE DILIGENCE 15

1 Reviewing Your Strategy 2 Corporations view strategic planning on two levels: from a corporate 3 perspective and from a business-unit level. Corporate strategy is about 4 being in the right portfolio of businesses, whereas business-unit strategy 5 is about making a particular business the best in its industry. Figure 2.1 6 illustrates this planning framework. 7 8 FIGURE 2.1 9 Strategic Planning Framework 10 11 Corporate Strategy 12 Corporate Capabilities 13 Portfolio of Business Corporate 14 Advantage 15 Business-Unit Strategy Shareholder Value 16 Costs 17 Customers Competitive 18 Competition Advantage 19 Core Competencies 20 21 During strategic planning, assess the strategic position of the business 22 unit that you suspect would most benefit from a transaction involving 23 external development through M&A, strategic alliance, or the like. 24 Analyze the “four Cs”—costs, customers, competitors, and capabili- 25 ties—to assess the full potential of a business. 26 27 Costs 28 First, analyze your business unit’s strategic cost position relative to its 29 competitors’, and identify opportunities for cost reduction. Address the 30 following questions: 31 Relative cost position. Do competitors have a cost advantage? Why 32 are we (or they) performing above or below what we would expect, given 33 our relative market position? What is our full potential cost position? 34 Experience curve. To what extent is the business unit using its expe- 35 rience curve to drive down unit costs? Where are we versus competitors? 36 What will prices be five years from now? 37 16 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Cost-sharing analysis. Is this business separate from another? How 2 well can competitors in related businesses attack our business? Does the 3 benefit of sharing costs with our other business units outweigh any lack 4 of focus that sharing costs across multiple businesses would introduce? 5 Best demonstrated practices (BDPs). How low can we take our 6 costs if we employ the best internal and external practices? How low can 7 competitors take costs? (Benchmarking is a related tool in this analysis.) 8 Product-line profitability/cost allocation/activity-based costing. 9 Which products and customers really make the money? Which ones 10 should we drop? 11 12 Customers 13 Next, turn to customers to identify revenue- and profit-maximizing strat- 14 egies. 15 Market overview and map. What is the market size? Is it growing? 16 How is it broken down by geography, products, and segments? What is 17 each competitor’s market share? 18 Customer segmentation. Which parts of the market require differ- 19 ent offerings? Are we fully penetrated in some segments and neglecting 20 others? Can we adjust our offerings to grow sales or increase price real- 21 ization? Which segments are financially attractive for us to invest in? 22 Distribution-channel analysis. What range of channels is possible 23 for each product/service? Do some offer superior economics? Are we 24 reaching our full potential in each? 25 Customer retention and loyalty. How can we identify the most 26 profitable customers? How many more of them are there yet to reach? 27 How do we increase our retention of our best customers? What is the 28 profit impact of increasing retention by X percent? 29 Customer acquisition. How/where can we acquire profitable cus- 30 tomers? What will it cost? 31 32 Competitors 33 Third, investigate opportunities to achieve differentiation and preempt 34 competitor moves. 35 Competitive position overview. What is the business unit’s market 36 share/revenue and profit by geography, product, and segment? What are 37 its strengths, weaknesses, opportunities, and threats (SWOT)? STRATEGIC DUE DILIGENCE 17

Profit pool analysis. Are we (or others) getting our fair (or better) 1 share of the industry’s available profits? Where in the value chain is the 2 profit concentrated? Can we move to capture more of it? 3 Competitive dynamic. How will competitors act or react to external 4 events? To our strategic actions (such as a merger or acquisition)? 5 Relative performance. How do we and each competitor make the 6 profits expected by the relative market share we have? Are we/they 7 underperforming operationally? Is the business correctly defined? 8 9 Capabilities 10 The fourth, and often overlooked, “C”—capabilities—considers strategies 11 that best fit with the business unit’s core competencies. 12 Core competencies. What special skills or technologies does the busi- 13 ness unit have that create differentiable customer value? How can it 14 leverage its core competencies? What investments in technology and 15 people will help build unique capabilities? 16 Make versus buy analysis. What products should the business unit 17 make itself, and what products should it buy from another company? 18 Organizational structure. What organizational structure will enable 19 the business unit to implement its strategy most effectively? How can all 20 other aspects of the organization be aligned with the strategy (such as 21 compensation, incentives, promotion, information flow, authority, and 22 autonomy)? 23 24 The business unit strategic planning process outlined above should 25 precede and inform any transaction. Meanwhile, corporate-level strate- 26 gic planning will help management distinguish the portion of corporate 27 growth that can be achieved organically from the areas where growth 28 through acquisition makes sense. 29 Not all external growth strategies—that is, growth through acquisi- 30 tion—succeed. The misguided expansions of Gillette when it bought 31 French pen maker Waterman and of Sears when it acquired Dean Witter 32 illustrate the perils of making acquisitions based on a poorly thought 33 through strategy. In the early 1980s Sears paid $6.7 billion for Dean 34 Witter, based on the strategy of creating a one-stop financial supermar- 35 ket for its department-store customer base. However, Sears soon found 36 that there was limited cross-selling and cost-sharing potential between 37 18 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the two companies and that the capabilities required to operate a retail 2 operation and financial services company were quite different. Sears refo- 3 cused on its core retail operations by divesting Dean Witter just over a 4 decade after the acquisition. 5 Strategic planning is obviously a crucial part of organic growth, but it 6 is even more critical when undertaking external expansion, because 7 strategic due diligence cannot occur unless a sound strategic plan is in 8 place. Strategic planning is what you do to determine whether a transac- 9 tion could help you achieve a goal. Strategic due diligence is what you 10 do to determine whether a particular target could fulfill the strategic 11 plan. For instance, as a part of its international expansion strategy, one of 12 the world’s largest consumer goods manufacturers decided to develop its 13 own distribution system in Turkey. The high profile of major competitors, 14 as well as the global ineffectiveness of the potential local partners, com- 15 plicated the situation. The company’s strategic planning, however, had 16 focused on market sizing and retail models to estimate market potential 17 and determine current demand. Market and competitor analysis had 18 helped to estimate the scale of local opportunities in each region, as well 19 as current regional distribution patterns and key distribution hubs. The 20 analysis also defined hub distribution methods and how to capture mar- 21 ket share. With all aspects of investigation pointing to an attractive 22 strategic opportunity, the company had the basis from which to negoti- 23 ate a major strategic alliance with the state monopoly to enter the mar- 24 ket. Most of the strategic due diligence work had already been done in 25 the strategic planning process. 26 Objectives identified through strategic planning can—and should— 27 inform the conduct of due diligence in both domestic and cross-border 28 transactions. 29 30 31 Achieving Value 32 As purchase multiples rise, the leeway to create value tends to diminish. 33 Buyers have a much smaller margin of error, because high multiples are 34 justifiable only with high growth and correspondingly high investor 35 internal rates of return. Whereas a buyer, as the more proactive party in 36 any transaction, might be happy to pay a multiple of 15 for a high- 37 growth business, it won’t for a more mature business. Such deals STRATEGIC DUE DILIGENCE 19 require rigorous purchase decisions and extraordinarily tight portfolio 1 management. 2 Until 2000, an increasing amount of capital chasing a limited number 3 of deals led to higher purchase multiples. Figure 2.2 illustrates the eco- 4 nomics of purchase multiples in transactions characterized by private 5 equity investors, a small subset of the merger and acquisition universe. 6 By 2000, multiples had leveled off, and what makes a deal at a given 7 multiple attractive has evolved again. Consider the changes over time: 8 During the 1980s, buyers made great returns because they put up to 90 9 percent debt on companies they bought. But there was little growth dur- 10 ing this period, and little multiple expansion. In the 1990s, lenders’ reac- 11 tion to the overleveraging of the 1980s as well as rising stock prices made 12 deals for buyer’s equity more attractive and debt-driven financial deals 13 less popular. But there was to be another great call on debt: The 1990s’ 14 rising tide of entrepreneurship culminating in an explosion of ventures 15 in e-commerce led to greater amounts of capital, and hence competition 16 for a limited number of deals. This led to the greatest multiple expansion 17 (up to infinite) of all time. Figure 2.2 illustrates the pattern of an increas- 18 ingly competitive environment. Multiples have since retrenched as in- 19 vestors realized that the growth aspirations of most dot-commers were 20 unrealistic and the market for Internet stocks corrected. 21 Today, buyers should look to tried-and-true ways to enhance the 22 value-creation potential of a transaction. Developing superior strategies 23 for growth, improving performance, and identifying excellent opportu- 24 nities are ways that transcend market fluctuations. This approach con- 25 sistently brings acquirers, joint venturers, and other investors to more 26 rigorous purchase decisions and to better portfolio management 27 through strategic insight and enhanced operating capabilities. Such 28 strategies should be formulated before due diligence begins. The due 29 diligence process should, among other things, map the extent to which 30 the prospective transaction does or does not enhance value creation for 31 the parties. 32 Strategic due diligence may appear to add extra layers of time and 33 money to transactions, but it occurs along with other forensic, account- 34 ing, legal, environmental, and actuarial due diligence. Strategic due dili- 35 gence, as a percent of equity, is relatively inexpensive, usually coming to 36 tens of basis points on the equity and a small fraction of the enterprise 37 20 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 FIGURE 2.2 2 3 U.S. Private Equity Deals 1994–2000 4 LBO funds Venture funds Increasing 5 Amount of 6 ’00 $155 B Capital 7 ’99 $88 B 8 ’98 $80 B Total 9 Dollars ’97 $50 B 10 Raised ’96 $35 B 11 ’95 $33 B 12 ’94 $24 B 13 14 $0 $50 $100 $150 $200 15 Chasing Limited 16 Number of Deals 17 ’00 283 18 ’99 350

19 Number ’98 306 20 of LBO/ ’97 275 Merchant 21 Bank Deals ’96 277 22 ’95 248 23 ’94 255 24 25 0 100 200 300 400

26 Means Higher 27 Purchase Multiples

28 ’00 7 29 ’99 8 30 ’98 8 .ventureeconomics.com

31 Purchase www ’97 7 32 Multiples ’96 7 33 ’95 6 34 ’94 5 35 .buyoutsnewletter.com;

36 0 1 2 3 4 5 6 7 8 www

37 Source: STRATEGIC DUE DILIGENCE 21 value. And the investment pays off in spades. For instance, since 1996, 1 Bain & Company has co-invested $60 million with its clients in seventy- 2 two transactions in which Bain assisted with strategic due diligence. Of 3 those, twenty-five transactions—about one-third of invested capital— 4 have been realized or revalued, outperforming the market with a gross 5 internal rate of return (IRR) of 67 percent. If Bain had invested that cap- 6 ital instead in the Standard and Poor’s 500 index (and borrowed half the 7 investment amount, as it did with its private equity investments), the 8 firm would have realized a 20 percent return. 9 Compare these results with fifteen other private equity funds that 10 invested $7.6 billion in 152 transactions that have been realized or reval- 11 ued; this cluster of transactions yielded a 56 percent gross IRR. The bot- 12 tom line? Buyout funds spend many times more on due diligence than 13 their corporate counterparts, and they reap on average much higher 14 returns. Given their lack of specific industry experience by which to test 15 a target’s projections, they build their own models and carefully evaluate 16 the downside. They attach a price tag to risk and achieve a high level of 17 confidence in the acquisition’s value to them. What can we learn from 18 buyout funds? 19 A small buyout group that had rolled up a U.S. construction equip- 20 ment manufacturer into a new company approached a major private 21 equity firm offering to sell the new company before it did an initial pub- 22 lic offering (IPO). The private equity firm conducted a strategic review 23 of the target company and tested the owners’ forecast of 20 percent rev- 24 enue growth. The team interviewed hundreds of end users, rental-fleet 25 managers, and competitors to understand market trends. It also analyzed 26 purchasing patterns for other types of heavy equipment to understand 27 the effect of economic cycles on demand. 28 Two major flaws emerged in the owners’ projections for the target 29 company. First, a projected year-long recession in the construction 30 industry during the next five years would result in sell-offs by rental 31 fleets. As a result, increased sales of used equipment would depress new- 32 equipment sales and prices for an estimated three-year period. Second, 33 the owners had forecast that the U.S. market would grow to match 34 European penetration levels—an assumption that turned out to be 35 wrong, as strategic due diligence uncovered. The equity firm discovered 36 that lower equipment-ownership levels in the United States were the 37 22 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 result of a highly efficient, mature rental market, suggesting that organ- 2 ic growth in this sector would be severely limited. This situation con- 3 trasted with the absence of a rental market in Europe, which drove much 4 higher equipment sales there. 5 As a result of this strategic due diligence, the private-equity group 6 decided not to pursue the deal. The small buyout firm went ahead with 7 its IPO. The company’s share price stagnated near the IPO level for two 8 and a half years. After earnings per share dropped 66 percent in one year, 9 a strategic buyer acquired the company for a pittance. 10 Investors must recognize that economic cycles happen in different 11 countries and in different industries at different times. For instance, it’s 12 important for a Canadian investor to have a handle on when the Italian 13 construction industry might take a downturn if it seeks to do an Italian 14 construction industry transaction. 15 16 17 Factoring in Cross-Border Complexities 18 The cross-border deal adds an extra layer of complexity: lack of familiar- 19 ity with foreign markets. A complex combination of legal, economic, and 20 cultural factors drives potential market penetration levels for any product 21 by country. It would be naïve to assume, for example, that just because 22 the United States has 99 percent penetration of Internet applications, 23 the same potential exists in France. Yet it’s harder in cross-border deals 24 to peel away such assumptions and grasp different market dynamics to 25 understand the true potential value of a cross-border deal. 26 Such complexity existed when a U.S. health and fitness club sought to 27 roll out its concept in Europe. Although the U.S. company was unfa- 28 miliar with European markets, strategic due diligence helped it assess the 29 attractiveness of the markets and ease of entry into key European coun- 30 tries. Extensive research and interviews quantified size, growth, demo- 31 graphics, and spending trends in each market. Further efforts assessed 32 the level of consolidation within each country, rental/property costs, the 33 cost of leisure-sector assets, the number of large operators, and the num- 34 ber of available targets. 35 Strategic planning showed that the European market had high growth 36 prospects, that supply was fragmented, and that the players were local or 37 regional. Part of the strategic due diligence thus focused on identifying STRATEGIC DUE DILIGENCE 23 and assessing potential targets to create a pan-European club. Face-to- 1 face interviews with leading targets in priority markets determined the 2 availability of each target, its level of fit with the buyer, and the eco- 3 nomics of club operations in each country. 4 After the benefits of a number of targets were identified and quanti- 5 fied, it became clear that the U.S. company could also improve the tar- 6 get’s postdeal profitability by applying its best practices (better operating 7 systems and more effective marketing) from the U.S. market to existing 8 European players. Note, however (as many have failed to), that for 9 industry investors, the driver of successful expansion is strategic fit. Deals 10 justifiable only because they appear capable of generating operating effi- 11 ciencies should be viewed warily. 12 13 14 Identifying Your Strategic Rationale 15 As we have made clear, the chances for transactional success dramatical- 16 ly improve when the target’s business is aligned with the buyer’s strate- 17 gic goals. Discussed below are five principal strategic rationales for trans- 18 actions: active investing, scale, adjacency, scope, and transformation. 19 Each rationale should be evaluated as part of the corporate strategic 20 planning process and the results used as guidelines to determine the 21 attractiveness of a target. 22 23 Active Investing 24 Leveraged buyout companies and private equity firms engage in “active 25 investing.” Unless the private equity investor has previously invested in a 26 company in the industry, this form of investing involves acquiring a com- 27 pany and running it more efficiently and profitably as a stand-alone firm, 28 with no operational integration. Typically, these transactions improve per- 29 formance through financial engineering, incentive compensation, man- 30 agement changes, and stripping out costs. Private equity player Bain 31 Capital’s purchase in 1990 and restructuring of Gartner Group illustrates 32 the power of “squeezing the lemon.” With its operations fine-tuned, 33 Gartner became a premier broker of computer-industry information. 34 According to Chris Zook’s Profit from the Core: Growth Strategy in an 35 Era of Turbulence, (Harvard Business School Press, 2001), Gartner 36 expanded its margins from 10 percent to 30 percent before Bain Capital 37 24 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 resold Gartner to Dun & Bradstreet in 1993. Active investing can, and 2 often does, add value; however, it is truly the domain of leveraged buy- 3 out and private equity firms. For strategic investors, a more persuasive fit 4 is needed. 5 6 Scale 7 The most common strategic rationale is to expand scale. Scale doesn’t 8 mean simply getting big. The goal is to use scale in specific elements of 9 a business to become more competitive. For instance, if materials costs 10 are a significant profit driver, reducing costs through volume discounts 11 will be a useful consequence of scale. If customer acquisition is critical, 12 channel scale (domination of a distribution channel to gain both distri- 13 bution power and cost reduction via bulk shipping or fleet maintenance) 14 will be critical. Getting scale-based initiatives right requires the correct 15 business and market definition. Setting initiatives can be tricky because, 16 over time, the definition of scale in an industry can change dramatically. 17 For example, the mergers of Pfizer and Warner-Lambert and of 18 SmithKline Beecham (SKB) and Glaxo Wellcome were responses to a sea 19 change in the internationalization of the pharmaceutical industry. For 20 decades, pharmaceuticals were national or regional businesses. 21 Regulatory processes were unique to each country, and such barriers 22 made drug introduction to foreign markets difficult. Distribution and 23 regulatory costs needed to be spread over as many local markets as pos- 24 sible. Today, many of those barriers have been lowered, while drug- 25 development costs have risen dramatically. Jan Leschly, retired CEO of 26 SKB, said it directly in the May–June 2000 Harvard Business Review: 27 “What really drives revenues in the drug business is R&D.” Research and 28 development can and should be spread across the entire global market, 29 leveraging drug discovery and commercialization to more countries, 30 more products, and more diseases. 31 32 Adjacency 33 Another strategic rationale prompting transactions is expansion into 34 highly related, or adjacent, businesses. This rationale can mean expand- 35 ing a business to new locations, developing new products in existing 36 markets, or providing products or services addressed to higher growth 37 markets or to new customers. Experience has shown that the additions STRATEGIC DUE DILIGENCE 25 should be closely related to the investor’s existing business. In Zook’s 1 Profit from the Core, he and coauthor James Allen provide empirical evi- 2 dence that acquisitions of closely related businesses drove some of the 3 most dramatic stories of sustained, profitable growth in the 1990s: 4 Emerson, GE, Charles Schwab, and Reuters, to name a few. Travelers 5 Insurance’s acquisition of Citicorp gave the merged companies, renamed 6 Citigroup, a complete range of financial services products to cross-sell to 7 their combined customers across a broad range of global markets. 8 9 Scope 10 Broadening a company’s scope is closely related to adjacency expansion, 11 but instead of simply buying a related business, the serial investor is 12 engaged in buying expertise to accelerate or substitute for existing new 13 business development or R&D. This serial transaction model has been 14 successfully employed in a number of industries, such as financial services 15 (for example, GE Capital), Internet hardware (Cisco), and chip manufac- 16 turing (Intel). For these firms and companies like them, organic develop- 17 ment is often too expensive, too slow, or too diluting of their focus on 18 existing businesses. 19 20 Transformation 21 Companies can use external expansion to redefine a business. This is an 22 appropriate strategy when an organization’s capabilities and resources 23 very suddenly grow stale, for example, due to a major technological 24 change. In such instances, a firm cannot quickly shore up its technology 25 or knowledge by making internal investments and incremental adjust- 26 ments. When telecommunications equipment provider Nortel Networks 27 embarked on a strategic shift toward becoming a provider of Internet 28 infrastructure, it transformed its business model through a series of 29 acquisitions. From January 1997 through the end of 2001, the compa- 30 ny made nineteen major acquisitions, including Bay Networks, a com- 31 petitor of market leader Cisco Systems. The mergers refocused Nortel 32 from supplying switches for traditional voice communication networks 33 to supplying technology for the Internet as well. It undertook mergers 34 and acquisitions strategically to make what then CEO John Roth called 35 Nortel’s “right-angle turn.” Hard hit in the 2001 technology downturn, 36 Nortel Networks nonetheless became and remains Cisco’s closest rival. 37 26 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Sometimes a bold strategic acquisition can redefine an entire industry, 2 changing the boundaries of competition and forcing rivals to reevaluate 3 their business models. This is the highest risk rationale. In the early 1900s 4 such mergers created the likes of General Motors and DuPont, and their 5 marks on respective industry competition have endured. More recently, 6 the AOL/Time Warner merger has tried to rewrite the rules for commu- 7 nication and entertainment. But the new model remains unproven. 8 9 Managers overseeing transactions face different problems based on 10 the strategic rationale of the deal. Thus, financial and scale deals, which 11 often attempt to squeeze more efficiency out of targets, differ from 12 deals attempting to enhance the scope of new technologies or products. 13 “If you acquire a company because your industry has excess capacity, 14 you have to figure out quickly which plants to close and which people 15 to lay off,” writes Joseph L. Bower, a professor at Harvard Business 16 School, in the March 2001 issue of the Har vard Business Review. “If, 17 on the other hand, you acquire a company because it is developing a hot 18 new technology, your challenge is to hold on to the acquisition’s best 19 engineers.” 20 Dynamic companies treat strategic planning as a work in progress, not 21 a one-time event. In response to a company’s ever-evolving strategic 22 focus, the company may approach future transactions based on different 23 strategic rationales. The London-based Grand Met is a classic example. 24 It completed a successful hostile buyout of Pillsbury, owner of Burger 25 King, in early 1989 for $5.7 billion. Grand Met’s adjacency-focused 26 strategy was to become the world leader in food, drink, and retailing, 27 based on the premise that it could capitalize on synergies among these 28 sectors. In 1997 Grand Met merged with Guinness. The combined enti- 29 ty, now known as Diageo, realized that projected operating synergies 30 between food and drink products might have been overrated and decid- 31 ed to focus primarily on drinks. Diageo has since begun divesting its 32 food holdings and targeting liquor and beverage acquisitions to further 33 increase its scale in that area, exemplified by its purchase of a piece of 34 Seagram, and divestiture of Pillsbury. 35 Even a single acquisition may provide more than one strategic bene- 36 fit. For instance, when a private equity firm married an Italian vending 37 machine company with a similar one in Scandinavia, it derived benefits STRATEGIC DUE DILIGENCE 27

1 FIGURE 2.3 2 Strategic Rationales for Top Ten Acquisitions 3 4 Less strategic More strategic 5

$80 B $600 B 6 100% 7 Business Redefinition 8 80% Adjacency Financial Engineering 9 10 60% Scale 11 12 40% Diversification 13 14 20% Industry Redefiniton 15 Adjacency 16 0% 17 1988 2000 Note: Dollar figures are nominal 18 19 by combining production and purchasing (to maximize scale) as well as 20 by implementing one company’s best-management practices in the other 21 (to broaden scope by acquisition of management expertise). 22 It should come as no surprise, then, that the popularity of different 23 types of deals shifts over time. As Figure 2.3 illustrates, the share of 24 financial engineering and diversification deals in the top ten mergers by 25 price tag has shrunk in recent years, while transactions based on scale and 26 industry redefinition have ballooned. 27 In 1988 fewer than 20 percent of the top ten mergers by price tag 28 reported were highly strategic. This was the era of LBO takeovers such 29 as RJR Nabisco/KKR and Federated/Campeau. In 2000, the era of 30 transformational mergers such as AOL/Time Warner and scale mergers 31 like Glaxo Wellcome/SKB, all of the top ten mergers were strategic. 32 (Acquisitions in 2000 include “announced” deals, such as the GE/ 33 Honeywell merger, which subsequently fell through for antitrust rea- 34 sons.) While deal volume declined in 2001, deal rationales remained 35 highly strategic. 36 37 28 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Undertaking Thorough Due Diligence 3 Once your strategic planning produces a sound rationale for pursuing a 4 cross-border deal, you must undertake a thorough commercial review of 5 each target you identify. The commercial review, or strategic due dili- 6 gence, process identifies the drivers of earnings to establish whether the 7 target is a good investment. The rigorous analysis evaluates the stand- 8 alone cash flow value of a deal. It addresses the four key aspects of busi- 9 ness attractiveness: 10 1 Market analysis 11 2 Competitive positioning 12 3 Customer evaluation 13 4 Company analysis 14 15 As discussed previously, however, good strategic transactions add sig- 16

17 FIGURE 2.4 18 19 Critical Due Diligence Activities

20 Market Competitive Customer Company 21 Output Analysis Positioning Evaluation Analysis 22 Market Definition/Sizing ● 23 24 Industry Dynamics ●●● 25 Industry Trends ● 26 ● ● 27 Competitor Market Map 28 Competitor Dynamics/Profit ● 29 Competitor Benchmarking ● ● 30 ●● 31 Customer Analysis 32 Impact of Input Costs ● 33 Cost Reduction Opportunities ● 34 35 Internal BDP Opportunities ● 36 Growth Opportunities ● ● 37 STRATEGIC DUE DILIGENCE 29 nificantly to the combined entity’s value over and above the target’s 1 stand-alone value. Due diligence also helps uncover prospects for mak- 2 ing operating improvements and assesses the potential for market redef- 3 inition. 4 Figure 2.4 shows the analytical activities that underlie each of the four 5 key steps in commercial review. 6 7 Market Definition 8 In market definition, you first identify the target’s industry and the 9 stages of the value chain in which the target operates. Second, you 10 determine whether the target’s products fit into one business or whether 11 they should be treated as distinct product categories. Third, it’s neces- 12 sary to establish whether the size of the market should be seen as local, 13 regional, or global. 14 15 Industry Dynamics and Trends 16 One must always be aware of industry dynamics and trends. Investors 17 often define a target’s business synergies by the extent to which the tar- 18 get company shares production costs and customers with the acquirer. 19 They inquire whether the target’s products are sold to the same cus- 20 tomers and whether the production and distribution processes share 21 costs. Cross-border issues add another dimension to the analysis. 22 Principal geographic concerns include whether customers are local, 23 regional, or global and whether they can be shared across specific geog- 24 raphies. For example, can producing globally unearth cost advantages? Is 25 the product cheap to transport, and are there significant economies of 26 scale across regions? The matrix in Figure 2.5 illustrates these issues. 27 In the following example, a potential acquirer investigated a global 28 building-materials firm as a target. As part of strategic due diligence, it 29 assessed whether it should consider the European market as a single mar- 30 ket or as a number of separate markets. This business definition not only 31 established the target’s relative market position in Europe but also 32 formed the basis of an investigation into potential cross-border synergies 33 that would result from an acquisition. 34 Upon investigation, the acquirer discovered that customers and dis- 35 tribution channels in the European countries were very different, and it 36 needed to view these factors, and hence its business units, separately. On 37 30 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 FIGURE 2.5 2 3 Business Definition Matrix 4 5 High One business with potential for One business 6 differentiation or niche position 7 8 Separate businesses with 9 potential for cost leadership 10 Cost 11 Sharing Separate One 12 Separate businesses businesses business 13 with with 14 potential for potential for 15 bundling substitution 16 17 Low 18 Low Customer Sharing High 19 20 21 the other hand, as transportation was a small proportion of total costs, 22 the European market offered opportunities for significant cost sharing 23 among both the acquirer’s and the target’s business units. This market 24 definition suggested that the acquirer should view the competitive land- 25 scape at a country level, but view production, and hence synergies, at a 26 pan-European level. On a pan-European basis, the target, the number- 27 one player, appeared to have a market share of only about 20 percent in 28 a highly fragmented market. When viewed at a country level, however, 29 the target was clearly a dominant player, with market share of 50 to 80 30 percent in most of its markets. 31 Market due diligence also requires determining trends in how the mar- 32 ket behaves. The forces that affect industry dynamics include the fol- 33 lowing: 34 t competition (pricing, tactics, consolidation, orderly behavior); 35 t distribution channels (direct versus brokers/third parties); and 36 t fundamental shifts (new technologies, replacement/substitution). 37 STRATEGIC DUE DILIGENCE 31

1 Competitor Market Map 2 A market map of competitors helps determine the size of each market 3 segment; which segments are attainable (for example, government con- 4 tracting may be off-limits to foreign firms); and the market share of com- 5 panies within each sector. In addition, market maps can be broken down 6 by distribution channel and customer type to establish the target’s 7 advantage within each subsector of the market. This breakdown can help 8 identify specific threats that other players may pose that are not captured 9 in a less differentiated overview of the market. 10 11 Competitor Dynamics 12 Competitor dynamics involves evaluating whether industry rivalry is pas- 13 sive or aggressive, understanding competitors’ strategies, and determin- 14 ing the basis of each player’s strategy, including the following factors: 15 t value proposition (price, service, breadth of offering, quality); 16 t strategic initiatives (channel/product focus, growth initiatives); and 17 t strengths and weaknesses (level of proprietary processes, level of 18 vertical integration, structural advantages/disadvantages). 19 20 In the example of the building-products manufacturer described ear- 21 lier, other competitors had gradually eroded its U.K. market by target- 22 ing specific distribution channels. To identify the cause of this market 23 share decline, the company constructed a market map, segment by seg- 24 ment, which uncovered an aggressive competitor. This competitor had 25 built a strong position targeting the market’s specification channel and 26 whose competitive advantage hinged on its focus on the top 100 archi- 27 tects/specifiers. Due diligence enabled the company to identify the rea- 28 son for its loss of market share, and, through interviews with leading 29 specifiers, develop defensive solutions that allowed the company to stem 30 further volume losses. 31 32 Competitor Benchmarking 33 You can determine the target’s position versus its competitors by com- 34 paring its cost of goods, operating costs, and returns on assets and capi- 35 tal against the industry’s best companies. Benchmarking is often based on 36 a combination of information a competitor publishes—such as annual 37 32 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 reports, press releases, and price lists—and interviews or site visits to dis- 2 cuss data that are not publicly available. The ability to benchmark com- 3 petitors also depends on geography: In certain countries, for example, 4 privately owned companies must file detailed financials, but in other 5 countries they may release only very limited figures. Benchmarking helps 6 the acquirer identify areas of potential improvement for the target. 7 During customer interviews the building-products company learned 8 that certain foreign competitors were able to sell similar products at 20 9 to 30 percent lower prices than its potential target and still achieve typ- 10 ical industry margins. Self-evidently, the competition had lower operat- 11 ing costs than the target’s. But which costs? Because many of the com- 12 petitors were privately owned, the acquirer could not obtain detailed 13 financials to define their components of cost. However, through inter- 14 views with raw material suppliers, the acquirer established that raw mate- 15 rials costs (approximately 70 percent of costs) were probably similar to 16 the target’s given the similar scale of competitors. On further analysis, 17 the acquirer discovered that competitors used the same machines as the 18 target, thus leading to the conclusion that the competitors’ cost advan- 19 tage lay outside the manufacturing process. 20 The acquirer looked hard at selling, general, and administrative 21 (SG&A) costs and concluded that the target’s problem lay in maintain- 22 ing a similar level of sales expenditure per each U.K. customer regardless 23 of profitability. This analysis identified a problem—and suggested a solu- 24 tion. Through profitability analyses, the acquirer could reduce the tar- 25 get’s number of unprofitable customers and introduce a new pricing 26 structure to weed out cherry-pickers. The target would thereby enjoy 27 margins comparable to those of its competitors, who targeted only cus- 28 tomers from whom they could obtain respectable margins. As the acquir- 29 er found, analyzing customer segments often helps pinpoint profit- 30 enhancing opportunities. 31 32 Customer Analysis, Input Costs, and Price Elasticity 33 Assess the target’s relationship with its customers and measure how price 34 affects demand—in other words, the company’s price elasticity. Increases 35 in input costs can have a major impact on a firm’s cash flow that cannot 36 be passed on to the customers without reducing sales. To assess cus- 37 tomer price elasticity, establish the historical impact of price changes on STRATEGIC DUE DILIGENCE 33 key inputs by investigating their relationship to margins. Cross–border 1 price elasticity issues are important to understand—especially the local 2 industry norms for price and cost adjustments based on raw materials 3 price increases. 4 For example, in a recent transaction, a company selling consumable 5 products to heavy industries faced a surge in the price of a critical raw 6 material at the same time that the underlying markets were declining for 7 the first time in years. From customer and management interviews it soon 8 became clear that in the United States there was a tacit understanding 9 that these costs temporarily could be passed on to customers. European 10 customers, however, were far less likely to be so accommodating. The 11 quid pro quo in the United States was that in periods of weaker input 12 prices, such customers would receive price cuts, whereas European cus- 13 tomers exerted far less pressure on their suppliers in such situations. 14 Due diligence not only evaluates the potential for cost reductions, it 15 also establishes the likely timing of when (if at all) such savings might be 16 achievable and how customers will react to the prices costs dictate. To 17 attain the right picture of price elasticity companies need to benchmark 18 costs internally, across the target’s plants or units, and thoughtfully eval- 19 uate the benefits of achieving best demonstrated practices (BDPs) 20 throughout the acquired or merged company and its offerings. 21 22 Growth Opportunities 23 The last part of cross-border strategic due diligence focuses on the tar- 24 get’s growth opportunities, often the greatest generator of value. 25 Determining these opportunities is one of the hardest aspects of due dili- 26 gence to execute. Eager to maximize price and terms, target manage- 27 ment too often makes “hockey stick”–shaped profit projections that 28 greatly exceed the company’s historical performance. Many targets proj- 29 ect growth from regions where they only recently have established a 30 presence. For example, a small U.K.-based supplier to the leading elec- 31 tronics companies realized that to serve the global market, it had to 32 establish new operations in Mexico, Central Europe, and China in addi- 33 tion to its existing plants in the United Kingdom and the United States. 34 The supplier, which we’ll call TechCo, accomplished this expansion 35 quickly through a series of acquisitions and joint ventures, at the same 36 time executing a management buyout. 37 34 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 The revenue from the first of TechCo’s acquisitions increased 2 TechCo’s apparent growth rates and raised expectations, which were 3 raised further due to a bidding war between potential investors in the 4 management buyout. Two years after management bought TechCo, its 5 revenue had turned flat, and the company was struggling to maintain its 6 debt repayment schedule, a problem exacerbated by the declining high- 7 tech markets. The cause of TechCo’s poor performance was that both 8 the management team and the investors had underestimated the com- 9 plexity of globalizing operations as well as the regional market share 10 required to compete effectively in different markets. 11 Hindsight is a marvelous thing, but it seems clear that more effective 12 strategic due diligence would have questioned TechCo’s ability to match 13 its customers’ fast growth rates by understanding the source of that 14 growth and the operational complexity of transforming a regional firm 15 into a global leader. Better due diligence could have thrown cold water 16 on the red-hot projections. 17 A target’s future cash flows must be established based on realistic 18 assumptions and converted into a more concrete value through the use 19 of discounted cash flow and comparative company analysis. In this 20 regard, number crunching based on unrealistic assumptions is a recipe 21 for disaster. Consider the case of a leading LBO firm contemplating a 22 $400 million acquisition of a major value-added reseller of personal 23 computers and networking products. At a four-times-earnings multiple, 24 the deal looked great. Management projected future growth from 25 increased hardware sales and a significant expansion of its service busi- 26 ness, which it planned to enhance by introducing higher-margin servic- 27 es like systems integration and outsourcing. 28 There was only one problem: The target’s five-year revenue and prof- 29 itability forecast was hopelessly unrealistic. A more penetrating analysis 30 revealed that the economics of direct versus value-added PC sales 31 favored the direct-sales channel, a sure sign that the target’s hardware 32 business was about to decline. Second, interviews showed that few large 33 customers perceived value-added resellers to be capable of delivering a 34 full range of services. The target’s existing customers had no intention 35 of extending the range of services they bought, giving the target no 36 prospect of generating sufficient incremental margin to offset the 37 decline in hardware sales. In fact, the survival of the whole value-added STRATEGIC DUE DILIGENCE 35 reselling sector was under serious threat. The LBO firm walked away 1 from the deal. 2 The next year, the value of the target’s public competitors declined 3 more than 5 percent. Another purchaser eventually bought the target 4 company for $100 million, a 75 percent drop in value. 5 6 7 Cross-Border Complications 8 Blaise Pascal said, “There are truths on this side of the Pyrenees which are 9 falsehoods on the other.” And Duncan Angwin, from Warwick Business 10 School in Coventry, England, asserts that we can today replace “Pyrenees” 11 with any national border to better understand the complexities of cross- 12 border transactions. As Figure 2.6 shows, these fall into three categories: 13 peculiarities of local markets, cultural differences, and regulatory and legal 14 issues. These factors affect the firm’s stand-alone value and become 15 increasingly important when evaluating the strategic rationale of a deal. 16 Peculiarities of local markets. A variety of factors, from climate to 17 the dominance of local players, drive customer trends in a market. One 18 classic example may be the popularity of sport utility vehicles (SUVs) in 19 the U.S. automobile market, compared with a much lower penetration 20 of such vehicles in Europe. There are many reasons why this is true, not 21 the least of which is substantially lower fuel prices in the United States. 22 Cultural differences. Different styles of doing business often make a 23 market for the same product vary from country to country. Also, cultur- 24 al peculiarities often dictate the organizational structure of the target 25 company (such as hierarchical organizational structures in Japan). 26 27 FIGURE 2.6 28 Cross-Border Complexities 29 30 Peculiarities Cultural Regulatory/ 31 of Local Markets Differences Legal Issues 32 Different sales Ways of doing business Labor laws 33 channels Organizational structures Tax implications 34 Different purchasing Local politics Antitrust laws patterns Financial/operational 35 reporting requirements 36 37 36 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Some cultural differences can be overcome; others cannot. Due dili- 2 gence can determine the extent to which change can or cannot occur 3 smoothly within a firm or market, a theme Chapter 7 develops further. 4 For purposes of this chapter, it is sufficient to point out that in assessing 5 whether a target is likely to satisfy corporate strategy, cultural compati- 6 bility issues should be considered. 7 Regulatory issues. The high-profile attempted takeover of Honeywell 8 by GE illustrates the complexities arising from regulatory differences 9 across regions. As it was a U.S.-to-U.S. takeover, GE appeared convinced 10 that once the U.S. Department of Justice approved the $41 billion pro- 11 posed merger, the deal was as good as done. The European Commission, 12 however, had a different opinion, and the combined companies’ sales in 13 Europe gave the EC jurisdiction. Legal considerations of this sort are fur- 14 ther highlighted in Chapter 5, but a rigorous corporate strategic planning 15 process should anticipate such issues early on. 16 17 18 Key Factors in Evaluating Strategic Rationales 19 Strategic rationales lie on a continuum, from deals that play by the his- 20 torical rules of merger transactions and valuation (like any classic LBO 21 scenario) to those that stretch the rules (like the Travelers-Citicorp 22 merger that aimed at scale benefits, adjacency expansion, and product 23 scope all at once) to those that transform these rules (like the 24 AOL/Time Warner deal, which sought to redefine the media industry). 25 With more complex rationales—such as business or industry redefini- 26 tion—more work is required to determine the right price. Figure 2.7 27 illustrates the value considerations for each type of deal. These consider- 28 ations include stand-alone cash flow, cost of integration, economies of 29 scale to be achieved, revenue and customer synergies, and value of the 30 option to compete in new businesses. 31 Although due diligence is most commonly associated with a target’s 32 stand-alone cash value, it also provides the insights to understand the 33 potential synergies and scale benefits that may be fundamental to the strate- 34 gic rationale. Without in-depth strategic due diligence, a thoughtful acquir- 35 er will find it difficult to determine whether its vision of redefining an indus- 36 try can become a reality. Extensive due diligence should therefore form the 37 basis of any investigation into a transaction’s desirability and real value. STRATEGIC DUE DILIGENCE 37

1 FIGURE 2.7 2 Strategic Rationales 3 4 Play by the rules Transform the rules 5 Redefining 6 Value Active Agency Business Redefining 7 Considerations Investing Scale Expansion Scope Models Industries 8 Stand-alone cash flow ●●●●● ● 9 Cost of integration ●●●● ● 10 Scale economies ●●●● ● 11 12 Revenue and ● ●● ● customer synergies 13 14 Value of ● ● 15 business options 16 17 By definition, a deal will take place if the buyer prices the target at an 18 equal or higher value than the target values itself. To get a return on a 19 transaction, the buyer must believe either that the target is undervalued 20 or that more effective management or strategic fit will increase its value— 21 or that of the combined entity. To avoid the pitfall of buyer hubris that 22 has caused untold numbers of deals to fail, the buyer must rigorously test 23 whether it can realistically trim costs and enhance revenue sufficiently to 24 make the deal worthwhile. In more strategic investing, the buyer must 25 test its potential to add value to the stand-alone company and the ability 26 to translate perceived strategic advantages into profit. The primary role 27 of strategic due diligence is to test whether and how quickly these oppor- 28 tunities can become bottom-line realities and what price, therefore, is 29 justified. 30 31 32 Due Diligence for Scale-Driven Transactions 33 After discounting future cash flows to determine net present value of a 34 stand-alone business, a buyer in a scale-driven transaction needs to value 35 the benefits of combining the target’s operations with its own. Failure to 36 do so is likely to doom a deal. In cross-border due diligence, use the 37 38 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 framework described above to test whether the benefits of scale are easy to 2 translate across borders. It’s important to check your assumptions— 3 especially the ones that drive the biggest benefits—by doing the following: 4 t Define similarities/differences 5 t Identify overlap of shared customers, costs, and competitors 6 t Quantify level of expected scale economies, such as improved plant 7 utilization and sales force 8 t Calculate the cost of achieving such economies 9 t Estimate the experience curve (the rate of decrease in product cost 10 per unit based on combined volumes produced by the merged 11 companies) 12 13 One U.S. specialty retailer attempted to grow throughout Europe by 14 expanding its existing format into European markets to obtain a com- 15 petitive edge through superior purchasing scale and a retail concept 16 proven in the United States. But the ambitious rollout flopped, because 17 the company did not properly recognize the differences in markets from 18 country to country. A more thorough due diligence effort would have 19 spotted competition from high–end department stores in the United 20 Kingdom, small-shop retailers in Germany, and established “hypermar- 21 kets” in France. The U.S. retailer soon found that it could not exploit its 22 big-box format, so successful on its home turf. The out-of-town special- 23 ty retail concept was relatively unfamiliar to European consumers and 24 failed to catch on. 25 The economics were also different in Europe. For instance, U.K. 26 property costs are relatively high compared with U.S. costs. Large out- 27 of-town locations were difficult to find and required high traffic to gen- 28 erate profit. The U.S. retailer quickly tried to adapt by changing its prod- 29 uct portfolio to rival local competition and meet local consumer tastes, 30 a strategy that failed to realize the hoped-for synergies, like common 31 purchasing, that had driven its original case for expansion. 32 Careful strategic due diligence could have informed the U.S. compa- 33 ny, before it rolled out its big-box format into Europe, whether market 34 differences were consistent with its concept. The company’s failure to test 35 the assumptions behind its original investment thesis prevented it from 36 understanding the local consumer, store economics, and competition. 37 Deals based on scale benefits must explicitly identify and quantify STRATEGIC DUE DILIGENCE 39 expected economies. The first step is to determine which aspects of scale 1 really count—in other words, what allows the company to take advan- 2 tage of merging revenue and earnings streams? Different businesses 3 achieve the benefits of scale differently. Some, such as automotive com- 4 panies, gain it from global scale, while supermarkets gain it from region- 5 al or local scale. Others, like medical product manufacturers, get it from 6 scale within a distribution channel. In sectors such as cosmetics, prof- 7 itability is only partly linked to scale because branding has a stronger 8 impact on margins. 9 To achieve scale benefits, the merged businesses must be similar 10 enough to share some costs. In 1995, Rexam’s new chief executive, Rolf 11 Börjesson, envisioned transforming the U.K. company from a conglom- 12 erate of unrelated, cyclical, low-value-added businesses into the world’s 13 leading consumer packaging producer, through acquisitions. The first 14 transaction closed in 1999, when Rexam purchased Sweden’s PLM, 15 Europe’s largest beverage-can manufacturer. PLM provided opportuni- 16 ties for cost reduction through shared European manufacturing facilities. 17 In 2000, Rexam boldly purchased American National Can (ANC), mak- 18 ing Rexam the world’s largest can maker. When Rexam acquired ANC, 19 Börjesson focused his due diligence on making certain that ANC’s 20 processes were similar and that the two companies could share cus- 21 tomers. The scale achieved through the ANC acquisition brought fur- 22 ther cost savings and superior U.S. process technology to Europe while 23 opening up the U.S. market for Rexam. 24 To become an international leader in the industry, Börjesson has 25 planned to create a packaging conglomerate of sufficient scale to attract 26 investors’ attention. Börjesson and his team are building a position from 27 which Rexam can trade business units with other companies to pursue 28 the most efficient global mix of packaging operations and businesses. 29 Börjesson knew he would have a hard time convincing the market he 30 could overcome the significant challenges these deals created. Part of 31 Rexam’s due diligence therefore included significant postmerger integra- 32 tion planning to consider the likely difficulties that combining the opera- 33 tions would generate. Differences in management and manufacturing 34 style in Europe and America combined to make unlikely an easy cross- 35 border integration of eleven major company sites. Another issue was the 36 ongoing investigation from the European Union’s monopolies commis- 37 40 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 sion, which constantly changed the playing field. Börjesson and his team 2 developed a plan to integrate the companies quickly and establish a uni- 3 form strategy to avoid uncertainty during the transition. He also imme- 4 diately rebranded the company and put in place a senior management 5 team to provide clear direction to all members of the organization. 6 To earn early shareholder support, Börjesson focused on making a 7 success of each acquisition rather than trumpeting Rexam’s long-term 8 strategy. “Give them some detail before the deal, and lots after,” he says. 9 He picked acquisitions he believed could produce results quickly. “I ask, 10 ‘Can we have all the savings on the bottom line in three years?’ ” 11 After an acquirer understands how to capitalize on scale, it needs to 12 predict the financial impact of combining the companies to understand 13 the premium the acquirer would be willing to pay. For instance, the 14 Rexam synergies from two acquisitions were estimated at $49 million to 15 $56 million. At a 10.7 to 10.8 multiple, the capitalized value of these 16 synergies reached $530 million to $600 million. By the end of 2001, 17 Rexam had already captured $46 million in savings, or 82 percent of its 18 high-end goal. 19 Over time, as a company produces a certain product, the average unit 20 cost usually falls because the company gets better and better at produc- 21 ing it, resulting in lowered prices to customers because of those produc- 22 tivity gains. This relationship is captured by industry-experience curves. 23 Companies use experience curves to develop pricing strategies, 24 improve performance, and assess commercial prospects. In due dili- 25 gence, a company calculates its own and the target’s cost-experience 26 curve and projects an experience curve for the combined entity. For each 27 function the acquirer must ask the following: Where can I save on head 28 count? How many employees should be offered severance or rede- 29 ployed? Which plants, distribution centers, or stores can be closed, and 30 which activities can be moved to more efficient locations? What con- 31 tracts can be renegotiated at advantageous rates? What savings will these 32 changes yield, net of lost sales, closure, and severance costs? 33 Further questions relate to the balance sheet: What capital equipment 34 or property can the combined company sell as consolidation progresses? 35 Can inventory reduction free up cash? Will scale-related revenue benefits 36 result from a broadened product mix or a more effective advertising 37 budget? A cash-flow model, constructed from answers to these questions, STRATEGIC DUE DILIGENCE 41 will more reliably predict value than industry acquisition multiples or com- 1 parisons with top-performing companies. If the due diligence of a transac- 2 tion aimed to produce cost efficiencies suggests that such savings will be 3 modest, the acquirer might well ask whether this is a deal worth doing. 4 5 6 Due Diligence for Adjacency-Driven Transactions 7 A transaction provides the maximum cost savings when the target’s 8 products and services are similar to those of the acquirer. Incremental 9 revenue from such a transaction, which aims to make one plus one equal 10 more than two, is more elusive to obtain than many people think. Due 11 diligence uses the tools of market definition and customer evaluation to 12 test whether such benefits will occur if a deal goes through. 13 To help sales grow from existing customers and products, a company 14 usually needs to change its customers’ behaviors. This is no simple task. 15 For example, additional revenue may depend on cross-selling new prod- 16 ucts or persuading consumers to buy bundles of goods or higher-priced 17 brands and services. These objectives are tough to achieve at a time when 18 sales forces, brands, and pricing also may be changing. The key to cor- 19 rectly valuing incremental revenue involves rigorously testing whether 20 the new entity’s combined offerings would hold more appeal for cus- 21 tomers than separate, stand-alone offerings. Test adjacency by asking the 22 following: 23 24 Cross-selling 25 t Which customers purchase each product? 26 t Do they purchase products in a bundle? 27 t What are customers’ buying criteria? 28 29 Cost of achieving benefits of adjacency 30 t How much will it cost to retrain the sales force? 31 t How much must we invest in information technology? 32 33 The adjacency expansion of the U.K.–based bookseller W. H. Smith 34 illustrates these perils. Facing competition in its core markets, the dis- 35 tributor and retailer (with approximately 1,000 stores, including travel- 36 er, convenience, music, and book stores, and $3.5 billion in sales) 37 42 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 decided to launch a do-it-yourself chain; add new product lines such as 2 toys, typewriters, and gifts, as well as music through its bookstores; and 3 look for international growth opportunities. One part of this strategy 4 involved buying a United States–based music retailer, The Wall. After 5 losing $310 million in 1996, W. H. Smith decided to refocus on its core 6 business. Among the many reasons for this return to its core business 7 was W. H. Smith’s inability to effectively cross-sell some of the new 8 product lines. 9 A recent acquisition by a leading private equity group in Europe illus- 10 trates the many benefits of creating a pan-European player in markets 11 that were once dominated by large, nationally focused enterprises. As in 12 many European industries, multiple regional players dominated the cof- 13 fee vending machine market, which presented extremely attractive 14 opportunities for consolidation. Recognizing this opportunity, a private 15 equity firm acquired the number-two European competitor and then 16 sought to buy the number-one player to create a strong European posi- 17 tion. The strategic rationale of the deal was to provide buyers a one-stop 18 shop for coffee vending needs. 19 The rationale presumed that combining the highly complementary 20 products of the two companies would provide significant cross-selling 21 opportunities to a customer base seeking to consolidate suppliers. 22 Furthermore, consolidation within the vending services industry would 23 provide the opportunity for common platforms and standards. These 24 platforms would reduce the service costs for customers and create large 25 savings opportunities in production for the manufacturers. Such benefits 26 would accrue in addition to the significant cost savings available through 27 sales of redundant plants and overhead consolidation. 28 The due diligence focused on the benefits of cross-selling and the abil- 29 ity to consolidate operations and achieve cost savings. There were con- 30 cerns that instead of cross-buying benefits, existing customers might 31 reduce their combined purchases and shift some volume to other sup- 32 pliers in an effort to maintain multiple sources. However, extensive cus- 33 tomer interviews demonstrated that the combined company not only 34 would retain its volumes but also would grow them due to the products’ 35 complementary features, thereby proving the original thesis. A detailed 36 review of SG&A and production also conclusively demonstrated the 37 opportunities for significant consolidation. STRATEGIC DUE DILIGENCE 43

1 Due Diligence for Scope-Driven Transactions 2 Transactions can allow companies to add new capabilities or scope. Some 3 companies, most notably fast-growing technology outfits like Cisco, 4 Microsoft, and Intel, have used acquisitions as a principal source of 5 growth. They target companies with capabilities that would be too 6 expensive to replicate, too slow to develop internally, or too diluting of 7 managers’ focus on their existing businesses. To quantify the expected 8 profit implications from the additional scope, the potential buyer must 9 do the following: 10 t Identify capabilities sought 11 t Compare the value of revenue enhancement and cost savings to 12 costs and benefits of organic growth 13 t Determine whether the employees and company can successfully 14 be integrated 15 t Calculate the cost of integration, including the cost of retaining 16 key employees. 17 18 For these transactions, the potential for cost savings or revenue 19 growth is an important factor in the valuation, but the make-or-break 20 issue is whether a target has high-quality employees who can be inte- 21 grated into the buyer’s organization. 22 Transactions based on scope often are more complex than other 23 strategic deals. A scope-based acquisition requires something more than 24 simply extending the acquirer’s core competencies. 25 For example, an industrial conglomerate that produced automobile 26 and aerospace parts considered buying an industrial hydraulics manufac- 27 turer to widen the scope of its product offerings. Management wanted 28 to use the target employees’ skills to enter the lucrative aerohydraulics 29 market. The acquirer interviewed major customers, technical engineers, 30 and industry experts during the due diligence process. The investigation 31 determined that the skills needed to produce aerohydraulic parts were 32 very different from those needed to produce industrial hydraulic com- 33 ponents. In this case, the commercial review found that the strategic 34 rationale of the acquisition, namely scope, was flawed, and so prevented 35 a potentially costly mistake. 36 37 44 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Due Diligence for Transformation-Driven Transactions 3 Economic, technology, or industry changes may require a company to 4 alter its business fundamentally. Transactions based on changing the 5 combined entity’s business are often based on a vision that’s difficult to 6 quantify. As a result, they are risky and hard to justify. Here, due dili- 7 gence is essential to establish the risks of trying to redefine the industry. 8 The key tools applied for this type of commercial review are customer 9 and competitor interviews to carefully test whether a new business 10 model can be applied to the market in question. In implementing these 11 tools, companies must do the following: 12 t Focus on possible outcomes (scenario analysis) 13 t Test customer acceptance and cost and revenue synergies for each 14 scenario to develop probable outcomes 15 t Determine market size, expected growth, competitive position, 16 and customer acceptance of new markets 17 18 A clear example cited earlier in this chapter of an attempt to rede- 19 fine an industry comes from one of the highest-profile mergers of 20 recent years, the AOL/Time Warner merger. AOL/Time Warner 21 aimed to take a lead in redefining the way people buy media offerings. 22 The company made a bold, long-term strategic move that, as was 23 noted, has yet to prove itself but has certainly shaken up the music 24 industry. 25 In transformation transactions, executives are wise to address soft 26 issues, such as corporate culture, head-on. A Bain & Company study of 27 twenty-one high-performance business turnarounds shows that a fact- 28 based approach to solving soft issues works for businesses driving trans- 29 formational change. The study found three constants of corporate 30 transformation that yielded high returns: The most successful trans- 31 formers focused on results, not the process of change; they replaced key 32 senior executives, not departments wholesale; and they implemented 33 multiple moves quickly and simultaneously. 34 In business, as in life, the personalities of the people involved are 35 critical for success. The due diligence process must include an evalua- 36 tion of the capabilities of current management. If the acquirer deems 37 them unlikely to expand the company to achieve the necessary STRATEGIC DUE DILIGENCE 45 returns, it may need to replace them, or coach them. The potential 1 acquirer may rather drop the deal entirely or approach it differently. 2 3 4 Assessing Your Findings 5 Cross-border issues often complicate the due diligence process, reducing 6 the potential to realize the value sought. Many cross-border peculiarities, 7 such as market dynamics, local competitors, and local consumer tastes, 8 are as straightforward to quantify as they are in a domestic deal. 9 However, the risk of cultural differences between two firms can affect 10 the value. Although it is difficult to accurately quantify such risks, acquir- 11 ers must evaluate them. Nonquantifiable barriers associated with a deal 12 represent an execution risk that acquirers must consider and mitigate 13 through an effective implementation plan. 14 From a cross-border perspective, therefore, the probability that a deal 15 will succeed depends primarily on two factors: the quantifiable value of 16 the deal and the level of cultural barriers or execution risk. Figure 2.8 17 below shows how these factors affect the likelihood of any particular deal 18 succeeding. 19 A deal with high quantifiable value and few cultural barriers will have 20 the highest chance of success. Conversely, a deal that is likely to gener- 21 ate little value and has many cultural barriers is very likely to fail. 22 Generally, acquirers prefer transactions that fall into the “high 23 value/low barriers” segment. If there is a clear strategic rationale to the 24 deal, there may be little alternative to selecting a target that will involve 25 significant cross-border issues. A clear example of such a deal was the 26 attempted GE takeover of Honeywell. It would be naïve to assume that 27 Jack Welch was unaware of the potential European opposition to the 28 deal. However, the enormous strategic benefits of the deal made it a risk 29 worth taking. As he took ownership of the merger process, he said, “My 30 neck is on the line.” 31 Significant cross-border issues should not deter buyers from consider- 32 ing a merger or acquisition. A private equity firm that owned a U.K./U.S. 33 industrial products manufacturer was considering an acquisition of a 34 U.K./E.U. company. Significant cross-border issues included the cultur- 35 al differences between the entrepreneurial U.S. management team and 36 the European division management team; fundamental differences in 37 46 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 FIGURE 2.8 2 3 Cross-Border Success Matrix 4 High 5 Can we execute? High chance of success 6 7 8 Quantifiable 9 value of 10 deal 11 12 13 14 Is the deal an efficient Low chance of success allocation of resources? 15 Low 16 17 High Low 18 Risk of cultural barriers/differences 19 20 market dynamics (for example, distributor-based sales in the United 21 States versus direct sales in Europe); and different capabilities and sector 22 strengths. The strategic benefits included synergies in the U.K. opera- 23 tions, product portfolio enhancement, regional branding, scale benefits 24 through purchasing/production rationalization, and internal benchmark- 25 ing. These issues placed the deal in the “high value/high risk” box. The 26 buyer did not walk away. By addressing the risks, it was confident it would 27 realize synergies. For instance, the parties addressed and resolved brand- 28 ing issues and established the future strategy of the firm. 29 Figure 2.8 also underscores the possibility that a deal with very few 30 cross-border complications can still fail to add much value to the acquirer. 31 Companies that either are more risk averse or have a portfolio gap may still 32 be willing to undertake such deals. They accept a lower return in exchange 33 for the reduced risk that the relatively straightforward deal offers. Of 34 course, the price of a deal is likely to take this into account, so the returns 35 may be no easier to achieve. 36 Creating value through M&A transactions has always been an uncer- 37 tain business. Information that increases the level of confidence in value STRATEGIC DUE DILIGENCE 47 creation is extremely valuable. The added complexities of cross-border 1 deals accentuate the need for a comprehensive strategic due diligence 2 driven by the acquirer’s need to understand the key issues that could 3 affect the specific deal. A comprehensive review in the context of the 4 acquirer’s corporate strategy helps it understand the stand-alone value 5 6 of the deal, the potential for improvements through active investing, 7 and the potential to add value through strategic rationales unique to the 8 acquirer. 9 10 11 12 13 14 15 16 17 The authors would like to acknowledge the support of Bain colleagues 18 John Billowits, Katie Smith Milway, Robin Stopford, and Christian 19 20 Strobel in writing this chapter. 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 CHECKLIST 1 Cross-Border Strategic Due Diligence 2 3 EVERY TRANSACTION IS UNIQUE and requires a customized approach. 4 However, the following questions provide a guide to the types of issues gen- 5 erally encountered. Questions in bold refer to those specific to cross-border 6 deals. 7 GENERAL 8 1. Market Analysis 9 ❏ What is the target’s key market (market definition)? 10 ❏ What are the underlying trends in the target’s market? 11 ❏ How will these trends affect the growth and profitability of that 12 market? 13 14 2. Competitive Position 15 ❏ Which competitors participate in the target’s market? 16 ❏ What is the target’s size and growth relative to the competitors in the 17 market? 18 ❏ How has the competition developed over time? 19 ❏ How do the competitive dynamics vary by distribution channel? 20 21 3. Customer Evaluation 22 ❏ Who are the target’s customers? 23 ❏ What are the key trends in the customers’ markets? 24 ❏ What are the key criteria for gaining and retaining new customers? 25 ❏ How does the target meet the customer retention criteria? 26 ❏ How profitable are the different customer segments? 27 28 4. Cost Evaluation 29 ❏ What is your cost position relative to the target’s? 30 ❏ Who are your least profitable customers, and how much are they 31 costing you? 32 ❏ How much further can competitors drive down costs? 33 ❏ What costs can you truly share with your target? 34 ❏ How much further can you drive down costs on your own? As a 35 merged entity? 36 37 5. Company Analysis 38 ❏ How does the target’s profitability compare to the profitability of its 39 competitors? 40

48 STRATEGIC DUE DILIGENCE 49

❏ How sensitive are the target’s margins to input costs? 1 2 AC T I V E I N V E S T I N G (What is the firm’s full potential?) 3 1. Market Analysis 4 ❏ Are there any opportunities for the target to influence the market 5 structure? 6 7 2. Competitive Position 8 ❏ Are there any opportunities to increase the target’s market share? 9 ❏ Are there any threats to the target’s position? 10 11 3. Customer Evaluation 12 ❏ Is there an opportunity to weed out unprofitable customers? 13 ❏ Is there an opportunity to trade up customers to higher-value-added 14 products/services? 15 16 4. Company Analysis 17 ❏ Are there any opportunities to improve profitability (cost reduction 18 opportunities, revenue enhancement)? 19 ❏ Can you achieve these improvements (timing to full potential)? 20 21 STRATEGIC RATIONALE 22 ❏ What are the expected costs of integrating the two firms? 23 ❏ Do the quantifiable strategic benefits associated with the acquisition 24 outweigh the costs? 25 26 1. Scale 27 ❏ Does the target participate in the same market as you? 28 ❏ How will the transaction improve the competitive position of the 29 combined entities in the related markets? 30 ❏ What are the potential scale economies of the transaction? 31 ❏ What are the specific cost-reduction opportunities, and how quickly 32 can they be achieved? 33 ❏ Do you share customers/customer types with the target? 34 ❏ What are the similarities/differences of the markets in the different 35 countries? 36 ❏ Are competitors local, regional, or global? 37 ❏ Are scale economies relevant on a local, regional, or global basis? 38 ❏ Is there customer sharing between countries? 39 40 50 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2. Adjacency 2 ❏ Is the transaction highly related to your corporate strategy? 3 ❏ How large is the potential to cross-sell the target’s products with 4 yours? 5 ❏ How similar are the buying criteria for the two products? 6 ❏ Which roles will overlap in the combined companies? 7 ❏ What is the potential for cost savings in the combined companies? 8 ❏ Are opportunities for cross-selling transferable across borders? 9 10 3. Scope 11 ❏ Does the target possess the capabilities you seek? 12 ❏ Will the new capabilities significantly improve your profitability? 13 ❏ How does the cost of acquiring the capabilities from the target com- 14 pare to the cost of building them internally? 15 ❏ Can the capabilities be retained postacquisition? 16 ❏ Are the capabilities transferable across borders? 17 18 4. Transformation 19 ❏ What is the underlying potential for transforming the industry? Will 20 customers accept the transformation of the industry? 21 ❏ How will the integration of the target aid the transformation of the 22 industry? 23 ❏ How will the transformed industry benefit the combined companies? 24 ❏ Are the benefits of the transformation local, regional, or global? 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 1 2 Operational Due Diligence 3 4 3 5 LINDA D. ARRINGTON 6 NELSON M. FRAIMAN 7 CAROLYN E.C. PARIS 8 MICHAEL L. PINEDO 9 10 11 12 13 14 15 UE DILIGENCE BEGAN as a precautionary measure for securi- 16 ties underwriters. Although it is now a regular part of deal 17 D making, and a substantive exercise, due diligence often still 18 tends to be heavily weighted toward legal and financial aspects of the 19 target company. 1 20 As a result, the typical staffing of a “deal team” with corporate legal 21 and financial executives and their outside advisers means that operational 22 due diligence is often focused on balance sheet assets and their most eas- 23 ily documented qualities, such as location, appraised value, age, condi- 24 tion, and capacity. The key members of the deal team are not always 25 equipped to grapple with the less tangible but no less critical aspects of 26 operations, like process, work flow, and quality control. 27 Mapping these qualities of a target company is not as simple as locat- 28 ing records in a file cabinet or its virtual equivalent; companies’ policies 29 and practices regarding operations analysis and documentation vary. 30 Hence, what is really important to know about the target probably can’t 31 be found in documents in a data room. For this reason, dealing with crit- 32 ical questions such as “How good is this business, and does it fit with 33 ours?” requires the involvement of line-operating professionals. 34 If the acquirer has no line-operating professionals with the expertise 35 to perform due diligence on the target’s operations, that in itself might 36 be a warning sign: Most successful deals involve a target that is engaged 37

51 52 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 in the acquirer’s core business or a closely related business. In a 2 Harvard Business Review roundtable, Mackey McDonald of VF 3 Corporation commented, 4 5 In our business, we find that if we venture too far from our core com- 6 petencies, the risk isn’t worth it. Many of the companies we buy are run 7 by entrepreneurs who generally know a lot more about why they’re sell- 8 ing than we know about why they’re selling. We like to stick to our core 9 businesses so if we run into problems, we have the resources and know- 10 how to resolve them.2 11 12 Operational due diligence is often given short shrift, due to real or 13 perceived time constraints. Even when performed well by the persons 14 having the right expertise, it is too often not integrated within the over- 15 all management of the deal process. Thus, teams of specialists are field- 16 ed to “sign off” on the areas of their expertise, but their findings aren’t 17 always cross-checked. More important, the operational questions relat- 18 ing to postmerger integration don’t surface. 19 Although a checklist approach (which often, not coincidentally, cor- 20 responds to prospectus requirements) is a good way to manage a com- 21 plex information-gathering process under time pressure, it won’t, by 22 itself, yield answers to the most important questions. Instead of relying 23 on responses to a list of unrelated questions parceled out to specialist 24 teams, due diligence that focuses on development of a post-transaction 25 integration plan, which is itself premised on clearly defined so-called 26 value drivers, is most likely to be useful in answering the ultimate ques- 27 tions: Should we do this deal? And if so, how much should we pay? 28 When due diligence is not approached in this way, the postdeal integra- 29 tion team at best duplicates the due diligence effort or may find itself car- 30 rying out the due diligence that should have taken place before the deal 31 was finalized—often with poor outcomes. 32 33 34 Operational Due Diligence in the Cross-Border Context 35 In U.S. domestic transactions, both parties typically share an under- 36 standing about the need for and scope and depth of due diligence. But 37 due diligence concepts don’t always cross borders easily. In cross-border OPERATIONAL DUE DILIGENCE 53 transactions, there may be little due diligence performed beyond the 1 bare bones required to establish the legal structure and financial terms of 2 the deal. 3 As in some domestic deals, this may be because the parties feel they 4 already have a good grasp of each other’s businesses or because the deal 5 is being struck principally on the basis of a strategic vision that does not 6 accord much weight to details of execution. In a cross-border deal, it 7 may also be because one or more of the parties is used to operating in a 8 business culture that emphasizes relationships and trust rather than full 9 disclosure and close scrutiny. In such cases, operational due diligence is 10 not deemed a priority, and, if performed, takes place after a long period 11 of confidence building. 12 13 14 Designing Due Diligence from a Strategic Perspective 15 The nature and scope of operational due diligence for a given transac- 16 tion should be determined by management’s goal in pursuing the deal. 17 Typical articulations of such a goal might be: 18 t to enter a new market or otherwise expand territorial scope or 19 market share in existing territories; 20 t to share and leverage complementary products, skills, and knowl- 21 edge across the conjoined territories; or 22 t to exploit synergies arising from scale or scope efficiencies. 23 Interestingly, it is not always clear that top management has as a stat- 24 ed goal to increase shareholder value. World Class Transactions: Insights 25 into Creating Shareholder Value Through Mergers and Acquisitions 26 (KPMG, 2001) reports that, based on a survey of larger global deals 27 completed between 1997 and 1999, reasons stated for pursuing M&A 28 opportunities were to increase market share (29 percent), to enter new 29 geographic markets (28 percent), to maximize shareholder value (23 30 percent), and other (20 percent). KPMG found no correlation between 31 the stated objective of the transaction and the success of the deal in terms 32 of creating shareholder value. 33 Too often, focus seems to be on the top line, not on the bottom line. 34 But an unstated rationale for any transaction, including one across borders, 35 must be that the deal will end up being profitable to the acquirer, or pro- 36 vide a defensive or survival strategy (in other words, eat or be eaten). 37 54 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 The trend toward growth through cross-border deals is particularly 2 strong in those industries that see inevitable consolidation due to global 3 pressures and technological changes affecting the fundamental business 4 proposition. In many businesses, managing global production efficient- 5 ly is most easily accomplished when the business has a critical mass of 6 volume. Most of the growth in international production has been via 7 cross-border M&A, not through greenfield production, in large part 8 due to the perceived need for speed. Or a business, such as financial 9 services or pharmaceuticals research, may be so dependent on large-scale 10 information technology infrastructure—networks, databases, and the 11 associated systems engineering or statistical analyses—that the related 12 investments can be supported only by an enterprise of significant size. 13 Merging permits companies to share the costs of critical systems infra- 14 structure and innovation. 15 Too often overlooked, however, are the transaction overhead costs 16 that may take several years to work through the system, jeopardizing 17 productivity and profits in the interim. In the rush to complete a strate- 18 gic merger, parties have overlooked critical liabilities or made overopti- 19 mistic assumptions about the cost, the time required, and even the fea- 20 sibility of the theoretical integration plan. 21 Well-executed operational due diligence allows the parties to deter- 22 mine how the combined enterprise will conduct its business to maximize 23 earnings. Such due diligence is required in order to assess whether the 24 hoped-for transaction benefits can be realized, and, if so, in what way, in 25 what time frame, and at what cost. Operational due diligence should 26 answer the question: Does the combination result in economies, effi- 27 ciencies, and synergies that make the company a more profitable, more 28 competitive enterprise than it was predeal, without incurring large incre- 29 mental investments or unacceptable risks along the way? 30 31 32 Validating and Integrating Other Due Diligence Efforts 33 Well-executed operational due diligence by line-operating managers 34 will integrate a number of other aspects of due diligence that might oth- 35 erwise tend to be reviewed in isolation and signed off on by area 36 experts. Areas of operational due diligence that should dovetail with 37 HR, finance, accounting, IT, legal (including intellectual property, OPERATIONAL DUE DILIGENCE 55 environmental, and insurance), and strategic due diligence include the 1 following: 2 t Workforce needs, staffing assumptions and practices, recruitment 3 and training 4 t Environmental matters, other potential liabilities arising from the 5 company’s operations 6 t Cross-border risks and issues (exchange and currency risks, tax 7 burdens, and political risks broadly defined to include human rights con- 8 cerns) 9 t Other macro-level issues, such as shifts in methods of production, 10 changes in demand, or vulnerabilities such as exposure to uncertainties 11 in the supply of power, labor, or raw materials 12 t Information systems 13 t Insurance 14 t Proprietary business know-how and intellectual property matters 15 t The cost-accounting bases for operating profitability 16 t Projected capital expenditure needs 17 A thorough operational due diligence exercise can validate assump- 18 tions or documentary findings regarding these and other important busi- 19 ness matters, or it can highlight areas of concern. 20 21 Serving as the Foundation for the Integration Plan 22 Operational due diligence should provide the intelligence needed to 23 develop the postdeal integration plan. Experience has shown that a 24 merger is more likely to succeed if the combined entity shows incre- 25 mental revenues and profits—not just cost-cutting—shortly after clos- 26 ing, and that a key to achieving this sort of success is having a detailed 27 integration plan (and the team to implement it) in place and ready for 28 execution at closing. The only way to get to an integration plan at clos- 29 ing is to have worked through all the operational issues during the due 30 diligence process prior to closing. 31 32 Serving in Support of Deal Strategy and Pricing 33 If operational due diligence has been carried out and translated into an 34 integration plan, the resulting conclusions should have made their way 35 into the financial projections. These projections for the combined com- 36 pany form the basis for the pricing and structuring of the deal and, of 37 56 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 course, for any related financing. Therefore, operational due diligence, 2 carried through to the relevant conclusions about the integration and 3 subsequent operations of the combined entity, should come into play to 4 support the negotiation strategy and pricing. 5 To summarize, operational due diligence should not be a pro forma 6 exercise of “kicking the tires” but rather should serve as a prudent real- 7 ity check on strategic vision and global ambition and reduce unpleasant 8 surprises. Operational due diligence should accomplish the following: 9 t Validate (or not) the value proposition for the transaction 10 t Validate (or not) the findings gleaned from legal and financial due 11 diligence 12 t Provide a realistic basis for the preparation of financial projections, 13 and thus aid in developing negotiating strategy and pricing for the deal 14 t Form the basis of a detailed integration plan, ideally one that will 15 be in place at closing. 16 In a cross-border transaction, there is even more reason to emphasize 17 strong operational due diligence. For example, the parties may mistakenly 18 believe they have a good understanding of one another’s businesses. This 19 may be because of something as fundamental as a language problem or 20 something less obvious. People may be speaking the same language for- 21 mally but from a different frame of reference, so that misunderstandings 22 are subtle and pervasive. Further, when communicating cross-culturally, 23 it is sometimes quite difficult to pose hard and probing questions in a way 24 that elicits a constructive response; it is quite easy to make the other party 25 uncomfortable, angry, or defensive, and it is easiest of all to defer, and 26 assume the details will be worked out later. 27 If the communication is potentially more difficult in the cross-border 28 context, the reasons to nail down details are more compelling. In addi- 29 tion to the usual problems with workforce integration, management must 30 consider language barriers and differences in work and communication 31 styles. In manufacturing, measurements and engineering standards might 32 differ. Where engineering is embodied in physical plants, re-engineering 33 for compatible platforms may be required at large cost. Something as 34 superficial as optimum packaging size and design can be quite important 35 and can vary significantly country to country. Services or products devel- 36 oped for one market may require rethinking in the context of a new 37 cross-border market and possible redesign. Mundane aspects of life such OPERATIONAL DUE DILIGENCE 57 as the relative size of housing, what people eat and wear, and how peo- 1 ple communicate may have implications for product mix and design. 2 And, in addition, managing communications across time zones is often 3 difficult. (One of the participants in a conversation across ten or twelve 4 time zones is likely to be tired.) 5 6 7 What Should Operational Due Diligence Cover? 8 Properly framed and executed, operational due diligence can help the 9 parties generate a mutual understanding of the key business processes 10 from the ground up. It encompasses the following subjects: 11 t The processes that create value, including products and services, 12 market positioning and brand, sales and distribution, and customers; 13 manufacturing or other production of goods/services; and procure- 14 ment of supplies, supply-chain management, and external infrastructure 15 requirements 16 t Information, communications, and general systems support of the 17 value-creation processes 18 t People, training, and corporate culture (including management 19 structure and labor relations) 20 Designing an appropriate operational due diligence program starts 21 with a clear definition of the acquisition rationale: What is the strategy 22 underlying the transaction? (For a thorough discussion of strategy, see 23 Chapter 2.) All aspects of operations require review, but key drivers of 24 revenue growth and improved profitability for the combined enterprise 25 merit special focus. 26 Three principal kinds of businesses may be the subject of operational 27 due diligence: 28 1 Manufacturing: extracting or transforming tangible goods for sale 29 (for example, the automotive industry) 30 2 Services, including retail sales: providing professional or other 31 services (for example, transportation), and goods and services sold at 32 retail (such as financial services and specialty apparel retailers) 33 3 Information and communications: the media and information indus- 34 tries (content creation), telecommunications, and the software industry 35 Many businesses contain elements of more than one of these types of 36 industries, but it is helpful to consider characteristics of prototypical 37 58 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 businesses in order to understand how operational due diligence should 2 be conducted for each, as illustrated in Table 3.1. 3 4 TABLE 3.1 5 Due Diligence Focus by Industry 6 Operational Due Diligence 7 Type of Industry Emphasis 8 9 Manufacturing/extraction Physical plant/process, supply chain 10 Services/retail; networks (e.g., Systems, including supply chain 11 transportation/communication) 12 Content creation; design-driven People; intellectual capital/ 13 retail/manufacturing; professional intellectual property 14 services 15 16 17 Mapping the Value-Creation Process 18 In cross-border operational due diligence, it’s important to chart the 19 processes that create value. Such a chart should map supply chain, facili- 20 ties, personnel, and products and services produced against sales, distribu- 21 tion, and marketing channels for the combined enterprise. The big-picture 22 questions include: (1) products and services, market positioning and 23 brand, sales and distribution, and customers; (2) manufacturing or other 24 production of goods/services; and (3) procurement of supplies, supply- 25 chain management, and possible related reconfiguration of distribution 26 processes; external infrastructure requirements; and system cash needs. 27 28 Products and Services, Market Positioning and Brand, Sales 29 and Distribution, and Customers 30 Starting with the customers first, where are they and how will the com- 31 bined enterprise meet their needs? What is the product mix, and what are 32 the brand and pricing dynamics? Are products of the combined enter- 33 prise competing with one another? At what stages are the products in the 34 product life cycle in each of the relevant markets? What is the competi- 35 tive picture in each of the targeted markets? What will be the dynamics 36 between country managers versus centralized management in terms of 37 marketing strategy? OPERATIONAL DUE DILIGENCE 59

From a pure operations perspective, it may seem counterintuitive to 1 work from the customer back through production into procurement. 2 But cross-border deals often fail because the parties never defined exact- 3 ly what the products, services, customers, and markets of the combined 4 enterprise would be. In “A CEO Roundtable on Making Mergers 5 Succeed” (Harvard Business Review, May–June 2000), Tig Krekel, for- 6 mer president and CEO of Hughes Space and Communications, said, 7 “In the drive to complete a deal, it’s easy to lose sight of the concerns of 8 customers. There’s almost never any detailed analysis in due diligence of 9 how the customers will react or of the pros and cons of the deal from 10 their point of view.” 11 Some of the most prominent cross-border deals of recent years have 12 struggled over the issue of brand. The failure to get a firm grip on brand 13 management was a problem for BMW when it bought Rover, and it has 14 also been an issue for DaimlerChrysler. BMW planned to use the Rover 15 brand to expand into new market segments and grow volume, but the 16 plan was never achieved. BMW tried and failed to bring Rover up to the 17 BMW perceived standard of quality. For DaimlerChrysler, Chrysler did 18 not turn out to be a successful design or marketing platform for small 19 cars, part of the value that Daimler-Benz sought in acquiring Chrysler. 20 There were also problems with product positioning. In each of these 21 cases, product lines of the two companies actually competed (BMW X5 22 with Land Rover Discovery and Range Rover; BMW 3 with Rover 75; 23 Mercedes-Benz M class with Jeep Grand Cherokee). 24 The United Kingdom’s Marks & Spencer likewise struggled with the 25 Brooks Brothers brand and associated pricing and sourcing decisions after 26 it acquired the U.S. company in 1988. Brooks Brothers had classic brand 27 positioning and a tradition of quality. It was dependable and represented 28 good value for high-quality wardrobe basics that lasted season to season. 29 Not cutting-edge fashion, Brooks Brothers clothes were private label, 30 manufactured in their own factories, or by stable long-term suppliers. 31 Marks & Spencer brought in competitive bidding and disrupted these 32 long-term supply relationships. In addition, in an attempt to compete 33 both with Polo (Ralph Lauren’s more fashion-forward rendering of the 34 same Ivy League styles) and with mass marketers selling American basics 35 (such as The Gap, Banana Republic, and J. Crew), Brooks Brothers alien- 36 ated its traditional clientele and entered a more crowded, and probably 37 60 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 overextended, marketplace. Brooks Brothers also may have confused cus- 2 tomers, with the mix of clearly lesser-quality goods competing on price 3 points, and to some extent on fashion, with middle-market merchandis- 4 ers. In late 2001, Brooks Brothers was sold for less than one-third of the 5 price Marks & Spencer had paid thirteen years earlier. 6 In terms of designing operational due diligence, the message is clear: 7 Before you can analyze productive capacity and the associated engineer- 8 ing and sourcing questions, you must have a firm grasp of what the post- 9 deal company is going to be producing and how it is going to attract 10 customers and compete. 11 Consider the following: “Fine Papers” was a family-run paper business 12 in Germany. Founded in the early 1800s, it had two mills and produced 13 high quality paper for the German domestic market. The company’s 14 paper had a reputation as being the best for art books, annual reports, and 15 fine catalogs, and its clients were household names. The family had just 16 completed a large capital investment in a state-of-the-art paper machine 17 when it decided to sell its business. It approached the U.S.-based wood 18 and paper company that had been its long-term supplier of pulp. The 19 U.S. company was amenable to a quiet, friendly deal that would provide 20 an entrée to the coated paper market in Europe. The deal was concluded 21 on the basis of a valuation analysis. There was no operational due dili- 22 gence, not even a visit to the mills. 23 Once the acquirer started running the business, management made 24 some interesting discoveries, among them that the company, with over 25 400,000 tons of coated paper output and 2,500 employees, was hemor- 26 rhaging cash. The mills’ operating efficiencies were below industry stan- 27 dards, with each stage of production from paper production to coating 28 running at different speeds, creating built-in bottlenecks. In addition, as 29 the company shifted runs on its lines to meet different orders, it was 30 oscillating between an acidic pH treatment and a neutral pH treatment 31 on the same line. At the end of the production cycle the company was 32 producing five different paper grades. 33 At the heart of the problem was the company’s market niche and 34 product mix. It produced its paper—admittedly of the finest quality—to 35 meet very small volume requirements, while competitors were specializ- 36 ing in fewer grades over much larger volumes. The U.S. acquirer had 37 failed to understand the market in which the paper company operated. OPERATIONAL DUE DILIGENCE 61

In doing the deal, it had not followed its own guidelines for approach- 1 ing an acquisition. After the U.S. company spent several years improving 2 productivity and financial efficiency, it sold the paper company, which 3 was no longer viewed as a strategic fit. 4 5 Manufacturing or Other Production of Goods/Services 6 How well is the combined enterprise, consisting of existing personnel, 7 plant, and other facilities, equipped to meet the needs of the projected 8 market? Based on the company’s market strategy and sales projections, is 9 there overcapacity, and if so, where and how should capacity be reduced? 10 Or is there a need for capacity expansion? Are there logistical hurdles 11 (such as transport costs and production quotas, lack of available real 12 estate, lack of skilled labor), legal or regulatory inhibitions (costs of 13 downsizing, inability to obtain licenses for expanded production), or 14 cultural or systems issues creating barriers to integration or rationaliza- 15 tion of production? 16 In the retail and services sector, the location of outlets and related 17 staffing are key parts of any integration plan, and thus key elements of 18 operational due diligence. Are there unprofitable locations? How will a 19 migration to a unified marketing strategy be accomplished in physical 20 terms? How realistic is it to expect that multiple outlets in nearby loca- 21 tions will be eliminated, and in what time frame? 22 For an industry like telecommunications, operational due diligence 23 means working through the details of technological, infrastructure, and 24 regulatory problems and weighing these against projected subscriber 25 demand. Buildout costs are high, and figuring out how many customers 26 the company will have and how much they will be willing to pay can be 27 difficult. Observers noted that Deutsche Telekom’s offer price for 28 VoiceStream was very high on a per-subscriber basis, suggesting the 29 company was paying a premium to make up for deals it had previously 30 lost out on: Deutsche Telekom had earlier failed in its attempt to buy 31 Sprint and had lost out to Olivetti for Telecom Italia. 32 In another high-priced deal Vodafone paid over $14,000 per 33 Mannesmann customer, in a business where customers are notoriously 34 fickle. Vodafone’s acquisitions since 1995 have made it the world’s largest 35 operator of mobile phone services, with Mannesmann the largest of its 36 acquisitions. Getting control of such a huge enterprise is a clear manage- 37 62 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ment challenge, and the pricing environment ever more competitive. At 2 the same time, sales growth is slowing, and important uses of wireless, 3 principally Internet and other data transmission, are some years off. To 4 reduce some of the cross-border management challenges, Vodafone’s 5 involvement in the U.S. wireless market is through a 45 percent stake in 6 Verizon’s wireless business. Vodafone’s strategy has been to be the first 7 and the biggest with new services as the technology develops. Its game 8 plan features reduced infrastructure costs as a percentage of sales, and vol- 9 ume purchases eliciting the lowest possible prices from suppliers. One 10 advantage is Vodafone’s great brand name, which conveys the essence of 11 the business and crosses many linguistic and geographic boundaries. 12 In other information industries, it may be harder to define the value- 13 creating business as one transcending cultural borders. Also, maintain- 14 ing the right level of autonomy for management in a specific cultural 15 milieu may turn out to be difficult. Consider, for example, the difficul- 16 ties that non-U.S. companies (Matsushita, Sony) have had as owners of 17 Hollywood studios. 18 19 Procurement of Supplies and Supply-Chain Management: 20 Possible Related Reconfiguration of Distribution Processes, 21 External Infrastructure Requirements, and System Cash Needs 22 For manufacturing and retail, analyze the supply chain closely, and 23 review cross-border and other risks, as well as how relative wage costs 24 interact with timing factors and shipping costs. Supply-chain manage- 25 ment efficiencies, particularly in combining reconfigured distribution 26 processes, often present at least a theoretical benefit of growth through 27 cross-border deals—but can they be realized? Managing global produc- 28 tion necessarily requires a continuing reassessment of these factors, 29 which makes them factors to address in due diligence. 30 All businesses depend on external support infrastructure—communi- 31 cations capabilities, air and other transport, water, fuels, and utilities. 32 Operational due diligence should include a review of production 33 dependencies on these services and facilities, and suggest where backup 34 and redundancies should be constructed. 35 Finally, the review of the supply chain and resource needs can include 36 a global tie to the system’s cash needs, highlighting the criticality of the 37 combined company’s treasury function. OPERATIONAL DUE DILIGENCE 63

1 Systems and Know-How Support of the 2 Value-Creation Process 3 Another area of operational due diligence concerns the systems and 4 know-how support of the production or other value-creation process. 5 Historically, management information systems have focused on financial 6 accounting and the corporate record-keeping practices necessary to back 7 up financial accounting (payables and receivables, employee records, and 8 so on). Now, however, it is generally recognized that a firm’s know-how, 9 however embodied, is likely to be one of its most valuable assets. This 10 category of business assets includes not only intellectual property, as for- 11 mally defined to include patents, copyrights, trademarks and trade 12 names, and trade secrets, but also operating procedures, standards, and 13 product/services know-how. 14 Many of these assets are not recognized for financial accounting pur- 15 poses, and many are not legally protected as registerable “intellectual 16 property” or in contract rights. Nonetheless, their value can be enor- 17 mous. The value of the intellectual capital that turns raw materials into 18 finished goods, a group of educated people into a professional firm, 19 storefronts and finished goods into a branded retailer, or a group of air- 20 plane leases and landing rights into an airline must be considered inte- 21 gral to any transaction. Operational due diligence, not bounded by 22 financial accounting concepts or legal constructs, can catalog this valu- 23 able know-how, and help answer such questions as the following: What 24 are the processes and technologies in this company that create value? 25 Does the company have rights to the know-how it is using? If it has them 26 under license, what leverage does the licensor have? 27 Is a given process or technology transferable? How must a process or 28 technology be tailored to local needs in the cross-border context? How 29 easy or hard would it be for competitors to duplicate the process or tech- 30 nology? This set of questions can have an important impact on the form 31 of a transaction. On the one hand, a particular technology or process 32 might not work in another country because of differing technological or 33 social constraints. This might argue for teaming up with a foreign part- 34 ner with local expertise. On the other hand, you would not want to con- 35 clude an international alliance or joint venture on a basis that permitted 36 your partner to take your know-how and become your competitor. 37 64 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Does the company have an R&D capability (which could include a 2 customer list or an R&D database), transaction system, or computer- 3 based algorithmic capability—such as a scheduling system—that is a sig- 4 nificant asset? If so, how will the asset be protected, deployed, and scaled 5 going forward? 6 Scaling R&D expenditures over an expanded product and geograph- 7 ical market base, in response to downward pressures on drug prices, is the 8 driver for much M&A activity in the pharmaceutical business (notable 9 examples include Upjohn/Pharmacia/Monsanto, Glaxo Wellcome/ 10 SmithKline Beecham, and Zeneca/Astra). In the May–June 2000 11 Har vard Business Review, Jan Leschly, former CEO of SmithKline 12 Beecham, stated: 13 14 … There are enormous opportunities in the new technologies now being 15 developed. When we looked at merging with Glaxo, for example, we 16 were talking about synergies in R&D. By merging the two organizations, 17 we probably could save in the neighborhood of $500 million. That’s 18 $500 million more a year we could reinvest in the R&D itself, and that’s 19 where the merger’s real benefit would be. 20 In terms of improving growth, though, I’d have to say that we have 21 been much more successful at acquiring products and technologies than 22 at acquiring companies. We have a venture capital fund that invests in 23 start-up biotechnology companies whose products and services we then 24 buy. We invest small amounts—half a million dollars here and a million 25 there—and we put our people on the boards. Once the companies get 26 going, we can decide whether to buy them out completely or not. With 27 large acquisitions, you’re buying an awful lot of problems along with the 28 products and technologies they bring. 29 30 Information technology implementations pose questions at two lev- 31 els. The first is principally technical: What systems are in place? What will 32 it take to get them to work together? What are the specific issues for sys- 33 tem integration: hardware, software, technical staff, languages? How 34 much will integration cost, and how long will it take? Are there inter- 35 mediate solutions, or can we expect productivity lags during the inte- 36 gration period? 37 At a second level, information technology should be viewed as a tool OPERATIONAL DUE DILIGENCE 65 in the enterprise’s overall management and production system. It should 1 be thought of as supporting value creation and corporate strategy, not as 2 an end in itself. Where should the combined enterprise be headed in 3 terms of IT deployment—in other words, what are the database needs, 4 network needs, manufacturing-support and decision-support needs, or 5 other intelligent agent systems needs? How will financial accounting be 6 supported, and how will knowledge sharing be accommodated? IT due 7 diligence that comes from an operational perspective can be a useful 8 complement to work undertaken by experts focused solely on more 9 micro issues, such as systems compatibility. 10 11 12 People, Training, and Corporate Culture 13 The inquiry into the “people dimension” is emerging as one of the most 14 important in domestic and cross-border deals alike. (This topic is the 15 focus of Chapter 7; we cover it here briefly as it relates to operational 16 considerations.) At one level, the questions are quite concrete. They 17 include such items as: How are people organized to do the work? Where 18 do they work, and how is their work day structured? How will different 19 workforces interact after the integration? Where are there opportunities 20 to reduce the workforce, if that is part of the strategic plan? How costly 21 will that be in terms of hard costs such as severance and other benefits 22 payments, and what are the intangibles associated with a reduction in 23 force, such as low morale, voluntary departures, and lower productivity 24 among the remaining employees? How are recruitment and training 25 accomplished now, and what will be required in the future? Seen in con- 26 junction with a facilities analysis, these questions may be difficult to 27 resolve but are susceptible to a rather straightforward analysis. 28 Corporate culture raises a more difficult and intangible set of issues. 29 Some commentators have noted that corporate culture may be more 30 important than national culture in determining how well the combined 31 enterprise works. Corporate culture is embodied in the characteristics of 32 top management, but while the issue of top management roles has 33 always received significant attention, the corporate culture issue is far 34 more pervasive. The relative compatibility of corporate cultures deter- 35 mines the degree of friction in the system after closing and affects the 36 quality of the transaction process pre- and post-closing. 37 66 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Corporate or business culture is defined by many small behaviors, all 2 of which together add up to how the people in the enterprise work 3 together. How do they dress in the office? What methods of communi- 4 cation are favored? Do they tend to be formal or informal? What is the 5 attitude toward sharing (or hoarding) knowledge within the company? 6 What are the roles of labor and management in the enterprise? Are work- 7 ers at each level encouraged to show initiative or instead rewarded for 8 keeping their heads down and not asking questions? Do work processes 9 tend to be fluid and open, or are they rigidly defined and rule-bound? 10 What will be the effects if the existing workforce does not like changes 11 that are likely to be implemented? 12 Corporate culture problems crop up even in a domestic context. For 13 example, consider the acquisition of Snapple, an entrepreneurial company 14 with an unconventional marketing strategy, by the more conservative 15 Quaker Oats. Blending disparate corporate cultures also has been difficult 16 in high-profile service industry mergers, such as Morgan Stanley/Dean 17 Witter, PriceWaterhouse/Coopers&Lybrand, and Citibank/Salomon 18 SmithBarney under the Traveler’s umbrella. Different salary scales (as 19 between “commercial bankers” and “investment bankers,” for example, or 20 among different groups of bankers) and a history of competition are espe- 21 cially likely to incite friction between merged workforces. Differing salary 22 scales and corporate culture issues generally have been noted as major prob- 23 lems for DaimlerChrysler, for example. 24 In the cross-border context, the people part of the equation is 25 extremely important, because the corporate cultures of the parties may 26 operate within disparate background cultures. For example, is the back- 27 ground business culture one that accords a significant amount of weight 28 to written contracts, or do long-term business relationships depend 29 more on personal or family trust and connections? How much is written 30 down? Do companies typically share information with outsiders, such as 31 lenders and investors, or do they tend to be secretive? If written rules and 32 procedures exist, are they likely to be followed most of the time, ignored 33 most of the time, or somewhere in between? What is the general business 34 community’s attitude toward financial accounting standards, taxation, 35 and regulatory compliance? What are general practices and attitudes with 36 respect to customer service and product warranties (for example, some- 37 thing as seemingly trivial as the right to refunds and exchanges)? What is OPERATIONAL DUE DILIGENCE 67 the background understanding about the basic social contract with 1 employees? 2 Does the background culture value change and fast response or sta- 3 bility and the status quo? One U.S. executive noted a difference in how 4 his managers and the managers in a French subsidiary might tend to 5 react to falling prices—the U.S. managers looking immediately for ways 6 to cut costs, and the French managers likely to move with more deliber- 7 ation in the belief that prices may well recover. 8 Which are the most important questions among these depends in part 9 on the type of industry. In manufacturing, labor/management issues 10 typically come to the fore and are intricately bound up with production 11 analysis. In services, in particular in retail, design and marketing are crit- 12 ical parts of the product delivery. Understanding for a given market the 13 way of life and how customers value different product and service attrib- 14 utes is key: Is staff up to the task and sufficiently sensitive to cross-cul- 15 tural issues? Will employees be able to spot potentially costly and embar- 16 rassing mistakes before they occur? For service firms, will the personnel 17 of the combined enterprise be able to present an identifiable and consis- 18 tent face to the public, appropriately tailored to the customers’ needs? 19 Is the “people” value of the target likely to remain with the surviving 20 company or walk out the door? This is obviously a key question in pro- 21 fessional and financial services firms. The CSFB acquisition of DLJ 22 attracted negative commentary when several of DLJ’s star producers 23 went elsewhere. CSFB agreed to high levels of guaranteed compensation 24 in order to keep others, arrangements that had to be undone when the 25 industry hit hard times. 26 Staff retention also has been an issue in high-tech industries, where 27 keeping the contributors at the firm and happy with the work environ- 28 ment is critical to success. Even in manufacturing, design and engineer- 29 ing executives may be very important to the success of the combined 30 business. The loss of some key executives at the time of the merger prob- 31 ably did not help in the DaimlerChrysler situation, for one. Even if a 32 workforce rationalization program is successful in retaining desired 33 workers, these very workers may suffer from low morale as their teams 34 are disbanded and reorganized or as they are asked to pick up more 35 work. Typically, these are the employees who have the greatest opportu- 36 nities for obtaining positions elsewhere. 37 68 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 In the content-creation industries, will the creative, design, and edi- 2 torial staff stay put and stay productive under a new regime? Will their 3 work product translate successfully in new marketing environments, and 4 will they be able to work with others from a different cultural milieu to 5 good effect? 6 Managing corporate culture issues is one of the biggest challenges in 7 cross-border deals. It may have a bearing on choosing the best structure 8 for executing a cross-border strategy. In some countries and regions, it is 9 easier to team up with a local alliance or joint venture partner than to try 10 to master the cultural issues; Western executives often take this approach 11 in Japan. Translating a global vision into profitable enterprises worldwide 12 is difficult. For example, Merrill Lynch bought Yamaichi Securities, a 13 large Japanese brokerage house, in 1998, when Yamaichi was in financial 14 difficulties. By 2002, indications were that Merrill had decided to reduce 15 its commitment to the retail end of that business, having closed some 16 twenty of twenty-eight branches in Japan. 17 18 19 What Can Go Wrong 20 The typical scenario for a cross-border deal that goes wrong involves 21 partners who feel under pressure to merge to address some vulnerability 22 or who entertain a global strategic vision that is short on detail. A com- 23 pany considers its declining profitability and seeks to cut per-unit costs 24 by growing volume. Or perhaps a company feels it must merge to avoid 25 becoming the target of an unsolicited takeover. In problem cases, the 26 transaction often represents not organic growth but instead dramatic 27 repositioning that is supposed to cure the ills of the combining compa- 28 nies. For companies that feel they have run out of options, there aren’t 29 likely to be many other potential partners to consider, and having found 30 each other, the parties may become more interested in running upside 31 scenarios than in conducting in-depth due diligence. 32 When Japan’s Bridgestone sought to gain a foothold in the North 33 American market with its 1998 acquisition of Firestone, what it got, 34 according to the New York Times article “Cross-Border Mergers May Face 35 Unexpected Hurdles” (May 8, 1998), were “five old factories with out- 36 dated equipment and employees who wouldn’t accept” the extended work 37 schedule that Bridgestone demanded (twelve hours a day for three or four OPERATIONAL DUE DILIGENCE 69 days in the week). Only after years of losses—including two years of a 1 strike—did Bridgestone/Firestone win acceptance of the work schedule. 2 The strike and quality control problems at the plant where the strike 3 occurred have been cited in connection with the Ford Explorer/Firestone 4 liability situation. 5 Automotive woes. BMW wanted to expand its presence into larger 6 markets without losing its brand image, so in 1994 it bought Rover, with 7 the idea of bringing it upmarket. No substantial due diligence was con- 8 ducted, and no investment bank was engaged to handle the deal. The 9 new owners of Rover failed to see the danger signs. Once inside, BMW 10 found “run-down production plants, overstaffing, low productivity, 11 poor quality and increasing costs as the British pound rose in value” 12 (“DCX, BMW-Rover: Parallels Abound,” Automotive News, March 19, 13 2001). Meanwhile, the new BMW SUV, the X5, was cannibalizing sales 14 of the Land Rover Discovery and the Range Rover. BMW was slow to 15 react, relying on Rover’s old management team. It wasn’t until 1998 16 that BMW sent a turnaround team to England. Ultimately, shareholders 17 lost their patience, and the board fired the BMW executive who had con- 18 structed the deal. After putting billions into the Rover business, BMW 19 sold Rover Cars for the nominal sum of £10 in 2000; Land Rover was 20 sold to Ford. 21 Daimler-Benz also wanted to become a global player in the automo- 22 tive world. So it sought as a merger partner the mass-market brand of 23 Chrysler. Again, no meaningful due diligence was performed, and 24 Goldman Sachs was brought in only to make the deal happen. “There 25 was no due diligence,” said Juergen Hubbert, DaimlerChrysler board 26 member for Mercedes-Benz and Smart, in an interview with Automotive 27 News Europe. Daimler’s management was impressed by Chrysler’s profits 28 and projections but failed to notice brand and design weaknesses, excess 29 inventories, and increasing reliance on incentives to sell cars. There was 30 no detailed support prepared or required for earnings forecasts, while at 31 the macro level, Chrysler was facing industry overcapacity and tough 32 competition, leading to eroding margins and possible volume reduc- 33 tions, in an industry where worker layoffs are very expensive and retiree 34 costs are high. 35 The initial idea was of complementary product mix, but executives soon 36 found a mismatch, as Chrysler pursued a more upscale market with, for 37 70 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 example, the PT Cruiser. Logistically, there were problems in integrating 2 the operations and extracting operational synergies due to their different 3 drive concepts. Mercedes uses rear-wheel drive and Chrysler front-wheel 4 drive. Component sharing was limited and platform sharing almost impos- 5 sible. In Taken for a Ride: How Daimler-Benz Drove Off with Chrysler 6 (HarperBusiness, 2001), Bill Vlasic and Bradley Stertz reported: 7 8 DaimlerChrysler could save big money if the two sides shared mechani- 9 cal underpinnings—the “platforms”—on Mercedes and Chrysler cars. 10 But that, the Daimler executives argued, was out of the question. Any 11 platform sharing would dilute the sanctity of the Mercedes brand. 12 Mercedes charged premium prices for its cars, and racked up big profits, 13 precisely because its platforms were unique. Engines could be shared. 14 Transmissions, air-conditioning units, axles, and airbags could be shared. 15 But never platforms. “A Mercedes has to be only a Mercedes.” Image 16 was a major component of Mercedes’ allure. 17 18 In fact, when Daimler-Benz was faced with the decision to convert a 19 plant for $30 million or build a new one for $100 million, the M-class 20 Mercedes SUV was built on a Grand Cherokee line at Chrysler’s plant in 21 Graz, Austria. 22 As in the BMW/Rover situation, DaimlerChrysler’s brand strategy 23 was flawed. The new DaimlerChrysler cannibalized its own product line, 24 as the Mercedes M class collided with the Jeep Grand Cherokee, affect- 25 ing one of Chrysler’s most profitable product lines. Chrysler was sup- 26 posed to pick up the small-car segment, but the Chrysler brand didn’t fit 27 the small-car image. Management did not realize this until some months 28 after the deal closed, leaving DaimlerChrysler looking for a new partner 29 to develop the small-car segment. Neither Daimler-Benz nor Chrysler 30 could successfully engineer for emerging markets. 31 There were significant pay and compensation disparities in 32 DaimlerChrysler; the Chrysler chairman came into the deal with an 33 annual compensation many times that of his German counterpart. In 34 general, American salaries were much higher, but the Daimler-Benz 35 travel and entertainment expense policies were more generous. The dif- 36 ferentials in salaries created friction, while the lavish T&E irked Chrysler 37 cost cutters. German executives were willing to relocate to Michigan, OPERATIONAL DUE DILIGENCE 71 but very few American executives were willing to move to Stuttgart. 1 More generally, there was a classic corporate culture mismatch, with the 2 Daimler-Benz style characterized by formality and hierarchy. All the 3 German executives spoke English, but almost none of the American 4 executives spoke German. Key “change agent” executives left Chrysler 5 at the time of the merger. The time difference led to the German side 6 of the business being “ahead” of the Americans, every day. 7 What were the rationales for the deal? Chrysler was very weak inter- 8 nationally and topped out in production, so the Daimler-Benz distribu- 9 tion network in Europe and elsewhere outside the United States was 10 attractive. Chrysler offered Daimler-Benz logistical and service support 11 in the United States, as well as, in theory, a down-market branding plat- 12 form. Combining purchasing, R&D, and eventually vehicle develop- 13 ment was supposed to generate $3 billion in annual cost savings. The 14 expressed basis of the deal was a merger of equals, and there were to be 15 dual headquarters. But control ended up with Daimler, and Daimler- 16 Benz head Juergen Schrempp acknowledged that his intent all along had 17 been to own and control Chrysler as a division of Daimler, which embit- 18 tered the already confused and disappointed Chrysler workforce. Less 19 than two years into the deal, as the American economy weakened, 20 Chrysler was embroiled in a bloody incentives war to maintain market 21 share and run its shifts, resulting in losses of hundreds of millions of dol- 22 lars and putting Daimler-Benz in a loss position. By the time Daimler- 23 Benz placed a German executive in charge of the Chrysler division, the 24 story was one of massive layoffs and plant idlings, with negative effects 25 on DaimlerChrysler’s stock price. 26 Media misfires. The Matsushita/MCA deal was also concept-driven 27 but not well thought through. In 1990, Matsushita Electric Industrial 28 bought MCA, the owner of Universal Studios, and in 1995 sold it to 29 Seagram for roughly the price it had paid (in dollar terms; the sale price 30 was far less in yen terms). Matsushita had thought of the acquisition as a 31 means by which to get a lock on content for electronic media equipment 32 like videocassette recorders and high-definition television sets. But theo- 33 retical synergies between content production and entertainment equip- 34 ment manufacturing did not materialize. Cultural and management issues 35 played a part as well. The film industry is idiosyncratic and volatile in its 36 investment yields, with big winners in the portfolio making up for the 37 72 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 losers. And there’s a strong emphasis on deal making in each project. This 2 up-and-down, talent-driven, entrepreneurial business is very different from 3 the line manufacturing of consumer goods at which Matsushita excelled. 4 Vivendi’s 2000 acquisition of Universal from Seagram raised ques- 5 tions about whether there was a plan that would generate new profits or 6 only a grand scheme to own media businesses worldwide. Vivendi also 7 was engaged in the media distribution channel through the acquisition 8 of pay-television company Canal Plus in France and was said to be look- 9 ing at significant cross-marketing opportunities. By latter 2002 it was 10 uncertain whether Vivendi’s management would be able to hold togeth- 11 er its various media and communications properties in a way that gener- 12 ates incremental profits. Note that content producers generally want to 13 see their material placed with as many distributors at each level of distri- 14 bution as possible, so distributing its content through its distribution 15 channels alone seemed risky. The sale of content in a single distribution 16 channel became the subject of a U.S. investigation into the recording 17 industry’s proposed online music distribution businesses. In addition, 18 Vivendi was reporting a significant credit squeeze that cast doubt on its 19 media business strategy. 20 In another cross-border media play, Madrid-based Terra Networks 21 SA bought Lycos, the U.S.-based Web search service, in the fall of 22 2000. Terra had the dominant position as ISP/portal in Spain and 23 much of Latin America. Terra’s hope was that via Lycos it could 24 expand its market reach to include Hispanic households in the United 25 States, Asia, and Europe. But the person originally chosen to be CEO, 26 and in particular to add value to Terra’s Spanish/Latin American 27 access business, did not speak Spanish and had lived and worked in the 28 Boston area almost his entire life. Beyond the management difficulties, 29 it is unclear that the rationale for the deal had developed into a con- 30 crete action plan at the time of closing. A year later, the business was 31 still running at a loss. 32 33 34 Deals That Got It Right 35 Of course, many cross-border transactions work out well. 36 Volkswagen’s acquisitions of Audi, SEAT, and Skoda are viewed as 37 successes. With these acquisitions, Volkswagen was able to execute a OPERATIONAL DUE DILIGENCE 73 common platform for becoming Europe’s biggest automaker. 1 GE Capital has bought unprofitable Japanese finance companies at 2 low prices and has achieved success in integrating them. In general, its 3 acquisition strategy has been to find small companies and methodically 4 bring them into the GE fold. 5 Tyco International achieved most of its growth from acquisitions. 6 Dennis Kozlowski, Tyco’s then CEO (later ousted and indicted for sales- 7 tax evasion), said at an analyst presentation in February 2001, “Our 8 deals are fed from the bottom up. … Corporate only negotiates deals. 9 Operations people take ownership of the deal, making sure it goes 10 smoothly.” In Tyco’s approach, corporate executives developed the 11 deals, while manufacturing and sales employees scouted the competition 12 for potential targets and then determined how they could integrate the 13 target into their business. Tyco’s key to integration was to move fast. 14 Kozlowski points out, “We move very, very fast on this front. That way 15 everyone can focus on growth and not worry about more layoffs, and 16 anxiety within the organization doesn’t fester.” 17 Royal Ahold owns supermarkets in Europe, Asia, Latin America, and 18 the United States, as well as food service businesses in the United States. 19 In an industry known for thin margins, Ahold became profitable as it 20 grew through acquisitions. In April 2001, CFO Magazine attributed 21 Royal Ahold’s success to its disciplined approach to the operations side 22 of the acquisition equation: 23 24 … Ahold makes sure it maximizes the know-how of local management, 25 relying on local managers to determine their own product assortment, 26 pricing policies, and store formats, while also having them take respon- 27 sibility for human resources and real estate. On a global basis, mean- 28 while, its supermarkets jointly procure, source, and deliver products, and 29 work from standardized IT networks. 30 31 Even Ahold stumbled when it took its formula to Asia, however, 32 facing punishing competition from both the local street stalls (“wet mar- 33 kets”) still favored in Asia and hypermarkets run by Carrefour, Casino, 34 and Tesco. Still now, in Asia, the grocery store does not seem the favored 35 venue for food shopping. The lesson here is that even a winning opera- 36 tions strategy won’t do the trick if the market isn’t receptive. 37 74 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 In the real world, it’s not likely that a typical deal will permit com- 2 prehensive operational due diligence into every aspect of the target 3 and/or the combined enterprise. Therefore, as covered in Chapter 2, a 4 pre-established rationale for the proposed transaction—a strategy that 5 examines products, markets, synergies, or complementarity—will allow 6 operational due diligence to focus on the kinds of issues that can best test 7 whether the transaction makes sense. The results of such a focused effort 8 will ensure that management has the information it needs to make 9 appropriate decisions in directing or terminating negotiations or in 10 restructuring the deal. If the deal goes forward to closing, the integra- 11 tion team, armed with these data, will be prepared to address the issues 12 presenting the greatest downside risk and upside potential. 13 14 Chapter Notes 15 16 1. Deloitte and Touche/Deloitte Consulting, “Solving the Merger 17 Mystery: Maximizing the Payoff of Mergers and Acquisitions,” indicates 18 that focus areas of due diligence are financial review and analysis (39%), 19 operational review and analysis (35%), legal review and analysis (35%), 20 and other (2%) (540 companies responding to a survey regarding M&A 21 activity for 1995–1999). 22 2. Harvard Business Review, May-June 2000, “A CEO Roundtable on 23 Making Mergers Succeed.” 24 3. “Many Big Cross-Border Mergers Don’t Make Returns Expected,” 25 Bloomberg Markets, April 2001. 26 27 Author’s note regarding sources: The references in this chapter to vari- 28 ous public companies and the descriptions of particular transactions 29 involving those companies or their M&A activities generally are based 30 entirely on publicly-available press reports and other publicly-available 31 sources, not listed here due to space limitations, but which the authors 32 acknowledge and are happy to provide upon request. 33 34 35 36 37 CHECKLIST Cross-Border Operational Due Diligence 1 2 BELOW IS A SUGGESTED CHECKLIST for operational due diligence from a 3 strategic and integrated perspective. It incorporates most of the points 4 noted in this chapter as checklist items. As a generic checklist it will be over- 5 inclusive for some deals or industries and underinclusive for others. 6 However, by adapting it you can design an operational due diligence useful 7 to your deal and integration teams. 8 9 FRAMEWORK FOR OPERATIONAL 10 DUE DILIGENCE INQUIRY 11 12 1. Deal rationale 13 ❏ Identify rationale for the transaction (e.g., markets, territories, prod- ucts and product development, other strategies for revenue growth, 14 strategies for cost savings). 15 16 2. Concrete goal 17 ❏ What concrete goals are expected to be met, and over what time 18 frame? How will achievement of those goals be measured? 19 3. Preliminary plan for achieving goals 20 ❏ Specifically, what is the preliminary plan for achieving the goals out- 21 lined above? 22 4. Drivers of value creation 23 ❏ Based on the above, what is the preliminary view regarding the driv- 24 ers of value creation for the transaction? 25 5. Most significant hurdles: preliminary view 26 ❏ What is the preliminary view of the biggest hurdles to achieving the 27 goals set for the transaction? 28 29 6. Key due diligence 30 ❏ Are there aspects of due diligence, including operational due dili- gence, that are especially critical to the plan for the combined enter- 31 prise? 32 33 7. Integration plan 34 ❏ How will the due diligence process be developed into an integration 35 plan? Are the people and processes in place to make sure there is a 36 seamless transition from due diligence to integration? 37

75 76 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 8. Negotiation and pricing strategy 2 ❏ How will information and analyses generated through the due dili- 3 gence process be taken into account in the negotiation and pricing 4 strategies? As the deal negotiations proceed, will due diligence be 5 appropriately retargeted along the way? Are the people and process- 6 es in place to make sure that these things happen? 7 9. Macro framework for due diligence 8 ❏ What are the deal team’s key assumptions about macro economic 9 and demographic factors that should frame operational due dili- 10 gence? These include world economic growth; trade growth; and 11 population growth, age profile, income levels, and other demo- 12 graphic assumptions in the relevant jurisdictions. 13 10. Economic factors affecting the relevant jurisdictions 14 ❏ What are the assumptions about economic factors affecting the rel- 15 evant jurisdictions: foreign exchange rates, currency exchange regu- 16 lations, and fiscal and monetary policies, including taxation and 17 import-export? 18 11. Political factors 19 ❏ What are the assumptions regarding macro-level political/environ- 20 mental/ecological factors, such as political stability, potential human 21 rights issues, environmental or health issues, and community or 22 social development obligations? 23 24 ANALYSIS OF THE VALUE-CREATION PROCESS 25 26 Undertake the following analysis for the target company as well as for the 27 combined enterprise. 28 A. The Operations Overview Map 29 1. ❏ On one or more maps, chart the supply chain, facilities, personnel, 30 and products and services produced against sales, distribution, and 31 marketing. 32 ❏ 33 2. On these maps, analyze the following: Markets, including new markets, for products/services 34 t Competitive positioning 35 t t Distribution channels 36 t Marketing strategies 37 OPERATIONAL DUE DILIGENCE 77

t Operations and technology strategies 1 t Sales/service outlets 2 t Planned production 3 t Supply and transportation synergies and vulnerabilities 4 t Political and macroeconomic trends and vulnerabilities 5 t Personnel overlap and shortfall 6 t Flow of funds and financing needs, both operating and capital 7 expenditures; analyze currency requirements and foreign 8 exchange and exchange control risk, as well as taxation and trans- 9 fer pricing issues (see also Chapter 6). 10 B. Sales, Distribution, and Marketing; 11 Customer Relationship Management; 12 Channel Management 13 3. Product analysis 14 ❏ Describe the company’s products/services. Break down into relevant 15 categories and describe territorial markets. Describe uses of the prod- 16 ucts and assess the qualities of the products against those of competi- 17 tors, including product substitution. Consider the following factors: 18 t Price 19 Quality t 20 Service t 21 t Availability/sales formats 22 t Design/engineering features and standards 23 t Sales terms (right to return, credit terms, charge-backs, war- ranties) 24 t After-sales service, upgrade, follow-on, etc. 25 ❏ Which of the above are most important to customers in the various 26 markets? In which of the above does the company enjoy an advan- 27 tage, and is that advantage sustainable or natural, or is it marginal 28 and temporary (can be copied or eroded)? 29 ❏ At what stage of the product life cycle are the various products in 30 their various markets? 31 ❏ Do any of the products of the combined enterprise compete with 32 one another? What is the proposed approach to this problem where 33 it exists? 34 ❏ Are there any known negative qualities associated with the product, such as health risks, product liability risks, or negative environmental 35 or social qualities? 36 37 78 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 4. Market analysis: demand 2 ❏ How is demand generated, and on what does the level of demand 3 depend? For example, is demand dependent on general economic 4 conditions or conditions in a specific industry? Is it seasonal or cycli- 5 cal? Is product substitution or technological obsolescence a major 6 risk in terms of basic demand? To what extent can the company con- trol demand? What are the biggest drivers of changes in demand? 7 8 5. Market analysis: competitors 9 ❏ Describe the competitive situation by product/market and its effect 10 on product design, product mix, marketing and positioning, and 11 pricing. 12 6. Market analysis: customers (and end users) 13 ❏ What is the market, and who are the company’s customers? If cus- 14 tomers are not end users, this analysis should be done for direct 15 customers and at each stage of the distribution chain all the way to 16 end users. Break down along all relevant categories (for business: 17 industry, size, profitability, outlook; for retail: national, cultural, 18 income level, lifestyle choices, other demographic features), includ- ing geographic. For each major category of customer (end user), 19 assess prospects and indicate the most significant macro trends that 20 could affect demand. Indicate whether customer (end user) relation- 21 ships tend to be long term, one-off, or something in between. Is 22 there dependence on one or just a few customers? 23 24 7. Customer data ❏ What level of information is available and useful, on a realistic basis, 25 about customers (and end users, if different) and the market? How 26 much of that information is being gathered now? How much of the 27 gathered information is, or should be, analyzed for marketing or 28 product design and positioning purposes? What are the implications 29 for IT needs, in terms of capture of customer data in a database, data 30 mining, and customer relationship management? 31 8. Using product/market data to identify synergies (cost reduction, 32 rationalization, product extensions) 33 ❏ Map existing products and services to existing customers/markets. 34 Are there obvious overlaps? Are there obvious product or market 35 extensions? What are the implications for production rationalization, 36 cost reduction through efficiencies over a greater base, design and 37 production for product extensions? OPERATIONAL DUE DILIGENCE 79

9. Pricing 1 ❏ Describe price levels and pricing strategies on a product-by-product 2 or product category basis, and broken down by geographic market 3 and selling format. 4 ❏ What are the major external factors on price levels—for example, 5 market structure, changes in demand? To what extent can cost 6 increases (and which cost increases) be passed on to customers in the 7 form of increased prices? If there is an RFP or bidding process that is 8 typical for the company in selling, describe the typical other parties 9 and the dynamics of the process. 10 10. Management of pricing and marketing 11 ❏ How are pricing and marketing strategies determined and to be 12 determined going forward? In particular, are there country/local 13 managers? If so, how is their role reconciled with that of prod- 14 uct/marketing managers and with centralized corporate policy on 15 these issues? How are profit centers determined, and how much of a role does profit-center analysis play in executive compensation? 16 (See, in particular, Chapter 7.) Are the cost and price assumptions 17 in the deal model consistent with the realities in the various juris- 18 dictions? 19 20 11. Advertising and promotion 21 ❏ What leads up to the point of sale? How do people come to be cus- tomers/clients? Describe all marketing channels and all sales or new- 22 business materials. Describe other promotional activities. For all 23 marketing and promotional initiatives and expenditures, how is their 24 reach and effectiveness measured? What is the cost? What cost/yield 25 figures are available or can be generated? 26 27 12. Distribution generally ❏ Describe product distribution or delivery of service generally. Where 28 and how does this occur? 29 30 13. End-user sales and service outlets 31 ❏ Map by products or product category the physical locations of end 32 user sales outlets/service centers. Indicate sale format, relevant pric- 33 ing information, and volume figures. Indicate where sales are direct; by franchisee through wholesale-retail or other multistage distribu- 34 tion chain; or by way of some other arrangement. 35 36 37 80 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 14. End-user remote sales 2 ❏ How much selling occurs remotely—by phone, mail, or computer? 3 Describe how this works and present volume figures and 4 product/customer information. Indicate where sales are direct; by 5 franchisee; through a wholesale-retail or other multistage distribu- 6 tion chain; or by some other arrangement. 7 15. Point of sale analysis 8 ❏ What exactly happens at the point of sale? In terms of display, prod- 9 uct packaging, and pricing, describe the point of sale. Describe the 10 point of sale in terms of human (or other, such as online) interaction. 11 If people are providing a service or assisting at the point of sale, 12 describe how they interact with customers, the level of staff, the type of interaction with customers (on-off versus ongoing and personal- 13 ized), staff turnover, the level of training, and quality control. 14 15 16. Inventory analysis 16 ❏ Analyze inventory levels and mix. What are the levels of stock-outs, 17 substitutions, and back orders? What is inventory turn at each level 18 and by product/product category? What is the analysis at each level of fast-moving, slow-moving, and obsolescent inventory? 19 20 17. Wholesale comparable analysis 21 ❏ If the company makes a significant amount of sales on a whole- 22 sale or other mediated basis, prepare an analysis comparable to 23 that above regarding the point of sale, sales volume by product, 24 and so on. 25 18. Sales and distribution analysis 26 ❏ Based on the above, and as relevant, chart the company’s sales 27 through distribution channels, indicating markup or other cost at 28 each level and the associated method/timing of transport. Does this 29 analysis suggest possible cost-reduction and efficiency moves, such 30 as the following: Elimination or consolidation of duplicated or overlapping 31 t sales/service outlets 32 t Elimination or consolidation of duplicated or inefficient distribu- 33 tion paths 34 t Use of centralized warehousing 35 t Creation of additional distribution centers 36 t Negotiation of better transport contracts or integration of the 37 transportation function. OPERATIONAL DUE DILIGENCE 81

19. Possible weaknesses or anomalies 1 ❏ Is the distribution system subject to channel stuffing or “field ware- 2 housing”? What portions of sales are made on consignment or on 3 approval? What is the experience with returns and charge-backs? 4 What are the possible effects of FIFO/LIFO/average basis accounting 5 as used by the company and others in the chain of distribution, such 6 as retailers—for example, what are the dynamics or pressures relat- 7 ing to inventory management in different price scenarios? 8 20. Sales force analysis 9 ❏ How are people involved in making sales? Who employs them, or are 10 they independent agents/distributors? From the company’s point of 11 view, how are they organized (by product, by region, and so on), and 12 how are they compensated (salary, commission, and so on)? 13 21. Channel management 14 ❏ What are the sales channels? Is there real or potential channel con- 15 flict, and is it being managed? Does company organization maximize 16 sales overall, or are business units competing with each other for the 17 same business? Describe any existing areas of channel conflict, and 18 describe the effect of the proposed transaction in terms of channel 19 conflict. 20 22. Systems analysis of sales and distribution 21 ❏ What is the state of systems support of product or service delivery? 22 Consider physical and logistical aspects such as the following: 23 t The order-processing and order-fulfillment process from a systems 24 perspective. Are there possibilities for automation or for enhanced 25 support of sales personnel? Are sales data fully exploited for mar- 26 keting purposes, including customer relationship management? 27 What are the implications for IT support of this function? 28 t The state of inventory delivery to or availability at point of sale: Is that inventory sufficient, and is the product mix correct? If the 29 company sells through a retailer or other agent, is inventory man- 30 agement executed in a coordinated fashion resulting in optimal 31 product delivery and sell-through? 32 t Are the logistical aspects of product transport and delivery opti- 33 mized by actively managing scheduling? 34 t Are the logistical aspects of inventory storage and handling opti- 35 mized by use of coding, warehouse management, standardization 36 of materials and packaging, and so on? 37 82 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t How does information about sales make its way back into the 2 inventory ordering and management system? How does it make 3 its way back into product design and marketing? How frequently 4 and on what basis? 5 t Are there opportunities for rationalization of the sales and dis- 6 tribution system, such as streamlined order processing; smarter 7 coding and packaging; improved tracking; use of computerized stock picking and automated packaging; improved IT-based 8 scheduling systems, including loading dock scheduling and the 9 like; integration of scheduling systems with those of trans- 10 porters; tighter design of inventory management by use of cur- 11 rent sales data and automatic or rapid replenishment/redirection 12 strategies? 13 23. System flexibility and responsiveness 14 ❏ How much flexibility and responsiveness is built into the sales and 15 distribution system, and can it be increased (at what cost)? How 16 sophisticated is the company’s rapid replenishment capability, how 17 far back into the production process does it go, and what is the cus- 18 tomer’s ability to change or cancel orders? How does the company 19 deal with unhappy customers or those who change their minds after 20 order fulfillment has been completed? What is the IT support for the 21 above? 22 24. Outsourcing 23 ❏ If aspects of sales/distributions have been outsourced, describe. 24 What are the benefits and possible negative aspects of this out- 25 sourcing? 26 25. After-sale 27 ❏ What are the company’s responsibilities after sale? 28 ❏ What are the company’s policies on returns or exchanges? 29 ❏ What are the company’s policies on warranties? What is the associ- 30 ated pricing, if any? What is the company’s experience? Assess the 31 cost of warranties to the company, and analyze the warranty reserve, 32 if any. 33 ❏ If the company provides after-sale service, what are the terms and 34 pricing? How well is it performed? If there are call centers, are they 35 staffed and organized to optimize response against cost, using queu- 36 ing theory, IT support at the phone level, and knowledge manage- 37 ment tools to assist personnel? Analyze these systems and their cost. OPERATIONAL DUE DILIGENCE 83

If service is at the customer’s location, how is availability and training 1 of personnel managed? 2 ❏ How is customer satisfaction measured? Be specific. 3 26. Brand management 4 ❏ By product or product category, describe the company’s branding 5 strategy or other corporate identity as it is intended to be perceived 6 by the public, including customers. How is the company’s brand 7 managed across product categories and across borders? Is there a 8 corporate brand that serves as an umbrella across subsidiary brands? 9 Comment on how the branding strategy is or is not reflected in var- 10 ious communications channels, including online and intracompany. 11 Comment on how consistent the branding strategy is with the cor- 12 porate culture, and if there is a mismatch, how that is managed. Do 13 any of the aspects of the proposed transaction pose a challenge in 14 terms of managing brand? 15 27. Brand and product design and positioning 16 ❏ How is the company’s branding strategy translated into product or 17 service design and engineering and product positioning, including 18 pricing? Does branding strategy and market information get com- 19 municated effectively to R&D, engineering, and design professionals? 20 Is it adequately communicated to sales personnel and others who 21 interact with the public, including customer service call centers and the like? 22 23 28. Outside consultants and advertising agencies 24 ❏ Describe the company’s relationships with corporate image consult- 25 ants, PR firms, and advertising agencies around the world. Are any 26 firms or individuals especially important in this regard? Does the 27 company do most of the global coordination in-house, or do out- siders handle it? 28 29 29. Value of the brand 30 ❏ What is the estimated value of the brand? Does the proposed trans- 31 action pose any threat of diluting brand value? 32 30. Implications for the integration plan 33 ❏ Do any of the above points suggest potential cost savings through 34 streamlining of the sales and distribution channels, or potential prod- 35 uct or market extensions, product repositioning, or different or addi- 36 tional branding and marketing strategies? 37 84 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 31. Implications for projections, negotiation, and pricing 2 ❏ How strongly does the information regarding customers, products, 3 and markets support deal assumptions about projected revenues? In 4 particular, if revenue growth for certain product lines is assumed, does 5 the information gathered point to clear paths—through product or 6 market extensions, acquisition of new customers, or higher sustain- able price points—through which the increase in revenues can be 7 achieved? Discuss the implications for deal negotiation and pricing. 8 9 C. Extraction, Manufacturing, or 10 Other Production of Goods and Services 11 Assuming the target’s market and planned products/services have been 12 defined above, assess in general how well the existing manufacturing or other 13 production system is set up to profitably meet market demands (giving effect 14 to possible divestitures for antitrust or other reasons). As relevant, answer the 15 following questions on a physical site and/or process or process-unit basis. 16 32. Geographic map of production capacity 17 ❏ Review the map of productive capacity against customer needs on a 18 geographic basis. Indicate overall industry capacity for the relevant 19 markets. Tie product sales estimates arrived at above to production 20 capacity. 21 33. Process and process unit 22 ❏ Describe the process of production or provision of services at a 23 schematic/technical/engineering level. Categorize the work in terms 24 of work flow as special order, batch process, line process, or contin- 25 uous flow. Analyze the critical inputs into the production process: 26 capital investment, know-how, plant design or specialized machinery, 27 skilled labor, pool of available labor. Is the company’s use of these 28 inputs consistent with industry norms? Better? Worse? 29 34. Process flow analysis 30 ❏ Within a physical plant or between physical plants, and including 31 approval processes, transport stages, and all other stages of the pro- 32 duction process as relevant, chart process flow for production on a 33 critical path or other comparable basis, with special attention to the 34 following: 35 t How production tends to relate to production schedules, and how 36 production schedules relate to sales forecasts, specific orders, and so on 37 OPERATIONAL DUE DILIGENCE 85

t Defective production, excess production, returned goods, and 1 warranty claims 2 t Idle time and downtime, for all reasons (differentiate among 3 reasons) 4 t Waste and scrap 5 t At all points in the process, damaged or obsolete stock/inventory 6 t Absenteeism, accidents, grievances, overtime, employee turnover 7 (see Chapter 7) 8 Whether design and ongoing production reflect sophisticated t 9 operations management tools, such as economic production 10 order quantities, time and motion studies, queuing theory, and so on 11 12 t Capacity/throughput mismatches creating bottlenecks t Bottlenecks due to approval requirements or other management 13 processes (especially where approval from a different location or 14 time zone is required) 15 t Excess inventory buildups (with associated working capital cost) 16 t Critical inventory and spare parts requirements management 17 against lead times (where disruption in supply will result in imme- 18 diate stoppage) 19 t Flexibility for product changes (for example, setup time required, 20 batch size, potential to reorder custom steps toward the end of 21 the production process) 22 t Associated IT or other information-based or automated support of 23 the process, such as tracking 24 35. Outsourcing 25 ❏ Is some of the production outsourced? If so, describe the extent to 26 which the company can control execution against specifications, and 27 how quality control is managed, particularly in light of timing con- 28 siderations. Assess the pluses and minuses of the outsourcing arrangements. Are there potential environmental liabilities, social 29 obligations, or other costs, liabilities, and risks associated with the 30 production outsourcing? 31 32 36. Risk analysis based on process flow 33 ❏ Identify the most significant risks associated with the process flow, 34 and their impact on the business. Are backups, work-arounds, or replacements available? Is insurance coverage for the risk available 35 on a cost-effective basis? What risks cannot be either mitigated or 36 insured against? 37 86 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 37. Review of physical plant 2 ❏ Describe in detail the physical plant and facilities of the company: 3 t Type 4 t Location 5 t Size/capacity/throughput measures 6 t Measures of utilization, including as a percentage of capacity Level of downtime, exclusive of scheduled maintenance 7 t Scheduled maintenance and associated downtime 8 t Quality of output 9 t t Age, original cost, and method of depreciation 10 t Depreciated (book) value 11 t Market (appraised) value 12 t If leased, terms of lease 13 t Remaining useful life 14 t Adequacy of warehousing/storage 15 t Associated environmental facilities 16 t Social obligations (housing, medical, family care, schools, roads, 17 parks, other) 18 t Facilities related to social obligations (medical or day-care facilities, 19 other) Materials handling methods (pallets, conveyors, forklifts, trucks, 20 t vacuum or magnetic lifting or moving devices) 21 Proximity to transport 22 t t Utilities infrastructure support 23 t Climate and natural hazards (flood, volcano, earthquake, tornado, 24 hurricane, rain, snow) 25 t Building code and zoning 26 t Real estate taxes and other fixed costs 27 t State of title (including leasehold title); liens and condemnation 28 proceedings 29 t Insurance coverage 30 t Safety and security features 31 t Maintenance costs; capital improvements 32 38. Review of machinery and equipment 33 ❏ List and describe principal machinery, noting the following: 34 t Age, original cost, and method of depreciation 35 t Depreciated (book) value 36 t Market (appraised) value 37 t If leased, terms of lease OPERATIONAL DUE DILIGENCE 87

t Remaining useful life 1 t Maintenance 2 t Health and safety issues 3 t Auxiliary equipment—tools, patterns, materials handling equip- 4 ment 5 39. Quality of technology 6 ❏ Describe the technology used in overall terms: Is the company an 7 industry leader in advanced, high-quality technology? Is its applied 8 technology the most modern? What is the risk of rapid obsoles- 9 cence? How does the technology used rank in terms of production 10 efficiency (inventory, utilities, workers needed, maintenance require- 11 ments, periodic capital improvements)? Is there a rival technology 12 being utilized or upcoming that will create competitive difficulties for 13 the company or render its technology obsolete? 14 40. Quality control 15 ❏ What is the company’s quality control structure? Are the company’s 16 facilities ISO-compliant? What specific quality control measures are 17 used (Total Quality Management, Statistical Control Processes, Six 18 Sigma, and so on), and what is the management structure for deal- 19 ing with quality control problems? 20 41. Review of engineering platforms and standards 21 ❏ Describe in detail the engineering platforms and standards used in 22 production. If it is assumed that the production process will be spread 23 among different facilities in order to optimize capacity utilization, 24 have the underlying assumptions been identified and checked out— 25 engineering platforms, measurements and standards, languages 26 used by engineers, and so on? How long will it take for manuals, 27 processes, and standards to be written down and harmonized to enable dispersed production? How will conflicts that arise in this 28 process be resolved? 29 30 42. Analysis of capacity on a combined basis 31 ❏ What does the analysis of process flow suggest about excess, dupli- 32 cate, or inadequate capacity at one or more points of production? 33 Analyze desirable production capacity, after smoothing within the system, against expected sales volume. 34 35 43. Excess capacity 36 ❏ If there is excess capacity, how should the determination to reduce 37 88 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 capacity be made, and what is the plan for disposition or shutdown? 2 What would be the financial consequences (on an accounting and 3 cash basis) of disposition or shutdown? 4 44. Additional capacity 5 ❏ If the analysis suggests that additional capacity is required, where 6 would it be located, and what would it consist of? How long would 7 it take to get online? What are the costs? Are there regulatory or 8 other barriers to the planned expansion? 9 45. Production cost structure analysis 10 ❏ If the analysis suggests the need for investments to improve the pro- 11 duction cost structure, quantify the cost of those improvements, tak- 12 ing into account the time required to effect the changes. Weigh 13 these against the expected operating cost reductions. 14 46. Tie production to cost accounting 15 ❏ What are the company’s policies for cost accounting? Are these con- 16 sistent with industry norms? Tie these to the process flow analysis 17 above, and reconcile for each company in the transaction. What is 18 the relationship between fixed and variable costs, the break-even 19 point, and the relation of volume to the break-even point? What are 20 the effects of idle capacity and volume variances? Is the company’s 21 production process satisfactorily profitable on a cost accounting 22 basis? What is the range for gross margin (by product or product cat- 23 egory as relevant) based on the price assumptions made in the pro- 24 jections and supported by the marketing analysis above? (See Chapter 4.) 25 26 D. Procurement and Supply-Chain Management; 27 External Infrastructure Requirements 28 47. Raw materials, intermediate inventory, and supplies needs 29 ❏ Analyze the company’s need for raw materials, intermediate inven- 30 tory, and supplies, based on the market and capacity analyses above. 31 Based on the process analysis above, describe critical items and asso- 32 ciated lead times. 33 48. Cost of raw materials, intermediate inventory, and supplies 34 ❏ Do raw material, intermediate inventory, or supplies needs represent 35 a vulnerability to price volatility or constricted supply? Track the per- 36 centage relation of these components of production to price levels 37 for finished goods, and for each category describe future price trends OPERATIONAL DUE DILIGENCE 89

and market conditions. Assess how much risk the company is taking 1 with respect to these inputs to the production process. 2 49. Supplier analysis 3 ❏ Describe suppliers by category of product and volume. Where are 4 they located? Are they stable financially? Are there multiple suppliers 5 for specific needs, or backup suppliers? Which suppliers are depend- 6 ent on the company’s business, and to what extent? On which sup- 7 pliers is the company dependent? 8 50. The procurement system 9 ❏ What is the procurement system? 10 11 t How centrally managed is it? t Does it balance cost savings and efficiency with design and quali- 12 ty control? 13 t To what extent does the company use a formal purchasing manu- 14 al, based on order quantities, up-to-date vendor evaluation files 15 (covering delivery and quality information), and a formal program 16 for reviewing the value and quality of purchased materials ? What 17 procedures are used in procurement? How are costs compared, 18 and how is purchase approval given? 19 What are the circumstances in which goods may be returned or t 20 result in charge-backs? How flexible is the procurement system in 21 dealing with changes in customer orders or fluctuations in sales? 22 t Does consolidation or streamlining of procurement represent future potential cost savings? If so, quantify. 23 24 51. Long-term contracts 25 ❏ If there are long-term contracts, describe the process for reaching 26 agreement on them, their status, and in what circumstances they 27 would be favorable and unfavorable to the company. 28 52. Utilities and other infrastructure support 29 ❏ Analyze the company’s need for utilities (including water supply) and 30 other infrastructure support, such as transportation and communica- 31 tion. Are these facilities all available on an assured basis, or can back- 32 up be arranged if there is a problem? Are there potential cost savings 33 here, or does infrastructure represent a vulnerability to price volatili- ty or constricted supply? 34 35 53. Support for facility expansion 36 ❏ If there is a decision to expand the facility, are sufficient supplies of 37 the following available at the selected location? 90 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t Manpower with the right skill levels 2 t Utilities, transportation, communication, and other infrastructure 3 support 4 t Raw materials and supplies on a secure and cost-effective basis 5 t Real estate at appropriate pricing with appropriate zoning 6 54. Supply-chain analysis 7 ❏ Analyze the logistics of the supply chain in light of rationalized pro- 8 duction capacity. Are there potential cost savings in the supply-chain 9 structure, such as streamlined order processing; smarter coding and 10 packaging; improved tracking; computerized stock-picking; auto- 11 mated packaging, improved IT-based scheduling systems, including 12 loading dock scheduling and the like; integration of scheduling sys- 13 tems with those of transporters; tighter design of inventory manage- ment by use of current sales/production data; and automatic or rapid 14 reordering/redirection strategies? 15 16 55. Supply-chain risk analysis 17 ❏ Are there vulnerabilities in the supply chain—to shipping disruption, 18 transportation price volatility, currency risks—and, if so, are there 19 available work-arounds, or are these risks inherent to the production process? 20 21 56. Collapsing the supply chain 22 ❏ Are there potential efficiencies in combining the company’s supply 23 chain to the point of production/shipping with the distribution/sale 24 to customers? 25 26 ANALYSIS OF INFORMATION, TECHNOLOGY, 27 COMMUNICATIONS, AND GENERAL SYSTEMS SUPPORT 28 OF THE VALUE-CREATION PROCESS; 29 INTELLECTUAL CAPITAL AND INTELLECTUAL PROPERTY 30 1. Traditional MIS 31 ❏ Describe the management information systems of the company as 32 they relate to traditional MIS functions: payroll, benefits, payables, 33 receivables, cost accounting, and financial accounting generally. What 34 is the target company’s hardware configuration for data processing 35 and for networking? What is the target’s software platform—vendors, 36 operating systems, database management system, programming 37 environments, and software applications—and how integrated is it across company units, both functionally and geographically? OPERATIONAL DUE DILIGENCE 91

2. Integration for MIS 1 ❏ What does an integration plan for traditional MIS look like? Can pri- 2 orities be applied, and are there any items that do not really need to 3 be integrated? What is a realistic time frame for MIS integration, and 4 how can functions be maintained with minimal disruption for that 5 period? 6 3. ERP 7 ❏ Does the company have an ERP system or other partially or fully inte- 8 grated IT system? Which one? Describe implementation, vendor, 9 contracts. 10 4. Other valuable IT systems and assets 11 ❏ Does the company have other valuable systems or processes that are 12 IT-based, such as: 13 t Online order or transaction processing 14 t Online search, tracking, or other information-retrieval systems 15 t Knowledge-sharing systems, such as a firm intranet or other 16 groupware 17 t Engineering platforms such as computer-assisted design systems 18 Computer-based scheduling or routing systems t 19 Document production systems that go beyond general office needs t 20 Special mathematical or engineering data-modeling or data-pro- t 21 cessing support, such as that required for minerals extraction 22 t Decision support systems 23 t Robotics 24 t Sensing, feedback, and control mechanisms in extraction or pro- duction 25 t Large database support of, for example, customer relationship 26 management or R&D 27 5. System assessment; IT personnel and budget 28 ❏ For any of the items above that are fundamental to the business, 29 a full-scale assessment of hardware (data storage, processing, and 30 network) and software adequacy, scalability, and robustness of the 31 systems is required. While a Web-based catalog transaction-pro- 32 cessing system is not very arcane at this point, the transaction- 33 processing needs of a typical bank would be a quite substantial IT 34 function. Security and backup are both very important to most of 35 these types of systems, as is error-free ordinary operation. For all 36 such systems: What level of personnel support is required? What 37 are ongoing maintenance costs? How long to obsolescence? Are 92 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 there multiple systems, and should some standardization be 2 imposed? How is procurement managed? 3 6. Ownership; vendor relationships 4 ❏ Does the company own the rights to its IT systems, or are some 5 aspects of the systems operated under license? What is the compa- 6 ny’s position in terms of vendor lock-in? How vulnerable is it to 7 forced and round-robin upgrades and price increases? Are some 8 aspects of the company’s IT systems proprietary to it, and if so, are 9 these proprietary aspects treated as confidential or otherwise as pro- 10 tected as they can be from duplication by competitors, including 11 departing employees? 12 7. Outsourcing 13 ❏ Are any of the company’s IT functions outsourced? Describe the 14 arrangements, the vendor (including the vendor’s stability), and the 15 backup and recovery systems. Describe the pros and cons of the 16 arrangements. 17 8. Systems risk analysis of the IT systems 18 ❏ Describe the systems risk inherent in the company’s IT infrastructure 19 and such issues as redundancy, backup, and disaster recovery. How 20 well does the system recover from ordinary system crashes, and how 21 often do these occur? What is the tolerance for IT failure in terms of 22 the company’s operations? 23 9. Intellectual property and know-how; licensing 24 ❏ What intellectual property underlies the company’s value-generating 25 processes? Describe these, including processes or branding concepts 26 that might not be written down or that might not fall within a legal 27 definition of intellectual property. Describe all licensing agreements 28 and their terms. 29 10. Ownership of intellectual property 30 ❏ Does the company have the right to use all of its important know- 31 how? What is the risk of infringement claims? How much of the 32 company’s valuable know-how is proprietary to the company, and of 33 that, how much is entitled to legal protection and under what 34 rubric—e.g., trademark and trade name, patent, copyright, trade 35 secrets? Has the company taken all appropriate steps to protect its 36 rights in its intellectual property? In answering this question, be sure to examine the cross-border implications (in what countries are the 37 company’s intellectual properties protected, and so on). OPERATIONAL DUE DILIGENCE 93

11. Product development and innovation 1 ❏ Assess the company’s general product development and product 2 innovation experience and strengths in design, engineering, and 3 general creativity and responsiveness. 4 12. Cross-border implications 5 ❏ For each aspect of the constituent companies’ important know-how 6 that it is assumed will be applied cross-border after closing: Must 7 such know-how be tailored to local needs and conditions? Will the 8 know-how retain its protected character if transplanted to the new 9 site? How easy will it be for competitors in the new territory to copy 10 the know-how? 11 13. R&D generally 12 ❏ How important is R&D to the company and to competitors? How 13 does the company’s R&D budget compare to that of comparable 14 companies, as a percentage of sales and against other measures? 15 How successful is the company at turning R&D into valuable prod- 16 ucts/services over a reasonable period of time? How integrated is the 17 company’s R&D effort with its marketing strategy (or how relevant is 18 its marketing strategy to its R&D effort)? 19 14. R&D facilities and capabilities 20 ❏ Describe in detail the R&D facilities, capabilities, and directions of the 21 company, and define areas of overlap or obvious areas of extension 22 for the combined enterprise. Are there opportunities for cost reduc- 23 tion or important new initiatives in the combined R&D functions? 24 15. IT and intellectual property/know-how overview 25 ❏ Of all of the company’s IT-based systems and other know-how noted 26 above, are some elements so valuable that they constitute a critical 27 aspect of the value proposition? If so, are they fully understood, and 28 is their legal status and confidentiality protected as fully as possible? 29 Can the associated systems and know-how be successfully scaled 30 and deployed across borders in the combined enterprise? 31 16. IT systems overview 32 ❏ What knowledge and information requirements of the combined 33 enterprise cannot be met through combination and integration of 34 the existing information systems? What are the budget and 35 timetable for these, and can they be grafted onto the more basic IT 36 infrastructure? 37 94 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 3 PEOPLE ANALYSIS: MANAGEMENT STRUCTURE, 4 LABOR RELATIONS, CORPORATE CULTURE, RECRUITMENT 5 AND TRAINING, AS RELATED TO OPERATIONS 6 (See also Chapter 7.) 7 A. Management Structure from an Operational Perspective 8 9 1. Management structure and lines of reporting ❏ 10 Document the official lines of reporting, and comment on manage- 11 ment communications formats that do not coincide with the formal structure. 12 13 2. Management structure and business units 14 ❏ How does management structure translate into operational/produc- 15 tion functions, entities, or units such as: 16 t Factories/mines/other facilities for extraction/production (manu- 17 facturing) Professional and production offices and studios (professional serv- 18 t ices firms, media) 19 t Networks and systems (transportation, communication) 20 t Sales outlets and customer service centers 21 t Corporate office; corporate-wide systems such as accounting and 22 finance, legal, information systems, procurement, brand manage- 23 ment and marketing, engineering, R&D, and quality control 24 3. Management operations across borders 25 ❏ Are there country/regional managers? How autonomous is the coun- 26 try manager, and how do country manager roles integrate corporate- 27 wide decision making? Are there matrix management structures or 28 other processes in place to coordinate country practices and policies 29 within a global strategy? 30 4. Identifying key personnel (nonmanagement) from an operational per- 31 spective 32 ❏ Which nonmanagement categories of personnel are key from an 33 operational perspective? Consider the following: 34 t Creative 35 —Writers and editors (media) 36 —Designers (retail/manufacturing) 37 —Marketing OPERATIONAL DUE DILIGENCE 95

t Scientists and engineers 1 —Systems and operations engineers (airlines, other transporta- 2 tion, telecommunications) 3 —Doctors and other health professionals and researchers (phar- 4 maceuticals, health care) 5 —Design engineers (automotive, other manufacturing) 6 —Software engineers, electrical engineers (information tech- 7 nology) 8 —Mining, construction, mechanical, or other engineers (extrac- 9 tion, construction, manufacturing) 10 t Finance/legal/other professionals —Lawyers, accountants, consultants 11 —Bankers 12 —Pilots (for an airline) 13 t Sales and customer-relationship management 14 —Sales and marketing personnel 15 t Skilled and unskilled production labor 16 —Office staff (for a professional services firm, for example) 17 —Factory skilled and unskilled workers (manufacturing firm) 18 ❏ For the target and the combined company, rank the relevant cate- 19 gories, and set forth the analysis and implications for integration 20 strategy: 21 Are there individuals or teams in this category so essential that los- t 22 ing them after closing would negate the value of the deal? Those 23 people can take the value of the business with them or become competitors (for example, key bankers leaving after a bank is 24 acquired, star sales managers leaving a marketing and distribution 25 firm, a key creative team leaving an advertising agency, the most 26 productive software engineers leaving a software development 27 firm). 28 t Is one category of personnel so essential that managing that 29 group as a whole is a key element of the deal (for example, airline 30 pilots for an airline, doctors for a health care organization)? 31 t Are replacement personnel available? 32 Will there be personnel redundancies postdeal? How will these be t 33 dealt with? 34 ❏ For existing personnel, consider in general terms their numbers, loca- 35 tion, work performed, compensation, and terms of employment (including union or other contracts). 36 37 96 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 B. Operational Questions across Categories of Personnel 2 5. Workers and planned strategic initiatives 3 ❏ Review all categories of workers in light of strategic initiatives for the 4 combined company. Will strategic redirection or reengineering of 5 processes render some workers unneeded, or will new categories of 6 workers be required? 7 6. Recruitment and training 8 ❏ How are workers recruited and trained? Is recruitment and training 9 appropriately geared to operational needs? 10 11 7. Workers and process review ❏ What are the general terms of employment as they relate to process 12 design and other operations matters, such as shift length, vacation 13 expectations, and flexibility in learning new skills and being rotated 14 into different jobs? Will these need to be reconciled between the 15 companies after closing, or reconfigured in order to implement new 16 process designs, and if so, how? 17 8. Workforce integration 18 ❏ Will there be integration of workforces? If so, what impediments are 19 there to smooth integration (such as language barriers)? 20 21 9. Workforce reduction ❏ 22 If a workforce reduction is contemplated, how will that be executed, 23 keeping in mind the need to retain motivated staff? How much will it cost—soft costs as well as hard costs? 24 25 10. New hires 26 ❏ If the combined enterprise plans relocation or expansion, or if new 27 facilities or lines of business are planned, will new employees be 28 required, and are they available? 29 11. Social obligations 30 ❏ Does the company have social obligations to its workers, such as 31 requirements to provide or fund housing, schooling, or medical serv- 32 ices? What is the basic infrastructure available to employees to meet 33 these needs? How do these obligations potentially affect operations? 34 C. Corporate Culture and Operations 35 Compare the corporate cultures of the parties to the transaction in 36 terms that seem most useful to the deal structure and to developing an 37 integration plan from an operational perspective. OPERATIONAL DUE DILIGENCE 97

12. General aspects of corporate culture 1 ❏ Some markers or attributes that might be considered in terms of how 2 employees work together might be these: 3 t Relative rankings of jobs as perceived in the companies, impor- 4 tance of formal hierarchy 5 t Formality, style of dress, office configuration, open doors or closed 6 doors 7 13. Communications formats 8 ❏ What are the formats for various types of communications, such as: 9 t Meetings scheduled in advance with/without prepared agendas 10 t Impromptu meetings 11 t Memos, e-mails, voice mails 12 Formal reporting lines versus back channels t 13 Formal committees versus “kitchen cabinets” t 14 Collaborative work t 15 14. IT support for communications 16 ❏ Is there adequate IT support for IT-based intra-company communi- 17 cations (for example, e-mail, an intranet, or other groupware is 18 important for intracompany communications, quality control and 19 promulgation of standards, and collaborative design and engi- 20 neering)? 21 15. Knowledge sharing and knowledge management 22 ❏ What is the attitude about information in the enterprise: Is it shared, 23 or do individuals tend to keep their knowledge to themselves? If 24 knowledge is shared, is that solely through informal means or by way 25 of formal training formats? What are the implications for IT support 26 of knowledge sharing and transference (for example, for worker 27 training and rotation)? 28 16. Company approaches to systems design 29 ❏ Are employees rewarded for exercising initiative or for acquiescence 30 in management instruction? How free do employees feel to question 31 their superiors? How comfortable are managers with questions or 32 challenges from those they supervise? 33 17. Documentation of systems design 34 ❏ Are work processes and practices fluid and open, or do they tend to 35 be rigidly defined and rule bound? Do work processes and practices 36 tend to be documented, or is there more of an oral tradition? 37 98 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 18. Conflict resolution and change management in integration planning 2 and systems design 3 ❏ How do employees react to things that they don’t agree with? Do 4 they have a forum for discussing and resolving issues with manage- 5 ment, or will dissatisfaction show up in other ways? Are people more 6 or less comfortable with group or consensus decision making in comparison to individual leadership? How important is it that 7 groups validate leaders’ decisions? What is the mechanism for cre- 8 ating “buy-in,” and has this process been considered in integration 9 planning at a practical level? 10 11 19. Life-balance issues in operations planning ❏ 12 How permissible is it to acknowledge the importance of family or personal life, and how flexible is the company in accommodating the 13 family and personal lives of their employees? 14 15 D. Background Culture Questions Affecting Operations 16 20. Language 17 ❏ What is the dominant language used for spoken and written com- 18 munications, within the company and with suppliers, customers, and 19 investors? Are there enough persons with multilingual capabilities to 20 bridge the language gaps? 21 21. How things really get done? 22 ❏ Does the background culture accord a significant amount of weight 23 to long-term contracts, or are the most important relationships or 24 aspects of relationships likely to be undocumented? A related ques- 25 tion: How are business agreements reached? Are key decision mak- 26 ers interested in and patient with lengthy and detailed negotiations? 27 Or do they rely more on establishing personal bonds with their cor- 28 respondents? Do people enjoy haggling, or do they avoid it? 29 22. Importance of documentation and record keeping 30 ❏ Are things generally written down or otherwise recorded and kept? 31 How important is record keeping and the memorialization of events 32 and decisions? How important are formal and written inquiries and 33 justifications? To what extent is arbitrariness accepted? 34 23. Transparency to outsiders 35 ❏ Do companies routinely share information with outsiders, such as 36 lenders, investors, or the press, or is information closely held? What 37 types of information are shared with vendors, suppliers, and cus- tomers, and on what terms? OPERATIONAL DUE DILIGENCE 99

24. Involvement of equity owners 1 ❏ Does the ownership structure of the company have an impact on 2 operational decisions—for example, has common ownership result- 3 ed in favorable or unfavorable business relationships with vendors 4 and suppliers or customers? Is the background culture one in which 5 professional management is given a great deal of leeway day to day 6 or one in which equity owners are likely to be involved in operational 7 issues? 8 25. Attitude toward rules and protocol 9 ❏ Do people tend to follow written rules and procedures to the letter 10 or take a more relaxed attitude? Do they feel it is appropriate to 11 question or override formal rules and procedures when circum- 12 stances are out of the ordinary? 13 26. Attitudes toward accounting standards, taxation, and regulatory com- 14 pliance 15 ❏ What is the company’s attitude toward these requirements? 16 27. The basis of customer relationships 17 ❏ How would you characterize typical business-to-business transactions 18 and business-to-consumer transactions? For example, is there more 19 emphasis on a branded or otherwise consistent corporate identity or 20 on local/personal relationships? In what circumstances are purchasers 21 entitled to refunds and exchanges? What are the most effective chan- 22 nels for marketing and product/company communication? 23 28. Social contract with workers 24 ❏ What is the background understanding about the social contract 25 with workers? Among government, the family, and business, who 26 bears the costs of various risks to workers: unemployment, health, 27 family care, retirement, need for retraining? What are the long-term 28 obligations assumed by a company when it hires an employee? 29 29. Attitude toward change 30 ❏ Is change and rapid response valued, or do people tend to value tra- 31 dition, the status quo, and stability? 32 33 34 35 36 37 This page is intentionally blank 1

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15 1 2 Financial and Accounting 3 4 4 Due Diligence 5 6 7 JORGE M. DIAZ 8 9 10 11 12 13 14 15 INANCIAL DUE DILIGENCE and accounting due diligence are 16 closely related. Financial due diligence is the process by which the 17 F investor determines whether the investment in the target makes 18 business or financial sense. Financial due diligence includes corroborat- 19 ing, by independent third party data, the financial information the target 20 provides. The financial due diligence process is the only opportunity the 21 investor may have to evaluate the target’s current economic viability and 22 future prospects and the capital demands required to realize the deal’s 23 goals. Unrealistic expectations, inappropriate or incomplete due dili- 24 gence procedures, or inadequate research relating to a target will cause 25 any transaction to fail, regardless of size or complexity. 26 Accounting due diligence, although similar to financial due diligence, 27 is more closely directed at the truthfulness and completeness of the tar- 28 get’s accounting information. Accounting due diligence procedures 29 should include tests of the reasonableness of accounting judgments and 30 estimates presented by target company management. In an effort to 31 maximize earnings and to enhance the target company’s financial posi- 32 tion, perhaps for the purposes of the contemplated transaction, the 33 accounting procedures at the target company may be aggressive. 34 Therefore, the investor’s due diligence team may have to step up its 35 efforts. In performing accounting due diligence, the procedures should 36 concentrate on the internal controls imposed on the target’s accounting 37

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1 systems and information, the accuracy of the information processed, the 2 correct application of accounting principles, the generation of estimates 3 and accruals, and other similar factors. 4 When preparing for a cross-border deal, the target’s senior manage- 5 ment may be tempted to put undue pressure on middle management to 6 make budgets, to meet revenue goals, or to achieve certain expectations. 7 Middle management may even consider violating existing company poli- 8 cies and procedures to achieve these goals. Even the most ethical of 9 organizations is susceptible to management efforts to manipulate the 10 numbers if unrealistic goals and expectations are imposed on the com- 11 pany’s employees. Often the pressure is not documented, but rather is 12 expressed privately. 13 To detect and account for this problem, due diligence is vital—and 14 should include as much contact as possible with as many members of the 15 target’s management and employees as possible. Without proper due 16 diligence, investors who are eager to close a deal may make hasty deci- 17 sions, which will unequivocally end in financial disaster. More often than 18 not, decisions to invest in deals that ultimately fail are based on factors 19 neither financially sound nor justifiable. 20 Typical of such mistakes are deals made solely to beat a competitor to 21 a deal or to control a particular market without considering the financial 22 and reputational risks. In fact, a deal made for the sole purpose of mar- 23 ket share expansion generally results in substantial costs and possible 24 losses to the investor. Investing in a company solely to beat a competi- 25 tor in achieving a presence in a particular market very often may be out- 26 right wrong for economic and financial reasons. Thorough due diligence 27 helps investors avoid these mistakes. 28 The two parties in a cross-border deal should be wary of committing 29 any of the following common mistakes: 30 1 Having no clear strategy, which leads to general turmoil 31 2 Attempting to blend and merge different cultures 32 3 Making destructive changes to an existing positive work environ- 33 ment 34 4 Losing key talent, which leads to restructuring 35 5 Ignoring employee-related issues, which leads to employee dis- 36 gruntlement 37 6 Failing to deliver on stated goals FINANCIAL AND ACCOUNTING DUE DILIGENCE 103

7 Allowing chaos to reign during the often stressful stages leading 1 up to and following completion of the deal 2 3 In this chapter, a number of these common mistakes are considered as 4 they relate to the performance of financial and accounting due diligence. 5 6 7 Addressing All Aspects—Whether Large or Small 8 Financial and accounting due diligence should address all aspects of the 9 target company’s business and operations, for even the smallest of indi- 10 cators may lead to serious issues requiring further investigation. Under 11 no circumstances should an investor ignore issues of potential concern 12 during due diligence. From time to time, what appear to be minor issues 13 will turn into major problems requiring the expansion of due diligence 14 and additional consultation with target management. 15 For example, in an acquisition of an overseas cable service provider, 16 the investor’s due diligence team requested that target company man- 17 agement provide a detailed budget for the purchase of property and 18 equipment. At first, the investor’s due diligence team perceived this to 19 be a small request. Target management, however, could not produce 20 such a budget, and the explanation provided suggested that manage- 21 ment simply bought what was believed to be necessary at the time. As a 22 result of additional investigation, the financial due diligence team dis- 23 covered that the target company had 24 t no total company budget, not even a capital acquisitions budget, 25 and that no financial plans had been presented to the board of directors 26 for review and approval; 27 t no plan or strategy for capital acquisitions; 28 t no research relating to the requirements for expansion to pene- 29 trate the competition’s market; 30 t no plans for the financing of the necessary purchases; and 31 t no analysis of the relationship between the potential benefits of 32 expansion and the costs associated with such expansion. 33 In essence, the target had no idea of its position versus its competi- 34 tion, and no knowledge of the requirements to expand and maintain its 35 market position, a point that proved to be critical to the acquisition. 36 Once the due diligence team prepared an analysis of the capital require- 37 104 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ments and of the benefits associated with the target’s expansion require- 2 ments, the investor abandoned the proposed acquisition. The absence of 3 budgets and planning information also revealed the inadequacies of the 4 target’s management. 5 In performing due diligence on a non-U.S. target in the airline indus- 6 try, an investor requested information about the carrier’s principal routes 7 and customers served. The target provided many types of information 8 relating to revenue passenger miles (RPMs) by geographic segment, 9 including an analysis reflecting the volume increases by segment, but not 10 by city pair or route. RPMs represent a critical indicator in determining 11 an airline’s revenues and profitability. Generally, RPM growth should 12 reflect an airline’s capabilities and indicate the potential to increase mar- 13 ket share. However, because the prospective investor was headquartered 14 in the United States, it considered the target’s route system vital. Once 15 it obtained the details, the due diligence team noted that approximately 16 20 percent of the target’s traffic was derived from flights to and from 17 Cuba, a country with whom U.S. companies are prohibited from trans- 18 acting business. Thus, the airline’s growth projections and objectives had 19 to be adjusted to reflect an additional growth factor of 20 percent, which 20 translated into a revised growth of approximately 35 percent for the air- 21 line to be a profitable investment. Given this high hurdle, the investor’s 22 due diligence team concluded that the target would not be able to gen- 23 erate sufficient RPM growth to justify the investment. 24 25 26 Financial Due Diligence Procedures 27 Financial due diligence procedures begin in the planning phase and are 28 not concluded until the transaction is closed. The reliability of the fig- 29 ures, analysis, account balances, reports, and other financial information 30 is only as good as the people and systems responsible for preparing and 31 producing such information. The entire due diligence process, much like 32 an audit in accordance with generally accepted auditing standards, is 33 based on trust. The level of trust varies based on the target’s (and its 34 management team’s) background and financial status. For example, a 35 U.S. public company whose shares or debt are registered with the 36 Securities and Exchange Commission is expected to produce more reli- 37 able financial information than a typical privately held company would. FINANCIAL AND ACCOUNTING DUE DILIGENCE 105

Depending on the sophistication of the target’s management team, the 1 scope of the procedures should be either expanded or narrowed. 2 Planning for due diligence is critical to the execution of the due dili- 3 gence program. Planning includes defining the scope of the work and the 4 conclusions to be reached. Testing the target management’s assertions is 5 initiated during the background evaluation and assessment process, par- 6 ticularly by the initial evaluation of the target’s internal controls. 7 Thus, financial due diligence procedures vary depending on the qual- 8 ity of the target’s personnel and systems. The due diligence team should 9 be prepared to adjust the scope of its work to adapt to new developments 10 and additional information. The due diligence team members should 11 hold frequent meetings to focus on the most important issues uncov- 12 ered, as soon as such issues are detected. 13 During the preliminary phase of one cross-border transaction in the 14 banking industry, the due diligence team noted the following: 15 t The target company management team lacked direct knowledge of 16 its own operations. 17 t The management team members did not work in concert, and cor- 18 porate goals were secondary to individual goals. 19 t The target’s data processing systems did not serve their intended 20 purposes and were outdated and unreliable. 21 t Environmental controls affecting the data processing systems were 22 not enforced and, for the most part, did not exist. 23 t Management team members did not have access to all of the avail- 24 able financial information. 25 t Company employees did not have adequate experience or training. 26 t The company’s senior management team failed to provide lead- 27 ership, goals, objectives, benchmarks, and compensation incentives, 28 thus creating an atmosphere of individualism, arrogance, and self- 29 preservation. 30 Given these findings, the due diligence team expanded the procedures 31 to test the reliability of the target’s financial and accounting information. 32 The team concluded that target management’s inexperience and lack of 33 knowledge would require far-reaching procedures to test and verify the 34 information supplied. 35 36 37 106 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 How to Verify the Numbers 3 Due diligence in any type of transaction is the responsibility of the 4 investor’s management team. While authority to make decisions may be 5 delegated and shared with independent financial professionals, the 6 investor must assume ultimate responsibility for the transaction, because 7 the investor is responsible for funding the transaction, thus bearing the 8 highest risk of loss. In other words, responsibility for financial due dili- 9 gence cannot be shifted wholesale to third-party professionals. 10 The form of the investment affects how due diligence is performed. If 11 the transaction is structured as an asset purchase, the level and scope of 12 the procedures will vary from those found in the share purchase, because 13 the risks assumed in the asset investment or acquisition relate only to the 14 known items. In a share acquisition, the investor assumes all of the risks, 15 for both disclosed and undisclosed assets and liabilities. 16 Asset purchases. For an acquisition of assets and liabilities, the reli- 17 ability of the numbers relates only to the information applicable to the 18 assets acquired and liabilities assumed. Unlike the purchase of shares, the 19 purchase of assets and liabilities restricts financial due diligence to the 20 information applicable to the selected items. 21 Verifying the information applicable to selected assets and liabilities is 22 simpler and much more direct than in the case of a share purchase. 23 Depending on the type of assets and liabilities being acquired, the prin- 24 cipal procedures should include the following, which are not necessarily 25 presented in order of importance: 26 1 The acquisition team should clearly identify the assets to be 27 acquired and liabilities to be assumed and determine the extent of the 28 due diligence procedures to be performed. 29 2 The due diligence team’s procedures should be adjusted to avoid 30 duplicating efforts. 31 3 The accuracy of information should be verified through the fol- 32 lowing: 33 t Physical observation of the assets, such as physical cash counts, 34 observation and counts of investment securities, physical counts of 35 inventory, and physical observation of property and equipment. For 36 example, in performing physical inspections of existing inventories, the 37 inventory should be stratified to understand the composition of the FINANCIAL AND ACCOUNTING DUE DILIGENCE 107 items. Valuable items should be identified, and more sample items from 1 the higher-priced categories should be selected. Minimal counts should 2 be made of the less-valuable items. Any missing items in the higher- 3 priced categories should be extrapolated to the total inventory to deter- 4 mine the potential error and possible adjustment to be recorded. 5 t Confirmation of the existence of assets held by other parties. 6 t Review of documents from third parties providing evidence of the 7 existence of the assets, such as bank statements, safekeeping statements, 8 broker advice, warehouse receipts, shipping documents, and similar 9 third-party-generated documents. 10 t Review of work done by other professionals, including the target’s 11 independent certified public accountants, applicable to the assets 12 acquired. 13 t Examination of communications from applicable regulatory agen- 14 cies to ensure that all relevant issues are analyzed and pursued. 15 t Review of documentation supplied by the target, including board 16 and board committee meeting minutes, paying particular attention to 17 the approval of significant purchases and investments in major asset cat- 18 egories. 19 4 For liabilities assumed, procedures similar to those performed for 20 the purchase of assets should be considered, including the following: 21 t Confirm outstanding payable balances directly with vendors and 22 other providers and suppliers. 23 t Perform a search for unrecorded liabilities, including a review of the 24 payments made subsequent to the cutoff date, evaluation of adequacy of 25 accruals recorded as of the cutoff date, and inquiries of senior manage- 26 ment about the existence of unpaid or unrecorded invoices. 27 t Review minutes of the meetings of the board of directors and its 28 committees to evaluate the existence of major purchase commitments, 29 legal contingencies, or other regulatory issues. 30 t Contact the target’s outside legal counsel to determine if any con- 31 tingencies or unasserted claims exist, and in particular review all lawyer 32 representation letters relating to existing or threatened litigation. 33 t Review the target’s income tax returns and communications from 34 the relevant regulatory agencies to determine if any unrecorded income 35 or other tax liabilities exist. In this procedure, the acquisition team may 36 elect to contact the target’s existing independent accountants or other 37 108 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 professionals and inquire about the target’s compliance with existing 2 laws and regulations. 3 5 Evaluate the results of the procedures performed and coordinate 4 with other members of the due diligence team to ensure that the find- 5 ings are evaluated thoroughly and consistently to minimize the possibil- 6 ity of duplicate efforts. Any and all issues noted should be investigated 7 and resolved. (Consideration should be given to performing certain pro- 8 cedures summarized below under the section entitled Share purchases 9 as well.) 10 Share purchases. The due diligence procedures applicable to share 11 purchases include all of those described above for the purchase of assets 12 and liabilities, as well as the following: 13 t Obtain a list of the financial reports produced by the management 14 and systems of the target. 15 t Obtain copies of any financial analytical summaries and trend 16 analyses prepared for internal use. 17 t Review the information presented and prepare summaries, paying 18 specific attention to the consistency of the information provided. For 19 example, an increase in inventory with a decrease in sales should pro- 20 voke questions about whether the recorded value of the inventory is 21 realizable and about the target’s customer base, marketing efforts, and 22 product mix. 23 t Consult with the tax and legal due diligence teams to ensure that 24 all of the required corporate and tax filings have been made. Using this 25 information, perform whatever procedures may be needed to determine 26 whether any contingent liabilities or exposures exist. 27 t Circulate confirmation requests with the target’s lawyers to deter- 28 mine whether any asserted or unasserted claims exist. Using the results 29 of the confirmations, determine the reasonableness of the litigation 30 accruals recorded by target management. 31 t Consult with other professionals as needed to determine whether 32 any actuarial liabilities on pension and profit-sharing and other benefit 33 programs exist that have not been recorded by the target company. 34 t If any groups of employees are represented by unions, review the 35 status of labor contracts to determine the need for any additional labor 36 cost accruals. Discuss with the appropriate management team members 37 the company’s intentions relating to renewal of the labor agreements. FINANCIAL AND ACCOUNTING DUE DILIGENCE 109

t Discuss the existence of any stock options or grants with senior 1 management, and determine the financial and accounting ramifications. 2 The amount of due diligence work to be done in a share acquisition 3 or investment obviously depends on the circumstances. The due dili- 4 gence team, in conjunction with the investor’s management team, must 5 decide on issues such as timing of the transaction, level of risk to be 6 assumed, and the detail of work to be performed. Prioritizing the objec- 7 tives is critical to the success of the work to be performed. At times, due 8 diligence teams may become too involved with the details without eval- 9 uating the “big-picture” issues. An effective investor team will identify 10 major risk areas and direct its efforts to such areas. Real-world time con- 11 straints may require that the work be done quickly and that certain non- 12 material areas not be tested at all. 13 14 Inbound Transactions 15 Inbound transactions (between a non-U.S. investor and a U.S. target) 16 are often complicated by the differences in disclosure practices. In one 17 sense, inbound transactions may be simpler to complete because of the 18 full disclosure characteristics of U.S. financial and legal practices and the 19 frequency with which American companies engage in cross-border deals. 20 Conversely, the need to jump through greater regulatory hoops in the 21 United States (such as environmental scrutiny and Securities and 22 Exchange Commission clearance) than in some other places or to docu- 23 ment that process more fully may sometimes make such transactions 24 more complex and time-consuming than in an outbound deal. Non-U.S. 25 investors from limited-disclosure countries may balk at doing transac- 26 tions in full-disclosure countries like the United States. 27 As explained earlier, most experts consider the reliability and avail- 28 ability of financial information in the United States to be better than in 29 other countries. However, inbound investors should not be overly con- 30 fident and should exercise healthy levels of professional skepticism. The 31 procedures to be performed in any transaction should consider the tar- 32 get’s internal controls system and other factors affecting its operations. 33 Under no circumstances should “complete the checklist” due dili- 34 gence be a substitute for old-fashioned common sense and good judg- 35 ment. This is especially important in outbound deals (between a U.S. 36 investor and a non-U.S. target), as discussed in the sections that follow. 37 110 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Outbound Transactions in Developed Countries 3 Financial due diligence for outbound transactions in developed coun- 4 tries is similar to that for inbound transactions, as described above. 5 Developed countries’ financial and economic systems are often as 6 sophisticated as the systems in the United States. The levels of human 7 and capital resources are similar to those found in the United States. 8 Accordingly, the due diligence procedures to be performed to test the 9 reliability, accuracy, and completeness of the financial information are 10 often similar to those performed for inbound transactions. However, 11 differences exist between generally accepted accounting principles 12 (GAAP) in the United States and GAAP in other countries. To illustrate 13 this point and demonstrate the need to understand the sometimes 14 marked differences in outcome between U.S. and non-U.S. approach- 15 es, here is an outline of certain major differences between U.S. and 16 Colombian GAAP: 17 18 19 ASSET REAPPRAISALS 20 Colombian GAAP. Reappraisals of property, plant, equipment, and 21 investments are made periodically and recorded in compensation 22 accounts, which are shown in the asset caption “Asset reappraisals” and 23 in the stockholders’ equity caption “Surplus from reappraisals of assets.” 24 The asset reappraisal for property, plant, and equipment is determined on 25 the basis of the difference between appraisals of such assets and infla- 26 tion-adjusted net book values. 27 At the close of each period the inflation-adjusted cost of investments 28 in the equity of subsidiaries must be readjusted to their market or equi- 29 ty value (net book value), either by write-downs charged to income or 30 by reappraisals recorded in the reappraisal accounts. Equity value is 31 determined on the basis of the target’s recent financial statements. 32 Market values are determined on the basis of the average quoted price 33 on the Colombian stock exchanges in the month of the transaction’s 34 closing. 35 36 U.S. GAAP. U.S. GAAP allows no asset reappraisals. 37 FINANCIAL AND ACCOUNTING DUE DILIGENCE 111

BASIC FINANCIAL STATEMENTS 1 2 Colombian GAAP. Until 1993, Colombian GAAP required a statement of 3 changes in financial position as one of the general-purpose financial 4 statements. Beginning on January 1, 1994, the statement of cash flows 5 is required in addition to the statement of changes in financial position. 6 U S. GAAP. Companies must include a statement of cash flows instead of 7 a statement of changes in financial position. The primary disclosure and 8 presentation requirements concerning the statement of cash flows are: 9 —disclosure is focused on cash and cash equivalents; 10 —cash flows must be classified into operating, investing, and financ- 11 ing activities; and 12 —the presentation of cash flow information using the direct 13 method—by major classes of operating cash receipts and disbursements 14 (that is, customers, suppliers, and employees)—is encouraged, but use of 15 the indirect method involving a reconciliation between net income and 16 net operating cash flows is permitted. 17 18 DEFERRED TAXES 19 Colombian GAAP. The effect on income taxes resulting from the recogni- 20 tion of revenues, costs, and expenses for financial accounting in periods 21 different from those recognized for tax accounting is recorded as 22 deferred taxes. In measuring the deferred asset or deferred tax liability, 23 the company must use the “deferred method.” Normally, no deferred 24 taxes are recognized for loss carryforwards. 25 26 U.S. GAAP. The following are the basic principles of accounting for 27 income taxes: 28 —A deferred tax liability or asset is recognized for the estimated future 29 tax effects attributable to temporary differences and carryforwards. 30 —The measurement of current and deferred tax liabilities and assets is 31 based on provisions of existing tax law; the effects of future changes in 32 tax laws or rates are not anticipated, but enacted changes in future tax 33 rates are reflected in tax expense in the period of enactment. 34 —The measurements of deferred tax assets is reduced, if necessary, by 35 the amount of any tax benefits that, based on available evidence, are not 36 expected to be realized. 37 112 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 INFLATION ACCOUNTING 2 Colombian GAAP. Accounting for the effects of inflation has been 3 required and regulated by Colombian law since January 1, 1992. The bal- 4 ances of nonmonetary assets and liabilities, equity, and profit and loss 5 accounts must be adjusted in accordance with changes in the country’s 6 general consumer price index. However, nonmonetary assets and liabili- 7 ties and equity accounts are not adjusted to reflect the effects of inflation 8 prior to January 1, 1992. Also, prior-year financial statements presented 9 for comparative purposes are not restated in terms of the purchasing 10 power of the currency of the latest year presented. 11 12 U.S. GAAP. Financial statements are prepared in accordance with the his- 13 torical cost convention. 14 PENSIONS 15 16 Colombian GAAP. Liability for pensions under Colombian labor law is 17 unfunded and shared with government agencies and with certain pri- 18 vate pension funds. The liability is determined on the basis of annual 19 independent actuarial studies. Amortization of deferred pension costs 20 and payments made to pensioners is charged to income. Companies 21 are liable for separation payments and other benefits to employees 22 under certain conditions specified by labor laws. Companies follow 23 the practice of providing for these indemnities through charges to 24 operations. 25 U S. GAAP. Pension liability is determined based on actuarial studies, 26 including factors such as age, years of service, compensation in the years 27 immediately before retirement, interest rates, mortality, and other factors. 28 The amount reflected in the balance sheet is the net amount of the plan’s 29 assets. 30 31 PRIOR PERIOD ADJUSTMENTS 32 Colombian GAAP. Prior period adjustments are charged to income in 33 the year the adjustment is made. 34 35 U.S. GAAP. Prior period adjustments are charged to the opening balance 36 of retained earnings and excluded from the determination of net income 37 for the current period if they result from the following: FINANCIAL AND ACCOUNTING DUE DILIGENCE 113

—Correction of an error in the financial statements of a prior period, 1 or 2 —Adjustments that result from realization of income tax benefits of 3 pre-acquisition operating loss carryforwards of purchased subsidiaries. 4 Additionally, if financial statements are presented for one of the years 5 being corrected, restated financial statements are required. 6 7 REVENUE RECOGNITION 8 Colombian GAAP. Revenues are recorded on the accrual basis, except 9 that interest income earned by financial institutions is not accrued on 10 commercial loans that are more than six months past due or on consumer 11 loans that are more than three months past due. Interest on such over- 12 due loans is credited to income when collected. 13 14 The Colombian Superintendency of Banking has set specific rules for the 15 valuation of loans by area and risk factors, on the basis of which 16 allowances for loan losses are recorded and updated periodically. 17 U.S. GAAP. Revenues, other than income from trusts and other fiduciary 18 activities, are included in results of operations as they accrue. An 19 allowance for loan losses is provided on the basis of management’s esti- 20 mate of the losses in the loan portfolio, based on historical loan loss 21 experience and evaluations of specific loans. 22 23 Given the differences noted above, which are comparable to differences 24 existing between the United States and other developed countries in 25 Latin America and elsewhere throughout the world, investors should be 26 aware of the effects of the differences and adjust due diligence proce- 27 dures accordingly. Clearly, the complexity of accounting principles and 28 disclosure requirements applied in other countries will present unex- 29 pected challenges and require additional time and resources. Based on 30 the restatement of the target’s financials to U.S. GAAP, an investor may 31 discover a very different company than the one appearing on the face of 32 the target’s originally provided financial statements. 33 34 Outbound Transactions in Emerging Markets 35 Financial due diligence of a target in an emerging market is complicat- 36 ed. One of the critical but often ignored issues is the control major fam- 37 114 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ilies exercise in the economies of emerging-market countries. U.S. 2 investors may encounter difficulties even in hiring professionals, given 3 the real or perceived conflicts of interest between those professionals and 4 the “leading family” clients they often represent. Moreover, certain indi- 5 viduals and families exert significant influence in the conduct of business 6 and the development of the country’s economic and legal systems. In 7 certain Latin American countries, for example, major families control a 8 conglomerate of companies. Accordingly, an investor looking to buy one 9 of the companies in the family’s portfolio may find that legal and 10 accounting professionals, particularly in the larger firms, are engaged in 11 serving that family in numerous roles. The families’ influence on the 12 local economy and on the professionals imposes an additional burden on 13 the investor and its due diligence team. 14 To further complicate matters, leading businesses in many emerging 15 markets are both socially and economically aligned with bankers, suppli- 16 ers, customers, and other parties. Independent verification of balances of 17 financial data and other economic and business information will require 18 extra time and effort to ensure that the information obtained is com- 19 plete, accurate, and not misleading. Without such information, risks 20 multiply exponentially. 21 22 23 Accounting Due Diligence Procedures 24 Experienced practitioners know that accounting is an art and not a sci- 25 ence. Thus, accounting due diligence requires experience, training, and 26 knowledge of basic accounting principles, awareness of a country’s prac- 27 tices and statutory requirements, and a basic understanding of the tax 28 ramifications of the transaction. Critically, those performing due dili- 29 gence must know how the proposed transaction will affect the investor 30 after the deal is closed. For example: 31 Restructurings. From an accounting point of view, a restructuring 32 allows a company to take a one-time charge to operations for expenses 33 directly related to the decision made by management to either abandon 34 or sell a particularly significant area of operations, such as two or three 35 production plants. Although similar to a discontinued operations charge, 36 a restructuring entails continuation of the production and sale of a prod- 37 uct in a given line of business. FINANCIAL AND ACCOUNTING DUE DILIGENCE 115

To illustrate, a shoe manufacturer may have production plants in 1 Poland, Austria, and Germany. The manufacturer decides to close three 2 of the plants in Poland, three in Austria, and four in Germany because the 3 equipment is outdated and because the remaining plants have the neces- 4 sary capacity to produce the volume eliminated by the closure of the ten 5 plants. The shoe manufacturer did not discontinue any operations, but 6 rather will restructure its operations to make them more efficient. Here, 7 all of the costs associated with the closure of the ten plants must be esti- 8 mated and charged to operations in the period when the decision is made. 9 Obviously the restructuring process requires many estimates and 10 assumptions. For example, the company generated an estimate of the sal- 11 vage value of the equipment to be sold at the plants. Once the equip- 12 ment is advertised for sale, the actual market value may be different from 13 the estimated realizable value, requiring adjustments to the restructuring 14 estimate. 15 In other cases, employment laws may change during the restructuring 16 process, requiring the company to pay more as a result of the employ- 17 ment terminations. Such changes in labor laws are common and may also 18 cause adjustments to the original restructuring estimate. The generation 19 of assumptions and estimates is critical to any accounting process. 20 However, the due diligence team should be aware of any restructuring 21 charges that may have occurred in prior years, because the effects of the 22 changes in estimates may affect the results of operations for the current 23 year. If the target’s management team decides to record adjustments, 24 favorable or unfavorable, to the restructuring charges, the results of 25 operations for the period in question may be either overstated or under- 26 stated. 27 The original estimates may have been overly conservative or overly 28 liberal, thus causing effects to be recorded in subsequent periods. The 29 due diligence team should be aware of unusual charges and changes in 30 estimates and investigate their impact thoroughly to establish the rea- 31 sonableness of the original estimates and the adjustments. 32 Investments in closely held companies. Determining the value of 33 closely held companies requires making many estimates. Because quoted 34 market values generally do not exist for closely held companies, the car- 35 rying value recorded by the target may be influenced by the following: 36 t Cash flows generated by the closely held corporation, in which 37 116 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 case an estimate of the value is generated by preparing a discounted cash 2 flow estimate. 3 t Negotiations with potential buyers who have indicated, either 4 orally or in writing, the intent to purchase the company. 5 t Calculation of a value estimate based on other statistical factors, 6 including earnings before interest, taxes, depreciation, and amortization 7 (EBITDA), number of units sold, and other similar factors. 8 Any time that target management prepares value estimates, the due 9 diligence team should question their reasonableness. In the case of close- 10 ly held corporations, the target’s management may have sought to 11 record excessive valuation provisions (accounting cushions) in earlier 12 years to record higher earnings in later years by selling the understated 13 closely held corporations. 14 The due diligence team should look for unusual gains recorded on the 15 sale of assets. Time should be devoted to analyze the impact that such 16 dispositions will have on the target’s future operations. 17 The due diligence team should include third-party professionals from 18 the target’s country, because, as has been noted, regulatory, legal, and 19 accounting practices are, in many instances, likely to differ from those of 20 the investor’s country. For example, the following illustration summarizes 21 the differences in accounting for discontinued operations between differ- 22 ent countries, including International Accounting Standards (IAS) and 23 U.S. GAAP (please note that these accounting policies and requirements 24 are subject to change): 25 26 27 DISCONTINUED OPERATIONS 28 International Accounting Standards. A discontinuing operation is a rela- 29 tively large component of an enterprise, such as a business or geo- 30 graphical segment, that the enterprise, pursuant to a single plan, either 31 is disposing of substantially in its entirety or is terminating through aban- 32 donment or piecemeal sale. Disclosures are required on an initial disclo- 33 sure event and must be made continually until the operation is disposed 34 of and comparative information is no longer reported. 35 Australia. Information relating to discontinued operations must be 36 included in financial reports together with continuing operations. 37 FINANCIAL AND ACCOUNTING DUE DILIGENCE 117

Voluntary disclosure may be made of the results and effect of discontin- 1 ued operations. 2 3 Austria. Discontinued operations are considered to be outside of ordinary 4 business activities. Resulting earnings and expenditures should be includ- 5 ed in extraordinary income and expenses. 6 Canada. The results of discontinued operations should be included in net 7 income. Such results should include and separately disclose the results of 8 operations prior to the measurement date, the net gain or loss from dis- 9 continued operations, and any extraordinary gain or loss (each net of 10 applicable income taxes). A net loss should be provided for at the meas- 11 urement date. A net gain should be recognized only when realized. 12 Income taxes applicable to the results of operations prior to the meas- 13 urement date and to the net gain or loss from discontinued operations 14 should each be disclosed separately. 15 16 Denmark. No specific guidelines exist. If the discontinuance of an opera- tion or sale of a subsidiary has a major impact on the group, the effect 17 on assets and liabilities, financial position, and the profit and loss account 18 is generally disclosed in the note. 19 20 France. No specific disclosure is required. 21 Germany. Provisions should be made for losses and closure costs. Gains and 22 losses due to the disposal usually represent extraordinary income or expens- 23 es, if material. Discontinued operations should be disclosed in the notes. 24 25 Italy. No specific disclosure is required. 26 Japan. No specific guidelines exist. Generally, gains or losses incurred by 27 disposal of discontinued operations are presented as extraordinary items 28 in the income statement. 29 30 Mexico. Once a formal plan to sell or abandon a segment of a business 31 has been adopted, the related identifiable assets and liabilities should be 32 adjusted to their net realizable value, taking into consideration the cost 33 of separation of related personnel. 34 The Netherlands. Discontinued operations generally lead to a devalua- 35 tion of the assets involved. An adjustment to a lower net realizable value 36 should be applied if the asset is no longer to be used in the business and 37 118 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 to a lower recoverable amount if the asset continues to be used in other 2 operations of the company. Discontinued operations also can give rise to 3 the formation of a provision. This provision relates to liabilities of uncer- 4 tain magnitude that will come to bear on the legal entity in connection 5 with winding up activities and reorganization of the company. 6 Norway. Revenue and expenses from discontinued and discontinuing 7 operations may, under certain circumstances, be presented separately in 8 the income statement in a parallel presentation or as “other items.” 9 Reporting entities should prepare pro forma figures for turnover and 10 operating profit from current and prior periods. In accordance with gen- 11 eral accounting principles, a provision for expected operating losses and 12 closure costs should be made. 13 14 South Africa. Turnover and operating profit arising from discontinued 15 operations must be shown separately on the face of the income state- 16 ment. Cost of sales, gross profit, and other operating expenses arising 17 from discontinued operations can be disclosed in the notes. 18 Spain. No specific guidelines exist. Discontinued operations must be dis- 19 closed in the notes to financial statements and any impairment of value 20 recognized as an expense of the period. 21 22 Sweden. Results from discontinued operations should be included as part 23 of the profit or loss from ordinary activities in the income statement. 24 Provision should be made for losses and closure costs. 25 Switzerland. In consolidated financial statements only, changes in the 26 scope of consolidation from the prior year, as well as the date of the 27 applicability of the changes, should be disclosed in the notes. 28 United Kingdom. Turnover and operating profit arising from discontin- 29 ued operations must be shown separately on the face of the profit and 30 loss account. Cost of sales, gross profit, and other operating expenses 31 arising from discontinued operations can be disclosed in the notes rather 32 than on the face of the profit and loss account. Prior-year comparatives 33 should be restated accordingly. 34 35 United States. Discontinued operations must qualify as a business seg- 36 ment (separate major line of business or class of customers), where dis- 37 posal is expected within one year. This excludes disposals of product lines FINANCIAL AND ACCOUNTING DUE DILIGENCE 119

and restructurings of operations, for which specific loss recognition rules 1 apply. Expected loss on disposal is recorded at measurement date; expect- 2 ed gain is recognized only when realized. Results of operations and gain 3 or loss on disposal should be reported separately in the income state- 4 ment, net of tax, after continuing operations but before extraordinary 5 items. Previous income statements should be reclassified to conform. 6 7 It bears repeating that accounting is an art and not a science. Ac- 8 cordingly, due diligence yields no guarantees. At best, due diligence pro- 9 cedures will identify areas of risk and opportunity in the target, and the 10 investor will weigh these and other factors to arrive at a “go/no go” 11 decision. The accounting due diligence process is influenced and affect- 12 ed by numerous factors, as discussed below. 13 14 Integrity and Qualifications of Company Personnel, 15 Their Practices, and Ethical Standards 16 No due diligence can completely uncover the sophisticated manipulation 17 of financial data by the target company’s management. At best, the tar- 18 get’s reputation in its community, media coverage of the target, and the 19 target’s relationship with local regulatory authorities will create an infor- 20 mational database. These kinds of data together with more obvious evi- 21 dence of problems, such as existing litigation and lack of compliance 22 with contractual obligations, begin to provide comfort or dismay to the 23 prospective investor. 24 The backgrounds of all senior and middle managers and of the board 25 of directors should be researched and evaluated by requesting personal 26 background investigations for each of the members of the target’s man- 27 agement team, including criminal investigations. Surprisingly, in a num- 28 ber of cases, managers may have criminal backgrounds, have violated 29 securities laws, or have pleaded guilty in criminal cases—suggesting that 30 these individuals may have a propensity to “cook the books.” Most inter- 31 national accounting firms will consider resigning from an assignment 32 should such factors surface during the due diligence process. 33 If it seems that target management is not trustworthy, it is likely that 34 the investment effort will need to be aborted. Accounting information is 35 highly susceptible to manipulation and unethical practices, so the due dili- 36 gence team should be alert to the possibilities for fraud and deception. 37 120 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Minimizing employee turnover and disruption should be a major goal 2 of the investing company’s due diligence effort. Good employees of the 3 target should be identified and assured that their efforts in facilitating 4 the due diligence process will be recognized and rewarded. The identifi- 5 cation of good employees is generally accomplished during the perform- 6 ance of due diligence by evaluating the accuracy and completeness of the 7 information prepared by those employees. Supervisory relationships also 8 should be evaluated to determine whether the data are reliable and accu- 9 rate. Rewards for the employees to be retained typically take the form of 10 performance bonuses and stock options. Continued employment of the 11 target’s key employees will often be a major factor in the success of the 12 proposed transaction, and their departure could be a major contributing 13 factor to its failure. 14 In a number of European and Latin American countries, the costs of 15 terminating employees may be substantial. Accordingly, the investor may 16 want to take such costs and expenses into consideration in determining 17 the total cost of the proposed investment. 18 The goal of retaining target employees should not overshadow a thor- 19 ough evaluation of all of the employees and officers to ensure that the 20 accounting standards applied are reasonable and appropriate. In countries 21 whose governments have historically controlled companies in certain 22 industries, those so-called national champions tend to be bureaucratic 23 and inefficient. Once the privatization of such a company has occurred, 24 the termination of redundant employees often becomes an overwhelm- 25 ing task. For example, before the privatization of Yacimientos 26 Petroliferos Fiscales (YPF) in Argentina in 1991, the company employed 27 52,000 employees. By 1995, the number of employees had been 28 reduced to 5,800, an 89 percent reduction. Before the privatization, 29 YPF, a petroleum company, owned supermarkets, movie houses, clubs, 30 and even churches. Though painful, the privatization process resulted in 31 a leaner and much more efficient company. YPF’s profitability increased 32 dramatically. The restructuring of the operations and reductions in 33 employee levels were critical to the success of the investment. 34 35 Relationship with Independent Certified Public Accountants 36 The relationship the target may have with its independent certified pub- 37 lic accountants should be indicative of the quality and reasonableness of FINANCIAL AND ACCOUNTING DUE DILIGENCE 121 its financial statements. Clearly, where the target has used the same 1 accounting firm for years and the relationship is positive, results are like- 2 ly to be more defensible than if the relationship with the accounting firm 3 is negative or adversarial. 4 The investor team should evaluate the closeness of the independent 5 certified public accounting firm with the target and the impact of the tar- 6 get’s fees on the overall billings of the firm. Although remote, the pos- 7 sibility exists that the target’s senior management may be able to influ- 8 ence the decisions of the firm’s representatives. 9 For U.S. public companies with shares or debt securities registered 10 with the Securities and Exchange Commission (SEC), the independent 11 certified public accountants and management must write to the SEC and 12 explain whether there were any disagreements relating to accounting 13 issues. The due diligence team should be able to obtain copies of any 14 such letters from the target’s management. 15 The due diligence team should organize private meetings with the tar- 16 get’s independent auditors to discuss issues, including the following: 17 t Adherence to independence rules. Ask how material the target 18 client is to the overall practice of the accounting firm. 19 t Relationship with the management of the target. Are there 20 any disagreements relating to the application of accounting principles? 21 Were there any limitations on the scope or imposed restrictions on the 22 procedures to be performed during the audit? 23 t Overall level of fees. Are there any concerns over the fee nego- 24 tiation process and the collection of fees? 25 t Rotation of accounting firm personnel. How long has the audit 26 partner assigned to the engagement served the target client? 27 t Access to the audit working papers. The due diligence team 28 should obtain access to the working papers and read the most significant 29 working papers prepared by the independent accountants. The due dili- 30 gence team should also ask for access to other important files, particu- 31 larly those concerning tax matters. 32 t Principal accounting issues. Identification of the principal 33 accounting issues should assist the due diligence team in focusing its 34 efforts on the highest risk areas. The principal accounting issues should 35 be analyzed to understand the effect that specific accounting issues may 36 have on the target’s financial statements. 37 122 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t Opinion shopping. Ask questions relating to the possibility that 2 target senior management may have solicited the opinion of other 3 accounting firms on specific issues. 4 t Recommendations for internal control improvements. Read 5 the independent accountant’s letters to management. Discuss any con- 6 cerns over the gathering, preparation, review, and approval of account- 7 ing information. 8 t Accounting adjustments. The suggestion of accounting adjust- 9 ments is a sensitive area. Ask the target’s independent auditors to provide 10 details concerning any adjustments suggested by target management. 11 Analyze any unexplained adjustments carefully. 12 Depending on the credentials of the target’s independent accounting 13 firm, if the timing of due diligence procedures coincides with the com- 14 pletion of the target’s annual audit, consider hiring the target’s account- 15 ants to execute certain due diligence procedures. The investor’s account- 16 ants should accompany target management in monitoring and coordi- 17 nating the work of those auditors. 18 19 Considerations in Evaluating Key Accounting Issues 20 Research and development expenditures. A target’s commit- 21 ment to improving the quality of its products through research and 22 development (R&D) should serve as an indicator of the focus and goals 23 of that company. If R&D expenditures are not material, the due dili- 24 gence team should determine whether the lack of financial commitment 25 to such an important area should be evaluated. 26 If the target is involved in significant research and development, the 27 due diligence team should focus on the likely success of the program 28 and the direction in which such efforts are headed. A successful R&D 29 program shows the target’s commitment to future growth and expan- 30 sion. In the United States, GAAP prohibits the deferral of R&D costs; 31 all such costs must be expensed. Accordingly, question any capitalized 32 R&D costs and consider proposing them as one of the adjustments to 33 reduce the target’s net book value—and potentially the target’s acqui- 34 sition cost. 35 Accounting for income taxes. Chapter 6 addresses the due dili- 36 gence procedures to be performed in connection with income taxes. 37 Suffice to say, however, that income tax provisions and accruals should FINANCIAL AND ACCOUNTING DUE DILIGENCE 123 be evaluated carefully. Timely discussions should be held with the appro- 1 priate tax personnel to ensure that no issues are overlooked. 2 Going concern considerations. Going concern considerations 3 apply to both domestic and cross-border transactions. Financial state- 4 ments are generally prepared on the assumption that the company will 5 continue as a going concern. But other assumptions may be appropriate, 6 such as the liquidation method, where assets and liabilities are stated at 7 their estimated liquidation value. The going concern concept assumes 8 that the business will continue for at least one year from the date of the 9 auditor’s report on the company’s financial statements. If target man- 10 agement and its accountants conclude that the business will not be in 11 operation for at least one more year, adjustments must be made to the 12 carrying value of assets and liabilities by adjusting them to their estimat- 13 ed net realizable value, which generally approximates liquidation value. 14 The due diligence team should determine if the target is experiencing 15 financial difficulties. The following is a partial list of factors the investor 16 team should consider in this context: 17 t Continued losses from operations 18 t Inability to generate positive cash flows 19 t Excessive levels of inventory, combined with decreasing sales and 20 increases in uncollectible accounts receivable 21 t Negative current ratio (current liabilities exceeding current assets) 22 t Inability to meet debt covenant requirements 23 t Delays in the issuance of audited financial statements caused by the 24 uncertainty of the realization of major transactions, such as material sales 25 of assets 26 t Disagreements with the target’s independent certified public 27 accountants 28 t Unjustified departure or resignation of key target employees and 29 officers 30 t Overdue accounts payable and instances where major suppliers 31 have refused to deliver goods or where cash-on-delivery terms are 32 required 33 t Termination of employees and curtailment of operations 34 t Inadequate capital (shareholders’ equity) levels 35 t Involuntary plant closures or involuntary disposition of assets 36 The existence of any of these factors sends a strong signal that the tar- 37 124 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 get is experiencing financial difficulties, which in turn may require its 2 management to be aggressive in applying accounting principles and 3 reporting the issues faced by the company. The investor team should rec- 4 ognize that the target’s owners may be more willing to accept a lower 5 purchase price to salvage whatever may be possible from their own 6 investment—or may try to inflate the price by neglecting maintenance or 7 by cutting back on R&D or on sales promotion. 8 Employee stock purchase and other employee stock benefit 9 plans. A number of companies issue options to purchase shares and offer 10 grant programs for employees, officers, and directors. These programs 11 generally require that such persons maintain a relationship with the com- 12 pany for a specific period of time. 13 The issuance of the share options or share grants may not require that 14 any entries be recorded on the issuer’s books at the time of the issuance. 15 However, the financial and accounting implications of these awards may 16 be significant to the investor. For example, the share options and grants 17 may include a provision allowing for exercise upon a change in the con- 18 trol of the target. Liberated from the restrictions on their equity partic- 19 ipation, target management may be inclined to leave the company with 20 the investor holding the bag. Due diligence should seek to determine the 21 intentions of such recipients. Consideration should be given to includ- 22 ing new incentives in the employment agreements as part of the deal to 23 ensure that the employees are contractually obligated to stay with the 24 company postdeal. 25 Environmental accounting issues. Environmental issues are receiv- 26 ing increasing attention throughout the world. A target may have sub- 27 stantial, and unrecorded, costs associated with environmental cleanup 28 projects. In many instances, companies may not even be aware of the fact 29 that they have violated the law. For example, if an investor acquires a 30 company in a country whose environmental laws require certain moni- 31 toring controls and procedures and the target has not complied with 32 such requirements, the investor may be liable for the cleanup costs. In 33 other countries, environmental hazards may exist but with minimal 34 restrictions on them. Due diligence should determine likely cleanup 35 costs if new environmental regulations in such countries appear possible. 36 The investor team should consider accounting for environmental 37 cleanup costs in completing the due diligence. If necessary, the investor FINANCIAL AND ACCOUNTING DUE DILIGENCE 125 should hire environmental engineers and other professionals to inspect 1 the target’s plants and other operation sites. 2 Provisions for losses. The preparation of provisions for losses re- 3 quires numerous, significant estimates and assumptions. The target’s 4 management must exercise reasonable judgment in preparing the com- 5 pany’s financial statements and the relevant disclosures. Aggressive 6 managers will record inadequate provisions for losses, which will gener- 7 ate losses after the investor has committed its funds and controls the tar- 8 get. The investor should review the reasonableness of the allowances for 9 losses to determine whether excessive amounts have been recorded, 10 which may result in additional profits to be recognized by the investor 11 in the future. 12 Target management also may have been liberal in recognizing provi- 13 sions for losses for legal and tax contingencies. Accordingly, investor 14 teams should obtain the appropriate professional assistance to determine 15 adequacy of legal and tax accruals. The investor team should recognize 16 that the preparation of estimates is susceptible to target management 17 manipulation. The level of documentation to support the accruals and 18 provisions recorded by the target should serve as a substantial indicator 19 of target management’s intention and approach to the preparation of 20 financial statements. 21 When considering the target’s write-off history, investors should be 22 careful in analyzing the adequacy of the allowance for uncollectible 23 account losses. Often, companies will continue to add provisions to the 24 allowance for losses but will not write off uncollectible accounts, thus 25 distorting the write-off ratios, which generally compare write-off 26 amounts to sales and to accounts receivable balances. 27 Accounting for barter transactions. Barter transactions are gener- 28 ally recorded by determining either the value of the goods or services 29 provided or the value of the goods or services received, whichever is 30 more readily determinable. In cross-border transactions, barter is gener- 31 ally conducted between companies under common control. 32 In industries such as radio and television, airtime is exchanged for 33 goods and services in lieu of cash payments. Barter transactions, if mate- 34 rial, may distort the results of operations and may have an effect on a 35 company’s future operations. Accordingly, the investor team should 36 identify the barter transactions by discussing the existence of such trans- 37 126 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 actions with target management, by reviewing the target’s financial activ- 2 ity with major customers and suppliers, and by evaluating the financial 3 information on barter transactions provided by the target. Other proce- 4 dures, including discussions with the target’s legal counsel and with 5 other professionals, should be considered. 6 Effect of off-book transactions and accounts. In the ordinary 7 course of business, companies enter into transactions that are recorded 8 not on their official financial statements but rather in secondary account- 9 ing records. For instance, in some industries, companies provide services 10 to customers without taking control over assets or liabilities. Thus, banks 11 provide private banking customers with investment and brokerage serv- 12 ices, which are not entered on the bank’s official accounting records. 13 That said, legal and financial responsibility for such services and for the 14 customer relationships still rests with the company providing the services. 15 Financial and accounting due diligence may require inquiry on items 16 not recorded in the target’s financial records. Documentation support- 17 ing the legitimacy of such transactions is a must. Income resulting from 18 such transactions should be tested to ensure that the income recognition 19 is appropriate. Individual transactions should be tested to ensure that the 20 income was recognized over the appropriate period of time. For exam- 21 ple, in cases where the fees charged to a customer are for services to be 22 provided over the course of one year, cash received in payment for such 23 services should be deferred and amortized into income over one year 24 and not recognized at the time of its receipt. 25 Counsel should be consulted to ensure that any potential contingent 26 liabilities resulting from providing these types of services are recorded 27 properly in the target’s accounting records. 28 Related-party transactions. Related-party transactions are those 29 economic activities effected between parties owned or controlled by the 30 same group of companies. Related-party transactions also include eco- 31 nomic activities between companies in which any officer or board mem- 32 ber of one company also occupies a decision-making position in the 33 other company. For example, say the president of a company borrowing 34 money from a bank is also a member of that bank’s board of directors. 35 The bank and the company are deemed related parties because the pres- 36 ident has significant influence over the operations of the company and 37 also influences the actions of the bank’s board of directors. FINANCIAL AND ACCOUNTING DUE DILIGENCE 127

The accounting records of any business are affected by related-party 1 transactions. U.S. GAAP fully applies to related-party transactions. In 2 most countries, generally accepted accounting principles require disclo- 3 sure of related-party transactions, including the terms of the transactions 4 and the effects of such transactions on the company’s financial statements. 5 Identifying related parties is often difficult and frustrating. Target 6 management may own interests in companies doing business with the 7 target and not disclose the existence of such relationships. For example, 8 in emerging-market countries, several companies under the same fami- 9 ly’s control often do business with one another and are not identified as 10 being related. The investor team should identify all such entities by 11 requesting a list of all major customers and suppliers and requesting that 12 the owners, officers, and directors of the customers and suppliers of such 13 companies be identified. This inquiry may be critical to determining 14 whether to proceed with the transaction. There is no substitute for 15 interviewing target management, completing background investigations 16 of major customers and vendors, and performing the other tests of the 17 information described earlier. Related-party transactions should be eval- 18 uated to determine whether the terms of the transactions were the same 19 as those applicable to arm’s-length transactions. Pro forma financials 20 excluding the related-party transactions should be prepared to deter- 21 mine the effect of related-party transactions and the “purified” results of 22 operations. 23 24 Statutory, Regulatory, and Legal Requirements 25 For both inbound and outbound transactions, in certain countries, 26 including the United States, statutory, regulatory, and legal requirements 27 serve to make transparent the presentation, accuracy, and completeness 28 of the financial information companies produce for third parties and 29 shareholders. Similarly, accounting standards are promulgated by gov- 30 ernment agencies, such as the SEC in the United States and the Central 31 Bank in Spain, to ensure that accounting principles are applied consis- 32 tently and correctly. Non-compliance with existing laws and accounting 33 regulations may result in criminal prosecution, civil penalties, or other 34 legal claims, which are generally difficult and expensive to defend. 35 Concerns over such penalties will, in most cases, induce company man- 36 agement to be honest and direct. 37 128 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Tough accounting rules, like the accounting requirements and finan- 2 cial statement disclosure rules enforced by the SEC, will generally 3 improve the reliability of financial information. Professionals and man- 4 agement alike will, as a result of such requirements and under pressure 5 from regulatory agencies, extend additional efforts to comply. The exis- 6 tence of laws, however, provides no assurance of compliance, nor should 7 their existence reduce normal levels of healthy professional skepticism. 8 Conversely, in those countries where transparency does not exist or 9 where regulations do not require much disclosure, the due diligence 10 team should perform additional procedures and tests. Finally, there are 11 countries like the Philippines that have embraced U.S.-style disclosure 12 systems but lack adequate enforcement mechanisms. 13 14 Industry Accepted and Generally Accepted 15 Accounting Principles 16 As non-U.S. companies have adopted U.S. GAAP to register debt or 17 equity securities with the SEC, they’ve suffered material reductions in 18 earnings and shareholders’ equity. As discussed previously, understand- 19 ing the difference in accounting practices and the effects of such differ- 20 ences is essential to successful cross-border due diligence. 21 Application of aggressive accounting principles and practices should 22 serve as an indicator of target management’s intentions and focus. For 23 example, if the target shareholders are considering selling a portion or all 24 of their share ownership, management may be instructed to accelerate 25 the recording of sales, which may or may not have been completed. In 26 such instances, the goods “sold” may not have been shipped by the cut- 27 off date, may have been sold under terms providing for buyback options, 28 or may have been sold on consignment. On the other hand, expenses 29 that should be recorded currently may be capitalized under the assump- 30 tion that such expenditures (such as advertising, salaries, software devel- 31 opment costs, and organization costs) may have future value. The 32 investor team should exercise caution in evaluating the recognition of 33 sales and the deferral of costs and expenses. 34 Conversely, when the target’s management is well known for applying 35 conservative accounting practices, the investor’s due diligence team will 36 recognize that a significant part of the due diligence process has been 37 completed even before any due diligence procedures are applied. When FINANCIAL AND ACCOUNTING DUE DILIGENCE 129 target management is recognized as aggressive, the due diligence should 1 be increased to reduce the risk of not identifying potential accounting 2 issues and differences with the investor’s accounting treatment of similar 3 accounts. As noted earlier, if revenues are determined to have been rec- 4 ognized prematurely, the due diligence team should consider performing 5 the following procedures: 6 t Review sales documents to determine whether customers ordered 7 the goods shipped and the dates of the orders as compared to the ship- 8 ping dates. 9 t Evaluate shipping documents prepared by different company per- 10 sonnel and by third parties to ensure that the information is consistent 11 with the information recorded in the accounting records. 12 t Confirm the existence of receivables directly with the customers 13 receiving the goods and request that any arrangements be described in 14 the confirmation responses. Efforts should be made to make direct con- 15 tact with the customers to discuss major transactions. 16 t Identify any returned goods subsequent to the cutoff date. 17 Research the target’s policies and procedures for issuing credit memos. 18 t Review the aging of the inventory and determine whether any 19 obsolete or excess inventory exists. Pay particular attention to the goods 20 shipped on or just before the cutoff date to determine whether the sold 21 goods were shipped before the cutoff date and whether they were obso- 22 lete or excess inventory goods. 23 24 Industry Practices 25 Certain industries are aggressive in the financial reporting of their oper- 26 ations. For example, in the financial services industry, the value of a com- 27 pany may vary significantly as a result of factors external to the compa- 28 ny’s operations. A decrease in the prime rate, negative information 29 released in labor statistics, and a decline in the economic outlook for a 30 given country may have uncontrollable effects on the company’s value 31 and must be monitored to minimize such effects. 32 To illustrate, assume an investor is planning to buy a bank operating 33 in a stable economic environment. Economic conditions, however, wors- 34 en as unemployment and loan default rates rise in the bank’s geographic 35 area. Although the target bank’s loan portfolio is performing as expect- 36 ed, the due diligence team understands that, considering the economic 37 130 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 downturn, the allowance for loan losses may not be sufficient. Application 2 of accounting principles may not require the recording of additional loan 3 loss provisions, and the bank’s management may not want to record the 4 additional provisions because they will weaken the bank’s capital position 5 and jeopardize its compliance with regulatory requirements. Given these 6 conditions, the investor may wish to terminate or renegotiate the pro- 7 posed acquisition. 8 In certain industries, the major companies will influence the manner 9 in which information and accounting disclosures are made. Multi- 10 national companies provide benchmarking opportunities for smaller 11 companies in the same industry. The financial statements of smaller com- 12 panies often mimic those of the majors in the field in order to comply 13 with industry standards. Comparing the target’s financial information 14 with that of major companies in the same industry can thus help deter- 15 mine conformity to existing industry practices and ensure that valuable 16 information is not missing. 17 18 Income Tax Laws and Regulations 19 In certain countries, such as Brazil and Mexico, the tax laws are diffi- 20 cult to understand and even more difficult to apply. Not all companies 21 pay their taxes, putting competitive pressure on those seeking to com- 22 ply with existing rules. In certain countries, management may main- 23 tain three or four different sets of books to satisfy different purposes. 24 Thus, the “real books” may contain all of the possibly recognizable 25 and taxable revenues, and the “tax books” will not include all of the 26 revenues required to be reported. Other types of books may include 27 the “regulatory books,” in which capital may reflect items not per- 28 mitted to be recorded under GAAP. But the world is changing. 29 Countries like Italy, where tax avoidance and even evasion tradition- 30 ally were rampant, are trying to modify the existing tax structure to 31 ensure that taxes are applied equally to all taxpayers and that compli- 32 ance is strictly enforced. 33 Investors should identify which set of accounting books is being pro- 34 vided to its due diligence team. The other books may include informa- 35 tion relevant to the due diligence team, therefore, all books should be 36 examined. Target company managers should be questioned about the 37 reasons for keeping different sets of books. From time to time, account- FINANCIAL AND ACCOUNTING DUE DILIGENCE 131 ing adjustments will be required as a result of comparing and analyzing 1 results from different sets of books. 2 The investor team should also look for tax avoidance strategies in 3 cross-border transactions. For example, a target may have established 4 royalty arrangements with affiliates to transfer income from a heavily 5 taxed jurisdiction to another with lower tax rates, thereby reducing con- 6 solidated company taxes. Other arrangements include manufacturing 7 goods in a high-tax country and recording sales in a lower-rate jurisdic- 8 tion. All of these strategies, even if legally permissible, should be ana- 9 lyzed to determine their effect on the investor once the transaction is 10 closed, especially if such strategies are not available to the investor. Tax 11 authorities may challenge these and other income tax reduction strate- 12 gies, thus exposing the investor to potentially serious future tax liabili- 13 ties. (For further discussion of these tax issues, see Chapter 6.) 14 15 Data Processing Systems 16 In cliches, one may find wisdom. For instance, the cliche “Garbage in— 17 garbage out” is true. Old, inadequate financial information systems will 18 cause due diligence problems for the investor team. For example, in a 19 bank acquisition, the ability to identify all loans to one borrower is crit- 20 ical in measuring the exposure the target bank may have to a single bor- 21 rower. If the bank’s systems do not produce reports summarizing the 22 loans to one borrower, the amount of time and effort required by the 23 investor team may be both excessive and insufficient. As a result, evalu- 24 ating the adequacy of the provision for loan losses will be an almost 25 impossible task. Manual schedules and analysis will have to be prepared 26 from available reports, summarizing and testing all of the information. 27 The information contained in all data processing systems must be tested 28 and corroborated with credible evidence for the investor team to be able 29 to rely on such information. 30 Data processing systems are only as good as the personnel inputting 31 the information, the controls over the systems, environmental safeguards, 32 and technical adequacy. If the target’s personnel are not adequately 33 trained or lack the necessary skills to input data, the due diligence team 34 must review and test the information produced by the target’s systems. 35 Old or obsolete systems may be not only impractical but also expen- 36 sive to manage and control. State-of-the-art systems and controls will be 37 132 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 useful in establishing the integrity of the financial and corporate account- 2 ing information gathering process. 3 Depending on the level of sophistication of the target’s data process- 4 ing systems, the investor’s team may want to hire experts to assist in the 5 evaluations of the hardware, software, and control environment. 6 Employees should be interviewed and observed to determine whether 7 the systems work as described and in accordance with the target’s estab- 8 lished policies and procedures. 9 The sophistication of the target’s data processing systems will be 10 affected by the economic conditions in the target’s country. In devel- 11 oped markets, the procurement of reliable and state-of-the-art systems is 12 much simpler than it is in emerging-market countries. However, the 13 principal factor in whether a company acquires the necessary software 14 and hardware for its corporate needs is directly related to the company’s 15 capital resources. Old and inefficient systems will require future cash 16 outlays from the investor (and should be an element to consider in for- 17 mulating any offer) and indicate that target management either has not 18 paid enough attention to data processing systems or lacked the means to 19 invest in such systems. 20 21 Political Environment in the Target’s Country 22 A country’s political environment affects potential investors’ inclination 23 or disinclination to complete transactions in that country. For example, 24 in a country plagued by dictatorships, civil wars, corruption, and other 25 adversities, investors will not be eager to invest capital. In other coun- 26 tries where fiscal or economic direction is absent, investors will avoid 27 making capital investments unless the rates of return are much higher 28 than in other locations. 29 Changes in the political environment in a country may prompt unex- 30 pected requirements to record additional loss provisions. Changes in the 31 political environment may generate new laws and regulations that must 32 be reflected in the target’s books and records. This is particularly true in 33 highly regulated industries like banking, petroleum, health care, and 34 transportation. For example, in dictatorships around the world, auto- 35 cratic leaders have been known to change the requirements on 36 allowances for loan losses for banks and other types of financial institu- 37 tions and for pension and labor costs. New or unanticipated changes in FINANCIAL AND ACCOUNTING DUE DILIGENCE 133 the law can result in unexpected losses and increased costs. The account- 1 ing for such changes should be thought through in advance, calculated, 2 and recorded as required. 3 In other instances, labor laws have been changed without consider- 4 ing the economic effects of such changes. For example, imposing re- 5 quirements that employees not be terminated will frustrate the plans of 6 companies trying to streamline operations. In a number of countries, 7 investments are high-risk propositions, and investors must be aware of 8 the implications flowing from the direction a new government may be 9 taking from its proposed new laws. As is the case in any domestic or for- 10 eign jurisdiction, effective relationships with government officials will 11 facilitate the due diligence process. 12 The target’s accounting systems may have to be modified to reflect 13 changes in regulatory requirements. The due diligence team should be 14 aware of such modifications and determine whether the required 15 changes have been effected properly, whether the information produced 16 is accurate, and whether the accounting applications are reasonable. If 17 not, and the consequences diminish value, the deal may need either to 18 be renegotiated with contingent payments, like milestone payments or 19 earn-outs, or simply to be abandoned. 20 In most countries, foreign companies with money to invest will be 21 welcomed guests. Capitalism works because of the incentives created by 22 the investment of capital. Due diligence is one of the tools used to 23 enhance the potential success of an investment. However, the vision, 24 imagination, creativity, and strategic direction required to make a deal 25 profitable depend on the experience and knowledge of the investor’s 26 team. Even in the worst economic and political conditions, investors will 27 find opportunities for profitable transactions. 28 29 30 31 32 33 34 35 36 37 CHECKLIST 1 Cross-Border Financial and Accounting 2 3 Due Diligence 4 5 IN AN IDEAL WORLD, target companies would be able to supply all or sub- 6 stantially all of the information set forth below. In the real world, targets may 7 have only a portion of the information sought. Targets in non-U.S. jurisdictions, 8 particularly in emerging-market countries, may not be able to provide all of the 9 requested information. But the investor goes forward at its peril without reasonable compliance regarding the data described in the checklist below. 10 11 12 DOCUMENTS TO BE REQUESTED FROM TARGET COMPANY 13 14 General Corporate Matters 15 1. Certificate or articles of incorporation and bylaws, as amended to 16 date, of the company and its subsidiaries. ❏ 17 2. Minutes of meetings (or written consents) of the company’s 18 shareholders and board of directors and any committees of the ❏ 19 board of directors. 20 3. List of all jurisdictions, domestic or foreign, in which the compa- ny or any affiliate is qualified to do business or has significant 21 operations or properties, and descriptions of operations in such 22 places. ❏ 23 4. History of the company’s formation and development. Detailed 24 organizational chart of the company and all of its affiliates. ❏ 25 5. Minutes of meetings (or written consents) of the shareholders, 26 board of directors, and any committees of the board of directors 27 of each subsidiary of the company. ❏ 28 6. List of officers and directors of the company and each of its sub- 29 sidiaries or affiliates. ❏ 30 7. List of option holders, warrant holders, and holders of securities 31 convertible into capital stock of the company and its subsidiaries ❏ 32 or affiliates. 33 8. All pre-incorporation, security holder, subscription or registration rights agreements, voting agreements, outstanding proxies, and 34 other agreements regarding the voting, ownership, or other 35 aspects of the company’s securities or management to which any 36 shareholder, the company, or any of its subsidiaries or affiliates is 37 a party. ❏

134 FINANCIAL AND ACCOUNTING DUE DILIGENCE 135

9. List of all corporations, partnerships, associations, joint ventures, 1 and other business organizations in which the company owns, 2 directly or indirectly, an interest or any shares of capitalstock. ❏ 3 10. Shareholder, partnership, or similar organizational equity holder 4 list, with names, number, and type of equity interests held by 5 each equity holder. Pay special attention to voting rights or their 6 absence. ❏ 7 11. History of any transactions in any of company’s types of stock 8 securities in the past two years, including documents evidencing 9 transfer of equity interests. ❏ 10 12. Stock book(s) available for examination. ❏ 11 12 Financial Information 13 1. Year-to-date financial statements, with comparison to same period 14 of prior year. ❏ 15 2. For the past three years, all annual and quarterly financial reports 16 and financial statements, including accompanying schedules, of 17 the company and its subsidiaries (balance sheets, income state- 18 ments, statement of cash flows, and reconciliation of retained 19 earnings). If available, include financial reporting (revenues and 20 costs) by line of business and revenues from top ten major 21 accounts. ❏ 22 3. Current trial balance and other significant financial statements 23 and internal financial reports of the company and its affiliates. ❏ 24 4. List of bank accounts, including bank type or account, account 25 number, and authorized signatories. Obtain copies of bank rec- 26 onciliations for review for all accounts for the last two months 27 and each quarter for the last two calendar years. ❏ 28 5. Bank statements for the last month of the fiscal year-end and of 29 the prior year and all months of the current year. ❏ 30 6. Summary of major accounting policies, noting any that may be 31 controversial or different from the investor country’s generally 32 accepted accounting principles (GAAP) or that may not be in 33 accordance with generally accepted industry practices. Listing of 34 accounting methods elections, particularly significant estimates 35 (e.g., accruals, valuation methods, and depreciation). ❏ 36 7. All auditors’ and independent certified public accountants’ let- 37 ters and opinions for the company and its affiliates. Obtain audi- 38 tors’ reports to management concerning internal accounting 39 controls and procedures and other matters and any management 40 136 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 responses thereto, and internal memoranda (particularly internal 2 audit or regulatory compliance memoranda) concerning the 3 company or its affiliates. ❏ 4 8. Financial projections, if any, for the remainder of the current year 5 and next year, including assumptions. Include full-year detailed 6 income statement by month, end-of-year estimated pro forma 7 balance sheet and cash flow forecast, budget for the current 8 year, and comparison of actual versus budget year to date for the 9 current year. ❏ 10 9. Identification and description of all contingent liabilities not re- 11 flected on the company’s financial statements, established mone- 12 tary provisions, allowances and reserves, and disagreements with 13 company’s outside auditors concerning the company’s finan- 14 cial reporting during the preceding two years. ❏ 15 10. Copies of letters to management relating to the potential 16 improvement of the company’s internal control systems together 17 with any reports, letters, or correspondence prepared by accoun- 18 tants of the company or any subsidiaries or partnership. ❏ 19 11. Copies of all tax filings and returns (including shareholder, cor- 20 porate, or partnership) for the last three years, including income 21 taxes, sales, use, property, employment, and franchise taxes (and 22 any other local taxes). Include copies of any correspondence with 23 tax authorities (other than routine transmittals) and copies of tax- 24 sharing agreements between the company and its subsidiaries or 25 affiliates. ❏ 26 12. Payroll tax reconciliations (two years), reconciling total payroll to 27 the reports submitted to the appropriate payroll tax regulatory 28 agencies. ❏ 29 13. All income tax audit results and any communication (documented 30 or oral) from the government agencies in all jurisdictions that 31 require tax filings. ❏ 32 14. Schedule describing ongoing tax disputes, together with copies 33 of tax authority reports, correspondence, and similar matters, 34 with respect to pending tax proceedings regarding open years or 35 items for the company or any affiliate. ❏ 36 15. Prior year’s tax returns for all companies acquired within the past 37 three years. ❏ 38 16. A schedule of shareholder “due to” and “due from” accounts 39 for the last two years. ❏ 40 17. A listing of any company expenses that may be regarded as per- FINANCIAL AND ACCOUNTING DUE DILIGENCE 137

sonal flowing through the business, which may be characterized 1 as “additional pretax profit add-back items.” ❏ 2 18. A listing of any significant nonrecurring expenses occurring in 3 the past year or current year. ❏ 4 19. A schedule of accounting firms that have represented the com- 5 pany or any of its affiliates in any material matters in the last five 6 years. ❏ 7 20. A schedule with supporting agreements showing cooperative 8 arrangements with suppliers detailing year-to-date payments and 9 remaining payments to be received for the balance of the year. ❏ 10 21. A schedule with supporting agreements showing commission 11 arrangements with top ten suppliers detailing commissions 12 received year to date and estimated commissions to be received 13 for the balance of the year. ❏ 14 22. A schedule showing current accounts receivable, including quality, 15 aging, and special classes thereof. Include current aged account 16 receivables listing. ❏ 17 23. A schedule showing current accounts payable, accrued expenses, 18 and customer deposits. Include current aged accounts payable 19 listing by supplier. ❏ 20 24. A schedule of property, plant, and equipment; depreciation 21 schedules, and amortization schedules. 22 25. Detailed listing of capital investments that will be made during 23 the current fiscal year, especially if not completed as of the date 24 of the company’s most recent financial statements. ❏ 25 26. Reports on the company from any outside consultants, analysts, 26 or others. ❏ 27 27. Description of contingent liabilities arising from any agreements, 28 severance payments for terminated employees, unresolved legal 29 matters, price redetermination or renegotiation, sales subject to 30 warranty or service agreements, product liability, unfunded pen- 31 sion plan liability, antitrust matters, equal opportunity matters, 32 and environmental or other matters. ❏ 33 34 Compliance with Laws 35 1. Documents showing any certification of compliance with or any 36 deficiency with respect to regulatory standards (for example, 37 environmental protection standards) on any of the company’s 38 facilities. ❏ 39 2. Principal licenses, permits, certifications, and authorizations to 40 138 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 carry out the business of the company or its subsidiaries from 2 United States federal, state, or local regulatory or licensing 3 authorities or any non-U.S. federal, provincial, or local regulatory 4 or licensing authorities. ❏ 5 3. Documentation of any investigation of the company by any gov- 6 ernment agency in any country. ❏ 7 4. All communication to and other filings with local, state, federal, 8 and non-U.S. government agencies during the last five years in 9 jurisdictions where assets are located or operations are conduct- 10 ed by the company or any of its affiliates. Any reports, notices, or 11 correspondence relating to any purported violation or infringe- 12 ment by the company or any of its subsidiaries or any partnership 13 and any suspended or revoked government permits or licenses 14 and copies of all other material correspondence with govern- 15 ment agencies. ❏ 16 5. Correspondence of the company or its subsidiaries with the fol- 17 lowing U.S. agencies and their non-U.S. counterparts: 18 t Federal: 19 —Securities and Exchange Commission ❏ 20 —Environmental Protection Agency ❏ 21 —Federal Trade Commission ❏ 22 —Department of Labor ❏ 23 —Department of Health, Education & Welfare ❏ 24 t State: 25 —State Securities Commission ❏ 26 —State Department of Labor ❏ 27 —State Department of Revenue ❏ 28 —State Department of Health ❏ 29 —Secretary of State ❏ 30 t Any other federal, state, local, or foreign government agen- 31 cies of significance to the company’s business or operations. ❏ 32 6. Press releases or articles concerning the company and its affiliates 33 within the past year in newspapers, magazines, and trade/industry 34 publications. ❏ 35 36 Financing Documents 37 1. Any significant debt agreements to which the company or any 38 affiliate is a party, such as trust indentures, term or revolving loan 39 agreements, bank lines of credit, mortgages, promissory notes, 40 significant property or equipment leases, and other similar agree- FINANCIAL AND ACCOUNTING DUE DILIGENCE 139

ments and arrangements, and all guarantees by the company or 1 any subsidiary together with any interest rate cap, hurdle, swap, 2 or other hedging mechanism relating to the foregoing. ❏ 3 2. Summaries of all evidences of compliance with the agreements 4 described in preceding Item 1, and any communications regarding 5 defaults, potential defaults, or waivers of defaults. ❏ 6 3. Documents relating to proposed new indebtedness, including 7 but not limited to term sheets, commitment letters, draft agree- 8 ments, and similar documents. ❏ 9 4. Disclosure documents used in public offerings, sales of control, 10 private placements of securities, industrial development bond 11 financing, or institutional or bank loan applications. ❏ 12 5. Copies of letters of credit, performance guarantees, and bonds. ❏ 13 6. All pledges, security agreements, or other agreements or docu- 14 ments creating or purporting to create liens or other security 15 interest in any assets of the company. ❏ 16 17 Operational Matters and Other Material or Significant Agreements 18 1. List of material suppliers. A supplier is considered to be material 19 to the company if payments to such supplier amounted to or 20 exceeded 5 percent of the company’s gross revenue in any of the 21 last three years, or if the loss of the supplier would result in a 22 material disruption of the company’s business. Provide a list with 23 amount of business with the top ten suppliers for the last three 24 years. ❏ 25 2. Material contracts or agreements concerning business or ser- 26 vices performed for, or materials supplied to, the company or its 27 affiliates. ❏ 28 3. List of material customers. A customer is material if it accounted 29 for 5 percent or more of the company’s revenues in any of the 30 last three years or if loss of the customer would have a material 31 impact on the company’s business or results of operations. 32 Provide the top ten customers for the last three years. ❏ 33 4. Material agreements concerning business or services performed 34 or products supplied by the company or its subsidiaries. Include 35 all contracts, agreements, or other arrangements with airlines, 36 cruise lines, hotels, car rental agencies, ground transportation, or 37 other travel service providers. ❏ 38 5. Marketing information, including advertising, Internet, catalogs, 39 and brochures. Obtain samples. ❏ 40 140 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 6. Any material licensing, royalty, trademark, franchising, joint ven- 2 ture, or partnership agreements to which the company or its 3 affiliates are a party. ❏ 4 7. Summary of insurance policies (casualty, property, liability, errors 5 and omissions, officers and directors, general liability insurance, 6 products liability insurance, workers compensation and environ- 7 mental impairment insurance, and other similar policies and cov- 8 erage) showing coverage, carrier, and premiums for each cover- 9 age. To the extent insurance carriers and coverage have changed 10 during the last five years, identify such changes. Summarize any 11 major claims filed during the last five years. ❏ 12 8. Copies of all insurance policies currently in effect and contact 13 information for insurance agents and brokers. Copies of all poli- 14 cies covering company-owned and personal vehicles used by 15 company personnel. ❏ 16 9. Reports on the company’s claims history (loss experience) with 17 respect to general liability and workers’ compensation. (It may be 18 necessary to contact the insurance companies to obtain these 19 documents.) ❏ 20 10. All agreements or plans for mergers, consolidations, reorganiza- 21 tions, acquisitions, or the purchase or sale of assets involving the 22 company or any affiliate, or agreements in principle or letters of 23 intent, currently in effect, with respect to mergers, consolida- 24 tions, reorganizations, acquisitions, or the purchase or sale of 25 assets involving the company or any affiliate. ❏ 26 11. Marketing agreements, including sales agent, representative, 27 dealer, distributor, consignment, and pricing agreements. If there 28 are numerous agreements entered into in the ordinary course of 29 business, simply provide a sample agreement and schedule of 30 parties and terms. ❏ 31 12. Government contracts and subcontracts. ❏ 32 13. Long-term service contracts, including any future contracts. ❏ 33 14. Management and service agreements. ❏ 34 15. Agreements between the company or any of its affiliates and any 35 director, officer, or management executive or consultant of the 36 company or its affiliates. ❏ 37 16. Any contract or arrangement of the company or any of its sub- 38 sidiaries, that involves payment or receipt in any year of an 39 amount in excess of 5 percent of its earnings or assets. ❏ 40 17. Any waiver or agreement of the company or any of its affiliates FINANCIAL AND ACCOUNTING DUE DILIGENCE 141

canceling claims or rights of substantial value other than in the 1 ordinary course of business, or any document relating to materi- 2 al write-downs or write-offs of notes or accounts receivable 3 other than in the ordinary course of business. ❏ 4 18. Contracts outside the ordinary course of business. ❏ 5 19. Any other material contracts of the company or its subsidiaries/ 6 affiliates. ❏ 7 20. Pricing schedule(s) or commission structures. ❏ 8 21. Policies and procedures for determining contractual adjustments 9 and allowances for bad debts. ❏ 10 11 Environmental Matters 12 1. Previous environmental audits or investigations. Phase I or com- 13 parable environmental studies, assessments, or similar work 14 done by or on behalf of the company or any affiliate. Reports 15 issued by the EPA and/or state and local authorities and their 16 non-U.S. counterparts. Environmental site assessment reports. 17 Reports filed with, significant correspondence with, and tran- 18 scripts of any significant proceedings before any state, federal, or 19 foreign regulatory agency during the past five years, including 20 copies of any state or federal surveys, reviews, or inspections. ❏ 21 2. All environmental permits, licenses, or other government 22 approvals. Pending environmental permit applications or applica- 23 tions for other environmental government authorizations. ❏ 24 3. Agreements (other than financing documents) with provisions 25 relating to environmental conditions or liabilities. These would 26 include representations and warranties, indemnities, escrow 27 agreements, and other similar agreements. ❏ 28 4. All enforcement-related documents or agreements, pending or 29 closed, such as consent decrees, administrative or other orders, 30 notices of violation, and agency correspondence alleging non- 31 compliance or relating to cleanup of sites alleged to contain 32 hazardous materials, government requests for environmental or 33 health and safety studies, and the responses thereto by the 34 company or any affiliate. ❏ 35 5. Insurance policies that cover liability for environmental impair- 36 ment. ❏ 37 6. Documents relating to the existence, monitoring, or insurance of 38 underground storage tanks. ❏ 39 40 142 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 7. Known or suspected environmental problems associated with 2 neighboring or related property. ❏ 3 8. Policies for handling and disposal of hazardous waste. Policies 4 and procedures governing safety and infection control. ❏ 5 9. Copy of any safety manual or right-to-know manual. ❏ 6 7 Properties and Equipment 8 1. List of addresses of properties currently owned or leased by the 9 company and related documentation. Obtain a summary of the 10 office floor plan, facility hours (times and hours per weekday), 11 and revenue generated by each facility. ❏ 12 2. Copies of all deeds or other titles evidencing ownership of the 13 properties owned by the company or a subsidiary/affiliate. ❏ 14 3. For each property owned by the company or affiliate, a copy of 15 the latest owner or leasehold title insurance policy issued, as 16 applicable, and the most recent survey covering such properties. ❏ 17 4. Copies of all leases for use of the real property owned or leased 18 by the company or any affiliate. 19 5. Copies of all mortgages encumbering the properties owned or 20 leased by the company or any affiliate. ❏ 21 6. All equipment and auto leases for a period in excess of two years 22 or that require payments in excess of an immaterial amount 23 annually. ❏ 24 7. List of all automobiles, including title documentation. ❏ 25 8. Plans with respect to any facility closings. ❏ 26 9. Summary of any construction plans for significant new facilities 27 and data on projected construction costs for such facilities and 28 for any facilities currently under construction. ❏ 29 10. Copies of all principal trademarks, licenses, patents, copyrights, 30 websites, toll-free telephone numbers, or trade names of the 31 company or its affiliates, the expiration dates thereof, and any 32 pending applications therefor. ❏ 33 11. Details of recent acquisitions, divestitures, spin-offs, or disposi- 34 tions of assets. ❏ 35 36 Management Information Systems 37 1. Description of core booking and product system (e.g., CRS, front- 38 end, database, developer, year developed, key technologies, key 39 applications, user features or advantages). ❏ 40 2. Description of website (give name) and key features. ❏ FINANCIAL AND ACCOUNTING DUE DILIGENCE 143

3. Call-center telecom information. ❏ 1 4. Technology infrastructure inventory, including all technology 2 infrastructure components (i.e., computer and network hard- 3 ware, operating system software, database management system, 4 and similar items). ❏ 5 5. Telecommunications inventory with details. ❏ 6 6. Information technology (IT) organization 7 t Organization chart of current IT organization, including 8 names, titles, and a brief résumé or background information 9 for each employee. ❏ 10 t IT budget or spending for past three years. ❏ 11 t Copies of any consulting agreements and/or outsource con- 12 tracts, including services that may be provided by hardware 13 procurement providers, hardware/software maintenance ven- 14 dors, or any other MIS service provider. ❏ 15 t Terms, conditions, and time frames for all existing consultant, 16 contractor, and/or outsourcer product or service arrange- 17 ments. ❏ 18 7. IT plans and initiatives 19 t Copy of most current IT strategy or systems plan. ❏ 20 t Copies of work plans, design documents, etc., for all current 21 or planned IT projects and/or initiatives. Include name and type 22 of application or project (e.g., “server replacement project”), 23 project objectives/goals, time frames/work plans, estimated 24 project costs, maintenance/operations overview, etc. ❏ 25 8. Schedule of hardware and all maintenance/repair agreements, 26 copies of all contracts, and itemized list of all equipment covered. ❏ 27 9. Application inventory 28 t Provide a complete inventory of all current (i.e., operational) 29 and planned (i.e., under development) applications software, 30 including the following: 31 —Application name ❏ 32 —Custom-developed or packaged software? ❏ 33 —Vendor name and contact information ❏ 34 —Application age ❏ 35 —Applications environment (language, database, versions, 36 and similar items) ❏ 37 —Cost of purchase/development ❏ 38 —Operating platform/architecture ❏ 39 —Maintenance specifications ❏ 40 144 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Legal Matters 2 1. Pleadings, briefs, and other documents pertaining to any materi- 3 al pending or threatened litigation, arbitration, or investigation 4 before regulatory or administrative bodies, in which the compa- 5 ny or its officers, directors, employees, or agents, as a result of 6 such status or as a result of action taken in such position, are 7 defendants. Summary of current provisions in the company’s 8 financial statements made for estimated liabilities arising out of 9 these matters. ❏ 10 2. Summary of material prior, pending, and threatened claims or 11 litigation. ❏ 12 3. Responses of the company’s outside counsel(s) to audit inquiry 13 letters in connection with the examination of the company’s 14 financial statements for the preceding year, including summaries 15 of litigation, if any. List of law firms used by the company and its 16 subsidiaries for the last five years. ❏ 17 4. Summary of material prior litigation settlements and all consent 18 decrees, judgments, orders, or other settlement agreements to 19 which the company or an affiliate is a party or is bound, requir- 20 ing or prohibiting any future activities. ❏ 21 5. Information about any existing consent decrees or settlement 22 agreements in which the company or an affiliate is not party but 23 which materially affect the conduct of the company’s or any of 24 its affiliates’ businesses. ❏ 25 6. Schedule of fines and penalties incurred by the company or any 26 of its affiliates arising out of the provision of its services, the 27 operation of its facilities or equipment, or the sale of its products. ❏ 28 29 Management and Employees 30 1. Any employment agreements or contracts, bonus or incentive 31 compensation plans, consulting contracts, or medical reimburse- 32 ment, death benefit, deferred compensation, or pension plans or 33 arrangements, including “golden parachute” agreements, sever- 34 ance agreements, and agreements not to compete with the com- 35 pany or any affiliate upon termination of employment. Copies of 36 all Internal Revenue Service (IRS) or its non-U.S. equivalent deter- 37 mination letters, if applicable, summary plan descriptions, and 38 Form 5500s relating to the foregoing. ❏ 39 2. Résumés of key members of management. ❏ 40 FINANCIAL AND ACCOUNTING DUE DILIGENCE 145

3. All labor agreements, collective bargaining agreements, employ- 1 ment agreements, and non-competition agreements. Provide 2 human resource records, including data on prior strikes, actual or 3 threatened. ❏ 4 4. Employee benefit, pension, health, deferred compensation, and 5 profit-sharing plans or programs, and related trusts, if applicable. ❏ 6 5. Share ownership plans, option and share appreciation rights 7 plans, incentive option plans, bonus plans, or similar arrange- 8 ments of the company and its affiliates. ❏ 9 6. A schedule of remuneration for the past and present year of all 10 shareholders, the five most highly compensated officers and 11 employees, and all officers and directors as a group, including 12 salaries, directors fees, commissions, bonuses, deferred compen- 13 sation, insurance benefits, and other fringe benefits. Include a 14 schedule of unpaid bonuses. ❏ 15 7. Summary of ownership of company’s shares by each officer and 16 director of the company, including date and price of shares when 17 acquired. ❏ 18 8. Agreements with management or key personnel other than 19 employment or consulting agreements. ❏ 20 9. Indemnification contracts and similar arrangements for officers 21 and directors. ❏ 22 10. Loans and guarantees to or from shareholders, directors, officers, 23 or employees of the company and its affiliates. All agreements 24 documenting transactions between the company and its 25 officers, directors, or stockholders. ❏ 26 11. Any actuarial reports prepared on existing pension plans. ❏ 27 12. List of all options proposed to be granted, if any, including names 28 and addresses of proposed option holders and number of options 29 to be held by each. Obtain similar information regarding all other 30 forms of share subscription, including names, addresses, and 31 agreements. ❏ 32 13. Copies of personnel policies, personnel manuals, employee 33 handbooks, and affirmative action plans. ❏ 34 14. Records showing the number of employees, by division or busi- 35 ness segment. ❏ 36 15. A schedule showing family relations among shareholders, officers, 37 and directors of the company and its affiliates. ❏ 38 39 40 146 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 INCOME ISSUES TO BE EVALUATED AND CONSIDERED 2 IN PERFORMING THE FINANCIAL AND 3 ACCOUNTING DUE DILIGENCE 4 5 Income Taxes 6 1. Review prior two years’ sales-and-use tax returns, if applicable. ❏ 7 2. Review any pending income tax disputes. ❏ 8 3. Review employment contracts. ❏ 9 4. Review assignable contracts. Analyze the income expected on 10 sales contracts through the date of their termination, and sum- 11 marize contract terminations and transferability. ❏ 12 5. Review any stock option agreements. ❏ 13 6. Review contracts with shareholders and/or related parties. ❏ 14 7. Review copies of all prior asset appraisals. ❏ 15 8. Determine whether corporation has nexus outside the United 16 States. ❏ 17 9. Review subchapter S, LLC, or other election or any non-U.S. 18 counterpart thereof, if applicable. ❏ 19 10. Review history of share ownership and classes of share or other 20 equity interests. ❏ 21 11. Review history of cash or share distributions. Determine whether 22 there are disproportionate distributions. ❏ 23 12. Verify any existing affiliates or related businesses. Are there any 24 tax-sharing agreements? ❏ 25 13. Determine whether S corporation, LLC, or their non-U.S. coun- 26 terparts were previously taxable entities. Assess built-in gains 27 exposure. ❏ 28 14. Document any unnecessary expenses potentially nondeductible 29 pursuant to Internal Revenue Code (IRC) Section 165 or its 30 non-U.S. counterparts. ❏ 31 15. Review documentation of prior spin-off transactions or disposi- 32 tions of business lines. ❏ 33 16. Analyze appropriateness of an IRC Section 338 or 338(h)(10) 34 election for S corporations or C corporations with net operating 35 losses. Provide similar information for non-U.S. entities. ❏ 36 17. Review for any prior amortizable goodwill, if applicable. ❏ 37 18. Verify whether corporation has any tax attribute carryforwards 38 (net operating loss, general business credits, and similar items). ❏ 39 19. Was there a prior IRC Section 382 limitation? If so, was it prop- 40 erly computed? Provide similar information for non-U.S. entities. ❏ FINANCIAL AND ACCOUNTING DUE DILIGENCE 147

20. Quantify IRC Section 382 limitation, if applicable. Provide similar 1 information for non-U.S. entities. ❏ 2 3 Additional State and Local Tax Steps 4 1. Does the company have exposure to any states or their non-U.S. 5 counterparts due to nonfiling of state income tax returns 6 because of aggressive positions toward the nexus issue? ❏ 7 2. Has a review been made of how income taxes are apportioned 8 between the states or their non-U.S. counterparts? Has the 9 apportionment factor been analyzed (i.e., effect of acquisition on 10 property, sales, and payroll factors)? ❏ 11 3. On a going-forward basis, has consideration been given to tech- 12 niques to push debt down to the target group to increase inter- 13 est expense at that level and reduce state income taxes? ❏ 14 4. Has the state income tax liability been analyzed (i.e., considering 15 the changes in state income tax liability as a result of acquisition), 16 including an analysis of nexus in particular states or comparable 17 non-U.S. jurisdictions? ❏ 18 5. If the acquisition is structured as a share purchase with an elec- 19 tion under IRC Section 338 or Section 338(h)(10), will the elec- 20 tion be respected for state and local income tax purposes or 21 comparable non-U.S. jurisdictions? ❏ 22 23 Capital Franchise Tax 24 1. Has the capital structure been reviewed for capital taxes? ❏ 25 2. Has the structure been reviewed for net worth taxes? ❏ 26 27 Excise and Transfer Tax 28 1. For real estate transfer taxes, review jurisdictions in which real 29 estate is located. ❏ 30 2. Has the company’s compliance with the sales and use tax in the 31 applicable states in which it does business been reviewed? ❏ 32 3. Does the company have exposure for sales or use tax on out-of- 33 state purchases of equipment or marketing materials? ❏ 34 4. If the company is claiming an exemption because the buyer of 35 the product is reselling it at retail, is the company obtaining and 36 retaining resale certificates? ❏ 37 5. Has an examination been made of the various states involved to 38 determine whether transfer of assets is subject to state sales or 39 use tax? ❏ 40 148 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 6. Do local tax authorities have requirements for bulk transfers? ❏ 2 7. Have allocations of cost of assets between tangible personal 3 property, intangible personal property, and real property been 4 properly made? ❏ 5 6 Ad Valorem (or Personal Property) Taxes 7 1. Has the company’s position in this area been reviewed? ❏ 8 2. Are there any disputes with local tax authorities over possible 9 major property tax increases? ❏ 10 11 Escheat 12 1. Has the company’s position in this area been reviewed? ❏ 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 1 2 Legal Due Diligence 3 4 5 5 6 NORMAN J. RESNICOW, ESQ. 7 CLIFFORD A. RATHKOPF, ESQ. 8 9 10 11 12 13 14 15 EGAL DUE DILIGENCE is mainly an exercise in proving the nega- 16 tive—or, perhaps, in looking for the proverbial needle in a haystack. 17 L Like most detective work, it is largely uneventful and sometimes 18 frustrating. It is not the glamorous part of a deal. The thrill of negotia- 19 tions with the give-and-take between skilled opponents, and the creative 20 means of financing the deal—these are the stars of the show. 21 Yet legal due diligence often is the key to a successful closing, and to 22 a deal that works as well post-closing as the parties had envisioned when 23 they shook hands. Legal due diligence requires care, completeness, and 24 sufficient coordination and communication among lawyers and their 25 clients throughout the process. It takes time, patience, focus, and 26 resourcefulness. The people involved in conducting cross-border due 27 diligence must take care not to assume that non-U.S. laws and practices 28 are similar or even analogous to corresponding U.S. laws and practices, 29 no matter how familiar the former may superficially appear. Good due 30 diligence will be reflected in the contracts that document the transaction, 31 including the all-important disclosure schedules. Like the foundation of 32 a building, due diligence is the key structural support, but not much of 33 it is visible when the building is completed. 34 Legal due diligence is critical in a wide variety of transactions. These 35 include large, multifaceted deals, such as acquisitions of shares or assets 36 of companies, public registrations and issuances of shares, joint ventures 37

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1 and strategic alliances, and secured lendings and other financings, as well 2 as smaller transactions, such as hiring a non-U.S. executive for a non- 3 U.S. subsidiary or establishing a long-term supply contract. The com- 4 mon theme for all such transactions is that one party is purchasing assets 5 or services of the other and expects to be able to receive and preserve the 6 full bargained-for value of the purchase. 7 In the due diligence process, while the buyer’s team is focusing on the 8 target, the target’s team may also be engaging in due diligence—a self- 9 examination necessary to produce the required disclosure schedules or to 10 determine the value of the target’s or the buyer’s shares or assets. 11 Although a target’s instinct understandably is to accentuate the positive, 12 M&A lawyers advise that full and broad disclosure is the best protection 13 against post-closing liability. Full disclosure is especially important for 14 smaller privately held companies that may have been “underlawyered” 15 predeal, and for whom post-closing claims can have a major financial 16 impact. Due diligence by the target’s counsel is also necessary as the 17 basis of the legal opinion typically required of such counsel as a condi- 18 tion to closing (although the traditionally broad disclaimers in legal 19 opinions are geared toward demonstrating how little its lawyers really 20 know about the target). 21 22 23 “Legalese” across Borders 24 The greatest risk of legal mishap in the cross-border deal is in failure of 25 communication, especially where a significant part of due diligence takes 26 place in other countries. For example, in a due diligence review of a 27 European company preparing to obtain SEC registration for issuance of 28 American Depositary Receipts (ADRs), the company’s U.S. counsel 29 asked the company’s local counsel for a review of all “material” contracts 30 between insiders and the company. Just before issuance of the ADRs, the 31 U.S. counsel discovered that only a representative sampling of insider 32 contracts had been disclosed. The registration statement had to be 33 amended, and the issuance was delayed because of this failure to ensure 34 effective communications bridging the U.S. and European legal cultures. 35 A fundamental consideration in cross-border communications is, of 36 course, the fact that typically at least one additional language will be 37 involved. All contracts in a cross-border deal thus should contain a “lan- LEGAL DUE DILIGENCE 151 guages clause” specifying which language version will be considered offi- 1 cial or paramount, and whether translations have any interpretive rele- 2 vance. Even when the transaction involves a U.S. company and one in 3 the United Kingdom or in another English-speaking country, a real risk 4 exists in assuming there is a common Anglo-Saxon meaning of all tech- 5 nical words and concepts. For example, in British English a “billion” is 6 what Americans refer to as a “trillion,” while what Americans call a “bil- 7 lion” is referred to in British English as a “milliard”—an instance where 8 the tedious lawyerly custom of stating written numbers twice, in words 9 followed by numerals, proves its worth. 10 The risk of misunderstanding is magnified if key participants in the 11 transaction speak and write in English as a second language. In such 12 cases there is real value in involving bilingual lawyers in the due diligence 13 process. After all, words (as much as fees) are the currency in which 14 lawyers deal. But whether or not attorneys understand the foreign lan- 15 guage involved, they are charged with transforming the foreign legal ele- 16 ments into the familiar for the client. 17 The value provided to the client will be significantly enhanced when 18 an investor’s lawyers first can focus their foreign counterparts on the key 19 legal questions of concern to the client, and can then act as a critical 20 intermediary between the client and foreign counsel in presenting the 21 results to the client for analysis and decision making. Counsel who fail 22 to act as a critical intermediary, but instead simply pass along foreign 23 counsel’s due diligence reports and legal advice to the client, have not 24 earned their fee. 25 26 27 The Purpose of Legal Due Diligence: 28 Insurance against the Unknown 29 There are two facets to legal due diligence in a cross-border transaction: 30 1 the discovery of facts having legal, business, or financial implications 31 that could imperil the closing or ultimate success of the transaction, and 32 2 a review of the legal setting in which the transaction takes place to 33 ensure knowledge of the significance of those facts and the enforceability 34 of the transaction itself. 35 For the lawyer, the first of these takes place within a collegial setting, 36 coordinating counsel’s expertise with that of the business executive, the 37 152 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 accountant, and the banker, and perhaps a technology guru or private 2 investigator. The second, however, is primarily the province of the 3 lawyer, although the degree and manner of counsel’s involvement may 4 differ from deal to deal and country to country, every jurisdiction hav- 5 ing its distinctive legal norms and business customs. 6 Together, these two facets of legal due diligence provide a form of 7 insurance for the client. If nothing is found to be wrong, the premium 8 for the insurance (the attorneys’ fees) will simply be a sunk cost. But if 9 legal due diligence uncovers material problems, the reflected savings may 10 exceed that premium by many multiples. 11 12 13 A Good Deal Is Vastly Better Than a Good Lawsuit 14 Why should a buyer expend funds for legal due diligence and delay the 15 closing when it will be protected by appropriately worded contractual 16 representations, warranties, covenants, and conditions to closing? Non- 17 U.S. parties in particular may well see precontractual legal due diligence 18 as an expensive and time-consuming duplication of the contractual pro- 19 tections being negotiated. While the question is rarely put that directly, 20 pressure from the buyer on its counsel to rush or simplify due diligence 21 is typically based in part on that thinking. 22 The blunt answer is that a good deal is vastly better than a good law- 23 suit, and given a choice between a good lawsuit and an aborted deal, 24 most savvy buyers would choose the latter. The buyer who relies mainly 25 on the target’s representations, disclosures, and other promises without 26 a full legal due diligence is a gambler. It is not a matter of trust or com- 27 fort levels, for these are of limited value when a target has serious prob- 28 lems of which it, or its top management, is not aware, or has made faulty 29 judgments about known problems. 30 In cross-border transactions, the value of a good lawsuit may be fur- 31 ther discounted. For a purely domestic U.S. deal, the only “foreign” 32 jurisdiction involved may be another state. In a cross-border deal, the 33 process of determining liability, fashioning appropriate remedies, and 34 enforcing a judgment will involve different legal systems. This can 35 increase expense, time, and difficulty many times over. Even if the 36 court or arbitrator rules for the client, the recovery of assets located 37 overseas can be thwarted by roadblocks such as protective local laws, LEGAL DUE DILIGENCE 153 local political pressures, limited currency convertibility, or exchange 1 regulations. 2 Legal due diligence also addresses the buyer’s need to know whether 3 it should even get to the stage of entering into a contract, no matter how 4 ironclad the contractual language is expected to be. One can imagine, 5 for example, potential liabilities such as environmental problems that 6 would bankrupt the target, and possibly the buyer as well, making the 7 transaction a nonstarter. Another concern may be whether there are 8 third parties other than those represented by the target’s negotiators 9 who are able to block the transaction. 10 Information gathered during due diligence also supports and informs 11 the drafting of the agreement and the negotiations surrounding the con- 12 tent and wording of the disclosure exhibits. It is a rare target that does 13 not have some financial or operational problems that require the crafting 14 of legal protective devices. The buyer does not improve its odds of deal- 15 ing with such problems effectively in the contract by deferring their 16 placement on the drafting and negotiating table. 17 The foreign buyer should also consider that a contractual indemnity 18 may be insufficient to protect it. The seller may be liquidated immedi- 19 ately after the transaction closes, or may dispose of the purchase price in 20 such a manner that the buyer cannot reach it in an indemnity-based 21 lawsuit. In the worst case, in an asset deal the seller may have been left 22 with liabilities that result in a bankruptcy in which the buyer’s damages 23 exceed any available seller financial resources. 24 Finally, although the buyer’s counsel may believe that the deal agree- 25 ment is the client’s ultimate protective device, a court reviewing the per- 26 tinent contractual language may disagree. Often, complex issues must be 27 reviewed and the agreement negotiated and drafted under tight time con- 28 straints, and what the parties think the contract says may not be what the 29 “trier of fact” (in other words, a court or arbitrator) finally determines (as 30 Tyson Foods found when a court ordered it to consummate its merger 31 with IBP). The risk of unforeseen results in judicial contract interpreta- 32 tion is even higher when foreign law or accounting practices are at issue. 33 The best contract negotiation and drafting are no substitute for effective 34 due diligence. 35 36 37 154 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Defensive Due Diligence in U.S. Public Securities 3 Issuance Transactions: Proving Enough Was Done 4 In private transactions, due diligence serves as a form of insurance 5 against a broad range of business and other risks. In the area of U.S. 6 public securities offerings, due diligence by the underwriter and other 7 players in the offering process serves two additional functions—as the 8 foundation for preparing the legally required registration statement, and 9 as the key element for establishing these players’ (excluding the issuer) 10 statutory defenses against claims of security law violations in connection 11 with the registration statement. Thus, for the underwriters, the buyer’s 12 directors and principal executives, and the accountants, engineers, 13 appraisers, and other experts (including attorneys) involved, a central 14 question is whether they exercised, in their respective involvement in 15 preparation of the registration statement, sufficient due diligence to 16 uncover and disclose materially untrue statements or omissions. 17 In the context of the cross-border public securities transaction, where 18 the due diligence challenges extend well beyond the familiar, there is the 19 additional question of whether, under those unfamiliar circumstances, 20 they employed sufficient due diligence in investigating the issuer’s asser- 21 tions about the nature, materiality, and risks of foreign operations as 22 reflected in the registration statement. Recognition of the heightened 23 need for “defensive due diligence” in cross-border public securities 24 issuances will result in the most effective protection from legal claims 25 under U.S. securities laws. 26 What will be considered statutorily adequate legal due diligence in the 27 cross-border context will depend upon the circumstances, but three gen- 28 eralizations can be made. First, to the extent foreign operations are 29 material, the legal due diligence should be comparable to that undertak- 30 en for the U.S. operations. Second, due care should be taken in choosing 31 foreign counsel, in informing them of what is required, and in properly 32 reflecting the results of their efforts in the registration statement where 33 appropriate. Third, since the statutory defense is based on the adequa- 34 cy of the due diligence effort, counsel must keep available documents 35 evidencing the effort, including the non-U.S. portions of that effort, 36 and non-U.S. counsel involved should be made aware of that need at 37 the outset. LEGAL DUE DILIGENCE 155

1 Forces Working to Limit Due Diligence: 2 Quick Decision Makers versus Slow Scriveners 3 From the time of the “robber barons,” when J. P. Morgan reportedly 4 decided to buy Andrew Carnegie’s steel operations simply by saying “I 5 accept this price” in response to Carnegie’s scribbling of “$480 million” 6 on a sheet of paper, to the current climate, in which Jack Welch of 7 General Electric reportedly made a fast weekend decision to buy 8 Honeywell, the public has always admired businesspeople able to move 9 quickly. The caveats of the “legal beagles” and the cautions of the “bean 10 counters” go against that grain. Lawyers must accept that those attitudes 11 will not change, and that clients will continue to explain that this deal 12 really is a straightforward, friendly deal. 13 Buyers feeling pressure to rein in or at least foreshorten their lawyers’ 14 due diligence should consider some cautionary points. First, legal due 15 diligence can be a moneymaker and not just a cost center. Lawyers often 16 uncover facts that provide a basis for the buyer to renegotiate the deal to 17 its financial advantage. Second, academic studies show that many M&A 18 deals (two-thirds, according to one recent study) just don’t work post- 19 closing and result in a loss of value for the buyer. Experience further 20 shows that a significant number of deals do not close because of prob- 21 lems uncovered by legal due diligence in particular. Prudence recom- 22 mends improving the buyer’s odds by taking legal due diligence as seri- 23 ously as the other parts of the deal. Third, in a cross-border deal, where 24 physical and cultural distances make problems harder to see, the buyer’s 25 lack of enthusiasm for legal due diligence may be far more costly than 26 any feared lawyer overexuberance. 27 In a well-known European beverage manufacturer’s long-planned 28 acquisition of the shares of its longtime U.S. distributor, European man- 29 agement decided that, in light of the parties’ lengthy and close relation- 30 ship, no legal due diligence was necessary, and that the deal could be 31 signed and closed in the several weeks before year-end. When the 32 European buyer asked its U.S. attorneys to write a “simple agreement,” 33 its managers were astounded to hear that Hart-Scott-Rodino (HSR) 34 antitrust clearance would be necessary, as well as compliance with 35 numerous state and the federal alcoholic beverage regulatory require- 36 ments (including fingerprinting of the buyer’s president). This signifi- 37 156 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 cantly threw off the buyer’s business and financial planning by delaying 2 the closing into the following year. 3 Far sadder is the saga of a German machine manufacturer that decid- 4 ed to purchase its U.S. distributor, ending a thirty-year relationship. It 5 closed the deal without the assistance of any U.S. lawyers or significant 6 due diligence. Post-deal, having signed a four-page document largely 7 devoted to the employment terms of one of the distributor’s executives 8 for the newly owned U.S. operation, the German buyer asked a U.S. 9 lawyer to review the transaction to see if anything had been forgotten. 10 The lawyer found that the U.S. distributor had kept customer accounts 11 in an unpurchased affiliated company, instead of in the company named 12 in the deal. As a result, all significant accounts receivable remained in 13 the unpurchased affiliate. The distributor’s executive who negotiated 14 the deal was fired, and litigation ensued. The German buyer who had 15 sought to minimize use of U.S. lawyers ended up spending a large part 16 of his time with them. 17 A deal in which the buyer purchases assets and contractually assumes 18 only certain specified liabilities may lure the buyer into a false sense of 19 security, tempting it to limit due diligence (at least on the liability side). 20 Such a deal does not, however, preclude the possibility of successor lia- 21 bility to third parties in certain high-risk areas (environmental and prod- 22 uct liability, for example). Also, language limiting the scope of liabilities 23 assumed may not operate as expected when interpreted by courts. For 24 example, in negotiating the memorandum of understanding (MOU) for 25 the sale of the U.S. and Belgian assets of a U.S. manufacturer to an inter- 26 national investment group, the seller’s lawyers changed the liability 27 assumption language from “certain specified liabilities” to “all liabilities 28 incurred in the ordinary course of business.” Thereafter, in negotiating 29 the final acquisition agreement, when the buyer’s counsel tried to exclude 30 various fault-based liabilities from the assumed liabilities, the seller’s 31 lawyers prevailed by countering with U.S. case law interpreting “liabilities 32 incurred in the ordinary course of business” to include environmental, 33 product liability, and other fault-based liabilities—which, as the seller’s 34 lawyers argued, were assumed liabilities consistent with the MOU. 35 The business press has warned of the risks of sacrificing due diligence 36 for transactional speed. The Cendant fiasco elicited an article in Business 37 Week entitled “M&A Frenzy May Be Scuttling Due Diligence” (August LEGAL DUE DILIGENCE 157

17, 1998). This unusually candid critique observed that “investors are 1 beginning to wonder whether the frenzied race to do deals has left prop- 2 er due diligence in its wake.” The article noted that unlike in an initial 3 public offering, where nearly everything is to be scrutinized (at least in 4 theory), for M&A “in truth there is no agreed upon definition of proper 5 due diligence.” It concludes by prophetically quoting Harvard Business 6 School professor Mark L. Mitchell: “We are going to see more … deals 7 that turn out to be busts, in part because of a lack of due diligence.” 8 9 10 Avoiding Ruffled Feathers and Missed Opportunities 11 Many midsized and large commercial transactions in today’s global busi- 12 ness environment involve material cross-border elements. Because the 13 focus of due diligence will vary with the nature of the transaction, the 14 task at the outset is to tailor the due diligence plan to the objectives, 15 demands, and subject matter of the deal at hand, resulting in a focused 16 due diligence process. Counsel should avoid the temptation to take an 17 “off-the-rack” approach instead of custom-tailoring the process, except 18 where the modest size of the deal does not permit tailoring. 19 A focused investigative approach may not, however, be a welcome one 20 for the company or the individuals being investigated, especially in a 21 cross-border transaction in which the foreign party does not understand 22 the need for and benefits of this approach. The U.S. party’s attorney 23 should help the foreign party (whether target or buyer) to understand 24 that the process is integral to U.S.-type deals, and that although it 25 appears adversarial in nature, its true purpose is to uncover problems to 26 ensure that the deal will stand up to scrutiny. This may not be an easy 27 selling job for the attorney. 28 The acquisition of a private U.S. target by a foreign buyer provides 29 special due diligence challenges. The U.S. target’s shareholders and man- 30 agement are, more likely than their non-U.S. counterparts, conditioned 31 to issues of disclosure, even if they have not previously participated in an 32 inbound transaction. Their experience with litigation discovery, gov- 33 ernment reporting requirements, and the like makes the U.S. target 34 expect the buyer to seek extensive information about its financial and 35 operating condition. If the foreign buyer does not take full advantage of 36 this expectation, two serious and potentially costly mistakes are made. 37 158 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 First, the chance to obtain significant information to mold the negotia- 2 tions, financially and otherwise, is lost. Second, the target will have a low 3 regard for the buyer’s business acumen, which may create difficulties 4 later in the negotiations, and perhaps post-closing as well. Thus, if the 5 foreign party is not transactionally sophisticated, the first and most crit- 6 ical part of legal due diligence may be an educational process. 7 Providing foreign clients with a full legal due diligence checklist, such 8 as the one at the end of this chapter, is a good starting point, provided 9 that counsel makes sure they understand the reasons why it is seeking 10 those items. This procedure typically results in the identification of a 11 number of issues that require further education of both the client and its 12 non-U.S. legal advisers. 13 The U.S. client as well may need to go through an education process. 14 Consider, for example, the straightforward scenario of a purchase of an 15 individual’s services, where you are the lawyer advising a U.S.-based senior 16 executive recruited by a non-U.S. company for a post abroad in a civil law 17 jurisdiction. You must explain to the client how the familiar two-tier struc- 18 ture of U.S. corporations (board of directors and officers) gives way to a 19 three-tier structure (executive board, management board, and officers). As 20 a result, to assist with negotiating and preparing the employment agree- 21 ment, you may have to advise the client of the need for some significant 22 legal research (either directly or through foreign co-counsel) regarding 23 how your client would be able to carry out management responsibilities 24 and obligations under the three-tier structure. If you are retained before 25 the compensation package is set in cement, you should advise as to whether 26 it is customary for executives in that country to obtain equity as incentive 27 compensation, and if so, whether equity incentives are available to the exec- 28 utive as a foreigner in that country, and if so, under what circumstances. 29 The education task for counsel in this scenario is no different from that of 30 U.S. counsel advising a foreign buyer of a U.S. business. 31 32 33 Fitting Due Diligence into the Structure and Timing 34 of the Deal: Sooner Is Better 35 Both the buyer and the target should consider the typical transaction’s 36 structure and timing and how the results of due diligence mesh with the 37 contractual protections savvy buyers expect. After initial discussions in LEGAL DUE DILIGENCE 159 which the buyer and target determine there is some mutual interest in a 1 transaction, and after the target discloses some very basic operating and 2 financial information, it is common for the parties to enter into the 3 MOU, typically a nonbinding letter of intent and confidentiality agree- 4 ment. Characterizations of MOUs as nonbinding are only partly correct, 5 because various provisions of the agreement are meant to be legally 6 binding (such as confidentiality clauses, “no shop” covenants during 7 exclusive negotiation periods, “no raid” clauses to protect the target’s 8 employees, and “breakup fees,” among others), while the remaining 9 parts are meant solely to describe the parties’ current intentions regard- 10 ing the transaction. 11 After the MOU is signed, the buyer may present the target with a 12 document disclosure list that forms the initial subject matter of the due 13 diligence inquiry. Thereafter, the parties usually move into a process of 14 due diligence and contract preparation that can last anywhere from a few 15 weeks to several months or longer. 16 Despite some differences between the structures of an acquisition of 17 shares versus assets and the acquisition of private versus public targets, 18 the main parts of the acquisition contract are much the same. The target 19 is expected to agree to a long list of representations and warranties con- 20 cerning, among other things, ownership, authority, legal capacity, line 21 items on its financial statements, and various nonfinancial statement lia- 22 bilities, and to disclose exceptions to the representations and warranties 23 on disclosure statements attached as schedules to the contract. The tar- 24 get is also expected to agree to specified covenants governing the con- 25 duct of the target’s business and finances between contract signing and 26 closing. After providing for these so-called reps and warranties and 27 covenants, the contract typically contains a detailed list of remedies for 28 any breach of the target’s reps and warranties or covenants—specifying, 29 among other things, how much the target or selling shareholders must 30 pay back to the buyer as indemnities, as well as whether, when, and 31 under what circumstances the buyer may withhold part of the purchase 32 price against payment of any indemnities. 33 This common structure for a U.S. acquisition is similar to those used 34 outside the United States, although U.S. contracts tend to be longer and 35 more detailed. This difference occurs largely because foreign parties and 36 counsel in civil law countries are accustomed to legal code-based con- 37 160 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tracts, while U.S. and other common law parties and counsel operate on 2 the basis of caveat emptor (buyer beware), where “the law is the con- 3 tract.” The U.S.-style contract typically evolves as the due diligence 4 process develops and areas of concern are identified. This fluid process 5 may be disconcerting to foreign parties, and it is up to U.S. counsel to 6 walk them comfortably through the process. 7 Some buyers may be tempted to delay investing significantly in legal 8 due diligence until the definitive acquisition contract has been negotiat- 9 ed and signed, with serious legal due diligence efforts to be conducted 10 between contract signing and closing. While understandable, this 11 approach risks giving legal due diligence short shrift. It also makes nego- 12 tiating changes in the contract as due diligence unearths new informa- 13 tion more difficult—changing a signed contract is much more difficult 14 than changing a draft. Finally, in a cross-border context, legal due dili- 15 gence requires additional time, which may increase the length of the due 16 diligence process and, in consequence, delay the closing. Thus, it is 17 strongly preferable to conduct full legal due diligence after signing the 18 MOU and while still negotiating the final contract. 19 20 21 Organizing and Executing Legal Due Diligence: 22 The Buck Stops at the Top 23 Four key elements of effective legal due diligence are: 24 1 assigning qualified personnel; 25 2 organizing and delegating duties; 26 3 ensuring a searching investigation; and 27 4 communicating results effectively. 28 29 Assigning Qualified Personnel 30 Especially in cross-border transactions, counsel must initially determine 31 what the key issues will most likely be and who can most appropriately 32 handle each. This means that very early in the deal, usually when the MOU 33 is being prepared, the buyer and its counsel must start lining up the troops. 34 Will foreign counsel be needed? Likewise for foreign accountants, or does 35 the buyer’s current CPA firm have offices in the countries involved? Does 36 counsel or the client know the foreign counsel personally, or is the person 37 merely a referral? What is the depth of practice and experience of the LEGAL DUE DILIGENCE 161 foreign counsel? In a transaction involving a company in an emerging 1 market country, can competent counsel be found who doesn’t have a 2 prior association with the target—and therefore a conflict of interest? 3 One may have to choose between the best technical lawyer and the 4 best-connected lawyer; or one may be able to choose both if cost per- 5 mits, and if coordination issues are manageable. Is there a need for spe- 6 cialized consultants (often a euphemism for a local lobbyist who knows 7 where and how legitimate pressures may be brought to bear in critical 8 areas)? Although the legal team may change over time, it is often diffi- 9 cult to replace a key foreign team member in a timely manner; the first 10 choice must be a good one. 11 In addition to the lawyers, the legal team should include representa- 12 tives of the buyer’s management. Which executives should help identify 13 and field legal issues? Obvious examples would be the CFO, general 14 counsel, and any internal legal staff, as well as the managers of human 15 resources and information technology. The target’s legal due diligence 16 team, which prepares the critically important disclosure schedules, 17 should include managers who have responsibility for sensitive areas such 18 as environmental risk, tax compliance, product liability, intellectual prop- 19 erty, antitrust, labor relations, and litigation and other third party claims. 20 In the twenty-first-century business environment, where job changes 21 are increasingly frequent, companies may lack the breadth of human his- 22 torical memory that once existed when people spent a working lifetime 23 at a single company. This employee mobility presents a particular chal- 24 lenge to the target’s counsel, who may have to chase down former 25 employees and dig for buried files in order to prepare disclosure sched- 26 ules. Also, the target’s management and other employees who are aware 27 of the deal may be skittish about their futures and thus less than fully 28 focused on assisting with due diligence disclosure. Some of them may 29 suddenly depart for new employment in the middle of the deal. Keeping 30 their knowledge of the deal confidential may be critical, so it is impor- 31 tant to determine what information key personnel, whether currently or 32 previously employed, have received. For that to be done, they must first 33 be identified and located. Therefore, the target’s counsel should begin 34 this task earlier rather than later in the due diligence process. 35 The legal due diligence team may also need to import specialized 36 domestic or foreign legal expertise in technical areas that the buyer’s law 37 162 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 firm does not cover. These areas may include certain environmental lia- 2 bility and compliance, intellectual property, pension and benefits, and 3 labor union issues. One of the first decisions to be made is which of these 4 issues will be sufficiently important in the deal to require an outside legal 5 specialist on call from the beginning. 6 In addition to investment bankers, there are outside nonlawyer 7 experts who may be needed in various ancillary areas that may surface 8 within the legal due diligence context. If the target’s operations, for 9 example, involve significant real estate, an environmental audit firm, a 10 surveyor, and an architect or civil engineer may be required. If the tar- 11 get engages in import/export transactions, consider involving a good 12 customs broker. Although asset valuation matters are traditionally han- 13 dled by the client and its accounting firm and investment bankers, the 14 parties might also require the services of an experienced insurance agent 15 to see if the policies in place are sufficient in coverage and protect the full 16 value of the acquired assets. 17 The next issue, touched on briefly already in this chapter, is one of 18 language: Are translators needed? This question is not as simple as it 19 seems, because the terms being translated may not have local meaning. 20 Counsel’s foreign counterparts may appear to be fluent in English, but 21 if the context is missing, fluency does not help much. In one transaction 22 in which a U.S. buyer was acquiring a German company, the buyer’s 23 U.S. attorneys had no significant German experience. The target’s exec- 24 utives spent several days trying to figure out what the buyer’s attorneys 25 meant when they asked for “certificates of good standing or the local 26 equivalent” and were even more baffled when these attorneys tried to 27 explain that such documents would be necessary to ensure that all “fran- 28 chise taxes” were paid. As a result, the target’s executives hired a U.S. 29 attorney familiar with German practice to assist them and their German 30 attorneys with the transaction. The matter was quickly resolved when the 31 target’s U.S. attorney was able to explain to the buyer’s attorneys that 32 Germany has no franchise tax, and that unlike in the United States, fail- 33 ure to pay franchise taxes cannot lead to a corporate dissolution by the 34 state, so no official document resembling a certificate of good standing 35 exists. The buyer’s attorneys were finally satisfied that they could address 36 their concerns adequately by reviewing the target company’s entries in 37 the local Handelsbuch (the official commercial registry). This problem LEGAL DUE DILIGENCE 163 might have been resolved much sooner if the buyer’s attorneys had hired 1 German attorneys who could “translate” the request. 2 Because translations (whether or not by certified translators) are cost- 3 ly and time-consuming and are rarely sufficient for legal analysis, it is 4 best, if feasible, to bring to the team an attorney with the relevant for- 5 eign language and foreign and domestic legal skills. This attorney should 6 review non-English language due diligence material in its original lan- 7 guage, understand the legal issues resulting from the review, and prepare 8 English-language summaries of those documents, without the need for 9 any intermediate formal translations. 10 Finally, counsel should not overlook the critical assistance that a pri- 11 vate investigator can provide. More often than not, one of the most valu- 12 able acquired assets is target’s management team. It is surprising how 13 few due diligence investigations ever bother to do even cursory back- 14 ground checks on key management members. This can be a delicate 15 issue if management learns that it is being investigated, so counsel needs 16 to discuss the use of a private investigator first with the client. Practical 17 reasons (beyond issues of attorney-client privilege) will incline the client 18 to have the “private eye” be engaged by the outside law firm, instead of 19 engaging it directly. For more on the role of private investigators, see 20 Chapter 8. 21 The personnel assignment process may also involve establishing a 22 secure and sufficient document “war room,” which is a data room where 23 copies of all the documentary disclosures will be organized and stored 24 (traditionally at the offices of the target’s outside counsel), and assigning 25 the professional and clerical personnel to operate and control it. 26 Although a controlled data room is more frequently used when multiple 27 buyers view the same data, the procedure is recommended for all larger 28 transactions. It assists in the organization of the data and serves a further 29 purpose: Employees will not be disturbed by troops of “outsiders” por- 30 ing over company records at the target’s sites. 31 In more complex due diligence situations involving transactions 32 whose budgets allow for more up-front costs, consider setting up a 33 restricted intranet site on the target counsel’s network server (preferable 34 to the target’s server, as there may be issues of business confidentiality or 35 attorney-client privilege involved). All documents are scanned, indexed, 36 and electronically stored, usually in a format permitting electronic com- 37 164 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ments on the scanned document itself or in a corresponding file. This is 2 an invaluable way to share information among team members who can 3 log on to the site. It also avoids the traditional issue of whether all appro- 4 priate pages or copies of critical documents have been distributed to all 5 team members. Another option is to have one document intranet site 6 serve as a “virtual war room” available (on a strictly controlled basis) to 7 both parties’ due diligence teams, and have a separate site for comments 8 and analysis restricted to the buyer’s team. Especially in cross-border 9 transactions, where time differences often complicate communications, 10 these electronic data rooms have proven increasingly useful, because they 11 accelerate the process and reduce the need for air travel and face-to-face 12 meetings. 13 14 Organizing and Delegating Duties 15 Each deal typically has one individual lead counsel (in-house or outside). 16 The lead counsel is the logical person to designate the head of the due 17 diligence team, who will be directly responsible for leading, coordinat- 18 ing, and communicating the results of the legal due diligence effort. 19 Because the attention of lead counsel will necessarily be divided, anoth- 20 er partner should focus primarily on due diligence. As noted above, it is 21 helpful to have lawyers who speak and read the language of the other 22 party’s country as team members, but this is not the principal qualifica- 23 tion for the team leader—deal experience, common sense, efficiency, and 24 organization and communication skills all rank higher. 25 Once the team members have been identified, the due diligence team 26 leader must clearly delegate to each team member his responsibilities, the 27 time frames in which particular responsibilities must be completed, and 28 the manner of reporting findings. The leader’s first administrative task is 29 to ensure that each person involved, including the lead counsel for the 30 buyer and the target, is provided with a contact list containing the 31 names, addresses, telephone and fax numbers (including mobile, home, 32 and weekend numbers), and e-mail addresses of all other team members 33 and a brief description of each team member’s responsibilities. 34 The team leader’s final organizational task is to have the key team 35 members assemble and distribute to all team members a confidential ini- 36 tial briefing book about the target, based on documents and information 37 that were disclosed at the MOU stage or that are publicly available. This LEGAL DUE DILIGENCE 165 briefing book should be periodically updated (using discretion as to sen- 1 sitive matters) with important findings as they develop. 2 3 Ensuring a Searching Investigation 4 Due diligence should proceed on two fronts: a review of documents and 5 other data from selling shareholders and the target, and an independent 6 investigation of public information concerning the target together with 7 expert evaluations of the target. 8 The investigation typically takes place off-premises and secretly unless 9 the target has already made public, as legally required or by choice, the 10 news that it is for sale. Targets are understandably concerned about the 11 deleterious effects an inspection tour may have on employee morale. 12 Once news of a possible sale of a company (or division or plant) becomes 13 known to employees, the rate of employee injury, sickness, and defection 14 increases significantly. Also, the minute the news of a possible transaction 15 goes out, salespeople of the target’s competitors will be knocking on the 16 doors of the target’s customers, trying to win them away with tales of 17 the target’s financial woes and impending doom. 18 The legal due diligence team must review documents to see if there 19 are any major impediments to the transaction or to the buyer’s continu- 20 ation of the target’s business post-closing. Thus, the team must examine 21 all major contracts to ensure that there is no bar to continuity. In the case 22 of an asset transaction, this analysis is of greatest importance, because if 23 there is a limitation on the target’s right to assign, the customer, land- 24 lord, or other third party whose consent is required may then refuse to 25 do so or, more likely, seek to squeeze concessions on pricing or other 26 terms as a condition to its consent. This is less likely to occur in a share 27 transaction, but a number of contracts may have change-of-control pro- 28 visions that act in the same manner as a nonassignment clause, even in 29 share transactions. 30 In obtaining third party consents to assignment, counsel should look 31 for the consent documents to include “estoppel certificates” stating that 32 no defaults have been formally called and, to the consenting third party’s 33 best knowledge, no basis to call a default exists. 34 Counsel should request such a certificate even if the underlying con- 35 tract between the target and the third party does not require it to be 36 given; the resulting protection afforded to the buyer can be significant. 37 166 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 In borderline cases where it is unclear whether a third party consent is 2 required, consents should not automatically be requested, especially for 3 nonmaterial contracts, because the very request may set in motion a 4 chain of “stickup” events that would not otherwise have occurred. In 5 other words, the third parties may refuse to consent unless prices or 6 other terms are renegotiated in their favor. Instead, a negotiated sharing 7 of identified risks between the buyer and seller may be the preferred 8 solution (with a carefully worded provision in light of the possibility of 9 forced disclosure of such provision in any subsequent litigation with the 10 third party). 11 Counsel should examine permits and licenses to see whether they will 12 survive the closing; if not, the team must work with the buyer to see 13 whether there is a way to be ready to do business following the closing 14 by putting in place new permits and licenses. Permits and licenses pass 15 immediately and automatically by law in share purchase transactions, so 16 (absent a change of control restriction in the permit or license) this 17 problem tends to be limited to asset deals, unless a condition of grant- 18 ing the permit or license has been a guarantee or other undertaking of 19 the target’s shareholders. 20 The legal due diligence team may also be involved in the buyer’s inter- 21 views of the target’s executives and key employees, as well as of any reg- 22 ular legal counsel the target uses. Understandably, the executive inter- 23 views are often less a matter of due diligence and more in the nature of 24 negotiation and planning sessions. 25 The Internet is a useful source of information about a target and its 26 assets, liabilities, business, and personnel. A good search engine and a 27 properly thought-out search pattern can often generate an amazing 28 wealth of information about a target. Except for official government 29 websites, the information obtained may not be wholly reliable, but it 30 provides a good starting point. 31 In the United States, subscription-based searches can be performed in 32 the Public Records search area of Lexis-Nexis, where one can find cur- 33 rent and historical information on any existing or previously satisfied 34 judgment debtors. However, because this information is recorded by 35 state, and by county within a state, tracking the history of a peripatetic 36 executive can become expensive. Likewise, obtaining a credit report 37 from one of the national credit agencies can be an invaluable source of LEGAL DUE DILIGENCE 167 information on individuals. If the target has had any significant borrow- 1 ing history, usually there will also be a Dun & Bradstreet, Moody’s, or 2 Standard & Poor’s (or equivalent) rating history. Although such reports 3 are not particularly geared toward legal due diligence, if available they 4 should be used, as they may point to specific problems or general credit 5 trends that will provide guidance to the contract drafters. 6 Broad information-gathering due diligence is more difficult in out- 7 bound transactions, and obtaining access to the local old-boy network 8 may become fairly important. Such networks may be found in informal 9 groups within the legal community. For example, in Australia, lawyers 10 capable of dealing with labor union matters exist as a sort of informal 11 club; either you are in it or you are not. 12 That said, the key objective in ensuring a truly searching and success- 13 ful due diligence process is to be certain that red flags are not missed or 14 misconstrued. A proper, and promptly updated, briefing book is the 15 start. But because the team’s junior members typically perform the bulk 16 of the hands-on due diligence, the key to success is regular and mean- 17 ingful partner supervision and intervention as needed. This should be 18 supplemented by the use of specialized personnel when feasible (which 19 is where the expert evaluations come in; see the list in item #1 of the 20 checklist at the end of this chapter) and a constant flow of clear com- 21 munications within the team to encourage informed skepticism for the 22 detective work being undertaken. 23 24 Communicating Results Effectively 25 In most transactions involving larger law firms, the due diligence team 26 leader will not be the person negotiating and drafting the contract or 27 reviewing the disclosure schedules. Thus, the team leader needs to see to 28 it that what the investigators in the field have discovered is properly and 29 promptly put into writing and distributed to the negotiators and drafters. 30 She should receive copies of all field memoranda and ensure that suffi- 31 cient time is set aside to review and analyze them. It is also critical that 32 the team leader take the time to discuss promptly with the buyer (either 33 directly or through the negotiators/drafters) the nature and scope of 34 problems that may have arisen and to explore potential solutions. 35 Details matter, and due diligence is heavily focused on them. A single 36 detail of communication became an issue in the above-noted 2001 litiga- 37 168 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tion between Tyson Foods and IBP. An outside lawyer for IBP received 2 by e-mail a letter from the SEC relating to proxy and financial statements. 3 His quick look at the document led him to conclude it concerned a prior, 4 irrelevant matter, so he did not forward it to Tyson Foods or his client. 5 The mailed version of the SEC letter arrived more than a week later, and 6 this communication time gap became a major issue in the lawsuit. 7 Once the deal has closed, all the due diligence documents (as well as 8 drafts of acquisition agreements reflecting the ongoing negotiations 9 prior to signing) should be gathered together and stored rather than dis- 10 carded. All too often, post-closing disputes arise concerning whether or 11 when a particular liability was disclosed, or what the buyer did or did not 12 know before entering into the acquisition agreement. These work papers 13 can be excellent evidence regarding such questions. 14 When the buyer’s counsel discovers a material matter during due dili- 15 gence that the target did not previously identify, the matter should very 16 quickly be brought to the attention of the target’s counsel, particularly 17 if further clarification is desired or if the matter may affect price or other 18 contractual negotiations. If, however, the buyer perceives that no such 19 clarification or adjustment is necessary or obtainable, the due diligence 20 team may be tempted to keep the matter from the target’s attention, in 21 order to hold the matter in reserve for possible use if the buyer later 22 seeks to abort the closing or to assert or defend post-closing claims. 23 With that possibility in mind, the target’s counsel will want to include 24 provisions in the contract to preclude such “sandbagging” by the buyer, 25 thereby preventing the due diligence process from becoming a game of 26 “gotcha.” Such an antisandbagging provision would state, in effect, that 27 the buyer cannot abort the closing, or assert claims against the target 28 post-closing, based on matters discovered by certain dates in the buyer’s 29 due diligence but not brought to the target’s attention by other certain 30 dates. These provisions can be complex, because they necessarily require 31 determining who knew what, and when. 32 It is bad practice for either party to sit silently regarding matters found 33 in due diligence. The far wiser practice is to bring them promptly to the 34 other side’s attention and request an explanation and further information, 35 because it is always better to know more, not less, about the other party. 36 This is especially true for buyers, because targets are typically in a far bet- 37 ter position to know their business than are the buyers. In cross-border LEGAL DUE DILIGENCE 169 transactions, in which the process of obtaining and analyzing information 1 is significantly more difficult and complex, full disclosure is even more 2 important. Thus, even putting aside the ethical issues and legal risks aris- 3 ing in a sandbagging strategy, the buyer’s disclosure to the target of dis- 4 covered matters is greatly preferable to nondisclosure. Similarly, as noted 5 above, disclosure is the selling shareholder’s best friend, for that which is 6 fully and fairly disclosed, especially as clearly set forth in the contract, can- 7 not be the subject of future liability. For both sides, candid disclosure will 8 prevent good deals from blowing up due to lack of trust arising from 9 efforts to conceal or mislead, and will abort deals that have fatal flaws— 10 in both cases saving time, effort, and expense in the process. 11 The final communication concern is to ensure that the all-important 12 disclosure schedules are not presented or modified at the last minute 13 without informed input from those junior attorneys who were in the 14 trenches conducting the due diligence investigation. Inevitably, the 15 drafting, analysis, and negotiation of those schedules lag far behind the 16 wording of the body of the agreement, even though the schedules are of 17 equal importance. In the end, the schedules and the agreement must be 18 integrated to form the complete document. (Interpreting the contract 19 text together with the wording of the disclosure schedules became an 20 issue in the previously mentioned lawsuit between Tyson Foods and 21 IBP.) To treat the schedules as less than a key part of the contract is to 22 run the race only to slow down before the finish line. 23 24 25 Certain Key Risk Exposure Areas in Legal Due Diligence 26 Not all due diligence concerns are equal. The key areas described here 27 (by no means an exhaustive list) are often of dramatic concern simply 28 because the financial and business consequences of nondiscovery or 29 faulty analysis are potentially cataclysmic. 30 31 Environmental 32 In any U.S. transaction involving significant real estate or production 33 facilities, a large part of due diligence should focus on the target’s com- 34 pliance with federal and state environmental laws and regulations and its 35 exposure to potential joint and separate environmental liability. In places 36 outside the United States that have meaningful environmental legisla- 37 170 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tion, such as Western Europe, the buyer should have many of the same 2 concerns. Larger problems attend environmental due diligence in coun- 3 tries emerging from an era of planned economies, and in developing- 4 market countries where environmental regulation is still in its infancy or 5 nonexistent. 6 The most common property contamination and toxic tort concerns in 7 a U.S. transaction include: 8 1 unregistered or abandoned underground storage tanks; 9 2 abandoned landfills and other disposal sites, septic systems, and wells; 10 3 failure to store, transport, or dispose properly of hazardous wastes 11 (possible exposure to CERCLA or “Superfund” liability); and 12 4 smokestack emissions and water and other liquid emissions. 13 Due diligence also should determine the historical uses of the target’s 14 sites by the target and its predecessors on the properties, and whether 15 there has been any historical use of asbestos in existing buildings and what 16 steps must still be taken for remediation. ASTM (formerly the American 17 Society for Testing and Materials) has established a number of standards 18 relevant to environmental due diligence, including the Transaction 19 Screen Process, Phase I and Phase II studies, restoration of brownfield 20 properties, and evaluation of USTs (underground storage tanks). 21 Steps in the review process. The first step in environmental due 22 diligence is to examine all permits to verify that they are still in force; 23 that they are in accordance with current regulations (or if not, are prop- 24 erly grandfathered); in a stock deal, whether there are change of control 25 restrictions affecting continuation of the permits; and, in an asset trans- 26 action, whether the permits are transferable. Part of due diligence 27 should be to prepare for the timely continuation or transfer of permits 28 (or if not continuing or transferable, to obtain new permits in the 29 buyer’s name) so that, post-closing, the target can continue to do busi- 30 ness seamlessly. A problem that arises in acquisitions where new permits 31 must be issued is that the buyer must meet current conditions for 32 obtaining the permit—often more stringent than the conditions of the 33 target’s original permit grant. If there are significant problems with per- 34 mits vital to the continued operation of the target’s assets, the buyer 35 may want to weigh the additional costs and risks of undertaking a share 36 transaction instead, where such permits pass to the buyer automatically 37 by law. LEGAL DUE DILIGENCE 171

The buyer’s counsel should be aware that land use permit issues can 1 arise even when the buyer plans an operational change that may not 2 appear to affect the land. For example, the Japanese purchaser of a U.S. 3 golf course complex planned to market memberships as tradeable inter- 4 ests (which had become the investment craze in Japan). The buyer 5 signed a purchase contract with the assistance of U.S. counsel, and then 6 brought in new U.S. counsel to conduct due diligence and close the 7 deal. The new counsel advised the buyer that the membership scheme 8 could not be implemented without permits from the California Coastal 9 Commission. Unfortunately for the buyer, the contract did not make 10 such permitting a condition to closing, and the buyer was unable, post- 11 closing, to implement its membership plan. 12 The second environmental step is to review all existing violations of 13 record to determine whether they have been corrected, whether there are 14 any outstanding remedial or financial obligations regarding the violations, 15 and whether the violations might have any material effect on the contin- 16 ued viability of permits needed to conduct business post-closing. In addi- 17 tion, counsel should discuss with the appropriate target personnel 18 whether there are any actual or suspected violations not yet officially 19 reported or investigated. 20 The third customary step in the United States is for the buyer to 21 determine whether it wants to obtain a current so-called Phase I study 22 of the property. This study is typically undertaken by an expert environ- 23 mental consultant and consists primarily of the expert’s on-site review of 24 operations and their potential environmental risks, including a review of 25 permit and violation problems. Quite often, sophisticated targets have a 26 set of records already prepared for the transaction, including its own 27 Phase I studies. Although these records may be helpful, the buyer should 28 still determine whether to rely on the target’s studies or to obtain an 29 independent study. A Phase I study is relatively quick and inexpensive, so 30 it is the rare case where having such an independent study done is not 31 recommended. In addition, lenders for the transaction typically require 32 a recent one. 33 Significant problems appearing in a Phase I study are likely to trigger 34 a demand for a Phase II study, which consists of test borings at the site; 35 laboratory examination of and reports on soil, water, and air samples; 36 and remediation suggestions. The process may be costly and take weeks 37 172 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 to complete. Depending on the nature of the historical use of the prop- 2 erty and the extent of the potential exposure, this may be a serious issue 3 to the buyer. 4 The target also may have some concerns with respect to the Phase I 5 and Phase II studies, especially if they involve a situation as yet unre- 6 ported to environmental regulators. Even if the deal fails to close, the 7 target probably will be under a legal obligation to report and remedy 8 violations uncovered in due diligence. On occasion, this leads to some- 9 times difficult negotiations between the parties on how to handle the sit- 10 uation and which party is to bear particular risks. For these reasons, the 11 environmental consultants (and other consultants) are typically retained 12 by the buyer’s counsel, in an effort to bring the results under the pro- 13 tection of the attorney-client privilege. 14 Special considerations. In cross-border deals, the process of envi- 15 ronmental due diligence depends largely on the level of applicable 16 administrative regulation. In Europe, for example, three levels of law and 17 regulation shape the examination process: European Union, national, 18 and regional or state regulations. Consider Belgium: In addition to the 19 uniformly applied EU and Belgian environmental rules, there are three 20 distinct local regulatory authorities: the Flemish Region (strictest), the 21 Brussels Metropolitan Region, and the developing Walloon Region. 22 Nonetheless, sticky problems for environmental due diligence arise 23 much less often within the EU—where a considerable body of expertise 24 has developed on which U.S. buyers can rely—than in the old Soviet- 25 bloc countries of Eastern Europe, where the pressures for production in 26 the centrally planned economies did not permit any extensive concern 27 for the environment. There, environmental problems are endemic. 28 Shortly after the latter countries adopted Western economic models, the 29 first generation of privatizations commenced. Western investors typical- 30 ly negotiated very tough site rules regarding remediation by the states 31 involved. This was not the case where nationals were able to purchase 32 production facilities by voucher or other systems. Now, when second or 33 third generations of transactions are involved, due diligence requires an 34 especially careful review of all remediation procedures, of any state guar- 35 antees or waivers of enforcement, and of the degree to which the latter 36 would be applicable to a current buyer. The careful buyer should also be 37 prepared to import Western environmental experts to work with the LEGAL DUE DILIGENCE 173 business and legal teams in order to prepare a useful pre-closing envi- 1 ronmental audit. 2 Not all of the former Eastern Bloc countries continue to suffer from 3 this problem. The Czech Republic, for example, gave massive guarantees 4 to Western private investors early on. After a major legislative overhaul 5 of environmental regulation in 1993, the Czech Republic now has over- 6 all strategic planning based on a brownfields solution to risk assessment 7 and risk taking, and a respectable body of environmental expertise and 8 information is available to the potential buyer. Nonetheless, the risks 9 remain that legislative or administrative concessions in such countries 10 could be modified by successor governments or as integration with the 11 European Community or other groupings moves forward. 12 13 Antitrust 14 The concerns of antitrust counsel in due diligence are both factual and 15 transactional. Not only does the predeal process have to seek to uncov- 16 er the target’s possible violations of various antitrust regimes, but the 17 process itself must be carried out in a manner calculated to avoid 18 antitrust violations. The latter encompasses two issues: (1) If the trans- 19 action involves a horizontal relationship between the buyer and the tar- 20 get, care must be taken with pricing disclosures and preclosing control 21 mechanisms; and (2) Assuming the transaction is large enough to quali- 22 fy, the parties must obtain clearance for it to proceed, such as compliance 23 with HSR filing procedures in the United States. The need for such 24 compliance can affect the timing and manner of the due diligence 25 process. 26 Key issues in inbound versus outbound transactions. Antitrust 27 issues are generally most important to lawyers who represent inbound 28 buyers, because the potential for antitrust liability is strongest in the 29 United States (although the EU antitrust blocking of General Electric’s 30 worldwide acquisition of Honeywell and EU scrutiny of other deals has 31 arguably raised the profile of foreign antitrust risks to a comparable, if 32 not greater, level). In outbound transactions, the most active govern- 33 ment antitrust agencies are found in Canada, Japan, Australia, the EU 34 and its affiliated countries in the EEA (European Economic Area), and 35 other neighbors that have adopted EU law as a precursor to EU mem- 36 bership. The major difference in these regimes is that unlike in the 37 174 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 United States, counsel for potentially injured parties cannot bring pri- 2 vate antitrust lawsuits featuring treble damages and attorney fees. The 3 U.S. statutory provisions governing such litigation were meant to pro- 4 mote and supplement government efforts in antitrust enforcement. 5 Due diligence for inbound transactions should focus primarily on the 6 issues of price-fixing, territorial restraints, intellectual property restraints 7 (discussed below), and exclusive dealing—all areas in which the so-called 8 per se rules can find application. These court-developed rules provide 9 that once a per se violation is proved, there is no need to go further to 10 prove the effect of the violation on commerce (contrary to the so-called 11 rule of reason violations). Thus, for a per se violation the deleterious 12 effect on interstate or international commerce is presumed, and the only 13 remaining issue for the plaintiff is establishing the nature and extent of 14 the remedy. 15 With those priorities in mind, legal due diligence should not overlook 16 other federal antitrust issues, such as interlocking directorships, viola- 17 tions of resale price maintenance rules, price discrimination, and the var- 18 ious state antitrust rules. Recall that the antitrust actions against 19 Microsoft involved not only the U.S. government as a plaintiff but also 20 many state governments as prosecutors regarding violations of state 21 antitrust rules. 22 The mechanics of antitrust due diligence vary with the type of trans- 23 action. It may be that the transaction will be subject to such antitrust 24 provisions as Section 7 of the Clayton Act, governing what types of 25 mergers and acquisitions are illegal or potentially so. If this is the case, 26 the investigation should focus on the prospect of antitrust liability, and 27 counsel should engage economists and other professionals to dig deeply 28 into the details of the structure of the target’s market and its business 29 practices to try to come to grips with the buyer’s legal exposure. 30 In transactions that meet the size-of-parties and size-of-transaction 31 tests of the HSR preclearance mechanism, the due diligence team often 32 must also assist the buyer in preparing, submitting, and monitoring the 33 required HSR filing. In this regard, particular attention should be paid 34 to identifying all affiliates of the buyer and target around the world, and 35 collecting and analyzing their sales and market share data. (Note that all 36 market studies and other competition-related analytics prepared for the 37 buyer’s directors or officers must be furnished with the HSR filing.) In LEGAL DUE DILIGENCE 175 outbound transactions, similar procedures are required for preclearance 1 of acquisitions in certain countries. 2 In conducting antitrust due diligence, basic questions should include 3 the following: 4 1 Whether the target maintains a written set of antitrust policy 5 guidelines for its personnel (which, if properly prepared, updated, and 6 enforced, give some comfort that inadvertent antitrust violations have 7 not occurred, and in certain cases can also significantly reduce liability if 8 a violation has occurred) 9 2 Whether the target regularly uses outside antitrust counsel (in 10 which case many of the due diligence questions can be dealt with more 11 quickly through such counsel) 12 3 Whether the target or selling shareholder is or has been the sub- 13 ject of any enforcement proceeding or consent decree anywhere in the 14 world (in which case the target will already have antitrust counsel, and 15 the issues of possible liability or violation should be discussed with that 16 counsel in depth) 17 The following key areas of inquiry apply in both inbound and out- 18 bound transactions. The inquiry should take into account the structure 19 of the relevant markets and the parties’ relative market shares when con- 20 sidering potential antitrust exposure. Due diligence questions include: 21 Does the target maintain membership in any trade associations or groups 22 that set some qualitative or quantitative standards for industry members? 23 If so, do any of the target’s officers, directors, or shareholders act as offi- 24 cers or committee chairpersons for such groups? Are there written min- 25 utes of meetings that can be reviewed? Are meetings attended by 26 antitrust counsel watchdogs to ensure that price-fixing, territorial divi- 27 sions, or similar discussions do not occur? 28 Do any of the target’s officers, directors, or shareholders act as direc- 29 tors of or in other key positions in any supplier, customer, or competi- 30 tor? Do they or key sales personnel of the target regularly attend indus- 31 try conferences? Are there periodic reports filed concerning meetings 32 and other activities that the target’s antitrust counsel has not reviewed? 33 This area of competitor cooperation has been the focus of antitrust 34 enforcement agencies for the past decade and has given rise to some 35 record-setting fines for international price-fixing. A well-publicized 36 example is Archer-Daniels-Midland’s involvement in the lysine cartel, 37 176 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 which led to worldwide fines and settlements for the corporation and 2 others well in excess of $100 million. 3 The buyer should determine whether the target terminated any 4 dealers or distributors within the relevant statute of limitations period 5 for contract actions (which are typically longer than those for antitrust 6 actions). If so, there may be antitrust issues, especially if the termina- 7 tion was at the request of a competitor of the terminated dealer or dis- 8 tributor, or was caused by the dealer or distributor failing to follow 9 suggested retail prices, reselling at deep discount or otherwise being 10 disruptive in the marketplace. There are draconian antitrust-based 11 rules applicable in certain industries to terminations of distributorships 12 (franchises, car dealerships, and beer distributorships, for example) in 13 the United States that should be considered if the target is in an affect- 14 ed industry. 15 Typically, the buyer’s counsel reviews any significant form contracts 16 that the target uses with its customers, as well as the actual contracts 17 entered into with its top customers and suppliers. When requesting these 18 contracts, counsel should consider stipulating that the prices charged to 19 the target’s customers (or by the target’s suppliers) be redacted if the 20 buyer is a competitor of the target or of any significant customer or sup- 21 plier of the target. This consideration is important because the due dili- 22 gence process itself can raise antitrust problems, especially when the 23 buyer and target operate in the same market. 24 Confidentiality concerns and other risks. If the buyer and the tar- 25 get are competitors, the target will naturally be concerned about reveal- 26 ing its pricing and discount structure to the buyer, as well as the identi- 27 ty and sales volume of its top customers. If, for any reason, the deal does 28 not go through, the target is left with critical sales and marketing infor- 29 mation protected at best by the rather cold comfort of a confidentiality 30 agreement. Aggressive buyers may, however, insist on disclosure of these 31 pricing and customer details in the period between contract and closing 32 and seek to impose controls over the target’s marketplace activities. 33 Antitrust issues will be a factor in negotiating such items. 34 Sometimes creative lawyering can solve these confidentiality concerns. 35 In the long negotiation of the agreement for the U.S. subsidiary of a for- 36 eign manufacturer to acquire the subsidiary’s main U.S. competitor, the 37 target objected to a presigning inspection of its facilities and machinery LEGAL DUE DILIGENCE 177 by the buyer’s executives. The target was concerned about what would 1 happen if the deal didn’t close. The target’s response to the buyer’s insis- 2 tence on this score was an offer to acquire the buyer. The buyer’s coun- 3 sel broke the logjam by suggesting that 4 1 the parties first complete negotiations to arrive at a contract they 5 would both be comfortable signing subject to a satisfactory inspection 6 by the buyer of the target’s facilities and machinery, and 7 2 in the days before a scheduled signing, each would conduct an 8 inspection of the other’s U.S. facilities and machinery. This strategy was 9 successful in providing the needed trust, motivation, and deal momen- 10 tum for the target to proceed to a signing and closing. 11 Antitrust concerns arising from steps taken preclosing caused the U.S. 12 Department of Justice to file a lawsuit against Computer Associates 13 International Inc. (CA) over CA’s two-year-old purchase of Platinum 14 Technology International Inc. (PTI). Although this transaction eventu- 15 ally closed, CA had contractually required a significant set of controls to 16 be placed on PTI that were effective during the thirty-day waiting peri- 17 od under the HSR law. These controls included requiring PTI to obtain 18 CA’s approval before entering into certain contracts with customers, and 19 installing a CA employee at PTI headquarters to review customer con- 20 tracts and other management decisions. By reason of this preclosing 21 jumping of the gun, the Department of Justice was, at this writing, seek- 22 ing $1.27 million in civil penalties from CA and PTI, as well as an 23 injunction barring CA from engaging in similar future conduct. With 24 such risks in mind, counsel for the buyer and target should, before clos- 25 ing, review how and what materials to disclose and what actions to con- 26 trol between signing and closing. 27 28 Intellectual Property 29 In an age in which intellectual property (IP) is often more important 30 than hard assets, IP due diligence may be critical to a buyer’s “go/no 31 go” decision. International treaties covering patents, trademarks, and 32 copyrights have made due diligence in the IP world somewhat uniform, 33 especially in determining whether IP assets exist and are registered in the 34 target’s name. However, checking the relevant national registries for reg- 35 istrations, renewals, and assignments is only the beginning of IP due dili- 36 gence. There are five larger issues: 37 178 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 1 ownership of employee inventions or creations; 2 2 trade secrets and other nonregistered confidential information; 3 3 the terms and conditions of licenses; 4 4 potential liability for infringements of third party IP rights; and 5 5 special problems associated with databases. 6 Each of these areas may have similarities from country to country, but 7 the differences can be crucial to the continued post-deal conduct of the 8 target’s business. 9 Ownership of employee inventions or creations, copyright 10 issues, and trade secrets. Issues relating to the ownership of employ- 11 ee inventions or creations tend to fall into the patent and copyright areas. 12 For employee inventions, some countries require that the employee 13 receive reasonable compensation for assigning a patent or patentable 14 invention to the employer; in others, the terms of an existing employ- 15 ment contract will govern. If due diligence uncovers any registered or 16 unregistered employee inventions, the team should ask the target to pro- 17 duce a waiver and confirmation of assignment letter from the employee, 18 including a confirmation that no other parties have any rights in or 19 claims to the invention. If such a letter is not obtainable, the buyer 20 should at least confirm that the employee made an effective assignment 21 to the target and is not instead licensing the invention to it. 22 The danger of not looking carefully into this kind of issue is illustrat- 23 ed by a German buyer’s acquisition of a U.S. target that had certain key 24 technology protected by an employee patent previously assigned to the 25 target. The buyer possessed complementary technology that it wanted to 26 exploit worldwide jointly with the target’s technology. The buyer was 27 given a copy of the waiver and confirmation of assignment signed by the 28 employee. Soon after closing the target’s new management terminated 29 the employee. The former (and now aggrieved) employee then contacted 30 an earlier employer and signed an affidavit stating that he had invented 31 the technology while employed there. Thus, according to his employ- 32 ment contract with the earlier employer, the technology belonged to 33 that employer and could not properly be assigned by the target. The fact 34 of when the technology was created was the crux of the matter, so the 35 waiver and confirmation letter was invaluable evidence for the German 36 buyer to rebut the credibility of the former employee’s affidavit given to 37 his earlier employer. LEGAL DUE DILIGENCE 179

The typical copyright issue, especially in the United States, is whether 1 the party creating the material (often important computer programs cre- 2 ated by a person hired specifically for the task) was an employee acting 3 within the scope of employment or, alternatively, an independent con- 4 tractor. If the former, in the United States and in most other countries, 5 the employer owns the registerable rights in the material (subject in cer- 6 tain foreign countries to the issue of compensation). If the person was 7 an independent contractor, the question becomes whether the material 8 is a “work made for hire” (with unique U.S. legal ramifications if the par- 9 ties have not signed a written document designating the work as a “work 10 made for hire”) or whether the independent contractor has retained 11 some or all of the rights in the work. (The computer program example 12 applies to all copyright issues; this could just as well relate to advertising 13 copy, or photographs shot by a freelance photographer.) Especially 14 where key technology for the operation of the business is involved, due 15 diligence should focus on such issues as whether there is any source code 16 available (in escrow or otherwise), as well as the terms of the agreement 17 with the person in question. 18 The independent contractor’s written agreement should specify that 19 the material or program is a work made for hire, and that any aspects of 20 the material or program not covered by such protection are assigned to 21 the company, together with any rights of registration. Special attention 22 must also be paid to “carve-outs,” in which the contractor retains rights 23 to use certain elements of the material or program for her own purpos- 24 es. The problem becomes infinitely more complicated if due diligence 25 must pin down all rights, especially in situations where the independent 26 contractor may have a development team linked by e-mail but located, 27 for example, in Ireland, India, and Indonesia. 28 Trade secrets and other confidential information are proprietary IP 29 and not protected by any registration. Therefore, in most areas of the 30 world, these properties are transferred and protected only by contract. 31 The task in due diligence is to determine whether the contracts are valid. 32 The first contractual relationships to consider are those involving the tar- 33 get and its employees and independent agents. Quite often, no employ- 34 ment or consulting agreements are in place, and the issue is whether a 35 general policy statement of the employer provides binding legal protec- 36 tion. Determining this may require investigating the target’s entire sys- 37 180 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tem for maintenance of confidential information and documents, such as 2 log-in or log-on procedures, safekeeping, encryption, and employee or 3 consultant hiring and termination processes. The second contractual 4 relationships to consider are those with third parties such as licensees or 5 licensors, where the contract terms are key to successful trade secret due 6 diligence. In a cross-border context, the due diligence team must pay 7 careful attention to local laws that may require disclosure of critical con- 8 fidential information for safety, health, or other public policy reasons, 9 notwithstanding contractual agreements requiring confidentiality. 10 An IP license, or conditional waiver by an IP owner of its right to sue 11 for infringement, may be of great importance to the target acting as 12 licensor or licensee. Due diligence regarding licenses (what is licensed, to 13 whom, for how long, for what compensation, and to whom the license 14 may be assigned or sublicensed) is often inadequate in cross-border deals 15 because U.S. targets, or those within the EU that are subject to possible 16 antitrust regulation, are often skittish about disclosing information to 17 potential buyers. 18 Global differences in IP focus and regulatory approaches. In the 19 United States, the IP issues to examine are fairly predictable and often 20 overlap with antitrust issues, and arise in a traditional legal context. 21 Examples include: 22 1 Horizontal cross-licenses, tying and full-line forcing (in other 23 words, compelling purchasers to buy additional goods, services, or rights 24 as a condition to the requested purchase or license) 25 2 Collection of royalties beyond the scope or term of the IP 26 3 A determination of whether any misuse of the IP is sufficiently 27 material to suspend or extinguish the IP rights 28 4 Analysis of exclusive licenses under the terms of Section 3 of the 29 Clayton Antitrust Act, with the required relevant market and competi- 30 tive injury determinations 31 U.S. counsel doing a transaction in the EU will meet with a different IP 32 focus and regulatory approach. The EU has certain per se rules on IP licens- 33 ing (so-called black list clauses), but the EU also grants advance clearance 34 to a number of restrictive clauses (“white list clauses”) that are permitted so 35 long as the licensor does not have more than a 40 percent market share. 36 Potential liability for violating third party rights is one of the core con- 37 cerns of due diligence in cross-border as well as domestic deals, but one LEGAL DUE DILIGENCE 181 of the most difficult to ascertain. The only real tools available to the due 1 diligence team are official registry searches and reviews of all threatening 2 correspondence. In the first category, all trademarks and patents impor- 3 tant to the target’s operations should be reviewed to determine whether 4 there are third-party-owned trademarks or patents that might present 5 infringement issues—infringement either by or against the target. 6 Counsel should consider retaining a commercial search company to con- 7 duct the search and at least a partial evaluation of potential infringements 8 on a relatively expedited basis; the benefit of using an outside search 9 firm—freeing up the due diligence team for other matters—often is far 10 greater than the cost. Of course, all correspondence addressed to the tar- 11 get over an extended period (six years would be comfortable) that 12 describes possible violations of IP rights must be investigated to see what 13 responses were made. In addition, the drafting team must deal with 14 these issues carefully in the “reps”—and not just by listing the possible 15 violations on a disclosure exhibit. 16 A cautionary note: In some countries there are new legislated forms 17 of IP, such as the British database right, that have no U.S. equivalent. In 18 doing any cross-border IP due diligence, the practitioner should first 19 review the general scope of IP laws in the countries in which the target 20 operates to see whether any of these new forms of IP exist. 21 Finally, if the target is located within the EU, due diligence must 22 focus on the current use of customer information accumulated in any 23 databases and the potential use for such database information post- 24 transaction. European database regulations are quite strict in protecting 25 consumer information that would customarily be extensively mined and 26 used in the United States. If the transaction involves any contemplated 27 use of the European target’s databases, the due diligence must deter- 28 mine whether the buyer is properly organized to take advantage of the 29 U.S. safe harbor rules that the EU has accepted. These rules enable a 30 U.S. company, upon voluntary compliance with other rules that the 31 United States and the EU have agreed upon regarding the use of per- 32 sonal information, to achieve substantial compliance with the EU data- 33 base regulations. Absent such safe harbor, the mining of the target’s 34 data, not to mention the use of the results, could result in significant 35 fines in Europe. 36 Taking a broad view of IP due diligence. Successful IP due dili- 37 182 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 gence takes a broad view of what constitutes IP, whether high tech or 2 low tech, because IP issues tend to surface where least expected. In the 3 worldwide merger of two of the largest international accounting firms 4 (carried out in each country by merger of the respective two local firms 5 there), due diligence turned up the fact that the “international practice” 6 name (in addition to the local practice name) of some of these national 7 firms had been registered by them—and in some instances by their 8 founding partners—as service marks (trademarks). These registrations 9 became a major issue in several countries where the national firms 10 refused to merge. When, upon such refusal, one of the two national 11 firms was chosen as the merged worldwide organization’s member in 12 that country, the other firm refused to relinquish its “international” 13 name, now part of the worldwide organization’s name. This led to liti- 14 gation in which the non-chosen firm claimed the right both to continue 15 to use the “international” name and to block use in its country of the 16 “international” name by the other firm or any other representative of the 17 merged organization. 18 M&A due diligence of a dot-com or similar company, in which IP is 19 far and away the most important asset, requires a different (or expanded) 20 due diligence effort. Certainly the due diligence on such companies 21 should be heavily focused on IP. As these tend to be newer businesses, 22 counsel can rely less on their management, who may lack business expe- 23 rience. Particular scrutiny should be given to noncompete agreements. 24 Still, dot-coms and other new-tech companies are businesses, and as more 25 businesses integrate fully into an information technology world, the dis- 26 tinctions for due diligence purposes will fade. Nonetheless, in a dot-com 27 or similar type of acquisition, the composition of the due diligence team 28 should be heavily tilted toward those with IP fluency and experience. 29 30 National Security Implications 31 The national security preclearance procedures for M&A transactions 32 under the Exon-Florio Amendment are sometimes lumped conceptually 33 with the HSR antitrust preclearance procedures, but are really more a 34 matter of technology, and thus of IP. In a nutshell, if a deal may result 35 in foreign control over defense or other national security-related opera- 36 tions or assets, the parties would be well advised to avail themselves of 37 the voluntary Exon-Florio preclearance procedures. The obtaining of LEGAL DUE DILIGENCE 183 such clearance minimizes the risks of a later forced divestiture action by 1 the government. In the post-9/11 environment, the government may 2 take a broader view of what deals have national security implications. 3 4 Litigation 5 The focus of due diligence is at least as much the avoidance of unantici- 6 pated liabilities as it is verification of the assets, so investigation of poten- 7 tial or actual litigation or administrative claims is central to the process. 8 The buyer wants to know what the opening balance sheet will look like 9 after the closing, and it certainly does not want to find any unexpected 10 red ink. There is, however, a conceptual gap confronting counsel seek- 11 ing to evaluate litigation or administrative claims when one of the par- 12 ties comes from a common law jurisdiction and the other from a civil law 13 jurisdiction. 14 Process and timing issues. At common law, the parties largely con- 15 trol the process and timing of litigation. The parties use pretrial disclo- 16 sure devices as widely as possible to obtain whatever information they 17 can about their adversary’s actual or potential position. As a result, dis- 18 cussions with the target’s litigation counsel can take place on a rather 19 informed basis, and counsel undertaking a due diligence investigation of 20 the target can often independently review claims and evidence in the dis- 21 pute in order to form opinions on liability and damages. 22 These procedures are truly anomalous to many European attorneys. 23 They view litigation as something largely conducted by the judge or mag- 24 istrate, who develops the evidence, conducts the witness interviews, deter- 25 mines the relevance and weight of the evidence, and controls the timing 26 of the lawsuit. Pretrial discovery is not generally available. Further, the 27 civil law attorney may not comprehend U.S. counsel’s view of litigation: 28 whether the facts of the case fit into (or can be distinguished from) a prior 29 decided case that can serve as legal precedent. The civil law attorney is 30 trained to view litigation issues in terms of general legal code provisions, 31 as refined by the writings of “eminent jurists” and “noted authorities” (in 32 other words, legal scholars). Also, consideration of industry norms and 33 standards is more important than prior case law (unless from, for exam- 34 ple, a country’s constitutional court or equivalent). 35 As a result, the request for an opinion on litigation must be carefully 36 explained, and the common and civil law attorneys must focus on the 37 184 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 likely ultimate outcome of the litigation rather than the particulars of the 2 ongoing litigation process. Whether the deal is inbound or outbound, 3 the goal is the same: to determine the potential liability and damage risks 4 to any of the target’s material assets. If the target is a U.S. public com- 5 pany or provides audited financial statements, the process may be easier 6 to start, because all material claims and litigation should have been pro- 7 vided to the auditors and, thus, disclosed in public securities filings. In 8 that event, due diligence will include a review of all of the target’s attor- 9 neys’ responses to the auditor’s requests for information regarding any 10 of the claims or lawsuits they are handling. This information should 11 cover the same historical time period for which the buyer has requested 12 the financial statements themselves—usually the prior full three fiscal 13 years before the date of the acquisition agreement, and sometimes up to 14 five years. Of course, as the Enron meltdown has reminded us, relying 15 solely on publicly filed information without further due diligence review 16 and analysis is risky, as things may be brewing below the public radar 17 screen that can have devastating effects on a buyer. 18 The target should be prepared to document for the buyer all claims or 19 proceedings that exceed a specified amount related to the size of the 20 transaction, or where the continued existence or use of a right or privi- 21 lege, such as a permit or license, of at least some importance could be 22 suspended or lost. In any case where there is a financial exposure, a crit- 23 ical issue is whether the event is insured and whether the insurer has been 24 notified, has conceded defense and indemnity for the claim, or has dis- 25 claimed coverage. This issue applies even in the case of an asset transac- 26 tion where the specific liability is contractually stated to be left with the 27 selling side—in which case the cautious buyer may want the target to add 28 the buyer as an additional insured or loss payee under the applicable 29 insurance policies, in light of successor or liability concerns. If a key per- 30 mit or license is involved, due diligence should also determine whether 31 the buyer can obtain the permit or license in its own name, and whether 32 this can be done in a sufficiently timely manner so as not to interrupt the 33 target’s post-closing operations. 34 Exposure issues. While due diligence concerns regarding litigation 35 are fundamentally the same in inbound and outbound transactions, 36 some important differences in the details can affect the amount of the 37 exposure. For example, in the United States in cases of blatant civil LEGAL DUE DILIGENCE 185 wrongdoing, victims commonly request punitive damages. Such dam- 1 ages are unconstitutional in Germany. U.S. counsel in an outbound 2 transaction may not have been exposed to the “English rule,” in which 3 the losing side pays the legal fees of the winning side, or the “German 4 rule,” which adds the element of legislatively fixed legal fees at each stage 5 of the proceedings based on the amount in controversy. Conversely, 6 English and German counsel are likely to find the U.S. system of con- 7 tingent fees to be equally strange and probably unethical. Class actions 8 present a U.S. litigation risk not always well appreciated outside the 9 United States. The presence of local counsel to sort out these and other 10 differences can be quite useful to avoid misunderstanding. 11 If the target makes consumer products, a foreign buyer’s litigation 12 concern should focus on exposure for product liability. Foreign busi- 13 nesspersons and professionals generally view the United States as a 14 product liability claimant’s paradise, and this is often the one area 15 where U.S. counsel gets little argument from its foreign client about 16 the extent of the due diligence. Counsel may have to calm the foreign 17 buyer’s concerns instead of rousing the buyer to appreciate the poten- 18 tial risk exposure. For example, in the acquisition of shares of a U.K. 19 manufacturer, the U.S. buyer had been subject to product liability lit- 20 igation. The target required the U.S. buyer’s counsel—before any fur- 21 ther due diligence could proceed—to travel to London to review with 22 the target’s barrister all of the buyer’s actual and threatened product 23 liability litigation and the insurance coverage for it. This demand 24 required hiring an international insurance adviser on issues of coverage 25 and policy limitations. 26 A foreign buyer’s inquiry into a target’s product liability exposure 27 must go beyond a review of existing one-off cases and claims. Counsel 28 should look for any developing claims patterns that could ripen into a 29 class action or a product recall. In reporting to the foreign client on the 30 amounts claimed in the complaints filed in pending product liability, 31 securities violation, employment discrimination, and personal injury 32 cases, among others, U.S. counsel must explain that the amounts 33 claimed are routinely inflated by multiples in the filed complaints, and 34 she must make a realistic assessment of the financial exposure for the 35 material litigation claims. Foreign clients may be unaccustomed to such 36 claim inflation. 37 186 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Security Interests of Creditors 3 U.S. lawyers acting as a buyer’s due diligence counsel are accustomed to 4 relying on several external sources of information regarding a target’s 5 creditors and the security interests they hold in a target’s assets. Primary 6 among these is the Uniform Commercial Code (UCC) search, seeking 7 evidence of secured creditors and the particulars of the security interests. 8 This search is often one of the very first things that U.S. attorneys will do, 9 if the buyer’s CFO has not done it already. In the United States, in order 10 to “perfect” (assure the priority of) a security interest in goods and intan- 11 gibles of a corporation where the security interest is otherwise not record- 12 ed or perfected by possession, a creditor would typically file a UCC-1 13 financing statement in a central state registry maintained by the secretary 14 of state (or like officeholder) of the state where the debtor is incorporat- 15 ed. This security filing is in addition to the security agreement with the 16 target that creates the security interest (but not its priority) and that is 17 often embodied in a document separate from the loan agreement or debt 18 instrument. That two-step process—security agreement and UCC filing— 19 provides the means of determining (by filing date priority unless otherwise 20 agreed by the creditors) the relative seniority of the lien. 21 U.S. counsel for a buyer in an outbound transaction will find that 22 experience with the UCC recording system offers help only in countries 23 that follow the Anglo-American common law system. For example, the 24 Canadian Registration of Personal Property Obligations Act provides a 25 similar system, as do a series of Australian statutes. While there is legisla- 26 tion establishing the framework for a system of recording liens in Russia, 27 the actual practice of recording is rather chaotic. Thus, placing any 28 reliance on whether a security interest is or is not properly recorded in 29 Russia, or actually exists, requires a large degree of faith. 30 Very few foreign countries using a legal system based on the Roman 31 law civil code system have any formal system of lien recording for per- 32 sonal property generally, and their laws regarding security interests are 33 usually much different from the U.S. model. If the target is located in 34 France or Germany, for example, the French lien (a privilege) or the 35 German security interest (a Sicherungsrecht) is good only to the extent 36 that a third party purchaser of the assets actually knows about it and can 37 be said to be purchasing in bad faith. LEGAL DUE DILIGENCE 187

Absent such evidence, what can the lien holder do, and how can the 1 buyer conduct due diligence on liens? A common practice in the United 2 States and elsewhere for larger tangible items is to place a plaque assert- 3 ing ownership on the asset itself; a part of outbound due diligence would 4 then be a physical inspection of the major assets. In a deal involving the 5 financing of oil barges in Venezuela, the creditor had foot-square steel 6 plaques made announcing its security interest. These plaques were 7 securely bolted to the barges’ pilothouse doors, and the captains (who, 8 importantly, were not government employees or agents) were paid a 9 small gratuity to ensure that the plaques did not disappear. 10 In the case of intangibles like accounts receivable, there is little the 11 creditor can do to perfect a security interest, other than to force the 12 account debtor to arrange to have payments on its accounts to be made 13 directly into some sort of escrow fund or to the creditor, from which it 14 is redistributed to the debtor so long as the debt is kept current. 15 Enforceable commitments obtained from account debtors, and lockbox 16 arrangements, represent the best possible buyer protection. 17 In some outbound deals the ability to identify recorded liens may be 18 limited. If so, the appropriate course of action is to add belt-and-sus- 19 penders security in the acquisition agreement itself, such as lengthy and 20 sizeable escrowed purchase price holdbacks. 21 In the case of real estate assets, foreign registry systems for owner- 22 ship are much the same as in the United States. What is different from 23 the U.S. system is the answer to the questions of the nature and loca- 24 tion of the property, and how you can be sure that there are no liens, 25 encumbrances, or rights of usage attaching to it. In a U.S. transaction 26 involving any significant real property, the U.S. lawyer should ask the 27 target for a copy of its most recent title search report and current title 28 insurance policy. Counsel should then arrange to obtain a current title 29 search report and to purchase title insurance effective as of the clos- 30 ing. The title report points out almost all known impediments to the 31 buyer’s receiving the bargained-for ownership interest in the real 32 property. This report makes the transfer and the securing of mort- 33 gages and other liens on real property relatively easy. If unusual prob- 34 lems emerge (such as the federally supported Native American land 35 claims against New York State uncovered in the sale of upstate New 36 York manufacturing facilities to an international investor), the target, 37 188 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the buyer, and the title insurance company can negotiate a special cov- 2 erage provision in the title policy plus a contractual representation 3 stating that there is insurable (not just marketable) title to the real 4 estate in question. 5 In most outbound transactions, a title report is not available. Thus, in 6 Australia the buyer should have the solicitor or title agent, rather than a 7 title insurance company, review title. Personal property liens on chattels 8 and intangibles can be searched at the same time, because the registry 9 office serves for both personal and real property. 10 In cross-border transactions involving European real estate (assuming 11 foreigners are permitted to own real property, which they are generally 12 not in Switzerland), the purchaser of real property must have title trans- 13 ferred before a notary public, who in Europe is a professional with sig- 14 nificant powers. It is the duty of the notary to make sure the parties are 15 aware of any mortgages, liens, encumbrances, and tax bills affecting the 16 real property, and that they have taken appropriate steps to discharge 17 them, before he officially reads the deed and has the parties sign it. The 18 notary system does not, however, give the buyer the same financial assur- 19 ances that American title insurance does. 20 21 Terminating Employment and Marketing Relationships 22 without Liability 23 A buyer typically expects to streamline costs and reorganize the target’s 24 personnel after the acquisition. However, the traditional “at will” termi- 25 nation that, although eroding at the edges, remains the cornerstone of 26 U.S. nonunion employment law is repugnant to both law and practice in 27 most developed countries. Accordingly, in cross-border deals involving 28 employees outside the United States, the matter cannot be resolved by 29 reviewing a few employment contracts and the company handbook. 30 Rather, it involves understanding the target’s historical employment 31 practices, the detailed administrative regulations that may protect 32 employees, and the costs incurred upon making changes and upon fail- 33 ing to honor such practices and regulations. 34 Plant closings also can create legal and political problems. If closings 35 are part of the acquisition plan, they must be organized in advance with 36 the precision of a military campaign. Among the local advisers engaged 37 LEGAL DUE DILIGENCE 189 should be skilled public relations professionals. U.S. law has its counter- 1 part with the procedures required under the so-called WARN statute. 2 In a number of jurisdictions, legal protection regarding termination 3 extends beyond employees to certain third parties, such as distributors 4 and independent sales agents. In Germany, for example, legislative provi- 5 sions govern in some detail the circumstances under which a terminated 6 sales agent must receive post-termination compensation (“indemnity”), 7 whether or not the issue has been reflected in the contract. As a result, 8 the review of a German target’s commercial contracts and business 9 arrangements must focus on, among other things, whether the third party 10 individual or entity may be deemed to be a sales agent and, if so, whether 11 any part of the contemplated transaction might constitute an actual or de 12 facto termination. 13 A Belgian statute similarly protects terminated distributors. This pro- 14 tection is considered a “mandatory” provision of Belgian law, and thus 15 cannot be circumvented by contrary provisions or waivers in the distrib- 16 utorship contract, by contractual designation of non-Belgian law or 17 courts, or by arbitration provisions. Likewise, if the contract has been 18 extended, either formally or informally, several times beyond its contrac- 19 tually stated term, it is likely to be considered subject to the statute as a 20 “contract of indefinite duration.” 21 Such statutes are not unknown in the United States. For example, 22 Puerto Rico has a statute protecting distributors generally from termi- 23 nation without compensation, and Wisconsin has a strong dealer pro- 24 tection statute not limited to specific industries or to franchises. 25 Ironically, a Belgian-owned company, which decided to do its own con- 26 tract due diligence review in its acquisition of a U.S. competitor, missed 27 a reference to a “joint venture” product supply relationship in the tar- 28 get’s contract with a Wisconsin customer. Because of the Wisconsin deal- 29 ership statute, the Belgians were stuck with an ongoing product supply 30 contract that it had intended to terminate post-closing. The lesson is that 31 terminating employment and marketing relationships and closing facili- 32 ties are often unforeseen triggers to liability outside the United States, 33 and sometimes within it as well. 34 35 36 37 190 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 The Preferred Result of Legal Due Diligence: 3 No News Is Good News 4 The best evidence of a legal due diligence job well done is that post- 5 closing, nothing happens: No skeletons in the closet are discovered, no 6 surprises come out of the woodwork, and none of the parties’ expecta- 7 tions are unfulfilled because of something that could or should have 8 been unearthed in legal due diligence. The invisibility of these non- 9 events (except perhaps when contractual or statute of limitation claims 10 periods quietly expire) provides no occasion for cork-popping expres- 11 sions of satisfaction. There is, however, a quiet but profound sense of 12 accomplishment in a job well done. 13 The quest for such accomplishment should prevent those performing 14 legal due diligence from turning it into an unimaginative, rote, one-size- 15 fits-all process that fails to accomplish the job and may sow the seeds of 16 future problems. Thus, every due diligence assignment on a sizable 17 transaction should be customized, mustering the best counsel can pro- 18 vide, so that the buyer can receive what it bargained for: nothing less on 19 the asset side, nothing more on the liability side, a seamless transition, 20 and an enhancement of value. 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 CHECKLIST Cross-Border Legal Due Diligence 1 2 IN A WORLD where risks of legal consequences touch on almost every 3 aspect of business, any legal due diligence checklist for major transactions 4 is inherently incomplete. The following checklist is intended to serve as a 5 template to be adapted to the transaction at hand. While this checklist is 6 geared principally toward buyers, targets may engage in similar due dili- 7 gence in transactions in which the buyer’s shares are a material part of the 8 consideration. There is inevitably some overlap with the checklists used by 9 other professionals on the deal team, but proper coordination should mini- 10 mize duplication of effort. Moreover, professionals may examine the same 11 document for different purposes (i.e., on environmental issues lawyers seek 12 to analyze legal exposure, accountants review balance sheet reserves, and 13 operations people evaluate the effect of such matters on day-to-day opera- 14 tions). Thus, much of the perceived duplication is more apparent than real 15 and is necessary to the conduct of proper due diligence. 16 17 1. Division of Responsibility 18 ❏ Counsel (is local—including foreign—or special counsel needed?) 19 ❏ Target’s personnel (including in-house counsel) 20 ❏ Accountants 21 ❏ Investment banker 22 ❏ Private investigator/information specialist 23 ❏ Title company 24 ❏ Consultants (such as pension, environmental, OSHA, insurance, cus- 25 toms) 26 ❏ Translators 27 ❏ Information technology personnel (to create due diligence sites) 28 ❏ IP commercial search company 29 30 2. Memorandum of Understanding (MOU) 31 ❏ Determine whether the parties have entered into any understanding 32 in the form of a MOU or other form of letter of intent, whether oral 33 or written, concerning the proposed transaction. 34 ❏ If so, determine whether all legally operative conditions to the trans- 35 action in the MOU were fulfilled or waived. 36 ❏ If not, determine whether a MOU is necessary and which provisions, 37 if any, should be stated to be legally binding. Note risks under for- 38 eign laws of inadvertently entering into binding MOU obligations. 39 40

191 192 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 3. Publicity and Confidentiality 2 ❏ Determine whether the target, on the buyer’s request, should agree 3 not to disclose information about the buyer obtained in negotiations, 4 not to negotiate with others for a period of time, and/or not to dis- 5 close existence of negotiations. 6 ❏ Determine whether the buyer, on the target’s request, should agree 7 not to disclose information obtained in negotiations and/or existence 8 of negotiations. 9 ❏ If joint public communications are to be made, establish which indi- 10 viduals must approve before dissemination. 11 4. Access to Books and Facilities 12 ❏ Arrange for access to the target’s books and records, including off- 13 site storage locations. 14 ❏ Arrange for access to the target’s facilities and to third party facilities 15 where the target’s property is located. 16 ❏ Obtain the target’s document retention and disposal policies and pro- 17 cedures. Consider requesting suspension of document disposal. 18 19 5. Capitalization and Shareholders 20 ❏ For a non-publicly-traded target, obtain list of voting and nonvoting 21 shareholders specifying their holdings and cross-check against the 22 stock transfer ledger. 23 ❏ Obtain particulars of bonds, debentures, and any other debt or 24 hybrid securities of the target, including indentures and other perti- 25 nent documents. Examine covenants in trust indentures and similar 26 documents for effects on transaction. 27 ❏ Confirm the status of preemptive rights or any other similar rights 28 and privileges. 29 ❏ Inquire about the existence of, or agreements to issue, options, war- 30 rants, or other rights or commitments relating to the purchase, sale, 31 or issuance of securities. Investigate for convertibility features of any 32 debentures or preferred stock and obtain vesting schedules, pricing, 33 and other conditions for options. 34 ❏ Determine status of shareholders (such as minors, trustees, deceased 35 or legally incompetent individuals, joint owners, partnerships, bank- 36 ruptcy estates). 37 ❏ As necessary, obtain trust and partnership agreements or other per- 38 tinent documents to determine if any shares are held in fiduciary or 39 partnership capacity or by an entity. 40 LEGAL DUE DILIGENCE 193

❏ Inquire about the existence of any stock option plans, employee 1 stock option plans (ESOPS), stock bonus plans, profit sharing, or 2 other plans that are holding the target’s shares. 3 ❏ Determine if shares are fully paid for legally adequate consideration 4 and nonassessable. 5 ❏ Inquire about compliance with federal securities and state blue-sky 6 laws for original and subsequent issues of the target’s shares (to 7 avoid rescission actions). 8 ❏ Check that shares issued do not exceed amount of authorized shares 9 and that shares are validly issued under state corporate law. 10 ❏ Determine whether there are any voting agreements or trusts, out- 11 standing proxies, or other shareholder agreements relating to voting 12 of shares. 13 ❏ Verify that no restrictions or trigger events exist regarding the trans- 14 fer or pledge of the target’s shares contained in stock purchase, 15 buy/sell, or repurchase (“put”) agreements. Check for first-refusal 16 rights; leases, licenses, service contracts, or other agreements making 17 sale of assets or shares an event requiring third party consent; loan 18 agreements collateralizing the shares; tax liens on shares; and other 19 shareholder or employment agreements relating to securities, assets, 20 or change of management of the target. 21 22 6. Seller’s Authorization of Transaction 23 ❏ Review specific authorization resolutions, and make sure authoriza- 24 tion is not contrary to articles of incorporation or bylaws of the target. 25 ❏ Determine whether shareholder approval is necessary (e.g., sale of 26 substantially all of the seller’s assets). 27 ❏ Check whether any third party approvals are necessary (private or 28 governmental, including foreign governments). 29 ❏ If possible, review reports to the seller’s shareholders or other own- 30 ers requesting consent or otherwise describing transaction. 31 ❏ Inquire whether there are any pending litigations or disputes with or 32 among the seller’s shareholders or other owners. 33 7. Target’s Organization, Good Standing, Structure, Subsidiaries, and 34 Affiliations 35 ❏ Obtain a certified copy of articles of incorporation, with all amend- 36 ments, and any other filings with the secretary of state. If the target is 37 required to file with other state government agencies relating to its cor- 38 porate purposes (e.g., banking department), also verify those filings. 39 40 194 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 For foreign entities, obtain a certified copy from corporate registry, 2 which may also show names of individuals authorized to sign for the 3 company and additional information. (Note whether more than one 4 signature is required.) 5 ❏ Obtain a copy of the corporate minute books, including bylaws with 6 all amendments, certified by the corporate secretary. Consider com- 7 paring the copy to the original minute books. 8 ❏ Obtain good standing certificates in states where the target is incor- 9 porated and states where the target is qualified; also obtain any 10 pending applications to qualify. 11 ❏ Ascertain jurisdictions where the target has substantial contacts or 12 files tax returns, and determine whether the target should be quali- 13 fied in any other states. 14 ❏ Review all (for past five years) minutes of meetings (or written con- 15 sents in lieu of meetings) of shareholders, board of directors, and 16 board committees (e.g., executive, nominating, compensation, and 17 audit committees and any nonboard committees); for major matters, 18 consider requesting materials, if available, distributed to the board in 19 connection with deliberations. 20 ❏ Obtain charts of corporate organization: corporate structure, includ- 21 ing names, locations, and functions of all subsidiaries and divisions, 22 and key personnel (directors, officers, and other key management 23 and technical personnel). Determine which directors and officers will 24 have to be replaced at closing. Identify any familial relationships 25 between shareholders/directors and employees. 26 ❏ Obtain annual reports for the past five years. Verify history of the 27 organization (i.e., how did the target come into existence?), and 28 investigate predecessor entities or businesses and terms of any prior 29 acquisitions, mergers, or consolidations. 30 ❏ Inquire about the existence of any partnership, joint venture, strate- 31 gic alliance, joint research and development, or joint marketing 32 arrangement, or any trust, agency, or nominee relationship, or any 33 investment to which the target is a party. Check for “no assignment” 34 and other restrictions in these agreements, and for potential capital 35 or loan calls on the target or requirements to provide loan guaran- 36 tees, security, or indemnities. 37 ❏ As applicable, obtain all of the records mentioned above in this sec- 38 tion for relevant U.S. noncorporate entities (limited liability compa- 39 nies, general and limited partnerships, etc.) and for foreign corporate 40 LEGAL DUE DILIGENCE 195

and noncorporate entities. For entities in foreign jurisdictions, check 1 the local ownership regulations and restrictions, and determine any 2 citizenship or residency requirements where directors or officers will 3 have to be replaced at closing. 4 5 8. Securities Filings 6 ❏ For publicly traded targets or sellers, obtain all filings made with the 7 Securities and Exchange Commission (SEC) and relevant state securi- 8 ties agencies, including relevant 10Ks, 10Qs, 8Ks, proxy statements, 9 and registration statements (S-1s, S-7s, or S-8s). 10 ❏ Determine whether there are any enforcement proceedings or inves- 11 tigations by the SEC or state securities commissions. 12 ❏ Determine federal and state securities implications of the acquisition, 13 including registrations, exemptions from registration, and restrictions 14 on resale. 15 9. Financial Statements 16 ❏ Obtain the target’s financial statements for the five preceding years 17 (and those of significant subsidiaries and divisions). 18 ❏ If financial statements are not audited, determine if a limited audit by 19 the buyer is necessary. 20 ❏ Obtain the target’s approval to have access to the target’s auditors’ 21 work papers, and consider meeting with the target’s auditors. 22 ❏ Obtain interim financial statements, and ensure that statements are 23 prepared on a comparable basis with prior periods. 24 ❏ If in existence, obtain the target’s financial projections. 25 ❏ Obtain auditors’ letters to management, and management’s responses, 26 for prior five years. 27 ❏ If there has been a change of auditors within the preceding five 28 years, investigate the circumstances, including review of relevant tar- 29 get files and inquiry of prior accountants. 30 ❏ Identify and analyze off-balance-sheet financing and other off- 31 balance-sheet structures, including securities law disclosure and 32 insider trading compliance. Confirm true ownership of entities 33 involved, and compliance with conflict of interest policies, and 34 whether terms are arm’s-length. Check for trading, swap, and other 35 arrangements that may amount to financings. 36 37 10. Bank Accounts and Securities Holdings 38 ❏ Obtain a list of all bank accounts, safe-deposit boxes, money market 39 accounts, escrow accounts, brokerage accounts, and other account 40 196 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 holdings. Determine who has signature power or access, and what 2 changes will need to be made at closing. 3 ❏ Obtain a list and particulars of all third party (nonsubsidiary) securi- 4 ties owned or held by the target (including corporate name, number 5 and class of shares, certificate numbers, location of certificates, or 6 restrictions on transfer). Determine whether such securities are 7 pledged or otherwise noted as security for obligations and, if so, 8 which obligations. Determine whether the number and type of secu- 9 rities held by the target subject it to regulation under the Investment 10 Company Act of 1940. If such securities appear on the balance 11 sheet, determine whether they have been marked to market or are 12 booked at lower of cost or market. 13 11. Loans, Contracts, and Commitments 14 ❏ Obtain loan and similar documents relating to third party and inter- 15 nal (affiliated entity or individual) loan and financing agreements and 16 instruments, whether the target is debtor or creditor (e.g., bank 17 loans, notes, letters of credit, factoring and other receivables financ- 18 ing agreements, or compensating balance arrangements). Consider 19 the effects of any covenants in those agreements on the acquisition. 20 ❏ Obtain security agreements, financing statements, pledges, condition- 21 al sales agreements, and other evidence of security for indebtedness. 22 ❏ Obtain correspondence with lenders for past three years, including all 23 compliance reports submitted by the target or its accountants, and 24 computations demonstrating compliance with covenants. 25 ❏ Obtain presentations given to lenders in the past three years in con- 26 nection with obtaining credit. 27 ❏ Determine whether debt can be refinanced or prepaid without penalty. 28 ❏ Obtain contracts with significant customers. Determine accounts 29 receivable (by customer), and identify any disputed items and 30 reserves for bad debts. Determine any formal or informal arrange- 31 ments permitting any customer later payments, discounts, rebates, or 32 other special financial treatment. 33 ❏ Obtain standard forms of all purchase and sale orders, quotations, 34 contracts, invoices, and lease, license, service, and support agree- 35 ments, and other documents used in connection with the purchase, 36 sale, or other ordinary course disposition of the target’s goods, other 37 property (e.g., technology, real estate, etc.), and services. 38 ❏ Obtain purchase and supply contracts, including for raw materials, 39 outsourcing, contract manufacturing, processing, toll milling, ware- 40 LEGAL DUE DILIGENCE 197

housing, utilities (energy, water, etc.), waste removal, and transport, 1 and agreements for technology support and maintenance. (For 2 equipment and other capital expenditures on order, check if cance- 3 lable, with or without penalties.) Determine any formal or informal 4 arrangements permitting the target later payments, discounts, 5 rebates, or other special financial treatment. 6 ❏ Obtain contracts and identify other arrangements with insiders or 7 affiliates. 8 ❏ Obtain installment sale, installment purchase, and sale/leaseback 9 agreements. 10 ❏ Obtain membership agreements and identify other relations with 11 trade associations. 12 ❏ Obtain guarantees, indemnities, and similar agreements. 13 ❏ Obtain franchise, distributorship, sale representation, sales agency, 14 commission, and other marketing agreements. 15 ❏ Identify arrangements with foreign agents, representatives, and 16 intermediaries, to ensure compliance with the Foreign Corrupt 17 Practices Act. 18 ❏ Obtain brokerage, consignment, sale, and return arrangements. 19 ❏ Obtain agreements with or commitments to attorneys, accountants, 20 investment bankers, business brokers, finders, consultants, advertis- 21 ing and public relations firms, executive search firms, architects, inte- 22 rior designers, engineers, lobbyists, charities, etc., and other non- 23 profit organizations (universities, public institutes), and government 24 or quasi-governmental agencies. Identify political contributions (U.S. 25 and foreign) by or identifiable with the target for legality and public- 26 ity risks, especially if the target’s business involves government con- 27 tracts. 28 ❏ Obtain product and service warranties given and received by the 29 target. 30 ❏ Identify and analyze agreements with respect to obligations or liabil- 31 ities for the return of goods in the possession of customers or other 32 third parties, including arrangements obligating or permitting the 33 target to buy back its products. 34 ❏ Identify and analyze agreements expected to result in loss to the tar- 35 get upon completion or performance. 36 ❏ Identify and analyze agreements restricting the target from carrying 37 on its business (or a portion thereof) in any geographic, product, or 38 service areas. 39 40 198 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ❏ Identify and analyze long-term agreements permitting pricing or 2 other financial adjustments. 3 ❏ Obtain any other agreements involving more than (specify appropri- 4 ate dollar threshold) or relating to obligations or liabilities outside 5 the target’s ordinary course of business. 6 ❏ In reviewing terms of all existing contracts, consider whether they 7 can be assumed or terminated; whether they can, by their terms, be 8 renegotiated to the buyer’s advantage or disadvantage; and whether 9 they have been modified in practice without any (or legally adequate) 10 written amendments. 11 ❏ Determine whether any powers of attorney have been given by the 12 target, and to whom (e.g., taxes). 13 ❏ Determine the existence of any prior (past ten years) or pending 14 acquisition, merger, stock or asset sale, or similar agreements, or 15 agreements for sales of material assets of the target or for acquisi- 16 tions of the shares or assets of any other business. Note whether 17 rights and remedies accrue to successors in interest, the contractual 18 time limits for claiming remedies, and whether any claims already 19 have been asserted, threatened, or expected. 20 ❏ If applicable, obtain agreements and offering documents relating to 21 sale of the target’s equity or debt securities for the past five years. 22 ❏ Determine existence of any commitments to brokers or finders, writ- 23 ten or oral (if binding in the applicable state), for this transaction. 24 12. Inventory 25 ❏ Determine whether any inventory is in the hands of vendors, at cus- 26 tomer locations, field warehoused, or otherwise not on hand to the 27 target, and whether it is owned by someone other than the target 28 (e.g., work in process, demos, etc.). 29 ❏ Determine obsolescence or salability; consider inspections on sam- 30 pling basis. 31 ❏ For contracts with U.S. government, confirm adherence to its cost 32 accounting requirements. 33 34 13. Real Estate, Machinery, and Equipment 35 ❏ Obtain list and particulars (location, type, acreage, building square 36 footage, date of construction, date of purchase, etc.) of all real prop- 37 erty owned or leased (as lessor or lessee) by the target, and all other 38 real estate interests (e.g., easements, subsoil rights, concessions, and 39 construction air rights). 40 LEGAL DUE DILIGENCE 199

❏ Note any recorded building or other violations, and identify ease- 1 ments and other burdens on the target’s real property. 2 ❏ Where the target is a lessor, determine creditworthiness of tenant or 3 subtenant. 4 ❏ Order new title reports and obtain past title reports (five years) and 5 all existing title insurance policies. 6 ❏ Obtain surveys and maps, building plans, and engineering studies. 7 ❏ Obtain all mortgages and mortgage notes and related financing 8 statements, rent assignments, and guarantees. (Note any due on sale 9 and change-of-control provisions.) 10 ❏ Obtain Uniform Commercial Code, tax, judgment, and other lien 11 searches in all applicable jurisdictions, and check for items affecting 12 real property interests and improvements (including machinery and 13 equipment affixed to land or buildings). 14 ❏ Obtain all pending real property purchase or option agreements, and all 15 agreements for construction, alteration, or furnishing of real property. 16 ❏ Review deeds, bills of sale, and leases. Check leases for assignability 17 (obtain consents if needed) and for use limitations and rights of affil- 18 iates to use property. Obtain estoppel certificates from landlords, ten- 19 ants, and mortgage lenders. 20 ❏ Determine location and condition of all plants and other facilities and 21 all machinery and equipment, and arrange inspections (for buildings, 22 especially asbestos, and “sick building” complaints). 23 ❏ Determine presence of any machinery, equipment, or other fixed (to 24 real property) assets held by the target but owned by persons other 25 than the target (e.g., leased). 26 ❏ Obtain existing or new appraisals of properties and compare with 27 balance sheet values. 28 ❏ Confirm zoning and other land use restrictions. Determine if these 29 would affect any planned post-closing changes or additions by the 30 buyer. 31 ❏ For leased property, obtain list of all leasehold improvements, show- 32 ing total cost by major items, amortization reserve, rates used, and 33 present unamortized cost. 34 ❏ Obtain any building or facilities management agreements and other 35 agreements for servicing real property (e.g., trash removal, cleaning, 36 landscaping, and exterminating). 37 ❏ Note and review any trust or other arrangements to comply with for- 38 eign restrictions on nonlocals owning real estate. 39 40 200 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 14. Environmental and OSHA 2 ❏ List all states in which the target previously owned, operated, or 3 leased property, conducted operations, or disposed of wastes. 4 ❏ For each site, identify the nature of operations or activities, and 5 chemicals or other toxic, caustic, or hazardous substances or wastes 6 or by-products that were used, generated, or otherwise present. 7 Describe handling procedures for such substances. 8 ❏ Determine whether the target has received a hazardous waste treat- 9 ment, storage, and disposal permit and, if so, whether there have 10 been any notices of violations or warnings with respect to the site. 11 ❏ Determine whether the target has generated “hazardous wastes” 12 and, if so, the location of storage or disposal of wastes, the maxi- 13 mum period of on-site storage of such wastes, and the volume of 14 wastes generated per month. 15 ❏ Determine whether the target disposes of its wastes off-site and, if 16 so, whether the target is or could be a potentially responsible party 17 in connection with any past or present off-site landfills on which it 18 has disposed of wastes. 19 ❏ Determine whether the target discharges wastewater or storm water 20 into something other than a publicly owned treatment works and, if 21 so, obtain the discharge permit and analyze any notices of violations 22 and any treatment facility changes required (noting costs involved). 23 ❏ Describe effluent streams (gaseous, liquid, solid, and particulate) at 24 each plant, present means of control (e.g., scrubbers), and any steps 25 being taken to bring nonconforming operations into compliance; 26 determine whether the target holds any permits under federal water 27 or air regulatory statutes or any other air emissions or water discharge 28 permits, and, if so, analyze any notices of violations or warnings. Also, 29 determine whether the target is aware of any air emissions or water 30 discharges for which it is not currently required to hold a permit. 31 ❏ Determine methods and viability of current means of handling solid 32 waste and effluent problems, and identify probable longevity of pres- 33 ent arrangements, potential liabilities that may result from the use of 34 current methods, and expenditures and timetable to correct existing 35 problems. 36 ❏ Determine whether the target ever had releases, spills, or fires and, if 37 so, whether the target reported them properly and ascertained the 38 level of cleanup necessary. Describe details of each such release, spill, 39 or fire (including type of substance involved, extent of spread of the 40 LEGAL DUE DILIGENCE 201

released substance into or onto the air, soil, and/or water, and reme- 1 dial measures taken to prevent a recurrence). State whether the tar- 2 get has filed any official notifications relating to release of any haz- 3 ardous substances on any property owned or leased by the target. 4 ❏ Determine whether any tank for storage of a petroleum product or 5 other material is located at the target (typical if the target operates 6 its own fleet of vehicles, forklifts, etc.), and for any such tank, list 7 contents; capacity; whether located above or below ground; 8 whether any permit, license, or other approval for tank has been 9 applied for or obtained or any notification has been submitted; the 10 nearest waterway or body of water and its distance from tank; 11 whether tank is covered by spill prevention control and countermea- 12 sure plan; and last date tank was leak tested and whether it was 13 determined not to be leaking. 14 ❏ Determine whether the target has received notice relating to involve- 15 ment in a superfund site and, if so, whether notice relates to on-site 16 contamination at the target’s property or to off-site disposal of haz- 17 ardous substances by the target or one of its contractors. 18 ❏ Determine OSHA compliance and complaint experience of the tar- 19 get, review all files relating to OSHA matters, and consider having a 20 private OSHA consultant inspect major facilities and review paper- 21 work for compliance. 22 ❏ Determine whether any hazardous substance (including asbestos) 23 has been detected in any monitoring, testing, or other similar inter- 24 nal or private study conducted by the target on buildings, air, soil, or 25 water (including groundwater and nearby surface water bodies) at or 26 near any of the target’s facilities and, if so, review copies of all rele- 27 vant documents. 28 ❏ Determine whether the target has ever acquired any enterprise or 29 line of business, or held an interest in one (e.g., in a joint venture), 30 having environmental problems and, if so, determine the target’s 31 potential exposure. 32 ❏ Determine whether the target has created reserves for potential envi- 33 ronmental or OSHA liabilities and, if so, analyze adequacy of reserves. 34 ❏ Review existing Phase I and II environmental assessments on the tar- 35 get’s sites, commission Phase I assessments, and, as necessary, com- 36 mission Phase II assessments. 37 ❏ Examine any foreign environmental and worker safety problems, 38 upon obtaining pertinent documents. 39 40 202 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 15. Intellectual Property and Information Technology 2 ❏ Obtain a worldwide list of registered and pending applications to regis- 3 ter patents, trademarks, service marks, and copyrights owned or used by 4 the target. Also obtain list of domain name registrations and applications. 5 ❏ Determine any oppositions to pending applications to register, or cur- 6 rent or threatened claims challenging existing registrations of, tar- 7 get’s owned or used intellectual property. 8 ❏ Identify key trade secrets, including past and current procedures to 9 maintain confidentiality, and known or suspected breaches of confi- 10 dentiality; verify internal compliance with confidentiality procedures; 11 and examine any claims of industrial espionage by or against the target. 12 ❏ Obtain and review all nondisclosure and similar agreements and 13 commitments involving target as discloser or disclosee. 14 ❏ Obtain and review copies of all license agreements from or to the tar- 15 get, and review records of royalty payments and receipts; note any 16 pending or threatened disputes over royalties. 17 ❏ Review the target’s compliance with license restrictions, in particular 18 copying of software or journals. 19 ❏ Review records retention, oversight of employee communications, 20 privacy, and other policies concerning employee use of the target’s 21 information technology and equipment. 22 16. Employees, Benefit Plans, and Compensation 23 ❏ Obtain chart setting forth the name, title, function, and years of serv- 24 ice of management and key technical employees. 25 ❏ Obtain list of all individuals (or entities acting for individuals) who are 26 consultants to the target, and determine whether they should be 27 classified as employees under tax rules. 28 ❏ Obtain and review existing employment contracts and résumés or 29 summary biographies of key personnel, noting golden parachute/ 30 change of control/change of title or responsibilities provisions in con- 31 tracts. Also obtain and review all other agreements for compensation 32 to key employees. 33 ❏ Obtain and review all severance agreements, compensation plans, or 34 other agreements or arrangements with key personnel that involve 35 payments or other compensation to them or any other person in 36 connection with resignation, retirement, or other termination. 37 ❏ Obtain schedule of all compensation paid during the last three fiscal 38 years to key personnel, showing separately salary, bonuses, and non- 39 cash compensation and perquisites (e.g., use of cars, club member- 40 LEGAL DUE DILIGENCE 203

ships). Look for patterns of charging personal expenses to the target 1 or expense account abuse. 2 ❏ Obtain and review documents establishing or defining any stock 3 option, bonus, profit sharing, pension, retirement, deferred compen- 4 sation, or similar plan currently in effect or proposed; the most recent 5 summary plan description and annual report filed with any govern- 6 ment agency concerning any such plan; any qualification letter from 7 the Internal Revenue Service concerning such plan; and any actuari- 8 al reports or other documents from actuaries regarding such plan. 9 ❏ Obtain and review documents establishing, or summary descriptions 10 of, employee benefit or similar plans, including employee booklets for 11 each employee benefit plan (i.e., life, long-term disability, short-term 12 disability, dental, medical, vision, and flexible spending accounts). 13 ❏ Obtain and review personnel policies, personnel and code-of- 14 conduct manuals, and employee handbooks. 15 ❏ Obtain and review confidentiality, noncompetition, and invention 16 agreements between the target and employees, including standard 17 forms of such agreements as currently used by the target. 18 ❏ Obtain list of former key executive employees who have left the tar- 19 get in the past two years and a brief description of circumstances of 20 their leaving. Consider obtaining statement whether the target has 21 any reason to believe such former employee has violated any nondis- 22 closure, noncompetition, nonsolicitation, or similar agreements or is 23 contemplating legal action against the target. 24 ❏ For business where certain employees must be licensed (e.g., regis- 25 tered representatives), obtain chart showing registrations by employ- 26 ee, type, and jurisdiction. 27 ❏ Review employee recruitment and hiring procedures, forms, and 28 files, noting compliance with procedures to avoid unlawful discrimi- 29 nation and hiring of nonqualifying aliens. 30 ❏ Verify compliance with requirements to pay overtime, including prop- 31 er classifications of employees for overtime. 32 ❏ For foreign operations, check adherence to and compliance with 33 applicable codes of conduct toward foreign employees and evidence 34 of protests in U.S. or abroad regarding the same. 35 36 17. Labor Relations 37 ❏ Determine scope of collective bargaining contract over specific 38 employees, job categories, and work functions, noting geographic 39 reach of contract and union’s jurisdiction. 40 204 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ❏ Determine collective bargaining contract restrictions on plant move- 2 ment, subcontracting, and internal modification of work methods. 3 ❏ Determine rates of compensation and size of workforce in each category. 4 ❏ Identify specific collective bargaining contract references to obliga- 5 tions for the target and buyer, especially obligations calling on the 6 target or buyer to notify or bargain with union regarding sale and (as 7 often seen in outbound transactions) the buyer’s obligation to adopt 8 collective bargaining agreements containing obligations to employ 9 target’s employees, including seniority, vacation and holiday benefits, 10 severance pay, etc.. 11 ❏ Identify collective bargaining contract obligations (including trust 12 agreements) to establish, maintain, or contribute to fringe benefit 13 funds for medical, pension, apprenticeship, or other welfare purpos- 14 es, noting contribution levels, eligibility formulae, and possible con- 15 tractual commitments to increase these at future dates. 16 ❏ Identify unions, their principal leadership, history of strikes and orga- 17 nizational drives, and ambitions to organize nonunionized employees 18 or invade jurisdiction of other unions. 19 ❏ Check outstanding recent litigation before the National Labor 20 Relations Board (NLRB) and other relevant federal and state labor 21 agencies, and identify labor-related judgments, settlements, consent 22 decrees, conciliation agreements, compliance agreements, etc., with 23 outstanding obligations or that affect future operations. 24 ❏ If closing a facility with 100 or more employees, prepare for compli- 25 ance with WARN (Worker Adjustment and Retraining Notification 26 Act) requirements for sixty days’ advance notice. 27 ❏ Check relations with other government agencies affecting employ- 28 ment, e.g., compliance with minimum wage laws, Title VII of Civil 29 Rights Act, and minimum standards imposed by statute on parties con- 30 tracting with U.S. government (Walsh-Healey and Davis-Bacon Acts). 31 ❏ For foreign operations, review history of strikes and other labor 32 unrest, as well as union representation. 33 18. Taxes 34 See Chapter 6 for a more extensive tax checklist. 35 ❏ Identify all tax litigation pending, determine status, and analyze 36 prospects. 37 ❏ Obtain all tax litigation settlement documents and tax dispute-related 38 correspondence for prior three years, and determine compliance with 39 settlements. 40 LEGAL DUE DILIGENCE 205

❏ Obtain and review law firm tax opinions (including backup opinions 1 and certificates) for material transactions within past five years, and 2 determine whether conclusions are in question, or whether regula- 3 tions or case law underpinning opinion has changed. 4 5 19. Litigation, Claims, Investigations, and Contingent Liabilities 6 ❏ Obtain complete pending litigation, mediation, arbitration, and other 7 legal proceedings list, and, for material claims, review files of the tar- 8 get and the target’s counsel. 9 ❏ Obtain documents and information on all threatened litigation, arbi- 10 trations, contested claims and complaints, notices of default, inves- 11 tigations, legal inquiries, internal compliance or incident reviews, 12 disciplinary proceedings, grievances, labor controversies, condemna- 13 tions, and other such prelitigation events, current or concluded in the 14 past five years. 15 ❏ Obtain target’s auditor’s attorney inquiry letters and replies for the prior 16 five years, and have the most recent updated by letter from counsel. 17 ❏ Obtain any current litigation reports to the target’s board of directors 18 by the target’s attorneys. 19 ❏ Inquire about existence of judgments, consent decrees, injunctions, 20 other judicial or administrative decrees or orders, stipulations, settle- 21 ment agreements, and other agreements or requirements arising 22 from contentious matters, noting those still requiring or prohibiting 23 future activities. 24 ❏ List products/services that historically exposed the target to product 25 liability or recall claims, and check for any newly emerging patterns 26 of claims or customer or user complaints or inquiries. 27 ❏ Obtain documents and correspondence relating to contingent liabil- 28 ities, including performance specifications guaranteed by the target, 29 penalty provisions in contracts, and investigations or violations that 30 may lead to civil or criminal penalties or forfeitures. 31 20. Insurance 32 ❏ Obtain all insurance policies and fidelity bonds, including general lia- 33 bility, product liability, key executive life, director’s’ and officers’ 34 indemnification, business interruption, employee claims, workers’ 35 compensation, product recall, kidnapping, or acts of terrorism. 36 ❏ Determine involvement in any group or company captive insurance 37 arrangements, and, if any, confirm tax deductibility of premiums paid 38 by the target to captive. 39 40 206 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ❏ Analyze pending claims and claim notices, whether claims have been 2 promptly reported, past claims experience, refusals to provide cover- 3 age, and cancellations of coverage. 4 ❏ Review most recent applications for coverage, and determine if any 5 applications or coverages were denied in the past five years. 6 ❏ Evaluate adequacy of insurance coverage, both as to types and 7 amounts of coverage, including extent to which the target is self- 8 insured. Note the geographical extent of coverage, and whether for- 9 eign subsidiaries are covered. 10 ❏ Contact the buyer’s and the target’s insurance carriers regarding pos- 11 sible continuation of coverage. 12 ❏ Investigate “tail insurance” for products liability coverage for unre- 13 ported, unknown preclosing occurrences, and determine whether 14 this coverage should be carried by the seller or the buyer. 15 21. Antitrust 16 ❏ Consider antitrust aspects of acquisition under Section 7 of Clayton 17 Act, Hart-Scott-Rodino (HSR) filing requirement, and other federal 18 antitrust and state unfair competition statutes. Also consider foreign 19 antitrust compliance, especially under the European Community reg- 20 ulatory regime. 21 ❏ Determine, for antitrust purposes, business objectives of the buyer 22 and the target, including whether prices are to be increased or 23 decreased, products and services are to be bundled, operations are 24 to be vertically integrated, etc.. Also, obtain and review any analyses 25 by buyer stating reasons for acquisition or plans for post-closing 26 operations. 27 ❏ Identify business lines of the buyer and the target. 28 ❏ Determine relevant markets (products and geographical areas) 29 involved in acquisition. 30 ❏ Evaluate competitive effects of acquisition on business of the buyer, 31 the target, and their competitors. 32 ❏ Inquire about the target’s past antitrust problems (e.g., allegations or 33 investigations of price-fixing, price discrimination, or monopolization, 34 and injunctions and consent decrees). 35 36 37 38 39 40 LEGAL DUE DILIGENCE 207

22. General Regulatory Requirements for Operations and Transaction 1 ❏ Obtain a list of all of the target’s other permits and licenses, and 2 determine requirements of all federal, state, local, and foreign regu- 3 latory authorities as to transfer, assignment, or sale of such other 4 permits and licenses (Food and Drug Administration, Interstate 5 Commerce Commission, Army Corps of Engineers, etc.). 6 ❏ Review such existing permits and licenses to ascertain their terms and 7 conditions for continuing compliance by the target postacquisition, 8 and whether acquisition triggers additional obligations (e.g., addi- 9 tional bonding) or the need for additional related permits or licenses. Note if any grandfathered exemptions under such permits or licens- 10 es will be lost upon acquisition. 11 ❏ Review the target’s compliance, policies, manuals, and records for 12 matters subject to government regulations. 13 ❏ Focus on regulation of the target’s particular lines of business, and 14 survey applicable federal, state, local, and foreign laws and regula- 15 tions for legal requirements of completing the transaction and for 16 how they affect post-closing operations of the combined company. 17 ❏ For inbound acquisitions involving the defense, technology, or other 18 national security sectors, consider whether to apply for U.S. govern- 19 ment pre-clearance under the Exon-Florio Amendment. Upon 20 approval, later forced divestment action by the governed is barred, 21 absent false information in the application. 22 23 23. Successor Liability 24 ❏ If an asset purchase, determine the target’s liabilities not intended to 25 be assumed by the buyer but that may, as a matter of law, become 26 the buyer’s responsibility as successor, including bulk sales liability; 27 sales/use, unemployment, and employee withholding tax liability; 28 product liability (injury, product recall); environmental liability; pen- sion benefits; labor union contracts; employment discrimination; lia- 29 bilities under regulatory permits or licenses; etc.. 30 31 32 33 34 35 36 37 This page is intentionally blank 1

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15 1 2 Tax Due Diligence 3 4 6 5 6 7 ROBERT T. BOSSART, ESQ. 8 9 10 11 12 13 14 15 ROSS-BORDER TAX DUE DILIGENCE for any investor involves a 16 balance between tax compliance review and future tax planning. 17 C The weight the investor gives to each can be a function of the 18 type of investment. An investor planning a purchase of a target’s assets 19 may spend more time planning future tax operations than worrying 20 about the target’s past tax compliance. This is true because in asset deals, 21 the target’s tax attributes and tax liabilities usually do not pass to the 22 investor (though some customs duties, sales and use, personal, or real 23 property tax liabilities may). Conversely, an investor acquiring the target’s 24 shares will be inheriting all of the target’s prior tax liabilities, structures, 25 and planning. Thus, tax compliance due diligence will likely present a 26 heavier burden in a share purchase than in an asset purchase. 27 28 29 Compliance versus Planning 30 Too many investors believe that tax due diligence focuses solely on the 31 target’s past compliance activities. The truth is that tax due diligence 32 needs to begin at the moment the investor decides to actively consider 33 the target. This allows the investor to carefully consider the structural 34 and financing form of the potential investment at the start. Too often, 35 tax advisers are brought in to look at a deal after the parties have already 36 structured it. In due diligence, tax experts may discover major tax prob- 37

209 210 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 lems arising from the planned form of the transaction or major tax 2 opportunities that can be seized only if the parties employ a deal struc- 3 ture other than the one contemplated. Typically, investors are unwilling 4 to retrace any part of the deal because it could open the entire transac- 5 tion to renegotiation. The result is often poor strategic tax choices that 6 fail to capture major tax benefits. 7 8 9 Due Diligence Coordination 10 It is important for those performing tax due diligence to coordinate 11 effectively with other members of the due diligence team. Many 12 investors wrongly assume that tax, financial accounting, strategic, intel- 13 lectual property, environmental, and other due diligence activities are 14 performed in watertight compartments. Nothing could be further from 15 the truth. In one deal involving a Swedish investor, the intellectual prop- 16 erty attorneys discovered many potentially valuable unregistered intangi- 17 ble assets, such as patents, trademarks, or copyrights, that were not visible 18 on the target’s tax returns. The investor was going to establish a U.S. 19 incorporated subsidiary to purchase the target’s assets for cash. By coor- 20 dinating tax and intellectual property due diligence, it was possible to 21 create large and permanent tax savings to the investor. 22 Even in a share acquisition, tax planning performed during due dili- 23 gence can significantly improve postacquisition tax efficiency. For exam- 24 ple, a U.S. company was going to acquire the shares of a target in Italy, 25 a high tax rate jurisdiction. The target’s principal asset was a manufac- 26 turing intangible for products sold around the world. The non-Italian 27 individual selling the target would not sell the Italian company’s assets, 28 only its shares. Here, tax due diligence practitioners from a number of 29 jurisdictions coordinated with other experts on the due diligence team. 30 Immediately after the acquisition, the investor subdivided the intangible 31 asset rights between the United States and the rest of the world. The 32 investor then transferred those rights from Italy at virtually no incre- 33 mental tax cost to the global acquiring group. The subsequent taxation 34 of the earnings of the transferred intangibles at a rate of approximately 35 one-quarter of the Italian tax rate paid for the total due diligence effort 36 and permanently reduced the investor’s global effective tax rate. 37 TAX DUE DILIGENCE 211

1 Local, National, and International Perspective 2 Another important area in international tax due diligence that affects 3 both compliance and planning is nonfederal taxes. Too many investors 4 focus solely on taxes at the national level and then only on income taxes. 5 Although national-level income taxes are exceptionally important, the 6 existence of nonfederal taxes should never be underemphasized. 7 Provincial, territorial, or state income or franchise taxes; local income 8 taxes; value-added or sales and use taxes; excise taxes; property taxes; 9 transfer taxes; and mortgage-recording taxes, among others, must be 10 considered in due diligence. 11 In a world of deals that cross many borders, the need for multifaceted 12 tax due diligence is of increasing importance. Traditional deals had an 13 investor looking at a target whose operations were primarily confined to 14 a single nation. Thus, traditional transactional tax due diligence focused 15 on whether the proposed deal was an asset or a share purchase and was 16 taxable or tax-deferred. Today, even a taxable asset acquisition of a tar- 17 get in one country is likely to involve the target’s ownership of shares of 18 subsidiaries in many different countries. Likewise, the growth of multi- 19 nationals and their related party transactions has increased the likelihood 20 that tax authorities in different countries can review the same interna- 21 tional group’s transfer of goods, intangibles, services, or capital, and 22 come to contrary conclusions about how much profit is taxable in their 23 jurisdiction. Intergroup transactions across national borders have grown, 24 causing taxpayers to more aggressively pursue an optimal global effective 25 tax rate. As a result, tax disputes with tax authorities and exposure to tax 26 disputes at all levels are rising. These events have only increased the 27 importance of involving internal and external tax personnel as early in 28 the deal process as possible. 29 30 31 A Word about Joint Ventures 32 Joint ventures are increasingly common and complex. Nevertheless, 33 both parties normally view themselves as investors rather than targets, 34 and each transfers assets or shares or both into the joint venture. Thus, 35 to a very great extent, applying the due diligence techniques described 36 below for asset acquisitions or share acquisitions will normally suffice. 37 212 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 However, one additional step of due diligence should be considered. 2 Since most joint ventures do not endure, each investor’s exit strategy 3 must be taken into account. Particularly important are the disposition of 4 intangibles—those each investor contributed to the joint venture and 5 those developed inside it. Likewise, the possibility of inheriting unwant- 6 ed liabilities at termination should receive very close attention before the 7 parties enter into the joint venture. 8 9 10 Taxable Purchase of Assets 11 A taxable purchase of assets provides the investor with the greatest 12 opportunity to generate future tax benefits from the investment. Hence, 13 the focus of initial due diligence is on those aspects of the target’s com- 14 pliance providing the investor the best information to use in planning 15 the transactional structure and the target’s postdeal operations. Before 16 examining specific compliance documents, however, the tax due dili- 17 gence team should have a very good idea of the target’s global legal, 18 operational, and tax structure and business functions. It is important in 19 reviewing the target’s legal structure to understand whether the pur- 20 chase will involve all or only some of the target’s assets. 21 Let’s assume the target will be selling assets in its country of incorpora- 22 tion but may be selling the shares of specific (primarily foreign) corporate 23 subsidiaries or selling operating divisional assets in various global sub- 24 sidiaries. Each scenario presents problems and opportunities for tax due 25 diligence to uncover for compliance and planning purposes. 26 27 Understanding the Target’s Operations and Structure 28 Operational considerations. One key to a successful asset acquisi- 29 tion is to understand the target’s production, distribution, and/or serv- 30 ice functions. It is particularly helpful to obtain functional flowcharts. 31 They allow tax advisers to coordinate with other due diligence team 32 members in reviewing the target’s operational structure, thinking about 33 exposure areas, and planning. For example, the investor may wish to 34 know the tax consequences of continuing all existing operations versus 35 discontinuing some. The tax due diligence team should clearly under- 36 stand any proposed changes in the target’s operations and whether such 37 changes involve the acquisition of designated assets or whole businesses TAX DUE DILIGENCE 213 outside the target’s country of incorporation. (For a complete discussion 1 of operational due diligence, see Chapter 3.) 2 In one situation, Corp X was selling all of the assets in its country of 3 incorporation. These assets included the shares of subsidiaries in twelve 4 other countries. Corp X had production facilities in nine countries. The 5 investor determined that, postdeal, it would cease production in five of 6 those countries. Therefore, it was important to focus the planning 7 efforts on the surviving production facilities, while simultaneously con- 8 sidering future tax costs or opportunities generated by the discontinued 9 operations. In this case, the discontinued facilities were all in high tax 10 rate jurisdictions and were participants in a cost-sharing agreement that 11 funded new manufacturing intangibles. Appropriately revising the cost- 12 sharing agreement provided income to entities that otherwise would 13 have had unused tax losses and gave the investor the opportunity to cen- 14 tralize many of the manufacturing intangibles in a very low tax rate juris- 15 diction. 16 Similar care should attend due diligence on distribution operations. If 17 the target has distribution subsidiaries outside its country of incorpora- 18 tion, it is important to understand whether the investor plans to contin- 19 ue those facilities in those countries, to integrate their operations with its 20 own in those countries, or to eliminate the workforce of those subsidiaries 21 while maintaining the function. Each scenario can have significant tax 22 consequences that will affect the investor’s future global effective tax rate. 23 Likewise, international tax due diligence should review service functions 24 to create tax opportunities for the investor. 25 Service functions can be offered to external customers or internally. In 26 one case, UK Target, Ltd., performed customer assistance/support and 27 warranty service locally, usually at a loss. The investor created a centralized 28 call center, an Internet tech support site, and an Internet distribution 29 function that reduced costs and increased income that was taxed at low 30 rates. In another case, acquiring only one of a French company’s four 31 operating divisions meant that the investor would not acquire support 32 functions that the French company performed as a centralized service. 33 As a result, the investor was able to create a shared service center in a low 34 tax rate jurisdiction outside of France to perform the vast majority of 35 support services for the acquired division. By charging these internally 36 shared services at a markup to each of its operating divisions in high tax 37 214 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 rate jurisdictions, the company lowered its overall taxes and reduced 2 global support costs. 3 Fully understanding the target’s structure and operations requires 4 understanding the target’s tax operations. For example, if a type of enti- 5 ty in any country is not designated in the U.S. income tax regulations to 6 be treated “per se” as a corporation for U.S. tax purposes, it is possible 7 for the shareholder to make a “check-the-box” election. This election 8 treats the entity as a branch (one shareholder) or partnership (more than 9 one shareholder) solely for U.S. tax purposes even though it retains cor- 10 porate limited liability in its local jurisdiction. In reviewing a target’s tax 11 status, it is important to understand whether, for U.S. tax purposes, 12 there are differences between the target’s global legal structure and its 13 tax structure. A U.S. target may have an Irish subsidiary, which itself has 14 subsidiaries in the United Kingdom, Germany, and Japan. For U.S. tax 15 purposes, whether these three entities are treated as corporate sub- 16 sidiaries or branches of Ireland will affect both U.S. tax deferral and for- 17 eign tax credit planning. Many non-U.S. companies also make use of the 18 “check-the-box” rules either to help structure their U.S. operations or, 19 before putting some of their non-U.S. operations up for sale, to maxi- 20 mize their value to U.S. buyers. 21 The 80/20 rule. Understanding the target’s legal, tax, and operational 22 structures helps determine where to expend the tax due diligence com- 23 pliance review and the acquisition and postacquisition tax planning 24 effort. Here, as elsewhere, the 80/20 rule applies. In most situations, 80 25 percent of the critical operations of a group are contained within 20 per- 26 cent of its entities, and 80 percent of the critical operations of an entity 27 are contained in 20 percent of its functions. Without time to review 28 every entity for every transaction, it is important to focus on the 20 per- 29 cent of those operations that provide 80 percent of the target’s revenue. 30 The due diligence team can review other aspects as time permits or by 31 exception. 32 Considerations relating to legal structure. Most target corpora- 33 tions prefer a share sale to an asset sale, because a selling shareholder’s 34 returns from an asset sale are diminished by taxes at the corporate and 35 shareholder levels. However, in today’s global economy there are many 36 opportunities for asset sales. A major multinational with many operating 37 divisions may sell the assets of one division because it can shelter the gain TAX DUE DILIGENCE 215 inside the company with other tax attributes or other expenses. 1 Sometimes, it simply has no other choice from a business operations per- 2 spective. Alternatively, it may have no intention of distributing the after- 3 tax proceeds of the asset sale. 4 Owner/operators of pass-through (nontaxable) entities for federal tax 5 purposes are more receptive to asset sales because of the possibility of 6 one level of tax. Subject to certain limitations, these entities can include 7 partnerships or U.S. S corporations. Perhaps the most important format 8 used by most new U.S. high-tech and other companies is the limited 9 liability company, or LLC. A U.S. LLC has all of the corporate limit- 10 ed liability attributes of a regular corporation, but it is a pass-through 11 entity for federal income tax purposes. Thus, a start-up or growing com- 12 pany in an LLC format is more likely to be willing to sell its assets than 13 would a regular “C” corporation, because the LLC is exempt from the 14 double taxation of the C corporation format. 15 An LLC format may therefore make a company a more inviting target 16 because that format enhances value to prospective buyers. For example, 17 assume that Softco, Inc. (a regular U.S. C corporation), establishes an Irish 18 operating subsidiary (“Ireland”). Softco and Ireland also enter into a cost- 19 sharing agreement to develop all future software wherein Softco retains all 20 of the American intangible rights and Ireland retains all the non-U.S. 21 intangible rights. A U.S. buyer wishes to acquire Softco. Because Softco is 22 a taxable corporation, its shareholders would greatly prefer to sell shares 23 and have only one level of U.S. taxes at U.S. capital gains tax rates. 24 Under such circumstances, the U.S. investor would obtain a new 25 member of its U.S. consolidated tax return group, and Ireland would 26 remain a subsidiary of that entity. None of the intangible property rights 27 of Softco or Ireland would change hands in the share acquisition, there- 28 by forcing all intellectual property planning into the postacquisition peri- 29 od. Meanwhile a non-U.S. investor seeking to acquire Softco would be 30 forced to acquire Softco’s shares. This creates a major tax problem, 31 because a non-U.S. investor would be forced to remit all of Ireland’s 32 low-taxed earnings through the U.S. tax system en route to the 33 investor’s home country. This is exceptionally costly and inefficient and 34 would probably result in a lower purchase price for Softco’s shares. 35 But there is a better way. Assume Softco LLC is a U.S. tax pass- 36 through entity that owns Ireland. As before, both companies own or 37 216 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 have beneficial rights to their respective intangible assets through the 2 cost-sharing agreement. Under these circumstances, any investor— 3 U.S.- or non-U.S.-based—could make a more tax-efficient acquisition 4 of Softco LLC’s business than of Softco, Inc.’s business. Such improved 5 tax efficiency should raise the purchase price. In both of these situa- 6 tions, the LLC’s shareholders should consider their structural advan- 7 tage in determining their asking price. All other factors being equal, 8 investors should also seek entities outside the United States with the 9 flexible characteristics of an LLC. 10 11 International Federal Tax Compliance Due Diligence 12 Reviewing prior federal tax returns from all relevant national tax juris- 13 dictions only sometimes offers significant help to the investor. Assume 14 the target has three divisions globally and is selling the assets of one. If 15 all three divisions are in one entity in each country, reviewing the target’s 16 federal tax returns may not provide the investor with any insight into tax 17 aspects relevant to the assets to be conveyed. In these circumstances, the 18 target’s divisional financial statements (or for purposes of the sale, the 19 target’s pro forma financials) may provide greater insight into the nature 20 of the assets in question. 21 On the other hand, assume the investor is acquiring all the assets of a 22 U.S. target. Here, a review of the target’s federal tax return may provide 23 valuable insights into tax planning opportunities. The target’s federal tax 24 return will show most of the types of assets the company owns, excluding 25 self-developed and previously expensed intangible assets. It will also pro- 26 vide a history of prior tax capital cost allowances or depreciation for real 27 and personal property and disclose acquired or capitalized self-developed 28 intangible assets currently being amortized for federal tax purposes. The 29 federal tax return will provide insight into issues like amortizable bond 30 premium, organization expenses, start-up expenses, and the tax amorti- 31 zation of R&D or purchased goodwill. 32 Federal tax compliance review also considers inventory cost account- 33 ing and employee benefit matters. It also may include special industry- 34 related issues or requirements, tax credits, or negotiated agreements with 35 the federal tax authorities as well. 36 Research and development expenses. If the target currently 37 expenses R&D, such expenses may, at best, be found as a supporting line TAX DUE DILIGENCE 217 item in some countries’ tax returns. Otherwise, they might be found as 1 a separate line item (although global in amount) in the target’s financial 2 statements. Knowing R&D expenses can be important in determining 3 the level of expenditures that meet the tax definition of deductible 4 research and experimental expenditures. In some countries, this defini- 5 tion is narrower than the one used for financial statement purposes and 6 can be important for two reasons. First, many countries permit compa- 7 nies to claim a credit for research and experimental expenditures as 8 defined under tax law rather than as defined under financial statement 9 principles. Second, if the investor acquires a U.S. business where either 10 the target or the investor owns non-U.S. subsidiaries of a U.S. entity, 11 one of the expenditures that must be taken into account in allocating 12 and apportioning expenses to foreign source income for U.S. Foreign 13 Tax Credit Limitation purposes is research and experimental expendi- 14 tures. Specific U.S. tax regulations determine how such defined expen- 15 ditures are allocated and apportioned and can affect repatriation costs. 16 Inventory accounting methods. The target’s tax return will disclose 17 the types and levels of its inventory. The target may be using first-in first- 18 out (FIFO) or last-in first-out (LIFO) or some other method for its 19 inventory accounting. Many countries outside the United States do not 20 allow the use of LIFO. In addition, some companies in the securities 21 industry are required to use the “mark-to-market” method to account 22 for their securities inventories. Observing the types of costs used in 23 determining inventories, their levels, and the accounting methods in use 24 can help provide information that may be valuable to the investor for 25 future tax planning purposes. 26 Employee benefits. Many issues arise on employee benefit matters, 27 even in an asset acquisition. Top management may have bonus payments 28 triggered upon a sale of the company’s assets. In the United States, these 29 golden-parachute issues can create a large additional cost to an investor 30 who acquires assets. Tax due diligence professionals should review mate- 31 rial employment-related documents for the existence and impact of such 32 executive benefits. 33 An asset transaction also may cause employee share options to vest 34 and be immediately cashed in, with the resulting additional compensa- 35 tion being a liability to the target. It is therefore important to deter- 36 mine whether the acquisition agreement makes such option payments 37 218 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the target’s responsibility. Material obligations of this sort may cause 2 the investor to rethink the price. 3 Assuming that the target’s workforce will transfer to the investor’s 4 company at the date of the asset acquisition, several issues arise regard- 5 ing employee benefit plans. Even in an asset acquisition, group health 6 and welfare plans may transfer from the target to the investor. The 7 investor may want such plans to transfer only to the target’s employees. 8 The investor may want all the members of the target’s management team 9 to become members of the investor’s existing health and welfare benefit 10 plans. It is therefore important to understand the investor’s expectations 11 on such issues. 12 Even in an asset acquisition, no area can create more uncertainty than 13 the target’s pension and profit-sharing plans. Due diligence should first 14 focus on the plans and tests under the national tax and/or labor rules 15 on what makes and keeps a plan qualified. For example, in the United 16 States the Employee Retirement Income Security Act (ERISA) of 1974 17 provides a series of rules that require annual testing. These tests include 18 whether highly compensated individuals are receiving greater than a 19 defined “fair share” of benefits. They also contain limits and require- 20 ments concerning the funding of liabilities. A disqualified plan repre- 21 sents a disaster to both the employees and the company. It is therefore 22 important in due diligence to review the plan’s compliance with all of 23 the federal tests. However, such concerns may not apply in countries 24 where pension funds are managed and controlled by the national gov- 25 ernment. 26 If the plans meet all of the tests, the investor still may need help decid- 27 ing whether to retain the plans or to liquidate them at the acquisition. 28 Thus, where all the assets of a business are acquired, in some countries 29 it is possible for a liquidating plan to acquire annuities for each benefici- 30 ary to be set aside until that employee retires. Under such circumstances, 31 the target’s employees become members of the investor company’s plans 32 but do not put their prior vested benefits at risk in their new company. 33 Alternatively, the entire plan might be assumed by the investing compa- 34 ny and kept separate so long as a separate trade or business exists inside 35 that entity. Here, coordination among tax counsel, HR personnel, and 36 investor management becomes critical. In countries where the national 37 government maintains the plans, fewer alternatives may be available. TAX DUE DILIGENCE 219

Withholding taxes. Employment taxes are another key area. Most 1 countries view such taxes as a fiduciary obligation of the company. 2 Therefore, tax and financial accounting members of the due diligence 3 team should coordinate to make sure that the target properly withheld 4 and paid prior employee payroll taxes, including social insurance contri- 5 butions, and properly filed the appropriate tax returns. This prevents the 6 possibility of a contingent liability (such as a lien) reducing the value of 7 the acquired assets. 8 Special circumstances. Reviewing the target’s federal tax return also 9 may offer the investor greater insight into industry-specific issues. For 10 example, many countries have specific rules regarding the taxation of 11 industries like banking, securities, energy, forest products, insurance, and 12 real estate. Under such circumstances, a review of the target’s federal tax 13 return will demonstrate how its assets have been deployed under the 14 rules for that industry and reported in the company’s tax return. 15 Likewise, many countries provide tax credits for specific activities even in 16 situations where they may not have special tax accounting rules for an 17 entire industry, such as, for example, research and experimentation, 18 energy, or investment tax credits. 19 The United States and other countries provide special tax credits for 20 activities outside their boundaries. Likewise, some countries provide spe- 21 cial tax credits or exemptions for activities in particular locations. The 22 United States has the Possessions Tax Credit, and countries like France, 23 Italy, and Israel have designated specific regions to receive special tax 24 breaks. Often, the income subject to the special tax regime is disclosed 25 either on the target’s federal tax return or on a separate tax return for 26 that tax regime. Reviewing such documents helps confirm that the tar- 27 get appropriately filed prior tax returns and paid the required taxes. It 28 also provides valuable information for future planning. 29 In some countries, the target may have reached a negotiated deal with 30 that country’s tax authorities covering how or on what income it is going 31 to be taxed. Typically, the target will have approached the tax authority 32 before starting operations in that place and negotiated a deal. In such an 33 instance, tax due diligence should confirm that the tax holiday, tax 34 exemption, or tax base that was negotiated will continue postdeal. In 35 some jurisdictions, the tax authorities do not automatically approve the 36 continuation of such tax arrangements when a change in the assets or 37 220 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ownership of the business takes place. Therefore, reviewing every nego- 2 tiated tax deal will help you comply with its terms or conditions postac- 3 quisition or determine whether the arrangement should be renegotiated. 4 5 Foreign Subsidiary Shares as Part of the Target’s Assets 6 One of the most important due diligence issues in an asset acquisition 7 arises when shares of a target’s foreign subsidiaries are among the assets 8 conveyed to the investor. The challenge is to provide appropriate due 9 diligence—while recognizing that these entities are scattered and of dif- 10 ferent sizes and importance—with scarce time and due diligence 11 resources. Here is another opportunity to employ the 80/20 rule, where 12 80 percent of the target’s foreign operations reside in 20 percent of its 13 foreign subsidiaries. Absent special circumstances, the investor’s review 14 of only those key entities usually provides sufficient comfort. 15 For each foreign entity chosen for review, examine the tax returns it 16 filed in its jurisdiction. For example, say the investor will succeed to the 17 target’s foreign subsidiary shares and inherit the entire tax history of 18 each subsidiary. This puts a premium on compliance due diligence. In 19 addition, due diligence will focus on how the target parent’s home 20 country taxes the receipt of dividend, interest, royalty, and other income 21 from sources outside its own jurisdiction. Usually the regulatory focus 22 is on dividends, because interest and royalties from foreign sources are 23 typically taxable. Nevertheless, some countries provide a total exclusion 24 for foreign source income, while others provide it only if certain tests 25 are met. 26 A Hong Kong entity’s Hong Kong source sales, for example, are sub- 27 ject to Hong Kong tax, but its sales sourced outside of Hong Kong are 28 exempt from Hong Kong tax. Likewise, if a Dutch company owns at 29 least 25 percent of a non-Dutch subsidiary, a dividend paid to the Dutch 30 parent is exempt from Dutch tax under the Participation Exemption. 31 Switzerland has a 20 percent ownership threshold for its Participation 32 Exemption. That same dividend paid to some other parent might be 33 fully taxable. Moreover, countries that tax receipt of the dividends may 34 provide either a partial or full foreign tax credit for income or withhold- 35 ing taxes paid by the foreign subsidiary. That said, every country with a 36 foreign tax credit system has its own foreign tax credit rules. Thus, the 37 tax due diligence team requires members who understand the rules of TAX DUE DILIGENCE 221 each country where an entity receives significant dividends to apply the 1 relevant foreign tax credit rules appropriately. 2 Note, for example, that for many years Japan allowed foreign tax cred- 3 its only on dividends from first-tier non-Japanese subsidiaries. It now 4 allows them from the second tier. The United Kingdom allowed foreign 5 tax credits on dividends in a way that favored putting all of the non-U.K. 6 operating subsidiaries underneath a Dutch subsidiary to blend their 7 effective tax rates. Unfortunately, the United Kingdom in recent years 8 proposed revising its foreign tax credit system. If the United Kingdom 9 adopted a per-country system, the amount of foreign tax credit the U.K. 10 dividend recipient could claim would be limited to the U.K. tax rate, 11 applied on a dividend-by-dividend basis, thereby increasing repatriation 12 costs from countries with rates lower than those of the United Kingdom. 13 The United States has the most complex foreign tax credit system, 14 one that currently allows deemed-paid foreign tax credits from as low as 15 a third-tier foreign subsidiary and is scheduled to allow U.S. taxpayers to 16 claim deemed-paid foreign tax credits from subsidiaries as low as the 17 sixth tier. In addition, the U.S. foreign tax credit limitation calculation 18 has a series of income groupings referred to as “baskets.” Foreign tax 19 credits are related to each type of basket. So, for example, the United 20 States has the overall foreign source income basket, the financial services 21 income basket, the passive income basket, and a variety of other baskets. 22 Different types of income from different countries can blend effective 23 foreign tax rates relating to that income within a specific basket. 24 However, foreign tax credits in excess of the U.S. statutory rate in one 25 basket cannot be used to offset the U.S. tax liability on income sourced 26 to a different basket that does not bring sufficient foreign tax credits to 27 eliminate the U.S. tax. 28 Likewise, exceptionally complex rules exist for the sourcing of income 29 received by a U.S. taxpayer. Depending on the type of transaction 30 involved, such as the sale of product, performance of a service, receipt of 31 a royalty, or other types of income, the sourcing rule is potentially dif- 32 ferent. Thus, tax due diligence for the acquisition of non-U.S. sub- 33 sidiaries that would ultimately pay dividends to a U.S. taxpayer would 34 have as one of its highest priorities understanding the non-U.S. opera- 35 tions and their foreign tax credit history. The investor can then do what- 36 ever planning is possible regarding the acquisition structure and the 37 222 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 postacquisition period to improve the tax efficiency of those operations 2 from both a non-U.S. and U.S. tax viewpoint. 3 Finally, understanding the tax structure of the foreign subsidiaries can 4 lead to other tax planning opportunities. Some of the opportunities will 5 be covered later when we describe taxable share purchase transactions. 6 7 Transfer Pricing 8 If the target has assets in one country and subsidiaries in others, thor- 9 ough tax due diligence will necessarily include a review of transfer pric- 10 ing issues. Transfer pricing is the exchange for a measurable value of 11 goods, services, capital, or intangibles between two related parties in 12 different tax jurisdictions. Assume a Japanese parent licenses a patent to 13 its Singapore manufacturing subsidiary in exchange for a sales-based 14 royalty. Disputes arise from the tension between companies’ desire to 15 pay the lowest possible tax and governments’ desire to raise revenue 16 from companies rather than voters. 17 A multinational group that makes products it sells globally would typ- 18 ically account for as much of the total profit as is legally possible in low- 19 tax rather than in high-tax jurisdictions. Governments are aware of such 20 corporate behavior and routinely complain that multinationals in their 21 country do not pay their “fair share” of tax by “artificially” shifting prof- 22 its out of the country through overly aggressive transfer pricing schemes. 23 In the example cited above, Japan would be concerned that an unusual- 24 ly low royalty from the Singapore manufacturing subsidiary would shift 25 significant profits from Japan (36 percent national tax rate) to Singapore 26 (10 percent tax rate) to generate a large (26 percent) tax rate savings. 27 Concerns about the potential shifting of taxable profits from high- to 28 low-tax jurisdictions has prompted many industrialized countries with 29 tax rates above 25 percent to examine closely the tax affairs of multina- 30 tionals in their countries for transfer pricing “abuses.” Such tax exami- 31 nations have led to transfer pricing disputes between multinationals and 32 governments around the world. It is small wonder, then, that transfer 33 pricing is the number-one tax examination issue worldwide. 34 Tax due diligence requires obtaining copies of all tax examination 35 reports from any country in which the target has tax operations. This is 36 especially important in obtaining an understanding of any risks posed by 37 existing transfer pricing policies among group members. In most multi- TAX DUE DILIGENCE 223 national transactions, there are one or more transfer pricing disputes at 1 the parent or subsidiary level. All of this information is important in 2 advising the investor on the risks involved in making the investment. 3 With effective due diligence, the investor’s acquisition of the target’s 4 assets can allow it to redefine the group’s transfer pricing practices. 5 Consider the following example: U.S.-based HardwareCo, Inc., had 6 significant intellectual property in a product line, produced that product 7 in subsidiaries around the world, and decided to sell the entire product 8 line as an asset sale. More than 70 percent of the product line’s revenues 9 were from non-U.S. sources. The investor’s primary goal in the global 10 asset purchase was to acquire all, or almost all, of the target’s intangible 11 asset rights in an international intellectual property holding company 12 (IPHC) in a low tax jurisdiction. The investor established a global cor- 13 porate tax structure to facilitate the licensing of the intangibles to all 14 manufacturing operations in exchange for royalties that resulted in low 15 or no withholding tax. The IPHC also acquired the marketing intangi- 16 bles and licensed them to its sales and distribution subsidiaries in 17 exchange for royalties. Overall preacquisition planning minimized 18 income subject to tax in high tax rate jurisdictions and maximized the 19 income in low tax rate jurisdictions—a tax home run. 20 Consider another example: In addition to the assets of FrozFood, 21 Inc., an investor also acquired FrozFood’s foreign corporate subsidiaries 22 holding such operations. Here, it was not possible for the investor to 23 acquire all of the marketing intangibles on the acquisition date, because 24 the foreign subsidiaries owned them. FrozFood had also previously 25 owned all of the manufacturing intangibles and licensed them to foreign 26 subsidiaries in exchange for royalties. Unfortunately, all of those royal- 27 ties were being returned to a high tax rate jurisdiction (the United 28 States). Once those royalties exceeded the ability of FrozFood, Inc., to 29 offset the excess foreign tax credits that came with its high-tax-rate 30 foreign subsidiary dividends, they were subject to a full U.S. tax instead 31 of being deferred offshore—an inefficient tax structure. During the 32 acquisition, a team including corporate, intellectual property, and tax law 33 practitioners arranged for the investor to establish a cost-sharing agree- 34 ment immediately upon closing the acquisition. Although the establish- 35 ment of a cost-sharing agreement would typically have the temporary 36 impact of increasing the effective tax rate of the overall group, this detri- 37 224 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ment was offset by implementing other tax planning. The result was a 2 gradual decline of the investor’s overall global effective tax rate. 3 4 Nonfederal Tax Due Diligence in an Asset Acquisition 5 As we have described, almost every country imposes significant provin- 6 cial, territorial, state, or local taxes. Depending on the form of the trans- 7 action, some of these taxes—such as income or franchise taxes, capital 8 taxes, sales and use taxes, value-added taxes, property taxes, property 9 transfer taxes, and mortgage-recording taxes—will, to a greater or lesser 10 degree, adversely affect the investor. In an asset deal, the investor must 11 cope with the nonfederal tax aspects of the target whose assets it is 12 acquiring. Typically, those assets also include shares of subsidiaries out- 13 side the target’s country of incorporation. As a result, it is necessary for 14 the investor to undertake due diligence at the nonfederal level for each 15 country in which the target has an incorporated subsidiary whose shares 16 the investor is also acquiring. 17 Nonfederal income taxes. Starting at the outbound target level, 18 some countries have relatively simple nonfederal tax systems. Consider a 19 country with eight provinces. In this country federal taxable income is 20 allocated to each of the separate provinces based on a formula (some- 21 what like Canada’s) that takes into account the receipts, payroll, and 22 property in each province. Each province then applies a tax rate to the 23 allocated federal income for provincial income tax purposes. As long as 24 the provincial tax rates are roughly equivalent and due diligence can 25 determine that 100 percent of federal taxable income has been allocated 26 to the eight provinces, due diligence at the provincial level is straight- 27 forward. However, like Canada, each province may have special incen- 28 tives, credits, or tax rates that increase the provincial due diligence effort. 29 In Japan, for example, the enterprise tax allocates federal taxable income 30 among those prefectures in which the entity has business offices or facto- 31 ries. Each prefecture applies national standard tax rates that it can increase 32 within limits. In Switzerland the federal tax rate is fairly low, and canton- 33 al taxes are the primary taxes to take into account. Effective cantonal tax 34 rates can be very low or as much as triple the national tax rate. In most 35 countries the tax base for jurisdictions one step below the federal level is 36 generally similar even if different tax rates apply. 37 In the United States, no single national model exists to allocate TAX DUE DILIGENCE 225 income across all states. Virtually every state that taxes income has a dif- 1 ferent method for doing so. Wyoming and Nevada have no corporate 2 income taxes. Some states have special tax vehicles that can receive pas- 3 sive income without incurring significant income tax. For example, a 4 Delaware intangible property holding company can receive dividends, 5 interest, and royalties at no Delaware income tax cost with only a small 6 return filing fee. 7 Many states use a method of apportionment to determine how much 8 of adjusted federal taxable income to tax. Some states start with that 9 entity’s federal taxable income and make specific state adjustments, such 10 as depreciation method adjustments or add-backs of the federal tax 11 deduction for state income taxes. Others use a three-factor apportion- 12 ment formula that compares the amount of payroll, property, and receipts 13 in that state to the total payroll, property, and receipts everywhere else in 14 that company. After each factor is added, the total is divided by three to 15 determine the apportionment factor against which to multiply the adjust- 16 ed federal taxable income to compute the amount of income the state 17 may tax. 18 Some states, like New York, have used a double weighting to the 19 receipts factor. Michigan and others have a single-factor formula. Each 20 state has absolute discretion on whether to impose an income tax, 21 whether to allow or require adjustments of federal taxable income, to 22 determine its allocation or apportionment factors, and to impose its own 23 tax rate. Inbound investors are justifiably flummoxed. 24 The nexus concept. Many inbound investors believe that the state 25 in which they locate their U.S. headquarters or, alternatively, where 26 they incorporate will be the state that taxes them. Both beliefs are part- 27 ly correct and wholly inadequate. States tax corporations based on a 28 concept called “nexus.” Nexus requires that, for state taxation purpos- 29 es, the corporation have “sufficient contact” with the state for that state 30 to tax it. 31 What “sufficient contact” means varies from state to state, because 32 each state defines its nexus differently. However, an office in a state is 33 clearly sufficient. If a company headquartered in one state employs sales- 34 people who live and work in another state where the company has no 35 formal office but who have a contract to sell the company’s goods in that 36 state, the company may have sufficient nexus in both states. In some 37 226 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 states, having a warehouse from which goods are shipped by common 2 carrier is sufficient nexus even if the warehouse is operated by a third 3 party. A South Carolina court held a Delaware corporation subject to tax 4 in South Carolina because it received royalty payments from an entity in 5 South Carolina despite having no other contacts there. 6 Many non-U.S. investors are surprised when they first establish U.S. 7 operations without incorporating a U.S. subsidiary. Often, inbound 8 investors comfortably rely on an income tax treaty between their coun- 9 try and the United States to shield them from U.S. federal income tax, 10 only to find that states in which they have nexus tax their operations. 11 This occurs because states are not parties to the U.S. government’s 12 income tax treaty network. Hence, a non-U.S. company may decide to 13 begin U.S. operations by merely having a warehouse from which it dis- 14 plays and ships goods in the United States. Virtually every U.S. income 15 tax treaty provides that such activity alone is not sufficient contact to give 16 rise to a tax liability for the non-U.S. party. Nevertheless, if that ware- 17 house, marketing office, subsidiary, agent, or intangible asset is located 18 in some states, those states may attempt to tax the U.S. sales proceeds of 19 the non-U.S. company. 20 Likewise, a non-U.S. party may have an office in the United States 21 that gathers market research but does not take orders for products. 22 Again, this may create sufficient nexus for the state to attempt to tax the 23 entity. As a result, whether or not the non-U.S. investor establishes a 24 U.S. subsidiary to make the investment, issues concerning state nexus 25 will continue to arise. These uncertainties will expand with new devel- 26 opments. For example, typical nexus issues concerning subsidiaries, 27 agents, or intangibles expanded with the advent of new types of entities 28 such as limited liability partnerships (LLPs) and limited liability compa- 29 nies (LLCs). Likewise, technology advances involving satellites, soft- 30 ware, and the Internet have generated new nexus issues. 31 From a tax due diligence viewpoint, the key issue is whether the tar- 32 get has filed the appropriate nonfederal income or franchise tax returns 33 in the appropriate province, territory, state, or locality. Where all federal 34 income is allocated to various provinces, the issue is easy to resolve. In 35 the United States, however, with its multiple forms of state and local tax 36 jurisdiction and different nexus rules, the issue can be very nettlesome. 37 It is important to remember that should the target be subject to taxa- TAX DUE DILIGENCE 227 tion, the statute of limitations begins to run only when a tax return is 1 filed. In an asset acquisition, the non-federal due diligence should focus 2 on making certain that the tax advisers know exactly where liability on 3 the target’s filed returns exists and identifying tax liabilities on unfiled 4 returns. 5 For example, assume that a single U.S. target entity has assets in ap- 6 proximately twenty states, manufacturing operations in a single state, 7 and distribution operations in forty states. Assume further that the 8 investor has identified those states where liability or potential liability 9 exists. As a result, the investor may decide to acquire the target’s assets 10 using a variety of investor entities to reduce state taxes. For example, it 11 may be possible to hold all manufacturing and marketing intangibles in 12 a Delaware IPHC, isolate the manufacturing operations in a single enti- 13 ty, and place other distribution operations in one or more entities. In 14 addition, the investor may give consideration to using some LLCs as part 15 of the acquisition structure. Thus, the planning technique is to isolate 16 income in a low-tax state even if other operations are in states with high 17 tax rates. Splitting up the target company’s assets among two or more 18 investor companies sometimes provides a measure of state tax planning. 19 But in California, for example, and elsewhere, unitary tax means that all 20 of the members of the group must be taken into account, perhaps even 21 globally, unless the entity files a “water’s-edge” election with the state of 22 California. 23 Transactional taxes. Transactional taxes are another area of nonfed- 24 eral due diligence. Many countries have value-added tax (VAT) systems 25 in which each party handling a product or performing a service is 26 required to charge a value-added tax for that portion of the product or 27 service attributable to that party. Many non-U.S. VAT exceptions exist 28 for exports and certain effects. The European Union is in the process of 29 harmonizing its VAT system but has not yet reached the total agreement 30 that it achieved on customs duties. Due diligence on VAT will provide 31 the asset-transaction investor with the opportunity to see whether VAT 32 is being paid and under what circumstances. This will help the investor 33 determine its VAT responsibilities and provide it with certain postdeal 34 planning opportunities. 35 In the United States, state sales and use taxes apply to transfers of 36 goods and, in some cases, services. Every state has its own rules con- 37 228 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 cerning these taxes. Some states do not tax food and clothing; others do. 2 Some states have bulk sales rules that exempt a sale of all the assets of a 3 business from their sales taxes. However, an asset sold in one state may 4 move to another and become subject to the second state’s use-tax pro- 5 visions, typically with a credit for the sales taxes paid to the first state. It 6 is important for the inbound investor to understand these issues on a 7 state-by-state basis, particularly for portable assets like trucks, fleets, or 8 rolling stock. 9 Although states have nexus rules for sales and use taxes, the definition 10 of nexus for income tax purposes versus the definition of nexus for sales 11 and use tax purposes in the same state can be different. Generally, nexus 12 for sales and use tax requires some level of physical presence. The expan- 13 sion of the Internet and federal legislation prohibiting new sales and use 14 tax applications to Internet sales has caused states to scramble to find 15 ways to apply nexus concepts for sales and use taxes to such transactions. 16 In a recent state court case, a bookseller owned stores in one state and 17 an Internet bookselling business in a separate entity. The latter had no 18 physical presence in the state, but its bricks-and-mortar affiliate accept- 19 ed returns and allowances for books purchased over the Internet. Under 20 such circumstances, the court ruled that the Internet company had to 21 pay sales and use taxes in that state. Similar Internet entities may trigger 22 VAT levies, particularly since the European Union has recently attempt- 23 ed to apply VAT where non-EU Internet sellers ship merchandise to EU 24 recipients or allow EU customers to download items from non-EU- 25 based websites. 26 Other areas to which local due diligence may properly apply include 27 property taxes, mortgage-recording taxes, and similar local tax issues. 28 Here the investor should ask the due diligence team to determine the 29 appropriate taxes. Likewise, a review of such taxes in due diligence may 30 provide planning opportunities. In a famous case, the deal design of a 31 $400 million real estate transaction avoided paying a real property trans- 32 fer tax by putting the real estate into a separate corporation and selling 33 the shares of the corporation rather than the real estate itself. 34 If members of the target’s group import goods, tax due diligence 35 should include a customs review of each relevant entity, subject to the 36 ubiquitous 80/20 rule. 37 TAX DUE DILIGENCE 229

1 Asset Acquisition Planning Opportunities: Overview 2 Investors can convert their tax due diligence efforts on compliance issues 3 into tax-saving ideas consistent with their plans for the target. These 4 ideas can affect such items as asset valuation, structure, acquisition 5 indebtedness, and accounting methods. 6 Purchase price allocation. Allocation of the purchase price among 7 the target’s assets provides the investor with both challenge and oppor- 8 tunity. Part of the challenge comes from the investor’s desire to achieve 9 the speediest recovery of its investment by allocating as much of the 10 price as possible to short-lived assets. For example, this can generate rev- 11 enue without taxation of the cash through tax basis in a short-term con- 12 tract. However, the investor’s proposed allocation of purchase price 13 between short- and long-term assets to achieve fast cost recovery may 14 conflict with the seller’s desire to create capital gains income either 15 exempt from tax or subject to preferential capital gains rates. 16 In some places, the clash between the investor’s and seller’s goals 17 results in inconsistent tax positions, particularly if the acquisition docu- 18 ment is silent or vague. In some countries, such inconsistent tax return 19 positions are not resolved until government examination, thereby put- 20 ting the taxing authority at risk. Other jurisdictions, like the United 21 States, require that the parties either consistently report the allocation of 22 the purchase price in their tax returns or identify the areas in which they 23 differ. U.S. tax law further prescribes the rules by which the investor and 24 target are to allocate the purchase price among seven classes of assets 25 defined in the income tax regulations. These seven classes of assets range 26 from cash as the most liquid to goodwill and going concern value as the 27 most broad based. However, even within broad classes of assets, it is 28 important for the investor to be as specific as possible to accelerate the 29 time at which a tax deduction or an exclusion from income takes place. 30 In one case, an investor was acquiring Biotech LLC in an asset acqui- 31 sition. Biotech LLC had one product on the market and five in various 32 stages of R&D. To the extent that the investor assigned a lump sum pay- 33 ment price to the five projects in the R&D pipeline, no amortization or 34 write-off of that amount could occur until the last of the projects either 35 resulted in a marketable product or was discontinued because no prod- 36 uct was likely to result. However, by assigning a specific value to each of 37 230 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the five R&D projects, it could amortize or write off the related amount 2 as each of the separate R&D projects came to fruition or was abandoned. 3 The same type of analysis applies when the investor acquires the assets of 4 a target that has contracts expected to generate income over time. To 5 achieve the optimum result, the investor should separately allocate the 6 purchase price to each of the contracts as part of a combined due dili- 7 gence effort involving the tax advisers in concert with the appraisal and 8 valuation group. 9 Because many cross-border asset acquisitions involve the acquisition 10 of shares of the target’s foreign subsidiaries, it is important to understand 11 the consequences of allocating purchase price to such shares. Different 12 outcomes result when all foreign subsidiaries are held through a single 13 foreign holding company versus when all foreign entities are owned 14 directly by the target whose assets are being acquired. It is also impor- 15 tant to determine whether the country in which the subsidiary is locat- 16 ed allows a step-up for the basis in the assets inside the company despite 17 the fact that its shares were acquired. (This topic is discussed in greater 18 detail later in this chapter in the section on share acquisitions.) 19 Asset acquisition structuring. Due diligence will usually provide the 20 tax due diligence team with a good idea of which tangible and intangi- 21 ble assets should generate the greatest value. Take particular care to 22 review intangibles not specifically set forth on the target’s balance sheet. 23 Such a review can help determine the appropriate structure for making 24 the acquisition. Often the simplest structure is best, such as incorporat- 25 ing a single entity in the target’s jurisdiction to make the asset acquisi- 26 tion. However, asset acquisitions almost always provide opportunities to 27 achieve a more tax-efficient result. For example, consider the possibility 28 of having a new or existing investor subsidiary in a low-tax jurisdiction 29 acquire the target’s intangibles (a typically tax-efficient strategy whether 30 or not the target is a high- or low-tech company). 31 Also consider whether hybrid entities should be used. A hybrid entity 32 is an entity treated as a corporation by one tax jurisdiction and a part- 33 nership or branch by another. Because of this hybrid concept, the U.S. 34 “check-the-box” rules noted earlier have become important to many 35 investors. Assume a U.S. entity seeks to acquire the assets of one of sev- 36 eral business lines of a French company. Suppose that the French tax 37 rules prohibit the deduction of direct acquisition indebtedness. To TAX DUE DILIGENCE 231 reduce taxes, the U.S. investor might set up a holding company entity 1 (“SARL”) that could be treated as a corporation for local national tax 2 purposes but as a branch for U.S. tax purposes, and designate SARL as 3 the borrower. SARL would then form a wholly owned French subsidiary 4 (“SA”) capitalized with the funds required to make the acquisition. 5 Assuming France allows for consolidation, the interest might be 6 deductible. Because the holding company would be treated as a branch 7 of the U.S. parent, so long as the interest is paid to anyone other than a 8 member of the U.S. shareholder’s consolidated tax return group, the 9 interest paid by the SARL also would create a tax deduction on the U.S. 10 tax return. If the debt runs directly from SARL to the U.S. shareholder, 11 the interest would be viewed as a payment from a branch to a home 12 office and disregarded for U.S. tax purposes. 13 Structure can be important where the target has a series of foreign 14 subsidiaries that it owns directly. The investor may prefer to use a single 15 foreign holding company with each of these entities beneath it. The 16 holding company becomes a deferral technique or central funds facilita- 17 tor without the need to repatriate funds from subsidiaries back to the par- 18 ent to reuse them outside the target’s country. Alternatively, in an asset 19 acquisition with all subsidiaries held as brothers/sisters by the target, a 20 multinational investor with a variety of business segments or subsidiaries 21 around the world may wish to have one particular group own a target 22 subsidiary in one such segment and a different group own a target sub- 23 sidiary in another business segment. This strategy is much easier to facil- 24 itate in an asset acquisition than in a share acquisition. 25 Asset acquisition debt considerations. Using a combination of 26 debt and equity to fund the acquisition can substantially increase its 27 short- and long-term tax efficiency. Two questions arise on acquisition 28 debt. One is whether the investor’s country subjects interest deductions 29 to limitations on the ratio of debt to equity. Many countries have a for- 30 mal rule that disallows interest expense where that ratio exceeds 3:1. 31 Germany previously allowed a 9:1 debt-to-equity ratio at a holding com- 32 pany level but a 3:1 debt-to-equity ratio at an operating company level. 33 Germany has since revised the former down to 3:1. This is a typical rule 34 of thumb outside the United States, which has no formal rule. 35 Whether or not a country has a formal debt-to-equity ratio for pur- 36 poses of deducting interest, the country may have limits on the ability to 37 232 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 deduct share acquisition debt or interest in general. Thus, France has 2 denied any deduction for interest on share acquisition debt. Other coun- 3 tries, like Canada, have disallowed interest paid to third parties when the 4 funds are invested outside the borrower’s country of incorporation in 5 assets that generate only passive income. Here, it might be important to 6 have two entities make the acquisition so that the entity with the debt 7 can acquire operating assets inside the target’s country. This allows the 8 interest deduction because the second entity would acquire the foreign 9 subsidiaries using all equity funds. In the United States, the “earnings 10 stripping” rules can limit the ability of a taxpayer to deduct interest when 11 such interest is paid to a non-U.S. related party with U.S. withholding 12 tax at less than a 30 percent rate or to a third party that is the subject of 13 a guarantee by the non-U.S. related party. 14 Post-asset acquisition considerations. How can you most effec- 15 tively tax plan for the surviving entity? Prior due diligence will have 16 already disclosed all of the key tax accounting methods the target used 17 under the laws of its jurisdiction. However, because the investor usually 18 forms new entities to make the acquisition, it gets to choose new 19 accounting methods, which may employ the same tax accounting 20 method as the target did or another one. Investors should take advan- 21 tage of tax-minimizing possibilities by considering deductions for R&D, 22 LIFO versus FIFO, inflation accounting in some countries, revaluations, 23 redefinitions of fixed assets, and a change of tax fiscal year-end. 24 25 26 Taxable Share Purchases 27 From a tax perspective, when the investor acquires the target’s shares, it 28 steps into the shoes of the target’s shareholders, inheriting the target’s 29 entire tax history. This inheritance includes the current-year tax structure 30 and contingent tax liabilities based on open tax years of all entities cur- 31 rently under tax examination or to be examined by the tax authorities 32 because the statute of limitations is still open. The investor also inherits 33 all of the target’s existing accounting methods, capital cost recovery 34 methods, and asset tax basis. Thus, the fundamental difference between 35 an asset purchase and a share purchase is that the investor’s purchase 36 price in a share purchase typically winds up in tax basis of the target’s 37 shares rather than in its assets. The inability to write up the target’s assets TAX DUE DILIGENCE 233 reduces the transaction’s tax effectiveness. Acquiring shares also increas- 1 es the investor’s exposure to the target’s prior tax return positions. The 2 investor may or may not inherit carryover loss and credit attributes of the 3 target, which may be subject to limitations even if inherited. 4 5 Tax Compliance 6 Because of the inherited character of a share acquisition, due diligence is 7 critical for compliance determination, a process that includes confirming 8 that all tax returns, in all jurisdictions, were accurately filed on time for 9 all prior periods and that all required payments were made. If any taxing 10 jurisdiction has issued within the past four years a report for the target 11 or any member of the target’s group, the tax due diligence team should 12 review it for the issues raised, the amounts paid, or those in dispute. If 13 the target is the subject of any ongoing tax examinations at any level for 14 any type of tax, the due diligence team should obtain access to ongoing 15 examination materials and get an assessment from the target or its out- 16 side advisers of the likely outcome in that examination. It is also impor- 17 tant to obtain copies of extensions of the statute of limitations for any 18 tax under examination. The investor should view years in which the 19 statute of limitations has not expired as “open” years. A master list or 20 matrix of open years by entity and by type of tax will help focus due dili- 21 gence efforts. Although, as a practical matter, not every year or type of 22 tax dispute can be thoroughly reviewed, it is a point from which the due 23 diligence team can put the 80/20 rule to effective use. 24 The investor’s tax due diligence team should closely scrutinize all tax 25 cases currently at administrative appeals or in court. The very fact that 26 the case is at administrative appeals or in court means that it could not 27 be resolved at the agent level and that the tone of the negotiation on the 28 disputed items already has been set. Because the likelihood of an addi- 29 tional payment is probably beyond the investor’s ability to control, the 30 tax due diligence team should write a strong tax indemnification clause 31 to add to the final acquisition agreement. 32 33 Transactions and Tax Reserves 34 A key area for tax due diligence in a share acquisition is the target’s prior 35 history of major transactions arising from deals—major acquisitions or 36 dispositions of assets or companies inside its group anywhere in the 37 234 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 world. In a prior major acquisition, the target may have deducted 2 expenses that should have been capitalized, thus creating a tax exposure 3 for open years. Likewise, gain recognized on the prior sale of divisional 4 assets may have been overly weighted toward items that would generate 5 low or no tax treatment. 6 Reviewing the target’s tax reserves is critical. There will be tax accru- 7 als for liabilities that have been incurred but not paid and reserves for 8 matters existing in returns already filed at parent and subsidiary levels. 9 Tax accruals will be a matter for the financial accounting due diligence 10 team to confirm, but in some cases, that team will be able to confirm 11 only the total amount of reserves for contingent tax issues. It is therefore 12 the tax due diligence team’s responsibility to review all reserves on con- 13 tingent tax items. Given the prospect of a big tax bill down the road as 14 a result of these items, it is unacceptable for the target to resist produc- 15 ing tax reserve schedules. 16 In all cases, have a lengthy discussion with the target’s in-house and 17 adviser tax personnel on the nature of the matters that are the subject of 18 the reserves and the degree of exposure. Many non-U.S. jurisdictions 19 require that the tax return conform to the statutory books. Thus, tax 20 reserves relating to such countries typically exist outside that country 21 either at the parent level or in consolidation. If a tax dispute results in an 22 additional tax, the amount of prior reserve at the parent or the consoli- 23 dated level equal to the additional payment is reversed and booked by 24 the entity responsible for the tax payment during the accounting period 25 in which the additional taxes are required to be paid. The offsetting 26 entries should have no financial statement impact. 27 As in the case of asset transactions, if the target has a parent company 28 and several foreign subsidiaries, the single most important tax examina- 29 tion for the investor will involve a hard look at internal transfer pricing 30 of goods, services, capital, and intangibles among members of the relat- 31 ed party group. This is especially important in the case of a share acqui- 32 sition because, by acquiring the target’s shares, the investor inherits the 33 target’s history of transfer pricing. It is thus up to the tax due diligence 34 team to thoroughly understand the target’s transfer pricing policies as 35 well as its production, distribution, and service functions in order to 36 appropriately evaluate such practices and the tax exposure resulting from 37 such practices. TAX DUE DILIGENCE 235

1 Consolidated Returns, Attributes, and Accounting Methods 2 If two or more members of the target group file a national consolidated 3 tax return in their home jurisdiction, the cross-border investor should 4 know how the consolidated tax rules work in that country. There may be 5 deferred tax items between members of the consolidated tax return 6 group, basis adjustment accounts that need to be resolved on a change 7 of group members, intercompany transactions within a given tax juris- 8 diction that can affect subsequent tax liabilities, and tax attributes calcu- 9 lated on a consolidated rather than a separate entity basis. These include 10 net operating losses, tax credits, and charitable contributions. This 11 review is especially important if any target member of a consolidated tax 12 return group worldwide is not going to be part of the overall transaction 13 and is being transferred by the target from its existing consolidated 14 return group. The transfer has special impact when there are existing tax- 15 sharing or tax indemnification agreements. 16 Given the successor liability character of a share transaction, the team 17 must review in great detail items like tax accounting methods for inven- 18 tory, capital recovery, research and experimental expenditures, and 19 amortization of intangible assets. Like any other aspect of due diligence, 20 problems that emerge from this sort of review may affect the price and 21 structure of the deal; the target’s representations, warranties, indemnifi- 22 cations, and covenants; or the investor’s conditions to closing expressed 23 in the merger documents. 24 25 Withholding Taxes 26 Within a target’s multinational group, withholding tax issues are doubly 27 important. From a national tax perspective, withholding includes all pay- 28 roll and social insurance obligations. Moreover, payments of income from 29 one tax jurisdiction to another may be subject to a 25 percent to 30 per- 30 cent withholding tax unless otherwise reduced by an existing tax treaty. 31 It is important to review intragroup payments that might be subject to 32 withholding tax for appropriate calculations, reporting, and payment to the 33 national tax authority. Assume a U.S. subsidiary paid dividends or interest 34 to a Dutch shareholder, but the Dutch shareholder was ineligible for the 35 benefits of the U.S.-Netherlands Income Tax Treaty. Here, the U.S. sub- 36 sidiary should have withheld a 30 percent tax under the U.S. withhold- 37 236 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ing tax rules. If the target used the treaty rate of 5 percent for dividends 2 and 0 percent on interest, it is liable to the IRS for the payment of those 3 taxes. Exposing this problem in due diligence prepares the investor to ask 4 for a tax indemnification or an escrow of some of the purchase price. 5 6 Employee Benefits 7 In share transfers, target employees are “assets” that transfer directly 8 over to the investor, thus requiring a review of all of the target’s benefit 9 plans and compensation, welfare, and benefit practices. Due diligence 10 should focus on the target’s compliance with national rules, including 11 highly compensated individual tests, discrimination tests, coverage tests, 12 and other tests imposed by national tax authorities in order for such plan 13 contributions to be deductible by the corporation and not constitute 14 income to the individual. One proposed share acquisition was dropped 15 within minutes of the tax due diligence team’s informing investor man- 16 agement that the target had improperly changed actuarial assumptions 17 for its pension plans at the end of the prior year. This change made one 18 plan appear to be overfunded by $500,000, but it really was underfund- 19 ed by $2 million. 20 In countries where the government runs all pension plans, payment to 21 the government is sufficient. However, there are a variety of non-U.S. 22 jurisdictions where employee benefit plans, particularly pension and 23 profit-sharing plans, do not have the same strict funding and testing 24 requirements as they do in the United States. In some countries it is suf- 25 ficient that the pension plan is established by the company and is carried 26 as a liability on the company’s balance sheet. Sometimes under those cir- 27 cumstances, no separate arrangement with an independent trustee need 28 be set up, nor does the plan have to be funded on a current basis. The 29 tax due diligence team should review and report on every type of com- 30 pensation, welfare, or benefit plan in each tax jurisdiction so that the 31 investor understands the ramifications of completing the transaction 32 given any tax exposures in the plans. 33 Two other areas for review include golden parachutes and share com- 34 pensation plans. Golden parachutes typically benefit a few very senior 35 members of top management and can create a significant nondeductible 36 cost to the company. Share compensation plans may take the form of 37 qualified stock options, nonqualified share options, thrift plans, war- TAX DUE DILIGENCE 237 rants, or other forms of share compensation based on the tax rules of a 1 given jurisdiction. Often, such plans have clauses that provide for vesting 2 immediately before a change of the control of the target. Likewise, some 3 target plans call for immediate vesting and cashing out of the target’s 4 shares should there be a change of control. This poses a potential con- 5 tingent liability to the investor that the team should investigate early on 6 in due diligence. 7 8 Foreign Tax Credits and Exemptions 9 The target may include a variety of foreign subsidiaries that may be in 10 almost any structural format. Use the 80/20 strategy once again when 11 considering which of the affiliates to examine. There may be exposure 12 items appearing at, above, or below the organizational level of a sub- 13 sidiary. It is important to understand how the target’s country treats the 14 receipt of income from foreign subsidiaries. As previously noted, many 15 countries have a foreign tax credit system allowing the recipient of for- 16 eign-source income to take a credit in its country for all or part of the 17 taxes paid by the dividend-paying foreign subsidiary. But take care, 18 because virtually every country’s foreign tax credit system is different. 19 While the United Kingdom, France, the United States, and Japan all 20 have foreign tax credit systems, each has its own distinct rules. In all 21 cross-border deals it is important to understand the foreign tax credit 22 rules in the country of each constituent party. 23 In the case of a U.S. investor, it will be important to develop a sig- 24 nificant amount of data on each foreign subsidiary for future foreign 25 tax credit planning purposes. These data should include the sub- 26 sidiary’s history of earnings and profits, the tax equivalent of financial 27 statement retained earnings. It will also include the history of non-U.S. 28 taxes previously paid, by entity and by year. Because the United States 29 has many antideferral rules, a flowchart of intercompany transactions 30 can help identify existing and prospective issues for U.S. and non-U.S. 31 targets alike. With a U.S. target, it is also important to determine 32 whether the target had income earned by a foreign subsidiary previ- 33 ously taxed in the United States because of the U.S. antideferral rules 34 that has not yet been distributed. The absence of relevant information 35 on this score can create a significant risk to the investor and endless 36 hours postdeal to straighten things out. 37 238 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 If the target is a non-U.S. company with foreign subsidiaries, it is 2 unlikely that the target will have this kind of information on hand. If the 3 investor is also a non-U.S. party, there is no need for such information 4 unless the target has a U.S. subsidiary that owns non-U.S. subsidiaries. 5 But if the investor is a U.S. party and the target a non-U.S. party, it will 6 be up to the non-U.S. tax due diligence team to try to estimate such 7 information as best as it can given the available time. 8 9 Tax Attributes 10 Typically, in share acquisitions the target’s tax attributes and those of its 11 subsidiaries carry over to the investor. These include net operating losses 12 and the carryforward of tax credits, including investment tax credits, 13 research and development tax credits, and foreign tax credits. These car- 14 ryover tax attributes may survive a change of control of the target in a 15 share transaction. However, the United States and some other countries 16 impose limitations on the ability to carry over such tax attributes. Some 17 tax experts believe that an investor should pay only for the ongoing busi- 18 ness and attach no value to carryover attributes, because of the difficulty 19 of using them. 20 21 Structuring the Share Acquisition 22 During due diligence, the tax team should consider the form that the 23 share acquisition structure should take in order to provide the investor 24 with the best possible subsequent tax results. This is an often daunting 25 task, because the typical share acquisition investor inherits the target’s 26 tax history and those of its subsidiaries without basis step-up. But even 27 share acquisitions can sometimes be structured to effect tax savings. For 28 example, the investor may wish to consider establishing an entity inside 29 the target’s country to make the acquisition, or making the acquisition 30 from an entity outside that country. The tax decision is often a matter of 31 choosing either the best jurisdiction from which to deduct acquisition 32 interest or the jurisdiction that permits the filing of consolidated returns. 33 There may be special circumstances under the laws of either party’s 34 jurisdiction that allow for attractive results. For example, the United 35 States has a special “Section 338” election. When a U.S. investor 36 acquires the shares of a foreign target for cash, it may make a Section 338 37 election. For U.S. tax purposes only, this election treats the acquisition TAX DUE DILIGENCE 239 of the target as an acquisition of the target’s assets rather than its shares. 1 In the target’s country of origin, the tax basis of the assets inside the 2 company stays the same for local tax purposes, and there is no local tax 3 impact. For U.S. tax purposes, the assets of the non-U.S. target are 4 stepped up to their fair market value. In addition, the target’s prior earn- 5 ings history is wiped out for U.S. foreign tax credit purposes. Any 6 retained earnings in the target are treated as “previously taxed income,” 7 thus allowing the U.S. investor to distribute such previously taxed 8 income into the United States with no U.S. income tax consequence. 9 Hence, unless the target’s shareholders are U.S. persons, under most cir- 10 cumstances a U.S. investor acquiring a non-U.S. target will immediately 11 make a Section 338 election after the acquisition. 12 Alternatively, a non-U.S. investor seeking to acquire for cash the 13 shares of a U.S. subsidiary in a U.S. consolidated tax return group might 14 discuss with the target the possibility of making a Section 338(h)(10) 15 election, one usually made when a U.S. selling group has a consolidated 16 net operating loss carryforward. As a result of the Section 338(h)(10) 17 election, the target agrees to take any related gain into its consolidated 18 tax return, where it is typically offset by any consolidated net operating 19 loss carryforwards. As a result, the investor can step up the basis of the 20 assets of the target for U.S. tax purposes in a share purchase under the 21 right circumstances. 22 As described earlier, a “check-the-box” election by the investor can 23 create significant tax opportunities. A non-U.S. investor seeking to 24 acquire a U.S. target may also have good reasons for using a check-the- 25 box structure. The investor’s team also should explore the ability to 26 deduct interest from deal debt, keeping in mind that limits imposed on 27 such deductions will vary from country to country. 28 29 30 Tax-Free Exchanges 31 For federal tax purposes, the U.S. treats statutory mergers, some share- 32 for-assets deals, and some share-for-share exchanges as tax-free “reor- 33 ganizations.” Each type of U.S. tax-free (more correctly, tax-deferred) 34 reorganization contains specific criteria to which the non-U.S. investor 35 must rigorously adhere to achieve tax-free reorganization status. U.S. 36 federal income tax law attempts to achieve symmetry for both sides to a 37 240 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 deal. Taxable transactions result in the investor’s ability to achieve fair 2 market value tax basis whether it purchased the target’s shares or assets. 3 In a U.S. tax-free reorganization, the investor takes the target’s basis in 4 the assets or shares acquired. One exception to this symmetry occurs 5 when selling shareholders are taxable under the “boot” rules of a statu- 6 tory merger or other tax-free transaction for receiving something other 7 than voting shares. 8 Some countries do not tax the gain on a shareholder’s sale or 9 exchange of its company shares. Those selling shareholders may not pre- 10 fer shares to cash, all other factors being equal. Only a few countries out- 11 side the United States have the concept of a tax-free exchange, although 12 the list is growing. For example, despite some setbacks, there has been 13 progress in European Union member countries. 14 A tax-free asset acquisition typically differs from a taxable asset acqui- 15 sition in two ways. From a U.S. federal income tax viewpoint, the basis 16 of the assets acquired may be a carryover from the target rather than a 17 fair market value or step up in basis, as discussed in the case of taxable 18 asset acquisitions. From a state and local tax viewpoint, whether state 19 sales and use taxes apply to the acquisition may depend on the type of 20 tax-free reorganization undertaken. For example, many states have spe- 21 cific sales and use tax exclusions for statutory mergers. However, when 22 the investor does a share-for-asset deal, a state may apply its sales and use 23 taxes, property transfer taxes, and mortgage-recording taxes to the trans- 24 action. Part of the inbound investor’s due diligence demands a review of 25 such matters on a state-by-state, tax-by-tax basis. As a result, all U.S. tax- 26 free reorganizations should be reviewed at the state level from the view- 27 point of whether the investor is acquiring assets or shares as a first step 28 to determining what types of due diligence apply to the transaction. 29 30 Although most deals don’t live or die as a result of tax issues, thought- 31 ful and searching tax due diligence can minimize tax compliance costs 32 and expedite future tax planning. Such efforts can save money by shift- 33 ing problems from the investor to the target and by planning that can 34 save taxes down the road—all in all an excellent return on the investor’s 35 time and funds spent in the process. 36 37 CHECKLIST Cross-Border Tax Due Diligence 1 2 NO CHECKLIST should be followed slavishly, because what is important and 3 what is not in a given transaction depends on the facts and circumstances 4 of the deal: shares versus asset acquisition, the status of the target and 5 investor, the corporate structure of each, and the transactional deal design, 6 among many other factors. Real-world due diligence adapts to the circum- 7 stances of the transaction. Many items below may be on the checklists of 8 other due diligence teams. Therefore, coordinate your requests for data 9 and share data common to more than one team—it will make life dramat- 10 ically easier for the target and remove a potential irritant in the parties’ 11 relationship. 12 13 CORPORATE STRUCTURE, GOVERNANCE, AND OPERATIONAL 14 MATTERS 15 1. Obtain corporate structure chart(s). 16 2. Obtain or create corporate tax structure chart(s), to the extent 17 different from the legal structure, e.g., hybrid entities by definition 18 under two countries’ statutes or the U.S. “check-the-box” rules. ❏ 19 3. Review corporate equity structure, including classes of shares, 20 voting rights, warrants, options, or other existing equity interests or 21 interests convertible into equity. ❏ 22 4. Review corporate debt structure, separating related-party debt 23 from third-party debt by entity, and intergroup related-party debt 24 across national boundaries. ❏ 25 5. Obtain target acquisitions, dispositions, and distribution history. 26 Coordinate efforts with financial accounting due diligence team, 27 investor management, and target on significant acquisitions, dispo- 28 sitions, and distributions by the target within the past three to five 29 years. ❏ 30 6. If target made acquisitions within past three years, discuss with 31 investor management the scope of review. ❏ 32 7. List intangible assets: Coordinate with intellectual property due 33 diligence team, investor, and target on identification, location, legal 34 ownership, and beneficial tax ownership (if different from legal 35 ownership) of intangible assets, any intangible asset cost-sharing 36 agreements, and any licenses, both in and out. ❏ 37 8. Obtain operational flowcharts for key production and distribu- 38 tion functions as well as services to external customers. ❏ 39 40

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1 9. Obtain flowcharts for internal/external financing as well as funds 2 flows from external operations, e.g., central treasury function, FX 3 management, and/or operational funds flows. ❏ 4 10. Create a chart that organizes tax obligations by level and type 5 of tax, jurisdiction, years open, and years under examination. ❏ 6 11. Obtain copies of all federal, provincial, territorial, state, local, 7 and foreign tax returns by type of tax for the previous three years 8 (or more if still subject to adjustment on examination). ❏ 9 12. Obtain copies of all correspondence concerning significant tax 10 matters other than examinations with any tax authority, including 11 applications for tax holiday, credit or base status; private letter rul- 12 ing, opinion of counsel, or Advance Pricing Agreement; election of 13 special purpose tax status (e.g., in the United States S corporation or 14 “check-the-box” entity); election or change of accounting method, 15 especially where prior approval of tax authority was required; or any 16 similar matter concerning the tax treatment of any material trans- 17 action involving the target. ❏ 18 13. Review examination reports of all federal, foreign, provincial, 19 territorial, state, and local authorities, including supporting materi- 20 als, as well as tax refund claims, investigations, examination, and/or 21 disputes for any fiscal year at any level not barred by the applicable 22 statute of limitations. ❏ 23 14. Create a chart of ongoing tax examinations, with level and type 24 of tax, noting extensions of the statute of limitations and date 25 of any report, issued together with alleged tax deficiency by year. ❏ 26 15. Obtain copies of all proposed adjustments to income tax liabili- 27 ties, together with related copies of the taxpayer’s submissions at 28 administrative, appeals, or court levels. ❏ 29 16. Obtain copies of tax liens. ❏ 30 31 PRIOR SHARE A CQUISITION OF TARGET 32 1. If over 50 percent of target was previously acquired within the 33 past three years, get details of any loss carryforward limitation cal- 34 culations. ❏ 35 2. If over 50 percent of the target was previously acquired within 36 the past three years, get details of any tax credit carryforward limi- 37 tation calculations. ❏ 38 3. If a national tax jurisdiction allowed a basis step-up in share 39 acquisition (e.g., Section 338 election in the U.S.), get the apprais- 40 al or valuation report used to allocate tax basis to tangible, intangi- ble, and/or real property assets. ❏ TAX DUE DILIGENCE 243

FINANCIAL STATEMENTS 1 1. Calculate tax reserves for accrued but unpaid taxes, coordinated 2 with financial due diligence team. ❏ 3 2. Calculate tax reserves for issues on returns previously filed, or to 4 be filed before or shortly after closing, by tax jurisdiction, entity, 5 year, issue, and amount, separately noting balance sheet location 6 and amount of any related accrued interest as well as whether or 7 not recorded net of any national tax benefit. ❏ 8 9 PRIOR BUSINESS ACQUISITIONS WITHIN THE INVESTOR 10 REVIEW PERIOD 11 1. For asset or share acquisitions with a Section 338(h)(10) election 12 in open years, get copies of appraisals to compare to results for tax 13 reporting purposes. ❏ 14 2. Get documentation supporting deduction or capitalization of 15 acquisition-related expenses. ❏ 16 3. Review postacquisition changes of accounting methods required 17 by operation of law, regulations, or election, as well as by permis- 18 sion granted from national tax authority on taxpayer request, 19 including inventories, research and experimental expenditures, and 20 fixed assets. ❏ 21 4. List postacquisition interest expense deductions for potential 22 application of limitations based on national tax law. ❏ 23 5. Detail prior-acquisition tax deductible goodwill or going-concern 24 amortization, relevant financial accounting detail, and book-tax net 25 difference schedule. ❏ 26 6. Detail applicable prior-acquisition nondeductible tax goodwill by 27 amount and entity, relevant financial accounting detail, and book- 28 tax net difference schedule. ❏ 29 7. Detail closing or postacquisition tax basis step-up by operation of 30 national law or election (e.g., U.S. Section 338 election) for non- 31 U.S. share acquisition. ❏ 32 8. Get details of foreign postacquisition distribution reporting for 33 tax exemption or foreign tax credit impact. ❏ 34 9. Review treatment of prior acquisition-related compensation 35 issues, e.g., golden parachutes, options, or other possibly nonde- 36 ductible payments made during open years. ❏ 37 10. Review treatment of prior acquisition built-in gains or losses in 38 open years. ❏ 39 11. Review postacquisition changes to any cost-sharing agreement 40 involving any of the previously acquired entities. ❏ 244 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 12. List amount and year generated of any of the target’s previously 2 inherited tax attributes and related limitations, as well as subse- 3 quent utilization in open years, including loss carryovers, credit carry- 4 overs, and tax basis of assets. ❏ 5 13. Obtain prior tax indemnification agreements. ❏ 6 7 PRIOR BUSINESS DISPOSITIONS WITHIN THE INVESTOR 8 REVIEW PERIOD 9 1. For asset sales by any target group member in its country of 10 incorporation, obtain details of gain or loss calculation and capital 11 gain or ordinary income treatment. ❏ 12 2. For sales by any target group member of assets located outside 13 its country of incorporation, obtain details of foreign taxability, 14 domestic taxability, sourcing of income, and any foreign tax credit 15 impact. ❏ 16 3. Obtain details of tax basis determination of property other than 17 cash received in dispositions. ❏ 18 4. For share sales by any target group member of an entity within 19 the member’s country of incorporation, obtain details of the gain or 20 loss calculation; capital gain or ordinary income treatment; and in 21 countries allowing consolidated tax returns, treatment of intercom- 22 pany transactions including deferred gains, adjusted stock basis, 23 and/or excess loss account recognition. ❏ 24 5. For share sales by a target group member of any entity outside 25 the member’s country of incorporation, obtain details of the foreign 26 income or withholding taxability, domestic taxability, sourcing of 27 income, potential conversion of capital gain to dividend or other 28 ordinary income, and any foreign tax credit impact. ❏ 29 6. Obtain details of compliance with special situations at national 30 tax level, such as the U.S. FIRPTA rules or the Canadian Departure 31 Tax rules. ❏ 32 7. Obtain documentation of any prior spin-off for compliance pur- 33 poses as well as potential for aggregation with this transaction by 34 tax authorities and related impact. ❏ 35 36 TAX ACCOUNTING ISSUES 37 1. Check method(s) of income recognition. ❏ 38 2. In an asset acquisition, review assignable revenue-generating 39 contracts, including term, degree of revenue certainty, associated 40 costs, and termination date with associated revenues or costs and TAX DUE DILIGENCE 245

conditions. Coordinate with appraisal/valuation specialist. ❏ 1 3. Check details of inventory methods, including elections of 2 method (e.g., FIFO, LIFO). ❏ 3 4. Check details of accounting for research and development costs, 4 including elections, as well as coordination with special tax regimes 5 (e.g., U.S. FSC or Possessions Corporations), R&D tax credits (e.g., 6 those of Canada and the U.S.), and foreign tax credits in the U.S. or 7 other countries with similar coordination. ❏ 8 5. Check details of capital recovery for tangible assets, including 9 capital cost allowances or depreciation, elections, and coordination 10 with investment tax credit provisions. ❏ 11 6. Review amortization by type of intangibles, e.g., organization 12 costs, start-up expenditures, or acquired intangibles, separating 13 permanent from timing adjustments. ❏ 14 7. Check details of interest expense “paid to,” “accrued but not 15 paid to,” or “guaranteed by” related parties by jurisdiction where 16 local deductibility is subject to limitations. ❏ 17 8. Check details of all other interest expense potentially subject to 18 limitations on deductibility. ❏ 19 9. Coordinate with financial accounting due diligence team to 20 check return filing and payment for all national income, social insur- 21 ance, and unemployment insurance withholding, as appropriate to 22 each jurisdiction. ❏ 23 10. Check other methods of accounting for income or costs, includ- 24 ing elections. ❏ 25 26 TRANSFER PRICING 27 1. Make descriptions of all intangible assets, specifying separate 28 beneficial ownership, if ownership is different. ❏ 29 2. Obtain contemporaneous documentation from any country 30 requiring it where the target has operations and intercompany 31 transfers. ❏ 32 3. Obtain copies of any cost-sharing agreement(s) among corporate 33 affiliates. ❏ 34 4. Coordinate with any transfer pricing specialist on due diligence 35 team. ❏ 36 5. Integrate operational flowcharts (Corporate Structure–Number 8) 37 and transfer pricing tax reserves (Financial Statements–Number 2) with 38 items above for analysis of investor exposure and/or opportunity. ❏ 39 40 246 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 CONTROLLED FOREIGN CORPORATIONS (“CFC” OR 2 “ANTI-DEFERRAL” REGIMES) 3 Based on the CFC rules of target’s country of incorporation, as well as any 4 foreign holding company whose country of incorporation also has CFC 5 rules: 6 1. Document transaction flow among members where CFC rules 7 may create income taxable to the shareholder without any cash dis- 8 tribution, e.g., “tax haven” rules of some EU countries or impact of 9 U.S. “check-the-box” rules. ❏ 10 2. Review supporting details for potential application of CFC rules, 11 including amounts, treatment on relevant tax returns, and coordi- 12 nation with tax reserves. ❏ 13 3. Review details of subsequent distributions from CFC income 14 where deferral was lost (e.g., “previously taxed income”), including 15 income recognition or exemption, as well as foreign tax credit con- 16 siderations in relevant national tax jurisdiction. ❏ 17 18 SOURCING OF INCOME 19 1. Review details of foreign source income by category (U.K.), by 20 basket (U.S.), and by type of transaction or other country-relevant 21 criteria. ❏ 22 2. Review details by entity of any active operating foreign source 23 income for consideration of exposure to foreign country Permanent 24 Establishment nexus for taxation. ❏ 25 3. Review details of expenses reducing foreign source income based 26 on country criteria. ❏ 27 4. Review prior foreign losses deducted in domestic return with 28 recapture/source conversion potential, e.g., sale of foreign branch 29 assets that previously generated losses or U.S. “dual consolidated 30 loss” rules. ❏ 31 5. Review details of calculation for countries that exempt foreign 32 source income. ❏ 33 34 FOREIGN TAX CREDITS (FTC) 35 1. Coordinate with due diligence teams in non-U.S. jurisdictions to 36 obtain detail of non-U.S. taxes paid that were, are, or will be 37 claimed as foreign tax credits. ❏ 38 2. Obtain details of distributions that generate foreign tax credits, 39 including, for example, U.S. post-1986 pools or individual pre-1987 40 layers of earnings and profits as well as related FTC chain distribu- tion effects to third-tier affiliates or below to sixth tier. ❏ TAX DUE DILIGENCE 247

3. Obtain details of FTC calculations under relevant country rules for 1 all open years. ❏ 2 4. Obtain details of undistributed earnings and foreign taxes paid 3 under the relevant country’s FTC rules. ❏ 4 5 CONSOLIDATED TAX RETURNS 6 1. Review consolidated tax returns filed in all countries and for all 7 target group entities. ❏ 8 2. Review details of special consolidated items, including deferred 9 gains, intercompany transactions, member share basis adjustments, 10 allocation of tax liability (including copy of any tax-sharing agree- 11 ment), and excess loss accounts. ❏ 12 13 EMPLOYEE BENEFITS 14 1. List details of all companies, businesses, or employees that are, 15 or may be, subject to Aggregated Group Rules under appropriate 16 national tax and/or labor laws, including the following: 17 A. Controlled Group of Corporations, identifying shareholders 18 and degree of interest or value owned in each entity for both 19 parent-subsidiary and brother-sister groups ❏ 20 B. Affiliated Service Groups, including A, B, and management 21 service organizations or local non-U.S. equivalent ❏ 22 C. Total number of leased employees ❏ 23 2. Review plans, programs, or other arrangements, written or oral, 24 of aggregated group members and other related employees under 25 local national rules (e.g., ERISA and non-ERISA). ❏ 26 3. Review details of each qualified pension and/or profit-sharing 27 plan of an actual or potential Aggregated Group Member or other 28 appropriate local national grouping, including the following: 29 A. Current plan document and amendments ❏ 30 B. Current trust agreement and amendments ❏ 31 C. Favorable Determination Letters from national tax authorities ❏ 32 D. Most recent filing application, including all attachments on 33 any current Favorable Determination Letter from a national 34 tax authority ❏ 35 E. Current Summary Plan Description ❏ 36 F. Most recent federal plan tax returns filed for past three plan 37 years (and note if any plan tax return was not filed in the 38 U.S. for any plan year beginning on or after January 1, 1988) ❏ 39 G. Any actuarial reports for the most recent three plan years ❏ 40 248 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 H. Any collective bargaining agreement for single-employer 2 plans ❏ 3 I. Insurance agreements ❏ 4 J. Other instruments, documents, or other written instructions 5 under which the plan is maintained or operated ❏ 6 K. Nondiscrimination testing, if applicable, for last three years 7 for which federal plan tax returns have been filed ❏ 8 L. Current administrative forms and procedures (qualified 9 domestic relations order procedures, notices and information 10 for qualified joint-and-survivor annuities, etc.) ❏ 11 M.Any fiduciary responsibility insurance ❏ 12 N. Fidelity bonds ❏ 13 O. Funding policy statement ❏ 14 4. Review details of each welfare benefit plan, whether or not 15 formed under specific national tax or labor law (e.g., ERISA and 16 non-ERISA benefit plans), including any: 17 A. Third-party administration agreements with respect to the 18 plan ❏ 19 B. Managed care agreements ❏ 20 C. Preferred provider agreements ❏ 21 D. Board resolutions adopting plan ❏ 22 E. Items A, B, E, F, I, K, and L of Number 3 above ❏ 23 5. Review details of each multiemployer pension plan of an actual 24 or potential Aggregate Group Member or similar grouping under 25 local national law, including the following: 26 A. Applicable collective bargaining agreement ❏ 27 B. Withdrawal liability reports, if available ❏ 28 C. Items A, B, E, F, G, and L of Number 3 above ❏ 29 6. Review details of any retirement plan not established under a 30 country’s national tax and/or labor law rules, e.g., a nonqualified 31 plan, including plan documents, arrangements for funding the 32 plan, and all related employee communications or agreements. ❏ 33 7. Review details of employee benefit plans not formed under spe- 34 cific provisions of national tax and/or labor law (e.g., non-ERISA 35 plans), including copies of the plan document and summary, all 36 employee communications, and the federal plan tax returns filed 37 for the last three years, if required. ❏ 38 8. Identify pending employee benefit investigations or examinations 39 being conducted by national authorities or government-related 40 entities (e.g., Pension Benefit Guaranty Corporation), including all relevant correspondence. ❏ TAX DUE DILIGENCE 249

9. Obtain documents and details of executive compensation 1 arrangements maintained or operated for any of the following: 2 A. Insured medical reimbursement plan ❏ 3 B. Qualified or nonqualified share option plans ❏ 4 C. “Top hat” plans ❏ 5 D. Golden parachutes ❏ 6 E. Any other arrangement particular to officers or senior man- 7 agement ❏ 8 10. Obtain personnel policy manual for each potential or actual 9 Aggregation Group Member or similar manual under the national 10 rules of all jurisdictions in which the company employs persons cov- 11 ered by the manual’s provisions. ❏ 12 13 OTHER PROVINCIAL, TERRITORIAL, STATE, AND LOCAL TAX 14 DUE DILIGENCE 15 1. In addition to copies of all income tax returns for the past three 16 years and access to all other tax returns filed for the past three 17 years, obtain or develop a separate schedule (for each type of tax 18 below) of all jurisdictions where one or more group members had 19 any of the following: 20 A. Employees, property (including leased premises), or receipts 21 but did not file an income tax return if the jurisdiction had 22 an income or franchise tax ❏ 23 B. Sales, particularly Internet sales, to a different jurisdiction but 24 did not file value-added tax returns for the recipient’s tax 25 jurisdiction ❏ 26 C. Employees, property, or sales in a particular jurisdiction by the 27 same company but the entity did not file sales and use tax 28 returns ❏ 29 D. Internet sales to a jurisdiction in which the e-business seller 30 had no employees or property but a related party did and 31 accepted returns of prior e-business company sales, where 32 the e-business did not file sales and use tax returns ❏ 33 E. Transported purchased goods into or installed purchased 34 equipment or parts assembled into an object or fixture for 35 self-use or self-service support in a different jurisdiction from 36 the one in which goods were purchased but did not file use 37 tax returns in the jurisdiction to which taken ❏ 38 39 40 250 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2. Develop a schedule of relevant provincial, territorial, state, and 2 local income or franchise tax apportionment factors, including pay- 3 roll, property, and receipts among others, noting double-weighted 4 factors where appropriate. ❏ 5 3. Document the debt/equity structure within each group in a coun- 6 try (based on a review of Corporate Structure–Number 4 above). ❏ 7 4. Detail the existence and function(s) of nonfederal or foreign 8 intangible property holding company for provincial, territorial, 9 state, and/or local tax purposes. ❏ 10 5. Check the use of special purpose entities, such as S corporations, 11 LLP or LLC, and/or “check-the-box” companies in the U.S. and their 12 impact on provincial, territorial, state, or local taxes, noting any 13 jurisdiction and relevant type of tax where special purpose entity 14 treatment below federal level is different (based on a review of 15 Corporate Structure–Number 2 above). ❏ 16 6. Assess the impact of a Section 338/338(h)(10) election for non- 17 federal income tax purposes. ❏ 18 7. List provincial, territorial, state, and local income tax attributes 19 acquired, including loss or credit carryovers; tax basis of assets; and 20 limitations on their use in the specific jurisdiction, in light of the 21 transaction form used to acquire the target. ❏ 22 8. Create a schedule of capital structure and application to target 23 for capital taxes, subsidiary capital transactions, and net worth 24 taxes. ❏ 25 9. Create a schedule of real property by location, including book 26 value and accumulated depreciation and cost segregation of per- 27 sonal property from real property ❏ 28 10. Confirm real estate tax payments with accounting due dili- 29 gence. ❏ 30 11. Detail by location real property transfer tax rates, methods, and 31 time for filing. ❏ 32 12. Cross-check nonfederal income tax, sales and use tax, and 33 property tax filings for nexus compliance issues. ❏ 34 13. Check use tax compliance for large out-of-jurisdiction purchas- 35 es brought into different jurisdiction where target is already filing 36 sales tax or equivalent returns, e.g., GST in Canada or property 37 moved from Maryland to Pennsylvania. ❏ 38 14. Check resale certificates filed for property purchased and resold 39 by target for sales and use tax purposes. ❏ 40 TAX DUE DILIGENCE 251

15. Check resale certificates from others to target for target sales 1 where recipients claim resale exemptions from sales and use tax. ❏ 2 16. Check VAT filings and reconciliations supporting purchases of 3 goods or services and revenues from sales of goods or services per- 4 formed. ❏ 5 17. Check details of VAT exemptions claimed, e.g., exports. ❏ 6 18. Based on personal property locations, in an asset transfer, check 7 each jurisdiction’s application of “bulk sale” rules to the proposed 8 asset transfer. ❏ 9 10 CONTINUOUS IMPROVEMENT 11 1. Discuss potential tax problems or opportunities with other due 12 diligence teams as necessary. ❏ 13 2. Review all tax problems or opportunities with the investor on the 14 investor’s schedule, with the exceptions as appropriate under cir- 15 cumstances previously set by or agreed to with the investor ❏ 16 17 18 PRE-CLOSING 19 1. Coordinate with financial accounting due diligence team to ver- 20 ify all pre-closing taxes due paid to appropriate tax authorities in 21 any country, including income, payroll, social insurance, unemploy- 22 ment, sales and use, VAT, capital, and property. ❏ 23 2. Based on prior due diligence and coordination with investor man- 24 agement, draft tax indemnification agreement. ❏ 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 This page is intentionally blank 1

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15 1 2 People and Organizational 3 4 7 Due Diligence 5 6 7 CYNTHIA N. WOOD, PH.D. 8 RICHARD C. PORTER 9 10 11 12 13 14 15 N 1990, GE ACQUIRED a majority interest in Tungsram, the inven- 16 tor of the tungsten filament for incandescent lights and one of the old- 17 I est, most internationally recognized companies in Hungary. But it 18 took four years before GE fully acquired Tungsram and ultimately 19 renamed it GE Lighting Tungsram. Even though GE is one of the 20 world’s most experienced deal makers, management was caught off 21 guard by conditions at Tungsram and required more time than expect- 22 ed to assimilate the company and meet strategic objectives. 23 What led to this protracted period of adjustment and delay in inte- 24 grating Tungsram with GE? Tungsram managers were reluctant to accept 25 individual responsibility for problems. There was a strong tendency to 26 blame others for problems and to say that they could not be fixed. At GE, 27 on the other hand, managers were rewarded for individualism and self- 28 confidence. They were expected to solve problems efficiently. 29 In addition, management controls and practices at Tungsram were 30 weak by GE standards. Communication was informal. Perhaps even 31 more important, Tungsram employees were accustomed to being taken 32 care of from cradle to grave. Their children attended company-run 33 schools; they lived in company-owned housing; they socialized at com- 34 pany-sponsored sports events; and they were accustomed to very few lay- 35 offs. At GE, however, the primary concern was providing an appropriate 36 return to stockholders. 37

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1 If even experienced deal makers like GE, which made more than two 2 deals per week at one point, tend to overlook the powerful impact of 3 organizational issues, it is not surprising that other less experienced com- 4 panies make similar mistakes. Some companies, for example, think that 5 financials tell everything, while others are uncomfortable with the so- 6 called soft side of due diligence. The result in both cases is that many 7 very promising deals fail to meet expectations altogether or require more 8 time and resources to achieve the anticipated return on investment. 9 Thorough organizational due diligence can ensure that “soft” issues 10 don’t lead to hard times. An effective organizational due diligence 11 requires understanding the deal’s strategic objectives; the target’s 12 national and organizational culture; its overall structure; its communica- 13 tion patterns and processes; its mission, vision, and values; its people 14 issues; and the individual functional areas of its organization. 15 16 17 General Considerations 18 19 Strategic Objectives 20 As discussed in Chapters 1 and 2, the primary consideration in prepar- 21 ing to conduct due diligence should be the strategic objectives of the 22 deal. They should serve as the overall framework for the scope and depth 23 of the due diligence effort. For example, the number of mergers and 24 acquisitions in the food industry has increased over the past decade as 25 companies have divested nonstrategic units and replaced them with pur- 26 chases that better matched their core competencies. With an annual 27 growth rate of nearly 2.2 percent, the domestic processed food market is 28 mature. Consequently, manufacturers are using acquisitions and divesti- 29 tures to boost growth and market share. In most cases, the deals’ strate- 30 gic objectives are to increase the acquirer’s share of a specific market or 31 to obtain new products with a high potential for growth. 32 Consider the cross-border case of Unilever. Through the 2000 pur- 33 chases of Slim-Fast Foods for $2.3 billion, Ben & Jerry’s for $326 mil- 34 lion, and Best Foods for $20.3 billion, Unilever moved from fourth to 35 second among global food manufacturers. Those purchases also gave 36 Unilever more favorable positions in the high-growth diet foods and 37 specialty ice cream markets. In all three cases, due diligence needed to PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 255 closely examine the target’s product development, sales, and marketing 1 functions. In the case of Ben & Jerry’s, which has a unique corporate 2 culture, due diligence also had to focus on the issue of corporate cultur- 3 al compatibility and the willingness of Ben & Jerry’s executives to 4 become part of a very different organizational environment. 5 6 Type of Deal 7 The type of deal contemplated also influences the nature of the due dili- 8 gence. A company planning a joint venture with majority ownership 9 needs very thorough due diligence, whereas a company entering into a 10 joint venture with minority ownership might be willing to have a more 11 hands-off relationship and, thus, conduct a much less detailed analysis. 12 Acquisitions with full integration and those with a more arm’s-length 13 relationship both require detailed due diligence. For acquisitions in 14 which full integration is planned, however, the buyer should conduct a 15 particularly thorough examination that includes extensive organization- 16 al due diligence. In addition, particular attention should be given to the 17 full integration of information systems and work processes. Many organ- 18 izations also find it useful to identify key personnel whom they wish to 19 retain after full integration has been achieved. 20 When preparing to conduct M&A due diligence, one of the primary 21 considerations shaping the focus of the analysis is whether the deal is a 22 “merger of equals”: a deal in which the two organizations involved 23 announce that they intend to proceed as equal partners in the formation 24 of a new entity. In such a case, the due diligence team must pay particu- 25 lar attention to management, personnel, and organizational issues. If an 26 announcement is made, for example, that personnel selection will be 27 evenhanded across organizational boundaries, but an imbalance in favor 28 of one entity develops, then significant problems in integration may 29 develop. Both the DaimlerChrysler/Mercedes-Benz and the Homedco 30 Group/Abbey Healthcare deals were initially portrayed as “mergers of 31 equals” but subsequently experienced difficulties because employees felt 32 betrayed and many eventually left. 33 In an acquisition, the due diligence team must examine the types and 34 depth of management expertise available in both organizations and pro- 35 vide data for determining who will be on the new management team. 36 Information should also be collected for use in selecting a new name for 37 256 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the organization and properly positioning product lines in the market. 2 When conducting due diligence involving virtual organizations and 3 strategic alliances, which are increasingly used to take advantage of time- 4 sensitive marketing opportunities, particular attention should be paid to 5 the interface of key information systems and market positioning. An 6 example of such an alliance is the one among IBM, Motorola, AT&T, 7 and Loral, which collaborated to develop a new PC chip. 8 9 Composition of the Organizational Due Diligence Team 10 Putting together an effective due diligence team requires careful atten- 11 tion to the specialized types of expertise required. In cross-border trans- 12 actions, due diligence teams should include not only legal and financial 13 experts but also the following: 14 t Human resources specialists who have a strategic view of the 15 organizations involved. 16 t Functional area managers with both technical expertise and the 17 ability to think strategically. 18 t Individuals with knowledge of the national culture where the 19 deal is to take place. These individuals are especially important because 20 it is very easy to become so engrossed in the technical minutiae of the 21 deal that not enough attention is paid to the big picture of the environ- 22 ment surrounding the deal. 23 t Representatives of the “other side” who can identify data 24 sources, make critical introductions, and help interpret organizational 25 peculiarities. These individuals are critical in situations in which there is 26 widespread organizational distrust of the due diligence process and 27 reluctance to cooperate. 28 In addition to technical expertise, cultural understanding is also 29 important when organizing the due diligence team. In Japan and Korea, 30 for example, attorneys are seldom employed in due diligence because 31 most Japanese business managers have some legal training and are con- 32 sidered qualified to conduct due diligence. In Korea, due diligence is 33 usually conducted by only accounting firms. In Saudi Arabia, the limita- 34 tions placed on female travelers may make it nearly impossible for them 35 to accomplish much. All individuals assigned to the due diligence team 36 should be prepared to stay until the completion of the process. The reas- 37 signment of personnel is considered a major breach of business etiquette PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 257 in some countries, such as Brazil, where people and personal relation- 1 ships are highly valued. 2 3 Impact of Organizational Experience and Cultural Milieu 4 The investor’s prior experience and the facts of the proposed transaction 5 affect the types of data that the investor collects and the data collection 6 techniques it uses. If the organizations involved in the deal are similar 7 and the investor has prior experience in the country and market area, a 8 less detailed due diligence may be appropriate. If, however, the investor 9 has little prior experience in a country or market, a more extensive due 10 diligence is essential. GE’s due diligence for the Tungsram deal, for 11 example, failed to take into account all the implications of conducting 12 business in a country emerging from a planned economy. Accounting 13 and management practices were different; there were multiple sets of 14 financial records; and company employees and consumers had very dif- 15 ferent expectations of organizational performance. 16 In some countries, typical so-called Anglo-Saxon due diligence 17 processes as conducted in English-speaking countries are considered 18 intrusive and threatening. In Russia and China, for example, there may 19 be one set of company records for outsiders and another for insiders. 20 There also may be legal restrictions affecting the disclosure of sensitive 21 company information, particularly if the company is engaged in an 22 industry deemed essential to national defense. 23 In Japan, Anglo-Saxon-style due diligence may be viewed as a sign of 24 mistrust. Consequently, Japanese executives are typically reluctant to 25 participate in a detailed disclosure until mutual trust has been estab- 26 lished. Indeed, in Japan and many other Asian countries, the deal may 27 be embodied in the establishment of a harmonious working relationship 28 rather than in legal documents. This emphasis on mutual trust and long- 29 term relationship building is also prevalent throughout Asia and Latin 30 America. 31 The timing of due diligence is also affected by cultural and legal con- 32 siderations. As previously discussed, in most countries in which Anglo- 33 Saxon-style due diligence is the norm, due diligence processes are based 34 on the concept of “buyer beware.” Consequently, Western businesses 35 generally prefer to conduct some due diligence before the formal agree- 36 ment to a deal and then complete a more thorough analysis after a letter 37 258 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 of intent has been signed. In most cases, satisfactory completion of the 2 due diligence is a condition for closing the deal. In other countries, how- 3 ever, where establishing mutual trust early is paramount, due diligence is 4 not conducted until after a deal has been concluded, and even then the 5 process may be quite protracted. The due diligence process in Japan can 6 involve months of negotiations with both the target company and the 7 Japanese government. The Japanese business system emphasizes harmo- 8 ny and hierarchy; hence the need to build many relationships before 9 obtaining information. 10 11 Negotiations 12 When beginning the due diligence process, it is important to establish 13 what will be done, when it will be done, and who will do it. Even the 14 seemingly straightforward development of a task list, however, is subject 15 to cultural considerations. The investor must determine what informa- 16 tion is absolutely essential and what would be useful to know but would 17 not preclude a deal. 18 To help establish mutual trust, the investor may need to be sensitive 19 to the cultural implications of the due diligence process and set aside cer- 20 tain information requests until later in the deal or even until the deal has 21 been consummated. In planning face-to-face meetings with the target, 22 the due diligence team should take into consideration cultural factors 23 affecting how the meetings will be conducted. In some countries, like 24 China, only the most senior members of the team actually communicate, 25 and participation at meetings by subordinates is considered inappropri- 26 ate. In other countries, junior members of the team deal with specific 27 technical tasks, whereas senior members conduct top-level strategy dis- 28 cussions. In many Latin American and Asian countries, there should be 29 no expectation of conducting business at the first or even the second ses- 30 sions. When meeting with Russian businesspeople, the due diligence 31 team should be prepared to present a unified front and to deal with 32 extensive delaying tactics, including emotional outbursts. Delaying tac- 33 tics are also common in discussions with Chinese businesses, but any 34 show of emotion or loss of composure is taboo. 35 Throughout the negotiations, particular attention should be paid to 36 what is being said and how it is being said. In many Asian countries and 37 in India, for example, there is a reluctance to say no because it suggests PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 259 a lack of harmony with others and is considered impolite. Indeed, the 1 various words used for yes have many other connotations than yes does 2 in the West. An Asian negotiator may seemingly say yes when what he 3 means is “I understand what you said.” Similarly, an Asian negotiator 4 may say “Perhaps” or “We’ll think about it” when the real intent is no. 5 Consequently, Western negotiators should take care to phrase questions 6 carefully and to probe for verification of the intent of what was said. 7 8 9 Key Components of Organizational Due Diligence 10 11 Organizational Performance Measures 12 In the current business environment of rapid change, businesses and ana- 13 lysts increasingly rely on nonfinancial metrics to help assess an organiza- 14 tion’s performance and prospects for the future. Although the precise 15 measures vary from industry to industry, typical ones include customer 16 retention, market share, innovation, and employee empowerment. In 17 high-tech and service industries, which are heavily reliant on intangible 18 assets, these nonfinancial metrics are especially important. Such indus- 19 tries tend to focus on knowledge and skills-based measures, such as 20 employee knowledge, training and development, and knowledge trans- 21 fer. Employee retention is also an important factor. 22 Nonfinancial metrics are an important source of information for 23 investors and due diligence teams. Unlike financial measures, which 24 focus on past performance, they are forward-looking. When beginning 25 a project, the due diligence team should determine whether the target 26 has nonfinancial performance measures such as those referred to in 27 Robert S. Kaplan and David P. Norton’s Balanced Scorecard method- 28 ology and whether such metrics have become part of the organizational 29 culture. As shown in Table 7.1, typical measures can be grouped into 30 three broad categories: those relating to customers, employees, and 31 internal business processes. Additional information on how these per- 32 formance measures relate to various components of the due diligence 33 process is provided in later sections. 34 35 36 37 260 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 TABLE 7.1 3 Nonfinancial Performance Measures 4 5 Category Metric 6 Customers t Retention 7 t Value proposition 8 t Satisfaction 9 t Market share by product/service line 10 t Image of products and services Understanding of customer segments within 11 t markets 12 t Global capability 13 t New product development 14 Efficiency 15 Cycle time 16 Employees t Innovation 17 t Ability to attract new employees 18 t Ability to retain employees 19 t Training and development related to strategic initiatives 20 t Succession planning 21 t Knowledge transfer processes 22 t Skills coverage of strategic areas 23 Current 24 Provisions for the future 25 t Performance-based compensation Teamwork 26 t t Access to strategic information needed to 27 do jobs 28 Internal Business Time 29 t Processes t Cost 30 t Quality 31 t Customer perceptions and satisfaction 32 t Process documentation 33 Up-to-date 34 Interface with other processes 35 36 37 PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 261

1 Cultural Factors 2 Culture is one of those “soft” factors that is frequently overlooked dur- 3 ing the due diligence process. Unfortunately, this oversight may be the 4 single most important reason for the high failure rate of cross-border 5 deals. After a deal, employees may find that behavior that once was 6 rewarded is no longer considered appropriate within the newly merged 7 or aligned business culture. There are new values and norms; communi- 8 cation patterns change. The 1995 merger of Electronic Data Systems 9 (EDS) and A. T. Kearney provides a classic example. EDS was a very 10 hierarchical, technology-driven organization, while Kearney was the typ- 11 ical entrepreneurial, ego-driven consulting firm. After the merger, the 12 EDS staff reportedly resented what some considered the arrogance of 13 the Kearney consultants, while the Kearney staff was not enthusiastic 14 about selling information technology services. There was resistance on 15 both sides to the creation of a new culture. GE, Chrysler, Daimler-Benz, 16 Guinness, and Unilever are other well-known organizations that have 17 been involved in deals that delivered less than satisfactory results because 18 of inattention to potentially conflicting cultural factors. 19 Culture has at least two components: national and corporate. 20 NATIONAL CULTURE. National culture refers to the unique norms, 21 values, and beliefs to which a group of people generally adhere. Cultures 22 differ, for example, in the ways they solve problems, view time, deal with 23 the external world, and perceive themselves and others. National culture 24 may be very strong and yet difficult to define. It is estimated that less 25 than 15 percent of a national culture is readily observable. It is such an 26 innate part of each individual, however, that cultural bias in favor of 27 one’s own experience can cause unexpected problems. For example, dur- 28 ing the 1980s, Finnish companies acquired a number of factories in 29 Sweden and sent Finnish managers to run them. Several years later, the 30 Finnish managers were startled to discover that their Swedish employees 31 referred to their management style as “management by cursing and 32 swearing.” The Finnish managers had erroneously assumed that 700 33 years of shared history meant that they also shared a common culture 34 with Sweden. 35 While cultural norms are deeply embedded in the national psyches of 36 all nations, greater exposure to other cultures through travel, television, 37 262 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 and the Internet is causing traditional national cultural norms to shift 2 rapidly. Young urban Chinese, for example, are becoming more individ- 3 ualistic and less concerned about collective values. Many Muslim 4 nations, not just those containing minority elements sympathetic to ter- 5 rorism, are concerned about creeping Westernization and the subse- 6 quent loss of traditional values and cultural norms. Consequently, the 7 challenge for global enterprises is to determine precisely how much sen- 8 sitivity to national cultural differences is required in both organizational 9 settings and marketing campaigns. 10 When undertaking the analysis of national cultural factors and their 11 implications for a deal, the due diligence team should examine the fol- 12 lowing factors that have particular significance for the success of cross- 13 border deals: 14 t Time. Is time viewed as a continuum or as a resource that must be 15 used carefully? In cultures where time is viewed as a continuum, there is 16 little emphasis on promptness, and personal matters are considered just 17 as important as business. 18 t Task orientation versus relationship building. This difference 19 is related to a culture’s perception of time. In cultures where time is 20 viewed as a continuum, there tends to be more emphasis on relationship 21 building. In those cultures where time is viewed as a resource, individu- 22 als tend to be more task oriented. 23 t Free will versus fate. In most Western cultures, individuals 24 believe that they can control what happens to them (“Where there’s a 25 will, there’s a way”); planning is considered important. In many Eastern 26 cultures, however, a philosophy that everything is determined more by 27 fate is more prevalent. 28 t Leading versus following. Western companies typically encour- 29 age employees to show initiative. In some non-Western countries (to 30 some degree India, for example), that is not always the case. Traditional 31 convention has fostered an environment in which Indian employees tend 32 to do what they are told, even if they know the instructions are incor- 33 rect. They are accustomed to having their managers make all decisions 34 and accept responsibility for everything. Consequently, many talented 35 employees in such a culture may avoid leadership positions because of 36 the accompanying pressure. 37 t Reward systems. In most Western cultures, rewards are generally PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 263 linked to merit; there are performance appraisal systems, and hiring is 1 linked to perceived ability to perform on the job. In other cultures, how- 2 ever, rewards and success are linked to family connections. 3 t Face versus open feedback. In most Western cultures, perform- 4 ance appraisal systems are used to provide regular feedback on job per- 5 formance; public praise is frequently considered good. In other cultures, 6 however, individual feedback and praise result in loss of face for the 7 recipient. Feedback must be given indirectly. 8 CORPORATE CULTURE. Corporate culture refers to the common set 9 of values, traditions, and beliefs that influences organizational behavior. 10 Corporate culture provides unwritten rules that help employees know 11 how to behave and what they must do in order to succeed. Strong cor- 12 porate cultures also have the ability to influence a company’s success or 13 failure. In the current U.S. economy, for example, companies with a cor- 14 porate culture emphasizing cost-effectiveness and stakeholder value are 15 more likely to succeed than those emphasizing more unconventional val- 16 ues such as novelty and fun (traditions which some organizations came 17 to herald as values in the dot-com heyday). 18 When undertaking the cultural component of an organizational analy- 19 sis, the due diligence team should take the following factors into con- 20 sideration. Taken together, these factors can be used to compile an accu- 21 rate description of a company’s collective personality. 22 t Self-image. How does the company describe itself? Is it self-con- 23 fident, flamboyant, conservative, innovative? Information on a compa- 24 ny’s self-image can be found in annual reports, brochures, press releases, 25 and interviews with employees. Sometimes an analysis reveals that a dis- 26 crepancy exists between the official company image and the unofficial 27 one perpetuated by employee interaction. 28 t Attitude toward risk and reward. A company’s compensation 29 system provides an excellent snapshot of its culture. Risk-taking organi- 30 zations generally have high levels of compensation at risk (modest salaries 31 and large bonuses, stock purchase and stock option plans, and the like), 32 while conservative cultures compensate conversely. Team-oriented cul- 33 tures tend to reward team rather than individual performance. 34 t Traditions. What does the company view as important enough to 35 pass from one generation of managers to the next? Celebrations of suc- 36 cess provide another way of verifying what is important to an organiza- 37 264 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 tion and its self-image. Information on traditions and celebrations usu- 2 ally can be obtained from interviews and corporate publications. 3 t Requirements for “getting ahead.” Part of the company’s risk 4 and reward philosophy may be observed in policy and procedures man- 5 uals that provide official information on how to move from one level of 6 the organization to another. Interviews with employees will provide 7 additional details about what actually happens. 8 t Decision-making processes. Are these processes structured or 9 unstructured; quick or slow; based on consensus building or unilateral? 10 t Communication processes. Are they open or closed; formal or 11 informal? (We’ll discuss this later in the section on communications.) 12 Both decision-making and communication processes provide informa- 13 tion on the company’s ability to operate effectively in a dynamic envi- 14 ronment and its willingness to empower employees to make decisions. 15 t Commitment to employee development and safety. Employee 16 development and safety practices indicate how a company views its 17 employees. Those organizations with comprehensive development and 18 safety programs and low accident rates have major pluses going for them. 19 The converse is also true. A review of HR records will provide statistics 20 on accidents and also show the emphasis on training in safe work prac- 21 tices. HR and departmental personnel records also will provide informa- 22 tion on the emphasis placed on employee development. 23 t Emphasis on people versus tasks. In some countries, relation- 24 ships with people are considered much more important than the imme- 25 diate completion of scheduled tasks. In Latin American countries and 26 Saudi Arabia, for example, it is not considered rude to interrupt sched- 27 uled meetings to deal with unexpected personal or personnel issues. 28 t Labor relations policies and philosophy. In Russia and other 29 countries emerging from a long history of centrally planned economies, 30 it is not unusual for large companies to continue to provide extensive 31 services, such as housing, day care, and recreational activities, for 32 employees. In Japan, until recently, employees typically joined a compa- 33 ny after graduation and expected to remain there until retirement. 34 t Community involvement and concern about social responsi- 35 bility. Does the company support local charities and encourage employ- 36 ees to become involved in their communities? Does the company have a 37 statement of social responsibility that reflects concern for key global PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 265 issues? New-employee orientation programs and HR records are both 1 useful sources of information. 2 t Degree of cultural diversity. Does the workforce include both 3 men and women of many different cultural groups? Is diversity valued 4 and supported? Cultural diversity may be an effective indicator of an 5 organization’s ability to operate in a global market. Records of hiring 6 practices and policies can be found in HR. 7 t Lifestyle indicators, such as management perquisites, distinc- 8 tions made between organizational levels, the working environ- 9 ment, and travel and entertainment practices. These factors provide 10 another view of what the company considers important and how it 11 treats employees. HR records provide a valuable source of information. 12 t Corporate values. The company’s view on its mission and vision 13 reflects its corporate values and provides useful information on how its 14 employees will behave under difficult circumstances. 15 16 Throughout its cultural analysis, the due diligence team must contin- 17 ually weigh the amount of adaptation required to demonstrate cultural 18 sensitivity. Today’s increasing emphasis on global business means that 19 there is also more widespread familiarity with other cultures. Most glob- 20 al businesses have found it important for two cultures to meet halfway, 21 not for one to dominate the other. Companies with experience in inter- 22 national M&A tend to recognize that the buyer and target always have 23 much to learn from each other. These organizations view cultural differ- 24 ences as opportunities to improve effectiveness, not as insurmountable 25 obstacles. 26 27 Mission, Vision, and Values 28 For the integration of two businesses to succeed, the resulting organiza- 29 tion must have a clear statement of purpose and guidelines for behavior. 30 When a “merger of equals” is anticipated, the creation of a new mission 31 is advisable. It must incorporate the major elements of the merging enti- 32 ties while also reflecting the market positioning and identity of the newly 33 created organization. When a larger organization acquires a smaller one 34 and complete integration is not planned, then the acquired organization 35 may be allowed to keep its mission if linkages to the acquirer are estab- 36 lished. In this case, the target is treated as a division of the acquirer. 37 266 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 A company’s mission and vision typically provide a statement of the 2 company’s purpose; general types of products and services offered; mar- 3 kets served; broad goals; general philosophy; and competitive strengths. 4 The values statement offers guidelines for personal and organizational 5 behavior. Typical values statements include themes such as agility, hon- 6 esty, innovation, trust, and respect for others. 7 The due diligence team’s task is to collect and analyze data concern- 8 ing the target organization’s mission, vision, and values and their simi- 9 larity and dissimilarity to those of the buyer. The results of the due dili- 10 gence analysis then can be used to identify potential cultural and values 11 clashes that might hinder integration and the achievement of overall 12 goals. Strongly held values, for example, can be a warning sign of poten- 13 tial cultural incompatibility. A case in point is suggested in the integration 14 of U.S. Ben & Jerry’s into Dutch-British Unilever since its acquisition in 15 2000. Will Ben & Jerry’s be able to maintain its distinctive values con- 16 cerning social action, which have clearly contributed to the company’s 17 success? Press reports have indicated that as a global corporation, 18 Unilever has had some concerns about Ben & Jerry’s continued funding 19 of a number of antiglobal trade groups as part of its outreach program. 20 In countries where the development of mission, vision, and values 21 statements is standard business practice, the team can use them to learn 22 about the target company’s expectations for interaction with competi- 23 tors, treatment of consumers and employees, behavior during crises, and 24 social responsibility in the local and global community. When conduct- 25 ing research for deals in countries with a strong traditional belief in fate 26 or a history of central economic planning, however, the due diligence 27 team may not find such meaningful information. Mission and vision 28 statements may be lacking or may simply be pro forma statements with 29 no actual impact on operations. 30 Mission, vision, and values statements are generally available in annu- 31 al reports, new-employee orientation programs, strategic plans, and pro- 32 motional materials. Some companies post mission statements in promi- 33 nent locations and give copies to employees and customers. Websites are 34 also useful sources of information. 35 Because of the importance of corporate mission, vision, and values 36 statements as indicators of corporate behavior, the due diligence process 37 should not only identify them but also determine whether they are in PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 267 fact integral to the organization’s culture and operating procedures. 1 Whereas some companies do little more than treat such statements as 2 promotional slogans, many others value their integration and make them 3 part of their values system. 4 Key questions the due diligence team should ask when considering 5 integration strategies include the following: 6 t Are the mission, vision, and values included in the new-employee 7 orientation program? 8 t Do most employees know the mission, vision, and values? 9 t Is there a regular process for updating the mission, vision, and val- 10 ues? 11 t Are the values reflected in the company’s performance-appraisal 12 process? 13 t Are the values congruent with the observed corporate culture? 14 Even more important, the due diligence team should review past and 15 present corporate behavior to determine whether there are discrepancies 16 between stated values and actual behavior. 17 18 Communications Patterns and Processes 19 Communication processes are indicators of corporate effectiveness and 20 efficiency. In typical Western companies, they also affect morale and 21 public image. Johnson & Johnson, for example, is perceived as having 22 very open communications with employees. The company credo states 23 that “employees must feel free to make suggestions and complaints.” 24 This same emphasis on open communication extends to customers and 25 helped the company deal with a product-tampering scare without signif- 26 icant loss of consumer confidence. 27 While communication processes are an integral part of a company’s 28 culture, they also are influenced by the surrounding national culture. 29 The due diligence team’s task is to describe the various types of com- 30 munication processes present in an organization and determine whether 31 they are effective and whether they will mesh well with the buyer’s 32 organization. 33 In describing organizational communications, the due diligence team 34 should consider whether they are informal or formal, and open or guard- 35 ed. Unless these tendencies are identified and their implications consid- 36 ered, individuals from the two companies will have difficulty working 37 268 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 together effectively. American organizations tend to have very open, 2 informal patterns of communications. Managers pride themselves on 3 having an “open door” policy that encourages interaction with employ- 4 ees. Subordinates often feel free to speak up at meetings, even when sen- 5 ior company officials are present. Managers, in turn, often give very 6 direct feedback to employees, sometimes even when others are present. 7 Many European companies, however, have much more formal com- 8 munication patterns. More information is put in writing, and junior 9 employees generally do not speak as freely at meetings. The precise 10 wording of memos is considered very important. In Asian companies, 11 negative feedback is never given in public; even in private it is often given 12 very indirectly so that the employees do not lose face. Daimler-Benz and 13 Chrysler, for example, experienced considerable difficulty at the begin- 14 ning of their “merger of equals” because they initially discounted the 15 importance of such disparities in communication. Employees at Chrysler 16 were proud of their informal work environment and ability to make deci- 17 sions quickly. At Daimler-Benz, bureaucracy was a well-known impedi- 18 ment to innovation and improved speed to market for new products. 19 The merger of Upjohn and Pharmacia AB of Sweden also has been 20 troubled by differences in communication styles. In this case, the 21 American company was accustomed to frequent and very detailed writ- 22 ten reports, which the Swedish company resented having to prepare. 23 Employees at Pharmacia AB expected to work in small teams that had 24 considerable autonomy, whereas the Americans were most comfortable 25 with a very hierarchical decision-making process. 26 27 The leadership styles of senior managers and patterns of conflict reso- 28 lution should also be examined and the potential impact of cultural and 29 personal differences noted. There were concerns that the Morgan 30 Stanley/Dean Witter deal would experience difficulties because of the 31 radically different leadership styles of the two CEOs. Personal chemistry 32 is important. 33 In the United States, a participative leadership style is generally con- 34 sidered desirable. By contrast, in Indonesia, India, and Mexico, for 35 example, leadership is more paternalistic, but the achievement of group 36 consensus is still considered important. In Saudi Arabia, leadership is 37 linked to lineage and social status, whereas in Singapore and other Asian PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 269 countries, age and seniority are considered important for leadership. 1 Note, however, that throughout this review of communication process- 2 es, the due diligence team should be aware that globalization is gradual- 3 ly lessening many of the differences in leadership styles. Many managers 4 have been educated in other countries and have worked in a variety of 5 national settings, thus providing them with increased familiarity with and 6 understanding of other leadership and communication styles. In Mexico, 7 for example (perhaps as a result of NAFTA), employees are becoming 8 much less passive and senior managers are becoming less concerned 9 about authority and status, thus resulting in a leadership style closer to 10 that used in the United States. 11 When examining the communication processes of a target organiza- 12 tion, the due diligence team should review both internal and external 13 communication processes. The following tables summarize types of 14 processes that should be analyzed and what the due diligence team 15 should look for in each case. As the due diligence team examines each 16 type of communication, it should constantly consider whether there are 17 major incongruities with the buyer’s communication patterns and what 18 the potential implications may be for the deal’s success. 19 The due diligence team should also note cultural factors that may pre- 20 vent the implementation of specific types of communication processes 21 that have proven successful in the buyer’s organization but that may not 22 be effective in the target. For example, over the strong objections of 23 Tungsram’s unions, GE followed its customary practice of installing a 24 hotline that employees could use to anonymously report ethics viola- 25 tions. GE failed to understand that the hotline reminded Hungarians of 26 the hated snitching on friends and neighbors that they were forced to 27 participate in under the Communist regime. 28 As Table 7.2 details, when examining external communication 29 processes, the due diligence team should examine messages for consis- 30 tency: 31 t Do the annual report, marketing brochures, and press releases tell 32 essentially the same story? 33 t Is the company’s image consistent? 34 The team also should consider interviewing key external stakeholders 35 to provide additional input on the effectiveness of the corporate identi- 36 ty program and key communication processes and communication tools. 37 270 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.2 2 3 Indicators of External Corporate 4 Communication Processes 5 Type of Communication What to Look For 6 Press releases Information on corporate achievements 7 t t Information on key managers 8 t How the company manages problems and 9 potentially difficult situations 10 t The company’s unique “spin” 11 Annual report t Basic financial and management information 12 t Product and market information 13 t Strategic positioning 14 t Mission, vision, and values 15 Brochures and other t Corporate image and its congruence with 16 marketing materials strategic intent and reputation 17 t Adherence to corporate values 18 Communications t Quality of supplier relations 19 with suppliers t Adherence to stated corporate values 20 Communications t Quality of distributor relations 21 with distributors t Adherence to stated corporate values 22 Communications t Guidelines for product recalls 23 with customers t Information on product safety 24 t Contingency plan for dealing with potential 25 product contamination during biological 26 terrorism 27 Corporate identity t How the organization perceives itself and 28 program wants others to view it 29 t What the organization considers important 30 31 Throughout the examination of the target’s communications, the team 32 should note processes that are especially effective and consider how they 33 can be used during integration. These tools appear in Table 7.3. 34 35 People Issues 36 Employees are many of a company’s most important assets. In the case 37 of companies with modest amounts of fixed assets, like advertising agen- PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 271

1 TABLE 7.3 2 Indicators of Internal Corporate 3 Communication Processes 4 Type of Communication What to Look For 5 6 Newsletters Openness of communication t 7 t What is important to management and employees 8 t What is celebrated 9 10 Bulletin boards t Openness of communication, including job Traditional postings and celebration of successes 11 Electronic t Communication of information concerning 12 safety and legal requirements 13 14 Letters to employees t How management shares information, especially very important facts 15 t General tone of communication, including 16 informality versus formality 17 Management by t Openness of communication between managers 18 walking around and employees 19 t Informality versus formality of organization 20 Strategic and t Incorporation of planning into ongoing 21 operational plans management activities 22 t Inclusiveness and openness of planning process 23 t Use of planning to communicate critical 24 changes in strategic direction 25 t Mission and vision 26 Meetings t Formal versus informal 27 All hands Efficient versus inefficient t 28 Departmental t Inclusive versus exclusive 29 Board t Decision-making style t Conflict resolution style 30 t Time-management style 31 32 Performance appraisal t Linkages between strategic plan and systems evaluation of results on individual level 33 t Linkages between values and evaluation of 34 individual behavior and performance 35 36 37 272 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.3 (continued) 2 3 Type of Communication What to Look For 4 t Openness (Western style) of appraisal process 5 t What the company considers important 6 New-employee t What new employees must know to succeed 7 orientation programs t How the company wants to be seen by others 8 Quality circles t Problem-solving processes 9 t Conflict resolution techniques 10 t Emphasis on teamwork 11 Hot lines t Processes for dealing with customer complaints 12 t Processes for dealing with employee complaints 13 t Number and types of complaints typically 14 resolved 15 Employee attitude t Morale problems 16 surveys t Adherence to corporate values 17 t Cohesiveness of corporate culture 18 t What employees consider important: what’s 19 working well and what needs improvement 20 21 cies or other consulting organizations, they are the company. Loss of key 22 performers or those with sensitive client relationships can quickly destroy 23 any added value anticipated from the deal. In the heady days at the end 24 of the twentieth century, it was not unusual in the financial sector for 25 whole teams to walk out at the time of an acquisition unless they were 26 given very large financial incentives to stay. The due diligence team must 27 assess the possibility of this prospect and devise a plan based on the risk. 28 Unfortunately, within twelve to eighteen months, it is not uncommon 29 for buyers to lose the target’s senior management team and many of its 30 most talented technical personnel. The buyer may suffer defections as 31 well. The result is a slower rate of integration and achievement of initial 32 goals for the deal. This loss of personnel may also result in confusion and 33 loss of customer confidence. 34 The due diligence team’s efforts in conducting a thorough profiling of 35 the target’s personnel can be invaluable. A comprehensive review com- 36 pleted early in the due diligence process enables the buyer to make a 37 timely announcement of the members of the senior management team, PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 273

1 TABLE 7.4 2 Profiles of Key Management Personnel 3 4 Type of Information Source Why Important 5 Personal profiles t Résumés t General background information 6 Name t Personnel files t Identification of any ethical issues 7 Position that might be significant in the 8 Education new organization Length of time with company 9 Ethical issues 10 Unique skills and talents t Résumés t How can enhance effectiveness 11 Technical t Performance of new organization 12 appraisals Identification of highly Managerial t 13 Other potentially useful skills t Interviews specialized skills critical to success not related to current position of the enterprise 14 15 Inclusion in fast-track t Personnel records t Indicator of perceived value to promotion programs and organization 16 succession planning 17

Attitude toward t Interviews t Indicator of willingness to 18 advancement t Performance grow and assume responsibility 19 Willingness to relocate to appraisals t 20 overseas offices 21 Résumés General background information Historical data on experience t t 22 and background t Personnel files t Interviews 23 24 Areas of responsibility t Résumés t Identification of talents and In the current organization t Personnel files experiences useful to new 25 With previous employers t Interviews organization 26 27 Compensation history t Personnel records t Compatibility of compensation t Current and previous systems of both organizations 28 compensation agreements 29 Consulting agreements t 30 t Golden parachutes t Union or collective 31 bargaining contracts 32 t When contracts due for 33 renewal 34 35 36 37 274 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.4 (continued) 2 3 Type of Information Source Why Important 4 Perceived intent to remain with t Interviews with indi- t Essential for staffing new 5 the company vidual and immediate organization 6 supervisor 7 Compatibility of key managers t Interviews t Congruence of leadership styles 8 with the acquiring organization and personal chemistry 9 Reputation t Interviews with peers t “Soft” informationproviding 10 t Internal and subordinates additional input on leadership External Interviews with and management styles 11 t t customers 12 t Interviews with 13 suppliers 14 15 personnel who will be terminated, and the plan for integrating all other 16 staff into the new organization. As a result, fewer key personnel are likely 17 to leave the organization, and morale is less likely to plummet. 18 Two primary tasks of the due diligence team, therefore, are to prepare 19 profiles of key management personnel and to conduct a staffing analysis. 20 Table 7.4 summarizes the types of information typically included in man- 21 agement profiles. Sources for key information also are included. 22 Although much of the required information is available in personnel and 23 other human resources files, the due diligence team should not overlook 24 interviews as critical sources of information. They can help clarify per- 25 ceptions and provide additional details concerning leadership and man- 26 agement styles. Interviews are also useful in learning more about unique 27 skills and talents, information that is especially important in companies 28 with few tangible assets. 29 If the due diligence team spots unhappy target company executives, it 30 also can be worthwhile to have a senior executive from the buyer invest 31 some time in talking with these executives to try to raise their level of 32 comfort with the changes that are likely to occur following the deal. 33 There are, however, legal risks in certain countries. For example, compa- 34 nies acquiring in the United States must be careful not to give reassur- 35 ances to only the younger members of a particular group—for example, 36 the sales force—as this could result in a later age discrimination class 37 lawsuit if it is only the older individuals who are let go. One president of PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 275 a beverage company unfortunately stood up in an all-company meeting 1 and said, “We are determined to build a young, dynamic workforce.” 2 These words duly came back to haunt him in court. 3 A staffing analysis should be conducted for each organizational unit. 4 Table 7.5 on the following page summarizes the key information that the 5 due diligence team should compile. 6 While conducting the staffing analysis, the due diligence team should 7 review key executives’ reputations within both the organization and the 8 business community. The team also should determine the host coun- 9 try’s definitions of “nationals,” “residents,” and “nonresidents,” as well 10 as the documentation required for each group. Some countries require 11 work documents and residency visas. Others restrict the movement of 12 foreign nationals and do not allow them to serve on corporate boards. 13 Many countries have restrictions on the employment of expatriates. 14 Some countries restrict the use of expatriates in certain industries con- 15 sidered critical to national security or economic development. Other 16 countries place quotas on expatriate labor and require companies to 17 have a plan for training nationals to replace expatriates within a certain 18 time frame. 19 20 Overall Organizational Structure 21 The main purpose of organizational due diligence is to examine the tar- 22 get’s existing organizational structure and determine its implications for 23 the future effectiveness and efficiency of the deal. In organizing the due 24 diligence effort, the team should keep in mind whether the buyer 25 intends to fully integrate the target into its organizational structure or 26 maintain it as a separate entity. Table 7.6 summarizes the types of infor- 27 mation that should be collected, where the data generally can be found, 28 and some general implications. 29 Many due diligence teams like to examine the organizational structure 30 and the organizational culture at the same time. The structure frequent- 31 ly has an impact on the culture and vice versa. A company with a hierar- 32 chical structure, for example, will have a very different culture and way 33 of doing business from one with a flat structure. The merger of two such 34 different entities generally requires more time, planning, and ongoing 35 employee communication to ensure that the deal meets its overall goals 36 for performance. 37 276 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.5 2 3 Staffing Analysis 4 5 Type of Information Source Why Important/Use 6 Level of staffing by function t HR files t Identify potential economies 7 and location t Interviews t Identify potential strengths and 8 t Level of staffing weaknesses Current Identify legal liabilities and related 9 t t t Anticipated for next 3–5 expenses 10 years 11 t Employee relations problems

12 Types of expertise available t HR files t Identify unique skills not in the 13 t Management t Interviews with key buyer’s organization 14 t Technical personnel and HR t Analyze areas of overlapping Global work experience and executives expertise 15 t perspective 16 t Strategic knowledge of 17 market 18 t Unique skills or knowledge 19 Types of expertise needed but t HR files t Identify unique skills not in the 20 not available t Interviews with key buyer’s organization t Management personnel and HR t Identify areas of overlapping 21 t Technical expertise 22 t Global work experience 23 t Unique skills or knowledge 24 Key personnel to be retained t Analysis of all relat- t Assist with postmerger integration 25 t Management ed due diligence and achievement of strategic Technical objectives 26 t 27 Key personnel to be terminated t Analysis of all relat- t Assist with postmerger integration Management ed due diligence and achievement of strategic 28 t t Technical objectives 29 30 Compliance with employee t HR records t Verify knowledge of new legal 31 welfare regulations. Example: requirements and potential impact In the United States, EEOC, Identify unexpected liabilities and 32 t NLRB, ERISA, OSHA expenses 33 34 35 36 37 PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 277

1 TABLE 7.6 2 Key Components in Reviewing 3 Organizational Structure 4 5 Data Required Source Why Important 6 7 Overall corporate organizational t Organization chart t Determine organizational focus: structure t Articles of incorpora- products, markets, regional, 8 t Recent changes, acquisitions tion global 9 Planned changes Bylaws Identify unresolved shareholder t t t 10 t Reporting relationships t Shareholder agree- and structural issues t Organizational focus: ments t Identify types of management 11 products, markets, matrix t Minutes of the Board control 12 t Shareholder list of Directors t Assess potential compatibility with 13 buyer 14 Responsibilities of each major t Position descriptions t Determine levels of authority and 15 functional area and key t Reporting relationships responsibility 16 leadership positions with them t HR and OD (organiza- t Determine management controls t Formal and informal tional development) and decision-making processes 17 procedures policies t Identify ability of different 18 Coordination of work across IT systems and inter- organizational levels to set policy t t 19 functional lines faces and bargain with labor 20 t Key business success t Fiscal systems and measures policies 21 t Interface with regulatory 22 agencies, labor groups 23 Coordination of work between t Interviews t Assess labor and morale problems 24 functional areas Employee surveys affecting effectiveness and t 25 t Ongoing conflicts t Work flow analysis efficiency t Conflict resolution t Functional area and t Identify changes needed in 26 processes departmental evaluation and reward processes 27 t Reporting processes and missions/charters t Determine need to re-engineer 28 flow of routine information processes 29 Morale and work environment Organizational climate Identify labor problems t t 30 within organizational areas surveys t Review leadership issues t Interviews t Assess reporting and structural 31 issues 32

Facilities for each functional t On-site analysis t Assess capacity 33 area, including current and t Equipment and —Overcapacity 34 planned facilities inventories —Undercapacity 35 t Buildings t Strategic plan t Identify duplication of facilities 36 t Work spaces t Environmental studies with buyer t IT systems 37 278 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.6 (continued) 2 3 Data Required Source Why Important 4 t Telecommunications t Review compatibility of IT and 5 t Plant equipment, including other major systems 6 age and appraisal t Assess age of technology and 7 t Environmental issues ability to meet future needs 8 t Assess environmental compliance costs 9 Community relations for each t Strategic plan t Verify corporate reputation 10 location t HR records t Identify potential PR problems 11 t Press releases 12 t Newspaper articles Interviews with com- 13 t munity leaders 14 15 16 Functional Areas 17 There is a tendency for due diligence teams to examine a target’s overall 18 organizational structure but not spend enough time analyzing the 19 unique capabilities of each functional area. Consequently, many buyers 20 receive unpleasant surprises after a deal is completed. One British com- 21 pany, for example, did not fully explore the financial and legal liabilities 22 related to compliance with environmental regulations affecting a pro- 23 duction facility owned by a company it acquired. The problem was much 24 more severe than anticipated and required considerable time and 25 expense to resolve. Another multinational company failed to understand 26 the complexity of combining sales and marketing functions in two seem- 27 ingly similar markets. A more thorough due diligence effort would have 28 revealed key cultural and operational differences. Accounting and infor- 29 mation systems also pose problems for the success of many mergers. 30 The following subsections provide guidelines for conducting thor- 31 ough organizational due diligence of major functional areas. 32 Information systems. Information systems are becoming increasing- 33 ly critical for the success of mergers, especially cross-border ones. 34 Companies rely on rapid access to accurate, up-to-date information for 35 decision making. Electronic mail, facsimile transmissions, electronic con- 36 ferencing, and websites are now essential for conducting routine internal 37 business, as well as interacting with customers and suppliers. PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 279

Manufacturing organizations are increasingly using e-commerce to 1 improve supply chain management, and these mechanisms and their 2 security are likely to become ever more important. 3 Information systems are both expensive and time-consuming to 4 update; system integration is often very difficult for two organizations to 5 achieve. Before beginning the due diligence process in this area, the 6 team should, as stressed previously, take care to consider the initial orga- 7 nizational goals of the planned deal—complete integration, partial inte- 8 gration, or very little integration—because each requires a different level 9 of systems integration. The team should also review the people and orga- 10 nizational portion of the due diligence to determine the following: 11 t Those individuals in the target organization who have unique 12 information-systems-related expertise and who are widely respected 13 enough to serve as champions of an integration initiative. 14 t The impact of organizational structure on potential systems inte- 15 gration. For example, organizations that are highly decentralized tend to 16 have difficulty standardizing information systems. 17 To be effective, potential systems champions must be willing to 18 remain with the new organization for quite some time. Other broad 19 issues that the due diligence team should examine include the following: 20 t Whether the target values information technology 21 t How information technology can support the planned deal 22 t The extent to which IT architecture supports business strategy 23 t The types of information required for the new organization 24 t How and with whom information will be shared 25 t Requirements for system security 26 t What the information technology strategy for the new organiza- 27 tion is 28 t The need to migrate from antiquated legacy systems to state-of- 29 the art platforms, applications, and technologies. 30 Table 7.7 summarizes five major categories of information that the 31 due diligence team should examine in detail. 32 Finance. Due diligence teams typically collect substantial financial 33 information. They tend to overlook, however, the issues related to the 34 integration of multiple financial functions. As in the case of information 35 systems, the degree of organizational integration that the buyer and target 36 expect to achieve is an important consideration for the due diligence team. 37 280 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.7 2 3 Information Systems Due Diligence 4 Type of Information Source Why Important/Use 5 Hardware and software t Information t Determine whether equipment 6 tOwned Technology (IT) and software are obsolete 7 tLeased department t Identify potential strengths and 8 tLocation documentation weaknesses Use Functional area Identify potential compatibility 9 t t t tAge records with equipment and software of 10 tReliability t System buyer 11 tEstimated capacity documentation t Determine implications for 12 tSystems security, especially in additional acquisitions in same locations where terrorist market area 13 attacks are likely t Identify unique systems 14 capabilities 15 t Determine if fire walls and other 16 security measures are sufficient to withstand systems attacks 17 Communications capabilities IT department t Determine whether equipment 18 t and networks documentation and software are obsolete 19 tTypes of voice and data com- t Functional area t Identify potential strengths and 20 munications systems used records weaknesses 21 tAvailability of local area or t Interviews with IT t Assess potential compatibility with wide area networks and functional buyer’s equipment and software 22 tNumber and location of ter- personnel t Determine implications for 23 minals and microcomputers t Interviews with additional acquisitions in same 24 allowing network access support users market area Web-based services Identify unique systems capabilities 25 t t t Determine if fire walls and other 26 security measures are sufficient to 27 withstand systems attacks

28 Technical support t IT department t Quantify adequacy of technical 29 tTechnical documentation t Interviews with IT support for current needs, includ- Vendor agreements and functional area ing staffing and technical expertise 30 t tTr aining, including plans for personnel t Verify ability to provide support 31 technical systems personnel during transition 32 and users t Determine ability of vendors and 33 tIn-house support in-house support groups to meet Standards for systems anticipated demand 34 t development and operation t Assess potential strengths and 35 weaknesses 36 t Identify unique capabilities 37 PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 281

1 TABLE 7.7 (continued) 2 Type of Information Source Why Important/Use 3 4 Business requirements and t Strategic plans t Identify potential areas of associated systems support t Objectives of deal common systems development 5 needed and processing 6 Buyer Determine basis for systems t t 7 tTarget integration plan t Identify ways to link systems 8 integration to strategic business 9 objectives 10 t Estimate time needed for systems integration 11 12 Compatibility of existing t Review and analysis t Determine need for new systems systems of all data collected development or modification 13 and examination of t Identify potential areas of common 14 strategic objectives of development and processing 15 deal t Establish basis for systems integration plan 16 t Estimate systems integration 17 time 18 Information systems organiza- t Corporate organiza- t Determine if the IS function is 19 tional structure tion charts strategically positioned 20 tRole of CIO t Job descriptions t Determine if the CIO plays a 21 tReporting t Interviews strategic role in the organization 22 23 Table 7.8 summarizes key finance-related items that the due diligence 24 team should examine. 25 Throughout each component of the financial function due diligence, 26 the team should keep in mind the dual needs for operating efficiency and 27 adequate controls to support future growth. The team should also con- 28 sider whether information systems are adequate to support the need for 29 financial information. 30 Sales. The target’s sales function can be especially important to a 31 buyer with little expertise in the global marketplace because it allows the 32 buyer to expand its operations while also gaining valuable expertise. For 33 example, through a series of acquisitions, a European beverage company 34 gained access to U.S. distribution channels in the spirits market. In such 35 a case, the buyer generally allows the sales function to continue as a 36 stand-alone entity; integration is not a critical initial consideration. More 37 282 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.8 2 3 Financial Function Due Diligence 4 Type of Information Source Why Important/Use 5 Budgets t Finance function t Assess adequacy and timeliness of 6 tTypes t Other functional areas information 7 tFrequency t Interviews t Create interface of budgeting and 8 tDistribution other processes Assess effectiveness and efficiency 9 tUse t tTime Frame of process 10 tIntegration of budgeting into t Determine need for adaptation of 11 daily operations existing process or development of 12 tProcess flowcharts new one t Determine how to make changes 13 without interrupting information 14 flow

15 Plans t Finance function t Identify potential philosophical and 16 tFrequency t Other functional areas cultural differences 17 tDistribution t Interviews t Assess adequacy and timeliness tUse t Assess effectiveness and efficiency 18 tTime Frame of process 19 tIntegration of budgeting into t Assess need for adaptation of 20 daily operations existing process or development of Process flowcharts new one 21 t t Determine how to make changes 22 without interrupting information 23 flow

24 Operating procedures t Finance function doc- t Assess adequacy 25 umentation t Facilitate integration Interviews Determine adherence to procedures 26 t t t Assess familiarity of personnel with 27 procedures 28 t Determine need for development 29 of common operating procedures Determine how to make changes 30 t without interrupting information 31 flow 32 Reports t Finance function t Identify potential financial and 33 tInternal and external t Interviews control issues 34 consistency t Evaluate familiarity of personnel tFrequency with reports and their purpose 35 tDistribution t Quantify effectiveness and 36 tProcess flowcharts efficiency of reporting processes 37 t Determine need for development of common reports and intervals PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 283

1 TABLE 7.8 (continued) 2 3 Type of Information Source Why Important 4 t Evaluate how to make changes 5 without interrupting information 6 flow 7 Cost processes Finance function Identify potential financial and t t 8 tProcess flowcharts t Interviews control issues t Determine familiarity of personnel 9 with processes 10 t Assess adherence to processes 11 t Evaluate effectiveness and effi- ciency of processes 12 t Determine need for adaptation of 13 existing processes or development 14 of new ones 15 t Determine how to make changes without interrupting information 16 flow 17

Credit and collection processes t Finance function t Identify potential financial and 18 Process flowcharts t Interviews control issues 19 Determine familiarity of personnel t 20 with processes 21 t Assess adherence to processes t Evaluate effectiveness and effi- 22 ciency of processes 23 Determine need for adaptation of t 24 existing processes or development of new ones 25 26 Guidelines for disclosure of t Finance function t Identify legal considerations information t Interviews with key t Identify cultural implications 27 managers t Identify potential difficulties in 28 integration 29 Staffing Finance function Assess adequacy of staffing levels t t 30 tCurrent and projected levels t Interviews t Assess potential for staff 31 tSkills and expertise t HR files reduction t Training and develop- t Assess need for reinvestment in 32 ment plans training and development 33 Identify unique skills and expertise t 34 of strategic importance 35 Organizational structure t Organization charts t Determine degree to which target 36 tRole of CFO t Job descriptions is finance-driven tReporting t Interviews 37 284 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.9 2 3 Sales Function Due Diligence 4 Type of Information Source Why Important 5 Sales systems and techniques t Sales department t Determine efficiency and 6 t Sales approaches used for flowcharts effectiveness of processes and 7 each product line, catalogs, t Sales department interaction with other processes 8 the Internet, company-owned policies and t Determine access to domestic and stores, sales representatives, procedures international markets 9 external distributors, etc. t IT department t Determine opportunities for synergy 10 t Sales strategies t Interviews with t Determine types of technology used, 11 t Lead development and customers their effectiveness, and compatibility Strategic plan 12 tracking t with the buyer’s technology t Customer calls t Assess efficiency in dealing with 13 t Closing sales complaints 14 t Order placement t Identify E-commerce effectiveness, 15 t Complaint resolution including security provisions E-commerce Determine if compensation is 16 t t t Compensation competitive and compatible with 17 buyer’s program 18 t Identify differences in strategic vision 19 that may affect postdeal success 20 Warehousing and shipping t Sales department t Identify adequacy of information operation IT department systems to provide controls 21 t t Information systems t Determine ability of systems to 22 t Automated systems interface with buyer’s systems 23 Government regulations t Sales department t Identify obstacles to achieve 24 t Corporate counsel objectives 25 t Identify recurring problems 26 Customer service t Sales department t Identify recurring problems with IT department specific products 27 t Resolution of complaints t t Number and type of com- t Identify recurring problems 28 plaints 29 Key accounts t Sales department t Identify sales priorities: increase 30 t Account volume market share or increase profit, etc. 31 t Types of purchases t Set strategy for reassuring key accounts 32 t Unique requirements t Pricing sensitivity t Determine how to deliver value 33 after deal 34 Products and services t Brochures and other t Identify appropriate staffing levels 35 t Descriptions of promotional items t Identify strengths and weaknesses 36 products/services t Strategic plan of product lines Sales department 37 t Descriptions of typical users t PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 285

1 TABLE 7.9 (continued) 2 Type of Information Source Why Important 3 4 t Legal liabilities related to t Corporate counsel t Identify areas of duplication with products the buyer’s product line 5 t New products being t Identify potential areas of synergy 6 developed t Identify continuing gaps in market 7 t Government regulations coverage 8 t Identify potential conflicts between buyer’s and target’s products 9 t Identify unanticipated, costly legal 10 issues 11 Forecasting techniques for each t Sales department t Identify how forecasts are used 12 product line t Determine accuracy of forecasts for the past 5 years 13 t Identify best practices 14 Staffing t Sales department t Identify unusually high personnel 15 t Current and projected needs t HR turnover and related problems 16 t Hiring processes t Re-affirm definition of corporate 17 t Turnover culture and treatment of people 18 t Management expertise t Identify “stars” who should be t Organization structure retained 19 t Determine the compatibility of the 20 existing organization structure with 21 plans for the new organization 22 Product knowledge of staff t Sales department t Determine staff’s product 23 t Knowledge t Interviews with staff knowledge t Training processes and customers t Identify best practices for transfer of 24 product knowledge to new recruits 25 Make plans for remedial training, if t 26 needed 27 Training and development t Sales department t Identify best practices that should 28 t Sales techniques t HR be preserved t Customer service t Identify need for remedial training 29 t Supervision t Re-affirm definition of corporate 30 Management culture and treatment of people: t 31 t Cost of training sink or swim culture, etc. 32 commonly, however, buyers choose to pursue full integration of the 33 target’s sales function with theirs. In both cases, the information pro- 34 vided by the organizational due diligence team is essential for ensuring 35 that necessary economies of scale are achieved and that key sales 36 accounts are retained. Table 7.9 summarizes critical information that 37 286 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 this team must collect and how that information can be used. 2 When reviewing the staffing of the sales function, the due diligence 3 team should also conduct a thorough analysis of the strengths and weak- 4 nesses of key managers. This analysis is especially important if the buyer 5 intends to integrate its sales team with the target’s. The analysis should 6 include each manager’s knowledge of key products, markets, and cus- 7 tomers; relationships with key customers and reputation within the 8 industry; ability to make accurate forecasts and achieve goals over a long 9 period of time; ability to work across functional lines and develop posi- 10 tive working relationships within and outside the company; ability to 11 hire and train potential winners for the sales team; and overall commit- 12 ment to the organization’s goals. 13 In conducting sales due diligence, the team should be especially care- 14 ful to avoid culturally induced myopia when analyzing data. There can 15 be a tendency for some due diligence team members to assume that what 16 works in their country or company will work in the target’s as well. 17 Unfamiliar legal restrictions on product development and distribution, 18 for example, may be overlooked, thus causing delays in achieving the 19 deal’s objectives. 20 Marketing. In the current atmosphere of globalization and industry 21 consolidation, many companies are setting organization-wide marketing 22 strategies at the corporate level but returning many other marketing 23 functions to units closer to the markets served. Companies also are using 24 outsourcing to increase flexibility and cost-effectiveness. This approach 25 enhances knowledge of local needs and provides a quicker response time 26 to changing regional/local market conditions. However, unless a buyer 27 has a clear understanding of the strategic advantages of centralization 28 versus decentralization for its situation prior to attempting postmerger 29 integration, considerable time and money can be wasted. The organiza- 30 tional due diligence team’s analysis of the target’s marketing function is 31 vital for sound decision making. In such cases, the team should focus on 32 the similarities and differences between the markets served by the buyer 33 and the target, as well as the potential added value of marketing support 34 services and staffing. Table 7.10 outlines key areas of analysis and some 35 implications of each area. 36 As noted in other contexts in this chapter, the organizational due dili- 37 gence team should pay particular attention to cultural issues affecting PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 287

1 TABLE 7.10 2 3 Marketing Function Due Diligence 4 Type of Information Source Why Important/Use 5 6 Market characteristics t Marketing department t Determine if target company will t Maturity —Regional help increase stability of buyer, e.g., 7 t Seasonality of products —Corporate because not all products are 8 Image and marketing cam- Strategic plan maturing at the same time or t t 9 paign associated with each t Interviews with key because products with year-round product line executives demand will balance those with 10 t Market share by product line t Advertising campaigns seasonal demand 11 t Impact of industry consoli- and other marketing t Review laws affecting advertising 12 dation materials, such as and promotion by country; identify 13 t Areas of conflict in markets websites differences and their implications in served advance 14 t Legal issues t Identify cultural taboos that forbid 15 t Cultural differences specific marketing strategies in 16 t Strategies for each product some countries, so that marketing line campaigns and standardized images 17 can be adjusted 18 t Determine effectiveness of marketing 19 strategies for each product line 20 and ability to meet changing requirements 21 t Assess compatibility of buyer’s and 22 target’s strategies 23 Support services t Marketing department t Assess quality and cost-effectiveness 24 Advertising HR Determine if outsourcing or in-house t t t 25 t Research t Interviews functions would be more effective 26 t Public relations t Samples of vendor t Identify areas of overlap with the t Printing work buyer’s marketing function 27 t Publications t Samples of press t Identify areas of excellence that 28 Technology available to sup- releases should be used to support the new t 29 port marketing function t Information organization technology t Identify need for new IT systems or 30 department new interfaces with the buyer’s 31 systems 32 Staffing t Marketing depart- t Determine ability of staff expertise 33 Unique areas of expertise ment to support buyer’s strategy t 34 available t HR t Determine staffing duplication and t Reputation within field opportunities for synergy 35 t Turnover t Identify key staff to be retained and 36 those to be terminated t Geographic location 37 288 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 global marketing and advertising strategies. As an example, France is 2 the world’s largest consumer of baby foods, including breakfast cereals. 3 The love of cereals, however, does not extend to French adults; only 17 4 percent of the French eat cereal for breakfast, and most of those who 5 do are children. Until recently, American breakfast cereal companies 6 found that they could not assume that French adults would put milk on 7 their cereal. Indeed, many preferred orange juice. 8 In Saudi Arabia, there is a large market demand for women’s lingerie, 9 but advertising it is considered unethical. In addition, most traditional 10 Western direct marketing strategies are not widely used there because 11 personal relationships are considered so important. Religious precepts 12 regarding gender segregation also make some forms of direct marketing 13 unacceptable. These same precepts mean that separate stores exist for 14 men and women. 15 Legal issues can be especially complicated. Only four of fifteen EU 16 countries do not consider advertising aimed at children harmful. Sweden 17 and Norway forbid all advertising targeted to children under age twelve. 18 The United Kingdom, however, has a very high level of advertising tar- 19 geted to children; only the United States and Australia have more. The 20 direct and indirect advertising of tobacco products in France is strictly 21 prohibited. In a recent court case, for example, photos of Formula 1 cars 22 and drivers wearing ads for tobacco products were considered indirect 23 advertising and therefore illegal. 24 Manufacturing. It is not uncommon for a buyer to select a target pri- 25 marily for its unique manufacturing technology or expertise. In the food 26 manufacturing business, there have been numerous recent mergers and 27 acquisitions driven by the search for new, more efficient manufacturing 28 processes. A food and drinks company, for example, recently acquired a 29 small company because it had a unique packaging technology that would 30 work well with the buyer’s products. 31 When conducting an analysis of manufacturing functions, the due 32 diligence team must keep in mind the deal’s overall objectives for value 33 creation through cost reduction or expansion into new markets. The 34 geographic location of the target’s manufacturing facilities and their effi- 35 ciency can be especially important as well. If the target’s manufacturing 36 facilities are in a low-cost, conveniently located area that’s at low risk for 37 terrorism or other potential dangers, then optimizing their use will be PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 289

1 TABLE 7.11 2 Manufacturing Function Due Diligence 3 Type of Information Source Why Important/Use 4 5 Facilities t Strategic plan t Identify whether currently operating 6 t Capacity t Visits to facilities over- or undercapacity and 7 t Potential for expansion t Interviews with plant implications for deal’s objectives t Potential cost reductions managers, IT depart- t Identify duplicate facilities and 8 t Age and condition of equip- ment, corporate whether they are more cost- 9 ment and technology counsel effective than the buyer’s 10 t Maintenance budgets t Determine if unanticipated 11 t Environmental regulations, investment in technology including areas of noncom- upgrades is required 12 pliance t Determine if expansion is cost- 13 Health and safety regu- effective t 14 lations t Quantify the cost implications of t Product safety and govern- compliance with regulations 15 ment controls 16

Manufacturing planning t Interviews with plant t Develop indicators of overall plant 17 processes managers and other efficiency 18 Production planning key personnel Determine need for unexpected t t 19 t Materials ordering t Interviews with IT investment to enhance efficiency 20 t Order entry personnel t Define type of manufacturing t Quality control environment—rigid or flexible— 21 t Relationship of sales fore- and ability to meet buyer’s needs 22 cast to production plan Determine the ability of the plan- t 23 ning and ordering functions to work together 24 t Determine need for and feasibility 25 of interface with buyer’s systems 26 Manufacturing operations t Interviews with plant t Identify core manufacturing 27 t Technology managers, engineers, competencies 28 t Processes and IT personnel t Determine if the technology is state- t Inventories t Plant data, such as of-the-art or will require upgrading 29 —Raw materials cycle time, cost per t Compare plant data to industry 30 —Work-in-process unit of output, first- standards to determine 31 —Finished goods run yield, ratio of competitiveness 32 t Setup or changeover times throughput time to t Determine if interface with the t Move to automation value-added time buyer’s systems is necessary and 33 feasible 34 Assess the effectiveness of process t 35 control, including automation and integration 36 37 290 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.11 (continued) 2 3 Type of Information Source Why Important/Use 4 Purchasing and suppliers t Plant records t Quantify the effectiveness and 5 t Just-in-time inventory t Interviews with plant efficiency of these functions 6 t Partnerships with key managers, IT person- t Identify best practices, such as reduced suppliers nel, and key suppliers inventories of raw materials and fin- 7 t Process for reviewing supply ished products, supplier partnerships, 8 base automated direct store delivery, and 9 continuous replenishment, to be 10 used company-wide 11 Staffing t HR records t Identify appropriate staffing levels t Plant managers Interviews with plant and whether overtime is routine, 12 t t Middle and supervisory level and HR personnel thus indicating staffing and cost 13 personnel t Personnel and climate issues 14 t Production workers surveys t Determine if managers have the Engineers 15 t appropriate management and t Maintenance personnel, etc. technical skills for their jobs 16 t Training t Determine if there is a plan for 17 t Location of engineers and regularly upgrading personnel skills 18 other key personnel t Identify employee relations problems, 19 such as poor working relations with collective bargaining units 20 t Determine level of employee 21 empowerment

22 Improvement initiatives t Plant documents t Evaluate organization’s ability to 23 t Training and development t Interviews with plant grow and change to meet new TQM personnel 24 t market demands t Re-engineering 25 t Problem-solving teams 26 Emergency preparedness t Plan documents t Evaluate readiness for dealing with 27 t Terrorist attacks t HR potential terrorist attacks and 28 t Disaster recovery t Corporate staff natural disasters Contamination of products 29 t with biological agents 30 31 highly desirable. A thorough analysis of the target’s manufacturing func- 32 tion is essential for ensuring that the deal has the potential to meet the 33 buyer’s strategic objectives and that there are no hidden liabilities. Table 34 7.11 details key areas that the due diligence team should examine. 35 As the due diligence team conducts its analysis, it should highlight 36 actions that can be taken to reduce manufacturing costs and enhance syn- 37 ergy between the buyer’s and target’s operations. Duplicate capabilities PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 291 and excess capacity should be earmarked for elimination. For example, a 1 European food and beverage company recently purchased a manufactur- 2 er of non-cola drinks. Organizational due diligence confirmed that the 3 target had no special expertise in manufacturing but was highly skilled in 4 new-product development and marketing. Consequently, after the deal 5 was completed, the buyer transferred all of the target’s manufacturing 6 operations to another division that was highly skilled in manufacturing. 7 The due diligence team also should carefully review relevant envi- 8 ronmental regulations to ensure that they are understood and that all 9 facilities are in compliance. This is especially important in cross-border 10 deals involving the environmental regulations of several countries. A 11 European beverage company, for example, bought manufacturing 12 facilities in the United States only to discover that there were serious 13 legal and financial liabilities related to water pollution. A more thor- 14 ough due diligence could have identified the areas of noncompliance 15 and their implications. (For topics relating to liability issues, see also 16 Chapter 5.) 17 Human resources. Companies tend to downsize their human 18 resources (HR) function whenever there is a consolidation, whether 19 through merged operations or some other structural change in the organ- 20 ization. Some HR functions, such as management development and 21 training, may be scaled back while others are decentralized. Current 22 trends in globalization also often lead to increased decentralization of HR 23 functions. Global organizations increasingly are decentralizing everything 24 except corporate-wide policy development, HR information system 25 development, certain company-wide training and development initiatives 26 deemed essential for strategy implementation or culture change, and suc- 27 cession planning for top-level positions. The purpose of such decentral- 28 ization is to more effectively attract, develop, and retain high-potential 29 performers in all global markets, not just the home market. 30 The task of the organizational due diligence team is to examine the 31 HR function of the target company and determine whether it offers 32 value. For example: 33 t Does the department typically meet its performance objectives, 34 and are they linked to key corporate initiatives? 35 t Does the department have its own planning process, and is it inte- 36 grated into the corporate process? 37 292 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 TABLE 7.12 2 3 Human Resources Function Due Diligence 4 Type of Information Source Why Important/Use 5 6 Corporate policies and procedures tEmployee handbooks t Determine if policies are congruent Vacation HR department files with buyer’s and if they are 7 t t t Other types of leave tInterviews to discuss company-wide or adjusted to 8 t Holidays application of policies meet local practices 9 t Work hours t Identify unique legal requirements by 10 t Expatriate management country and their impact Legal requirements Identify any areas of noncompliance 11 t t t Compensation and benefits with legal requirements 12 t Training and orientation 13 programs 14 t Support programs for spouses and families 15 t Security 16 t Repatriation 17 Benefits programs tPlan trust documents, t Identify unanticipated liabilities and 18 t Health insurance including amendments unique liabilities triggered by an 19 t Life insurance tInterviews to discuss acquisition t Travel insurance application of programs t Determine cost of programs and 20 t Disability insurance effectiveness in enhancing retention 21 t Retirement plans t Determine congruence of programs 22 t Profit sharing with buyer’s Bonuses Identify areas where adjustments will 23 t t t Stock options have to be made and the associated 24 t Tuition reimbursement costs 25 t Computer purchase t Identify best practices that should be 26 t Regional benefits considered for corporate-wide adoption 27 Compensation tCorporate and regional t Identify local variances from Executive HR departments corporate guidelines 28 t t Deferred tInterviews to discuss t Determine if compensation is 29 t Corporate guidelines application of programs standard for industry 30 t Local differences t Determine congruence with buyer’s 31 compensation 32 Hiring practices tHR policies and proce- t Determine effectiveness of practices: Corporate guidelines dures cost and retention 33 t t Local practices tInterviews with corporate t Identify potential cost savings 34 and regional managers through enhanced hiring 35 Succession planning process tCorporate and regional t Determine if process is in place and 36 HR departments working Interviews to discuss t Determine if information systems 37 t application of process must interface and are compatible PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 293

1 TABLE 7.12 (continued) 2 Type of Information Source Why Important/Use 3 4 Training and organization tCorporate and regional t Identify effectiveness and associated development HR department files costs, especially for recurring 5 t Recurring programs, such as tInterviews with HR programs 6 employee orientation and personnel and training t Determine degree of corporate com- 7 managerial skills development program users mitment to training and development 8 t Special strategy-linked t Determine best practices that should programs, such as values and be implemented corporate-wide 9 culture t Identify opportunities for synergy and 10 t Leadership programs cost savings 11 Performance evaluation processes tCorporate and regional t Identify effectiveness 12 Overall process flow HR departments Quantify uses of process t t 13 t Allowable variations based tEmployee handbooks t Identify unanticipated costs 14 on local culture tInterviews with process associated with process t Linkage of process to corpo- users t Determine if process should be 15 rate strategies maintained or buyer’s process should 16 be implemented 17 Human resource information Interviews with HR staff Determine ability of system to support t t 18 systems and other system users current business strategies and to 19 t Uses tInterviews with IT staff expand t Types of systems used t Determine if system should interface 20 t Level of satisfaction with the buyer’s and if interface is 21 cost-effective 22 Communication initiatives HR files Assess level and effectiveness of t t 23 t Hotlines tInterviews with HR and communications within the 24 t Newspapers other functional area corporation t Quality circles personnel t Identify best practices 25 t Employee surveys t Identify recurring issues 26 Community relations t 27 HR organization structure and HR personnel files Identify the reporting relationship of t t 28 staffing tInterviews with HR the HR function personnel and managers t Evaluate the role of HR head in 29 from functional areas developing and implementing 30 corporate strategy 31 t Determine if staffing level is adequate 32 t Determine if individuals have appro- priate types of skills and prior 33 experience 34 Identify individuals with unique and t 35 strategically important expertise 36 t Identify key personnel who should be retained 37 294 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 Is the department regularly involved in the development, imple- 2 t mentation, and evaluation of corporate strategies? 3 What are the internal and external reputations of the department? 4 t Are they consistent? 5 Table 7.12 details key areas that should be reviewed and explains why 6 they are important. As noted in the table, in our post-9/11 environment 7 it has become imperative for the HR function of most organizations, and 8 especially global ones, to have contingency plans in place for dealing 9 with natural disasters, political instability, and terrorist attacks at home 10 and abroad. 11 The due diligence team’s examination of the HR function is often 12 overlooked, but it is especially critical to the success of a deal. Policies 13 and procedures, as well as company benefits, can provide considerable 14 information that can be used to substantiate previously developed pro- 15 files of the corporate culture, overall competitiveness, and organization- 16 al effectiveness. 17 There are also numerous potentially hidden costs, legal liabilities, and 18 cultural stumbling blocks associated with the HR function that should 19 be identified before a deal is completed. The due diligence team should 20 be aware that in certain countries there are legal requirements concern- 21 ing the ascertainment of the following: 22 Outstanding employee grievances, particularly those that have the 23 t potential to develop into class-action lawsuits 24 Special employee deals or contracts that either must be honored 25 t or, worse, could trigger golden parachutes if a deal goes through 26 When considering wholesale changes to either the HR team or to 27 employee terms and conditions of employment, the due diligence team 28 should weigh the message that will be sent to the target’s employees. In 29 recent years, most companies have publicized the message that “our 30 employees are our most important asset.” Any goodwill that had been 31 carefully developed could be quickly squandered by precipitous action. 32 The due diligence team should be especially vigilant for signs of cul- 33 tural imperialism in the HR function. Warning signs include the tenden- 34 cy to hire few local nationals; failure to adjust job competencies to reflect 35 local conditions; and large differences in compensation for expatriates 36 and local nationals. 37 CHECKLIST Cross-Border Organizational Due Diligence Process 1 2 3 GENERAL CONSIDERATIONS 4 1. The strategic objectives of the deal should serve as a framework for the 5 due diligence process. 6 7 2. The type of deal also affects the level and emphasis of the due diligence. ❏ Acquisitions with full integration 8 ❏ Acquisitions with “arm’s-length” relationships 9 ❏ Mergers 10 ❏ Various types of strategic alliances 11 12 3. The composition of the due diligence team requires careful consideration 13 of the types of specialized expertise required. ❏ Human resources specialist 14 ❏ Functional area managers 15 ❏ Individuals with knowledge of the national culture 16 ❏ Legal experts 17 ❏ Financial advisers 18 ❏ Outside consultants 19 ❏ Representatives of the target 20 4. The prior experience of the company conducting the due diligence and 21 the cultural milieu affect the types of data collected and the collection tech- 22 niques. 23 ❏ Countries with a history of central economic planning 24 ❏ Differences in American and other legal systems 25 ❏ East/West values clashes 26 5. Negotiations: What will be done, when it will be done, and who will do 27 it must all be established at the beginning of the due diligence process. 28 ❏ Establishing trust 29 ❏ Face-to-face meetings 30 ❏ Cultural nuances of yes and no 31 6. Key components of organizational due diligence: Successful companies 32 increasingly use nonfinancial organizational metrics to help assess an orga- 33 nization’s performance and prospects for the future. 34 ❏ Customers 35 t Retention 36 t Value proposition 37

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1 t Satisfaction 2 t Market share for each product/service 3 t Understanding of customer segments 4 t Image 5 t Global capability 6 t New-product development ❏ 7 Employees Innovation 8 t Ability to attract and retain employees 9 t t Strategic training and development programs 10 t Succession planning 11 t Knowledge transfer processes 12 t Availability of strategic skills 13 t Performance-based compensation programs 14 t Teamwork 15 t Access to strategic information needed to do job 16 ❏ Internal business processes 17 t Time 18 t Cost 19 t Quality 20 t Customer satisfaction Availability of process documentation 21 t 22 7. Cultural factors may be the single most important reason a deal fails. 23 ❏ National culture: the unique norms, values, and beliefs of a group of 24 people 25 t View of time 26 t Task orientation versus relationship building Fate versus free will 27 t Leading versus following 28 t t Reward systems 29 t Indirect versus direct feedback 30 ❏ Corporate culture: the common set of values, traditions, and beliefs 31 that influence organizational behavior 32 t Self-image 33 t Attitude toward risk and reward 34 t Traditions 35 t Requirements for “getting ahead” 36 t Reward systems 37 t Indirect versus direct feedback PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 297

❏ Corporate culture: the common set of values, traditions, and beliefs 1 that influence organizational behavior 2 t Self-image 3 t Attitude toward risk and reward 4 t Traditions 5 t Requirements for “getting ahead” 6 Decision-making processes t 7 Communication processes t 8 Commitment to employee development and safety t 9 t Emphasis on people versus tasks 10 t Labor relations policies and philosophy 11 t Community involvement and concern about social responsibility 12 t Degree of cultural diversity t Lifestyle indicators 13 t Corporate values 14 15 8. Mission, vision, and values must be reflected in a clear statement of pur- pose and guidelines for behavior. 16 ❏ Impact of deal type 17 ❏ Impact of national culture 18 ❏ Potential clashes of values 19 ❏ Integration into corporate culture and daily operations 20 21 9. Communication processes and patterns serve as indicators of corporate effectiveness and efficiency. 22 ❏ Overall considerations 23 24 t Impact on public image t Influence of national culture 25 t Formal versus informal processes 26 t Open versus guarded 27 t Leadership styles and national cultural differences 28 t Patterns of conflict resolution and national cultural differences 29 ❏ Internal communication processes 30 t Newsletters 31 Bulletin boards: traditional and electronic t 32 Letters to employees t 33 t Management by walking around 34 t Strategic and operational plans 35 t Meetings 36 t Performance appraisal systems t New-employee orientation programs 37 298 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t Quality circles 2 t Corporate identity program 3 t Hotlines 4 t Employee attitude surveys 5 ❏ External communication processes 6 t Press releases 7 t Annual report Brochures and other marketing materials 8 t Communications with suppliers and distributors 9 t 10 10. People issues: Employees are some of a company’s most important 11 assets. Postdeal loss of employees leads to reductions in the added value 12 anticipated for the deal. ❏ 13 Key tasks: early identification of senior management team, personnel to be terminated, and those to be retained 14 ❏ Profiles of key management personnel 15 t Basic information: name, position, education, time with the com- 16 pany, ethical issues 17 t Unique skills and talents 18 t Inclusion in fast-track programs and succession planning 19 t Attitude toward advancement 20 t Historical data on experience 21 t Areas of responsibility 22 t Compensation history 23 t Perceived intent to remain with the company 24 t Compatibility with investor’s key managers 25 t Internal and external reputation ❏ 26 Staffing analysis Level of staffing by function and location 27 t Types of expertise available 28 t t Types of expertise needed but not available 29 t Key personnel to be retained 30 t Key personnel to be terminated 31 t Compliance with employee welfare regulations 32 ❏ Legal issues affecting staffing 33 t Host country definition of nationals, residents, and nonresidents 34 t Documentation requirements 35 t Restrictions on board membership 36 t Restricted use of expatriates in specific industries 37 t Quotas for use of expatriates PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 299

11. Overall organizational structure: What are the implications for the 1 future effectiveness and efficiency of the deal? 2 ❏ Impact of buyer’s intent to fully integrate organizations or keep them 3 separate 4 ❏ Organization structure 5 t Recent and planned changes 6 Reporting relationships t 7 Organizational focus t 8 ❏ Responsibilities of major functional areas and key leadership posi- 9 tions 10 t Formal and informal procedures 11 t Coordination of work across functional lines 12 t Key measures of business success t Interface with regulatory agencies, labor groups 13 ❏ Coordination of work between and among functional areas 14 ❏ Morale and work environment 15 ❏ Facilities for each functional area 16 t Buildings 17 t Work spaces 18 t IT systems 19 Telecommunications t 20 Equipment, including age and appraisal t 21 Environmental issues, especially noncompliance t 22 ❏ Community relations for each location 23 12. Individual functional areas 24 ❏ Information systems 25 Impact of deal’s strategic objectives on systems: full integration, t 26 partial integration, little integration 27 Hardware and software inventory t 28 t Communications capabilities and networks 29 t Technical support capabilities 30 t Relationship of business requirements and systems support t Compatibility of existing systems with those of the buyer 31 ❏ Finance 32 t Impact of deal’s strategic objectives on systems: full integration, 33 partial integration, little integration 34 t Budgets: types, frequency, distribution, use, time frame 35 t Plans: types, frequency, distribution, use, time frame 36 t Operating procedures: effectiveness and adequacy 37 t Reports: internal and external 300 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t Cost processes 2 t Credit and collection processes 3 t Information disclosure 4 t Staffing levels 5 ❏ Sales: This is an especially important functional area for companies 6 with little expertise in the global marketplace; due diligence should 7 avoid national cultural myopia and describe the target’s products, services, staffing, and costs. The review should consider the follow- 8 ing: 9 t Users of target’s products 10 t Legal liabilities resulting from those products 11 t New products in the pipeline 12 t Government regulations by product and national market 13 t Forecasting techniques used and their effectiveness 14 t Current and projected staffing needs 15 t Strengths and weaknesses of current staff 16 t Hiring processes 17 t Turnover 18 t Management expertise 19 t Organizational structure 20 t Product knowledge Training and development initiatives (types and cost) 21 t Sales systems and techniques 22 t t Sales approaches and strategies for each product line 23 t E-commerce ventures 24 t Compensation 25 t Warehousing and shipping operations 26 t Automated and information systems 27 t Government regulations 28 t Customer service 29 t Key accounts 30 13. Marketing: Ther e is a trend to decentralize many marketing functions to 31 enhance reaction to local market conditions. 32 ❏ Overall market characteristics 33 t Maturity and market share 34 t Seasonality of products 35 t Marketing campaigns for each product line 36 t Areas of conflict with markets served by the buyer 37 t Potential legal issues affecting marketing initiatives PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 301

t Cultural differences affecting marketing strategies and their 1 implementation 2 t Potential impact of industry consolidation 3 ❏ Marketing support services: internal or outsourced 4 t Advertising 5 t Research 6 t Public relations 7 Printing t 8 Publications t 9 t Adequacy of technology to support overall marketing function 10 ❏ Staffing 11 t Adequacy 12 t Unique expertise t Reputation in company and in the industry 13 t Turnover 14 15 14. Manufacturing: Discover how to reduce costs and enhance synergy 16 between the two organizations. ❏ Facilities inventory 17 18 t Capacity t Age and condition 19 t Maintenance budgets 20 t Environmental regulations and compliance with them 21 ❏ Manufacturing planning processes 22 t Production planning 23 t Materials planning 24 t Order entry 25 t Quality control 26 ❏ Manufacturing operations 27 Technology t 28 t Processes 29 t Inventories 30 t Setup or changeover times ❏ Purchasing and suppliers 31 t Just-in-time inventories 32 t Strategic partnerships 33 t Review processes for supplier base 34 ❏ Staffing 35 t Plant managers 36 t Middle and supervisory management 37 302 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t Equipment operations 2 t Training 3 t Location of engineers and other key personnel within the plant 4 15. Human resources: The role and organization of human resources is 5 changing to enhance flexibility within the global market. 6 ❏ Key questions for assessing the overall effectiveness of the HR func- 7 tion 8 t Accomplishment of performance objectives 9 t Linkage of performance objectives to key corporate initiatives 10 t Involvement in company-wide planning process 11 t Involvement in development, implementation, and evaluation of corporate strategies 12 Internal and external reputation of HR 13 t ❏ Specific areas for review 14 t Corporate policies and procedures 15 t Benefits programs 16 t Compensation 17 t Hiring practices 18 t Succession planning process 19 t Training and organization development 20 t Performance evaluation processes 21 t Human resource information systems 22 t Communication initiatives 23 t Staffing 24 25 26 27 28 29 30 31 32 33 34 35 36 37 1 2 Due Diligence Investigative 3 4 8 Technology and Know-How 5 6 7 JAMES B. MINTZ 8 9 10 11 12 13 14 15 VEN AFTER THE LEGAL, tax, accounting, and operating profes- 16 sionals exhaust conventional due diligence techniques, unresolved 17 E issues often remain. These professionals may need new techniques 18 to dig deeper. 19 Advances in investigative technology in recent years—including the 20 Internet and dial-up databases in many countries—have made available 21 powerful resources that can assist those responsible for legal, financial, 22 tax, operational, and human resource due diligence. These new ways of 23 gathering information worldwide can be helpful regardless of the border 24 being crossed, the type of transaction, or which party is doing the inves- 25 tigating. 26 27 28 How Investors Use Private Investigators 29 It will come as no surprise that as part of due diligence, investors rou- 30 tinely hire private investigators to check the backgrounds of a target 31 company’s executives before a transaction. But it may be less well known 32 that investigators also help due diligence professionals resolve issues 33 related to a company’s business practices. Consider the following: 34 Several years ago, the James Mintz Group surveyed the top ten invest- 35 ment banks on their use of outside investigative firms in the due dili- 36 gence process. Eight responded and indicated that investigators working 37

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1 with their due diligence teams had uncovered executives’ ties to organ- 2 ized crime, criminal charges, and other useful information. 3 But the surveyed investment banks also used outside investigators to 4 uncover operational problems, such as whether a company was making 5 inflated product claims. In another instance, a banker said his investiga- 6 tor found a company “had entered into a contract that was designed to 7 inflate numbers to create the impression of materiality.” 8 9 10 How Investigative Technology Can Help 11 The following examples show how investigative technology can provide 12 information to help due diligence professionals resolve tough questions, 13 and how a more traditional investigative step—quiet interviewing—is 14 often the necessary follow-up to electronically accessed information. 15 16 The International Public Record 17 New technology has begun to put at the fingertips of due diligence inves- 18 tigators, in domestic and especially cross-border deals, the very thing that 19 they most need: access to the international public record on the compa- 20 nies and executives with whom they are negotiating. That record includes 21 regulatory filings, criminal convictions, civil litigation, bankruptcy filings, 22 news articles, and reports by nongovernmental agencies. 23 Any computer plugged into a phone line can access the gigantic store- 24 rooms of public-record information that have become available in recent 25 years around the world. 26 Nexis searches have become standard operating procedure for many 27 due diligence professionals. But although Nexis (the news side of Reed 28 Elsevier’s LexisNexis Group) shows them how easy and fast it is to enter 29 this new universe of computerized public information, less well-known 30 databases permit them to go much further, pursuing due diligence con- 31 cerns in a variety of valuable directions. 32 Out there is everything from Swiss corporate records to the name of 33 the golf club to which a Japanese executive belongs; from enforcement 34 proceedings of the Budapest Stock Exchange to the thousand people 35 sanctioned for corruption by a commission in India; from a Swedish 36 business association’s warning list of companies engaged in fraudulent 37 practices to a database on international shipping fraud. DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 305

The new technology shuffles together significant parts of the public 1 record more comprehensively and conveniently in the United States 2 than in most other countries. For example, several databases now can be 3 used to check whether a person or company has been bankrupt any- 4 where in the United States. (Until these databases came along, one had 5 to figure out each federal jurisdiction in which a subject had lived and 6 then search each of those bankruptcy indexes in person.) A number of 7 other countries, however, now have their own useful data services, such 8 as Italy’s Alidata, which can be consulted, for example, to check for past 9 Italian litigation involving an individual or company. 10 In some countries, regulatory and other data either are unavailable or 11 appear unreliable. In those cases, you should look for other information 12 to bridge the gaps. So, for example, in Russia you might turn to the most 13 reliable archive of news articles in the country, which goes back to 1991. 14 Similarly, there is a Caribbean news service, and a service that has com- 15 piled information on lawsuits in Mexico City. In other countries, recent 16 leaps in transparency have brought the availability, on obscure but pub- 17 lic websites, of local enforcement actions. For example, you can down- 18 load the several dozen actions documented by the Czech Securities 19 Commission, which began operation in 1998. 20 The new technology provides access to other information helpful to 21 due diligence professionals that is truly international in scope. For 22 example, there is now a website (discussed below) that allows you to 23 search the indexes of hundreds of investigative books. Technology thus 24 begins to fill another hole in what amounts to the international public 25 record. 26 27 The Hometown Newspaper 28 A critical rule in cross-border due diligence is: Never do consequential 29 business with someone until you have checked the archives of his or her 30 hometown newspaper, wherever in the world home is. 31 The investigator’s road map for finding that Montreal’s Gazette is on 32 the Dialog database, and that the South China Morning Post is available 33 on the Factiva service back to 1984, is called Fulltext Sources Online. 34 This book also may help you decide which services to subscribe to. Due 35 diligence investigators should consider subscribing to specialized Nexis- 36 like news databases pertinent to the industry or location in question 37 306 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 because the data in most publications’ websites is too limited to be use- 2 ful in checking a company’s or individual’s background. 3 If you subscribe to any computerized databases, the people in your 4 office who do the searching should have an investigative mentality and 5 be thoroughly trained. For example, even the best-known databases, 6 such as Dun & Bradstreet’s reports about companies, contain valuable 7 tricks that due diligence searchers need to know. Here’s one: Re-query 8 the D&B database using the telephone number, instead of the name, of 9 the company in question. This extra step can reveal undisclosed compa- 10 nies sharing that phone line. 11 Even today, not everything is online, and some investigative field 12 work is often necessary. Small newspapers usually do not allow out- 13 siders to have access to their morgues, but local libraries often keep 14 clippings of people and businesses in the area. Go back ten to twenty 15 years, if possible, and get access to the most freewheeling press outlets, 16 such as Private Eye in London. Outside the world’s business centers, 17 where fewer newspapers are online, turn to local clipping services. In 18 one cross-border transaction, for example, investigators sought infor- 19 mation about whether the target was involved in an Argentine scandal. 20 Nexis and other news databases turned up nothing, so the investiga- 21 tors called a clipping service in Argentina, which found several relevant 22 stories. 23 One must dig deep for articles not only by relevant city but by rele- 24 vant industry. Trade-journal searches are a good way to develop a record 25 of someone’s career and at the same time verify a résumé. Many of these 26 (examples include publications such as Progressive Grocer, Singapore’s 27 Computer Times, and Australian CPA) are accessible online. In one 28 instance, an American investor knew even before the translator arrived 29 that a Brazilian business journal might have bad news about his target— 30 the word “Watergate” repeatedly jumped out from the otherwise- 31 Portuguese text. 32 Keep in mind, too, that the print media are only part of what’s out 33 there. With their increasing popularity, investigative television news shows 34 can be an important addition to the standard news-clip search. Check the 35 broadcast records using Burrelle’s Information Services, which tran- 36 scribes and indexes television and radio shows, to search for who said 37 what on any topic. Burrelle’s includes shows such as 60 Minutes. DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 307

1 The Backgrounds of Key Executives 2 3 Prime Questions Investigators Must Explore 4 Has the executive ever been in trouble? Investigators are routinely 5 asked to check whether a business executive has a criminal record. There 6 is no U.S.-wide method to search for criminal charges, much less an inter- 7 nationally comprehensive way, so the first investigative task is figuring out 8 in what jurisdictions a person has lived or worked in the past. 9 Due diligence investigators like to begin with databases that show a per- 10 son’s past and present addresses, date of birth, and possible aliases, con- 11 firming a person’s identity along the way. Our firm has investigated many 12 people who had never lived where our clients thought they did—some 13 lived under other names; one woman even turned out to be a man! 14 Before these databases came along several years ago, uncovering a per- 15 son’s identity was far more time-consuming. You could hire a private eye 16 to knock on neighbors’ doors, or write to the local post office, or visit 17 the capital of the state or country where you thought the person lived 18 and ask the Department of Motor Vehicles or its foreign equivalent for 19 data. Then you could have pored through phone books, city by city or 20 country by country. 21 Now, however, databases such as AutoTrackXP shuffle together 22 phone directories and real estate records with driver’s license records. 23 The latter include physical descriptions, which are particularly useful in 24 identifying people with common names—from among all the Joseph 25 Browns, you can pick out the one who is six feet tall and wears glasses. 26 Other databases may duplicate what AutoTrackXP has, but 27 AutoTrackXP particularly endears itself to investigators, for example, by 28 preserving historical information such as out-of-date Secretary of State 29 records on companies’ registered agents. 30 Only after you have fully identified a person can you effectively 31 uncover possible criminal charges that may be pending against him or 32 her. For example, in July 2001, the press reported that a man was 33 arrested soon after he had made a deal to buy a Manhattan restaurant. 34 The seller of the restaurant had believed the would-be buyer’s claim 35 that he was based in California, but routine searches would have shown 36 that he had a criminal record in New York. 37 308 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 In this example, a New Yorker allegedly got conned by another New 2 Yorker, but distance and cultural differences make it even harder to see 3 behind the masks that con artists wear. In one instance, some European 4 investors were so thoroughly deceived by the false identity put across by 5 a New York money manager that they continued to trust the money man- 6 ager even after new criminal fraud charges had been lodged against him. 7 Have executives been truthful about their backgrounds? An 8 Internet company’s search for a new CEO was cited in a recent Business 9 Week article for “bypassing the painstaking due diligence that averts hir- 10 ing disasters.” An electronic search might have stopped the CEO’s can- 11 didacy in its tracks, because it would have uncovered that he made false 12 statements about his age (according to the article), making six years of 13 his life disappear. Then there was the executive who claimed to have cre- 14 dentials and expertise on population migration. A database search con- 15 firmed he was an expert on migration—but of birds, not people! 16 International businessmen may present themselves as local to a coun- 17 try where they have a clean record, covering up their messy footprints 18 across borders. An investigative firm faced liability some years ago for 19 conducting an entire background check in one jurisdiction but missing 20 the subject’s bad record literally across the river. 21 Sometimes, the absence of online information is a red flag of some- 22 thing that requires further checking. For example, a private U.S. com- 23 pany wanted to check out a purportedly wealthy U.K. deal maker who 24 had expressed interest in making an acquisition. Having only a few 25 details about the subject, investigators were still surprised that they could 26 find no references to him in online databases. Here, the salient informa- 27 tion they derived online was that there was no online information. They 28 found out why when they followed up this electronic “dry hole” with a 29 visit to a town where the supposedly rich investor had once lived. There 30 they found a business creditor who told them that their subject had 31 changed his name two years earlier. Sure enough, the original name 32 quickly turned up on their databases: The subject turned out to be an 33 individual who owed several parties substantial amounts of money and 34 who had severe financial problems. 35 Recently, a high-profile senior executive was in the news when it was 36 belatedly discovered that he had neglected to tell his most recent 37 employer about some early, controversial episodes at jobs that he left off DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 309 his résumé. One of those missing jobs could have been discovered elec- 1 tronically in a 1981 press release, for example. 2 Due diligence professionals should investigate any lack of candor by a 3 target company’s executives about their personal background, particu- 4 larly if found in a résumé, license application, regulatory filing, or other 5 written representation. 6 It’s generally assumed that the most common falsehoods found in 7 executive résumés are academic degrees that were never earned or mili- 8 tary service that never occurred. It’s far more common, however, for 9 executives to omit brief stints at jobs that didn’t work out or didn’t fit 10 well with current career goals. Consider the airline executive who for 11 several months worked for a gambling-related company. Such individu- 12 als often hide the omission by stretching the dates of jobs held just 13 before and just after. It’s often the “little things” people edit out of their 14 pasts that a prospective business partner most needs to know. Pay close 15 attention to the dates in résumés and verify the story executives tell by 16 cross-checking the facts with such external sources as news articles, press 17 releases, regulatory filings, even college alumni bulletins. 18 Making false claims about college degrees is, of course, also quite com- 19 mon. Although these claims seem easy to check—university registrars 20 routinely answer requests about degrees by telephone—some people have 21 evaded disclosure by telling a well-worn story about why their schools 22 don’t have records of them. Here, you must press the candidate and col- 23 lege relentlessly. 24 Was the executive successful and trustworthy at prior jobs? 25 People leave jobs for many reasons, but when asked, many companies 26 confirm only a former employee’s dates of employment. Thus, in inves- 27 tigating it’s important to identify, and quietly interview, knowledgeable 28 former coworkers for their unofficial, confidential—and candid—assess- 29 ment of the ex-colleague’s tenure. In these informal conversations, read 30 their former colleague’s résumé to the person to check its credibility. 31 Most important, try to determine how the subject’s past employment 32 ended. It’s the only way to separate real resignations from “resign or 33 we’ll fire you” situations. 34 A surprising number of executives create companies they don’t tell 35 anyone about—not their employers, their bankers, or their prospective 36 business partners. The existence of such companies is often the clue to 37 310 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 the presence of self-dealing issues, such as using the company to sell 2 supplies or lease office space to the businessman’s employer. In one 3 case, a European information service helped trace a Belgian executive to 4 his secret company in Switzerland, which he was using to siphon busi- 5 ness away from his employer. These secret companies often surface 6 when investigators plug an executive’s home address or telephone num- 7 ber into a database. Other times, investigators discover a company 8 because its name is derived in part from personal information, like the 9 address of an executive’s country house or a combination of his and his 10 wife’s first names. 11 Does the executive have relationships with questionable people? 12 Investors sometimes ask if there’s a list to check to see if someone is 13 involved with organized crime. Although lists exist of the “made mem- 14 bers” of major crime families, such lists are available only to law enforce- 15 ment officials, and, in any case, the individuals listed rarely turn up in 16 normal business situations. Determining whether an individual or com- 17 pany is mob-influenced is complicated, because organized crime has 18 allegedly infiltrated a range of white-collar businesses, from stock bro- 19 kerage firms to prepaid-phone-card companies. 20 There are several ways to determine whether an individual or a busi- 21 ness has unsavory connections. First, you can check court records and 22 news coverage, then make discreet calls to regulatory agencies that mon- 23 itor such historically mob-connected businesses as trash hauling, casino 24 gambling, and construction. In one instance, when an initial search 25 proved fruitless in checking a bank’s suspicions that a prospective cus- 26 tomer had organized-crime ties, the bank’s investigators called a former 27 government investigator. He steered the investigators to the archives of 28 a weekly newspaper that had an old article linking the businessman to a 29 well-known mob figure. 30 There is now, at www.pir.org, a database called NameBase, where you 31 can search hundreds of out-of-print books and old magazine articles 32 about organized crime, among other things. For example, an apparent- 33 ly legitimate European businessman turned up with a NameBase refer- 34 ence identifying him as a money launderer for the mob decades ago. 35 36 37 DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 311

1 Resolution through Follow-up Investigation 2 It’s clear that database searches sometimes reveal issues that kill deals. 3 More often, the searches raise concerns that can then be resolved 4 through follow-up investigation. Here are several examples: 5 t A U.S. company was negotiating a joint venture with a Russian 6 entrepreneur who held the local franchise for a service business. The U.S. 7 company was concerned because the Russian was using armed ex-KGB 8 agents as bodyguards. The U.S. company hired investigators whose 9 sources in Russia determined that the Russian’s lifestyle was explained by 10 legitimate business successes and that his security concerns were justified. 11 t A U.S. businessman disclosed to a venture capital fund that he had 12 been indicted in a fraud case years before. The indictment was dismissed 13 before trial. The venture capital fund asked investigators to find out 14 whether the prosecution resulted from an isolated case of bad judgment 15 or was part of a pattern on the businessman’s part. The investigators 16 pulled the filings from the relevant courthouse and determined that the 17 subject was only peripherally involved in the fraud, and that this was the 18 only time he had ever been named in a criminal or civil matter. 19 t Investigators discovered that a number of real estate developers 20 who acknowledged that they had a “rough patch” during the downturn 21 of the late 1980s didn’t admit exactly how rough. Investigators checked 22 particularly for lawsuits by the developers’ lenders, and for any role that 23 the developers may have had in troubled savings and loans. A property 24 developer told one prospective investor that one of his companies had 25 filed for bankruptcy years before. The investor’s investigator contacted 26 some of the creditors listed in the bankruptcy filing and heard nothing 27 but praise for the developer’s efforts to make the creditors whole. 28 29 30 The Business Practices of the Target Company 31 Electronically available information and more traditional investigative 32 methods are as valuable in following up on due diligence concerns 33 about a target company’s business as they are about its executives. Due 34 diligence professionals may need company-related information on reg- 35 ulatory issues, business disputes, intellectual property, and many opera- 36 tional issues. 37 312 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 2 Regulatory Issues 3 Are regulators preparing to take action? It’s often not possible to 4 know if regulators are preparing to take action against a particular com- 5 pany, but sometimes, if you look in the right places, the handwriting is 6 on the wall. Thus, a well-known global financial institution acquired a 7 smaller company not long ago, even though the target had attracted 8 hundreds of lawsuits, scrutiny from the Federal Trade Commission, and 9 the hostility of some prominent consumer groups. Should the acquirer 10 have been surprised that within months of completing the deal, the tar- 11 get was sued by the FTC, and it was forced to acknowledge integrity 12 concerns at its newly minted subsidiary? 13 Documents from regulators’ files that can help predict future enforce- 14 ment problems include past subpoenas, consent decrees, and hearing 15 transcripts. The challenge in digging them out is that each federal, state, 16 and international agency makes this information public in varying 17 degrees, and through a maze of websites, databases, and Freedom of 18 Information procedures. To find the documents you are after, you need 19 to know what agency regulates the target’s business. Information about 20 a trash-hauling company, for example, might be filed with a local consumer 21 bureau, a state environmental agency, an organized-crime commission, or, 22 if the company is public, with the SEC. Obtaining the paperwork may be 23 just the beginning. The best nugget in regulators’ files is often the name 24 of the government investigator on the case, especially if that person is 25 now retired. A discreet conversation with that investigator can help you 26 understand what’s on the paper record. 27 Does the target have tax trouble? State and federal tax liens against 28 a U.S. company are readily obtainable from databases and may raise 29 questions about its financial health. Red flags include long-term out- 30 standing liens or a flurry of liens filed over a short time period. For exam- 31 ple, a business with cash-flow problems may miss a few quarterly pay- 32 ments of federal employee-withholding taxes and be hit with an IRS lien. 33 Likewise, missed payments of unemployment insurance premiums may 34 result in a state labor department lien. 35 In the United States, also call the U.S. Tax Court in Washington, 36 D.C. One call to this court checks the whole country for litigation 37 brought by taxpayers against the IRS. Some countries, like Russia, have DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 313 myriad tax laws that may be loosely enforced and difficult to comply 1 with. Often, a good way to determine if a target company is at risk from 2 the tax police is to check local press reports and the public record for 3 accounts of other companies that have actually been prosecuted. 4 Has the target been investigated by securities or banking regu- 5 lators? The SEC posts its sanctions electronically, and once one of its 6 investigations is closed, it will respond to a Freedom of Information let- 7 ter with revelations about whom it has investigated and even with copies 8 of depositions, usually within a couple of weeks. 9 In one case, investigators searched a U.S. database of securities and 10 banking regulatory actions and found that two real estate developers 11 were the subjects of orders of prohibition filed by the Office of Thrift 12 Supervision (OTS). This search gave the investigators enough informa- 13 tion to retrieve the relevant documents from OTS files, which might 14 otherwise have been impossible to find. 15 Many regulators abroad discipline people and companies, but the 16 sanctions are available only at their headquarters’ archives. Here you 17 must be particularly diligent and knowledgeable to chase the paper suc- 18 cessfully. 19 The numbers of disciplinary actions and sanctions on the books are 20 compelling. In connection with its investigative activities, the James 21 Mintz Group has compiled copies of regulatory compliance actions from 22 around the world. The file is focused particularly on matters of money 23 laundering, fraud, foreign corrupt practices, embargoes, and violations 24 of securities and banking regulations. In the securities and banking area, 25 for example, the material the firm has assembled includes the following: 26 t Two thousand sanctions against individuals and companies by 27 Italy’s Securities Commission since 1991 28 t The Reserve Bank of India’s list of 5,000 individuals and entities 29 sued for defaulting on loans and who had outstanding debts as of 30 March 1999 31 t More than 1,000 enforcement actions brought by the Hong Kong 32 Securities and Futures Commission since its establishment in 1989 33 Was the company or its executives implicated in a specific scandal? 34 One way investigators can help due diligence professionals identify regu- 35 latory red flags is by unearthing the details of past scandals in the target 36 company’s industry. Due diligence investigators must pay close attention 37 314 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 to the issues that arise in particular industries and regions and know how 2 to determine whether a given company is vulnerable. In one case, a library 3 of organized-crime exposés might be what’s needed; in another, it may 4 help to have the volume listing the German companies found to have 5 used slave labor during the Nazi era. Due diligence investigators keep 6 close at hand the U.S. Office of Foreign Assets Control’s list of “blocked 7 persons” (people who have violated economic and trade sanctions). 8 As an example of how such an investigation might proceed, assume 9 the following: 10 t The target makes a product similar to ones that were the subject of 11 a recent price-fixing prosecution and guilty pleas by American, European, 12 and Asian companies. 13 t The legal due diligence team has reviewed general media coverage 14 of the prosecution and received assurances from the target that it was not 15 contacted or targeted in the recent criminal case and, generally, that it 16 has not fixed prices with competitors. 17 t The due diligence team is still concerned that the target may have 18 engaged in improper meetings with competitors similar to the ones that 19 led to the prosecution. An investigator is asked to dig deeper. 20 The investigator might seek further details by: (1) accessing electron- 21 ically available information, like local newspaper coverage in the prose- 22 cuted companies’ hometowns; (2) pulling copies of filings in the crimi- 23 nal case; and (3) interviewing sources knowledgeable about the prose- 24 cution. Assume further that the investigator finds these additional 25 details: 26 t The price-fixers used conferences of an industry association as a 27 cover for getting together in secret meetings on prices. The few execu- 28 tives involved in the price-fixing stayed over for an extra day after each 29 association conference. 30 t These meetings were never in the United States, though some of 31 the participants were American. 32 t Each company’s lawyers attended the industry conferences but did 33 not stay over and attend the price-fixing meetings. 34 Armed with knowledge of these red flags, the due diligence team may 35 want to ask the target additional questions such as: Who attended indus- 36 try conferences? Any company lawyers? Were the conferences always 37 abroad? Why? Did everyone fly back together? If the answers heighten DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 315 rather than allay the team’s concern, the investigator could be asked to 1 locate and interview any of the conference and postconference attendees 2 who no longer work for the company. 3 Is the company being targeted by consumer or international 4 human-rights groups? When Ralph Nader in publishing Unsafe at 5 Any Speed (1965) helped kill the Corvair, he spawned a cottage indus- 6 try of consumer activists dedicated to exposing corporate abuses. You 7 may need to know whether any such activists have exposed—or are 8 about to expose—the target company. The challenge is to pick up signals 9 that whistle-blowing is about to take place. After identifying the relevant 10 activist groups in an industry, investigators often buy past issues of their 11 newsletters, or check their websites, which sometimes contain accusa- 12 tions against companies. Recently, sophisticated Internet searches have 13 made this kind of risk assessment easier. 14 Public-interest and human-rights concerns have gone global along 15 with business. Increasingly, information technology and other investiga- 16 tive techniques should be used to answer due diligence questions such 17 as: Is the target doing anything outside the United States and Europe in 18 an effort to skirt environmental, labor, or human-subject testing regula- 19 tions in those places? 20 21 Concerns about Intellectual Property 22 In an age of increasing numbers of “soft asset” transactions, it is partic- 23 ularly important to investigate a target’s claims about its key intangible 24 assets. Intellectual property (IP) is the key to many companies’ success, 25 and thus it is increasingly crucial in due diligence to determine their 26 bona fides. Effective investigation requires going outside the target and 27 finding independent sources of information and insight. Investigators of 28 IP must have special skills and resources to do this successfully, includ- 29 ing the following: 30 t A network of industry sources or the ability to develop them 31 quickly 32 t Research skills for identifying obscure, specialized newsletters and 33 websites 34 t Interviewing skills, for extracting insights and details from people 35 who don’t want to be quoted by name, possibly including competitors, 36 regulators, and former employees 37 316 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 t A healthy skepticism about all predictions of a technology’s com- 2 mercial prospects and an understanding of the limits of specific IP appli- 3 cations 4 Unlike other assets, IP assets know no borders. Thus, cross-border IP 5 investigation may require particularly creative and rigorous approaches. 6 Away from home, where your sources are probably thinner, you must 7 ensure that the few available sources are trustworthy. Bear in mind, too, 8 that counterfeiting and unauthorized copying of certain kinds of IP are 9 rampant in China and other parts of the world. 10 For example, assume a worst-case scenario for an IP due diligence 11 investigator: The target’s business prospects depend on as-yet-unmar- 12 keted technology that is subject to conflicting regulatory review and stiff 13 competition in several countries, and the company’s rights to the tech- 14 nology are being contested in litigation brought by a former employee. 15 Databases and the Internet may help you find independent information 16 and insight on some of the key items. Some issues and approaches are as 17 follows: 18 t Does the technology work, and does it have the value the target 19 claims? Check general business press coverage as well as industry-specif- 20 ic publications, websites, and experts. 21 t How is the regulatory process likely to go? Check newsletters that 22 cover specific regulatory agencies, and search databases for former offi- 23 cials of specific agencies. 24 t What problems with this technology would competitors point out? 25 Identify whom to contact at one of the target’s competitors (unless 26 revealing details of the technology to competitors would compromise 27 the target’s competitive edge or violate trade secrets). 28 t Did the company acquire its technology under circumstances like- 29 ly to cause controversy or dispute? A good way to find out: Ask former 30 employees. 31 32 Business Disputes 33 Has the company ever been a defendant in a lawsuit? It’s a sim- 34 ple question. But there’s no simple way to find out. With no national— 35 much less international—registry of civil litigation, records on millions 36 of cases are scattered geographically within each jurisdiction, filed in 37 separate federal, state, and local judicial systems. (Although databases of DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 317 case law—the reported legal decisions carried by Lexis, among others— 1 are useful, they are far from complete records of a person’s or company’s 2 litigation history.) For New York and several other states, a database 3 called Superior Information Services identifies defendants and plaintiffs, 4 as well as some of the lawyers on each side. But old cases or current 5 ones in some areas are frequently not accessible through computerized 6 databases. 7 Public Access to Court Electronic Records (PACER) is the U.S. gov- 8 ernment’s service to search federal district courts and bankruptcy court 9 dockets. Although these online searches may be unwieldy—covering the 10 whole country requires dozens of searches—other services like 11 CourtLink provide easier-to-use interfaces to these records. 12 Has the company ever been involved in “nonmaterial” litigation? 13 Litigation brought against a target is often worth reviewing even when 14 it is not material, active, or financially significant. Even lawsuits brought 15 by a company can provide insights into its operations and vulnerabilities. 16 A careful investor steered clear of one of the best-known corporate 17 frauds of the 1980s, ZZZZ Best, after due diligence turned up a case in 18 small-claims court that revealed part of the scam. Others who plunged 19 in based on shallower due diligence got swindled. 20 Inactive and immaterial cases can also show a company’s pattern of 21 bad relationships with lenders, customers, vendors, or employees. 22 Depositions taken of a company’s executives can be particularly reveal- 23 ing. There’s nothing like reading a transcript of a person’s sworn answers 24 to pointed questions to see how that person responds to pressure. 25 Are relations with key vendors and customers at arm’s length? 26 Investigators working for due diligence professionals are sometimes 27 assigned to determine whether the target’s significant customers and 28 suppliers have arm’s-length relationships with it. Look for undisclosed 29 ties like those reported not long ago in the business press about a 30 Belgian software maker. Published articles alleged that the Belgian com- 31 pany helped set up and finance Singaporean “customers” who, in turn, 32 bought software licenses from the Belgian company, boosting its report- 33 ed revenues significantly. Government investigations ensued, and the 34 Belgian company ultimately filed for bankruptcy. 35 In one case, due diligence investigators searched for the reasons 36 behind a target company’s relatively large volume of returned goods. To 37 318 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 determine whether the goods were shipped to inflate the prior quarter’s 2 revenue, investigators considered whether the target loosened its terms 3 on accepting returns (it had), and whether the customers doing the 4 returning had undisclosed ties to the company (they appeared to). 5 One database by which to identify cross-border customers is PIERS 6 (Port Import Export Reporting Service), a Dialog database that tracks 7 the manifests of freighters shipping cargo into and out of U.S. seaports. 8 A company contemplating business with an Indonesian company want- 9 ed to identify its U.S. customers before opening negotiations. At the 10 conclusion of a PIERS search, the company’s investigators had compiled 11 a list of more than 200 imports to scores of U.S. companies and were 12 able to build a comprehensive picture of the Indonesian company’s busi- 13 ness relationships with U.S. companies. 14 Is the target associated with questionable people? Check the 15 backgrounds of various kinds of individuals who are tied to a target, 16 including the following: 17 t Local agents in corruption-prone countries, whose reputations 18 might be worrisome in light of the U.S. Foreign Corrupt Practices Act 19 t Brokers and other financial consultants from obscure securities 20 firms who have stock-purchase warrants, board seats, or other ties, and 21 who may have checkered regulatory histories 22 t Labor relations consultants, finders of financing, and other agents 23 of the company who may have questionable reputations 24 25 26 Increased Pressure on Due Diligence Professionals 27 Due diligence professionals ignore at their peril information available 28 through new technology and through the old tried-and-true investigative 29 methods. The vast expansion of available data (and the misperception 30 among companies and the public that the Internet has put all information 31 within easy reach) spells trouble for professionals who do not use or keep 32 abreast of the evolving technology. At the same time, it is clear that the 33 new technology, while extraordinarily useful, is not a substitute for old- 34 fashioned legwork, interviews, and other data-gathering methods. 35 As an example of the former, consider the case of a large accounting 36 firm that conducted due diligence on a U.S. company on behalf of a 37 European investor. The accounting firm ran its standard background DUE DILIGENCE INVESTIGATIVE TECHNOLOGY AND KNOW-HOW 319 check on the president of the American company, which was, let’s say, in 1 Miami. The transaction went forward. As soon as it became public, the 2 client received a fax from someone in Miami: Some months before, the 3 local newspaper had accused the president of securities fraud and 4 revealed an active SEC investigation of him. It turned out that the 5 accountants’ due diligence check had used a standard database of news 6 articles, and the Miami newspaper was searchable only on a more 7 obscure database. 8 Another example: Until recently, due diligence professionals, seeking 9 to learn whether a public interest group in another country had negative 10 information on the target, would have spent many hours making in- 11 quiries. Today, that information is likely to be cited on the group’s web- 12 site, a few hours of quiet research away. 13 The new technology has expanded the concept of the international 14 public record, which opens new opportunities for due diligence profes- 15 sionals. Thus, electronically available information can provide certain 16 avenues on which to proceed, outside the confines of the target and its 17 representations, toward independent information and expertise. 18 The new technology, however, is not a panacea. Although it provides 19 valuable leads to the truth about some issues, the team also may need a 20 more old-fashioned detective’s skill: that of eliciting the truth from 21 strangers. In that regard, the electronically available data can lead due 22 diligence professionals to knowledgeable, reliable people. Such people— 23 regulators, activists, competitors, former employees, academics, re- 24 porters, litigation opponents, and so on—are clearly free to hang up the 25 phone. But surprisingly often they don’t, and the information elicited 26 from them can move the due diligence process dramatically forward. 27 28 29 30 31 32 33 34 35 36 37 CHECKLIST 1 Due Diligence Investigative Technology 2 3 and Know-How 4 5 BACKGROUNDS OF KEY EXECUTIVES 6 1. Where has the executive lived and worked? 7 ❏ Check for current and past addresses. 8 9 2. Confirm his/her identifiers, such as date of birth. 10 ❏ Check for possible aliases in databases such as AutoTrackXP. 11 12 3. Start your press searches with the hometown newspaper. 13 ❏ Use “Fulltext Sources Online” to identify relevant papers. 14 ❏ If the hometown paper isn’t online, call or visit the local library, or 15 try a clipping service, which is especially helpful in international 16 searches. 17 18 4. Search large media databases like Nexis, but don’t limit yourself to 19 them. 20 ❏ Include searches of television and radio transcripts through Burrelle’s 21 Information Services, for example. 22 23 5. Check to see if he/she has a criminal record or has filed for bankruptcy. 24 ❏ Be sure to check all jurisdictions where he/she has lived and worked. 25 ❏ Double-check any representations he/she makes about where he/she 26 is from. 27 28 6. Investigate any lack of candor, especially in a résumé or other written 29 statement. 30 ❏ Pay close attention to the dates in résumés for any evidence that they 31 have been “stretched” to cover undisclosed past jobs. 32 ❏ Be persistent in drilling down on possibly false claims: Keep calling 33 that college registrar’s office until it opens its records to you. 34 35 7. Was the executive successful and trustworthy at past jobs? 36 ❏ Identify and quietly interview former coworkers for their candid 37 assessment of his/her tenure and how his/her job ended. 38 39 40

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8. Check for self-dealing issues, as manifested in secret “side companies.” 1 ❏ Run his/her home address and telephone number through a data- 2 base such as Dun & Bradstreet to see if any company names appear. 3 ❏ Be wary of any companies run from other addresses, such as a P.O. 4 box or a country house. 5 6 9. Does the executive have relationships with questionable people? 7 ❏ Search news coverage and court filings for business associates. 8 ❏ Run his/her name through websites like www.pir.org, which has 9 indexed out-of-print books and magazine articles. 10 11 CONCERNS ABOUT THE BUSINESS PRACTICES OF THE 12 TARGET COMPANY 13 10. Are regulators preparing to take action, or have they already done so? 14 ❏ Identify which agencies regulate the target company’s industry and 15 search those agencies for material such as past subpoenas, consent 16 decrees, and hearing transcripts. 17 ❏ Familiarize yourself with any relevant freedom of information laws, 18 which can facilitate the gathering of regulatory information. 19 20 11. Has the company had tax trouble? 21 ❏ Pay special attention to any long-term outstanding tax liens, or to a 22 flurry of liens filed over a short time period. 23 ❏ Make inquiries with the U.S. Tax Court in Washington, D.C. 24 25 12. Was the company implicated in a specific industry scandal? 26 ❏ Pull copies of filings in any relevant criminal cases, and quietly inter- 27 view sources knowledgeable about the prosecution. 28 ❏ Keep in mind resources like the U.S. Office of Foreign Assets 29 Control’s list of “blocked persons,” who have violated economic and 30 trade sanctions. 31 32 13. Has the company been targeted by consumer or international human- 33 rights groups? 34 ❏ Obtain past issues of relevant consumer-group newsletters and check 35 their websites. 36 ❏ Be certain that the company isn’t doing anything outside the U.S. 37 and Europe in an effort to skirt environmental, labor, or human-sub- 38 ject testing regulations in those places. 39 40 322 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 14. Concerns about intellectual property 2 ❏ Research the viability of IP technology in industry-specific trade journals. 3 ❏ Check databases for former regulatory-agency officials with expert 4 knowledge of how the regulatory process is likely to go. 5 ❏ Pay close attention to whether the company acquired its technology 6 under circumstances that may cause controversy or dispute, and 7 whether any such dispute is being litigated in U.S. or foreign courts. 8 9 15. Has the company been involved in litigation? 10 ❏ Consult databases such as Superior Information Services, Lexis, and 11 CourtLink to help identify whether the company has litigated on the 12 federal, state, or local levels. 13 ❏ Pay attention to seemingly “insignificant” or small-claims litigation 14 that can provide insights into the company’s operations and vulnera- 15 bilities, or show a pattern of behavior with respect to lenders, cus- 16 tomers, vendors, or employees. 17 ❏ Remember that not all courts can be accessed online. 18 19 16. Are transactions with key vendors and customers at arm’s length? 20 ❏ Look for indications that the company has financed any of its key 21 customers. 22 ❏ Databases such as PIERS (Port Import Export Reporting Service) may 23 help to identify cross-border customers of the company. 24 25 17. Is the company associated with questionable people? 26 ❏ Vet any of the company’s local agents in corruption-prone countries 27 whose reputations might be worrisome in light of the Foreign 28 Corrupt Practices Act. 29 ❏ Examine any of the company’s brokers or other financial consultants 30 from obscure securities firms who have stock-purchase warrants, 31 board seats, or other ties. 32 33 34 35 36 37 38 39 40 1 2 APPENDIX: Cross-Border 3 4 Due Diligence in an Age of 5 6 7 International Terrorism 8 9 10 11 12 13 14 15 he seismic events of September 11, 2001, have had profound 16 effects on the political, social, and economic fabric of the United 17 T States and elsewhere. What these events and others following in 18 their wake portend in a period when no nation is immune from the 19 specter of terrorism only time will tell. Surely, however, those engaged in 20 cross-border transactions need to consider the potential impact of terror- 21 ism not only in those areas of the world where such activities have long 22 been a part of the landscape but also in places that, until very recently, 23 were thought to be havens of domestic tranquility. In the checklist that 24 follows, the chapter contributors offer their visions of how the threat of 25 terrorism may affect cross-border due diligence. Like any checklist, not all 26 of its suggestions will apply in every working environment. It is one thing 27 to investigate security measures taken by a company headquartered in the 28 Empire State Building or with a manufacturing facility in Peshawar, 29 Pakistan, and quite another when the target is located in a small office 30 complex in rural France. Therefore, use this checklist as appropriate in the 31 context of each cross-border due diligence investigation. 32 33 34 35 36 37

323 324 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 STRATEGIC DUE DILIGENCE 2 Apart from their baleful effect on specific industries like airlines and tourism, 3 the events of 9/11 have accelerated a global slowdown whose duration is 4 anybody’s guess. Thus, those events should cause corporate planners 5 engaged in cross-border due diligence to consider at least two major new 6 questions: (1) How will the increased international turbulence of the post- 7 9/11 era affect the value creation premises of the proposed transaction, and 8 (2) What added cross-border due diligence complexities should be consid- 9 ered in light of the new era? 10 11 1. Regarding the value-creation premises of the deal 12 ❏ What has been the impact on the market in which the target par- 13 ticipates? Should the market’s growth prospects be revisited and 14 projections (up or down) revised? What is the expected short-term 15 versus long-term impact of terrorism? Thus, for example, growth in 16 the U.K. tourism industry will be negatively affected by a likely decrease in the number of U.S. tourists; however, this is likely to be 17 somewhat offset by an increase in British tourists deciding to vaca- 18 tion at home instead of abroad. In the markets under consideration 19 in the transaction, it is critical to consider the potential impact on the 20 drivers of growth described in the main text of this book. 21 ❏ Have we properly defined the market? What is the likely impact of ter- 22 rorism on the customer and geographic segments in which the target 23 participates? Consider the fact that the prospects for casualty insurers 24 may be different from those of life insurers. Incorrect market defini- 25 tion could lead to an improper assessment of the potential effects. 26 ❏ How (if at all) have the events of 9/11 and since affected the com- 27 petitive position of the target company? Since 9/11 is the target’s 28 position better, worse, or the same in an absolute sense and versus 29 its competitors? How do terrorism and possible cost increases in its wake affect the target with a superior cost position? Could such a 30 company aggressively cut prices to stimulate demand and use bad 31 times to take market share away from competitors? 32 ❏ Does increased turbulence affect the deal’s strategic rationale? If the 33 buyer’s intent is to pursue adjacency expansion, are the markets still 34 attractive? If it proposes to gain scale in purchasing, how have the 35 events of 9/11 and thereafter affected supplier costs? 36 37 CROSS-BORDER DUE DILIGENCE IN AN AGE OF INTERNATIONAL TERRORISM 325

2. Regarding the additional complexities of the deal process 1 ❏ Will market dynamics change? Will consumers react the same way in 2 all markets? For example, purchasing patterns of Americans may 3 change dramatically. Throughout the year following 9/11/01, 4 Americans were spending less on air travel and more on cars. Will 5 this trend continue, and if so, for how long? Meanwhile, changes in 6 consumer spending in the United Kingdom probably will not be as 7 pronounced or prolonged, given Britain’s distance from the disaster 8 and British citizens’ unfortunate familiarity with terrorism. 9 ❏ Will the regulatory/legal environment change? Could trade restrictions be imposed on certain countries? Might increased security measures 10 adversely affect the buyer or the target? For example, growth prospects 11 for a German target with significant exports to the Middle East and Asia 12 may be significantly reduced if trade restrictions are imposed in the lat- 13 ter regions by the European Union or the United States. 14 15 OPERATIONAL DUE DILIGENCE 16 The events of 9/11 require revisiting the assumptions made by one or both 17 parties before that date about the size and character of the market, as dis- 18 cussed above. Given a material change in the assumptions, the pricing of 19 the transaction itself may require revision. In addition, the events highlight 20 systemic risk issues related to the target company’s positioning in a world 21 where there is likely to be a greater long-term focus on security needs. 22 23 ❏ It is generally assumed that transportation of goods will become 24 more cumbersome, costly, and time-consuming as security measures 25 are ramped up. What are the resulting implications for the target’s 26 suppliers and customer relationships? 27 ❏ Does just-in-time inventory management need to be revisited? 28 ❏ Are there other scheduling effects that require revision, such as a 29 need to adjust critical path analyses? 30 ❏ Describe whether (if at all) the target’s products/services and its 31 value production cycle will need to be altered to respond to employees’ and the public’s greater awareness of security risks 32 (e.g., enhanced screening of employees, improved information 33 gathering and dissemination regarding possible risks, tightened 34 physical security, improvements in materials handling, need for 35 evacuation plans). 36 37 326 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 ❏ Are there critical raw materials that are at greater than historical risk 2 in the changed or uncertain political environments that have been 3 affected by the events of 9/11? If so, can they be stockpiled or oth- 4 erwise safeguarded? ❏ 5 Are information systems adequately backed up on a “hot backup” 6 basis and otherwise sufficiently redundant and robust? Are there physically dispersed personnel who can handle systems recovery and 7 switchover to the backup? 8 ❏ Are advertising and marketing messages properly positioned in light 9 of the public’s current heightened and varied sensibilities? 10 ❏ What are the likely effects of recent events on the company’s insur- 11 ance needs and the cost and availability of coverage? 12 ❏ Are the company’s facilities and personnel optimally sited, weighing 13 the benefits of physical proximity against mitigation of risk? If not, 14 should there be a rapid redeployment or just a gradual evolution 15 toward a different building/staffing model? 16 ❏ Revisit utilities and other infrastructure support—water, electricity, 17 and communications. What are the implication for the target of any 18 air travel or other transport disruptions? ❏ 19 Are there some areas of business where the risk profile has changed so dramatically that a pullback should be considered? Or 20 are there opportunities for the target in the changed environment? 21 ❏ Does bioterrorism offer a real threat of product contamination? If so, 22 what steps have been taken to mitigate the risk? 23 ❏ Is there a policy to scan, for electronic retrieval and backup, docu- 24 ments received (other than online) from third parties? 25 26 FINANCIAL AND ACCOUNTING DUE DILIGENCE 27 The effect of terrorism on financial due diligence will vary somewhat 28 depending on whether the target was directly or only indirectly affected by 29 acts of terror. 30 31 1. For those targets directly affected by terrorism 32 ❏ How was the loss and the recovery recorded? Was the accounting 33 applied in a correct and appropriate manner for the circumstance? 34 ❏ What additional costs have been or were likely to be incurred over 35 the subsequent two years in the wake of 9/11? Have financial pro- 36 jections been revised to reflect these costs? 37 CROSS-BORDER DUE DILIGENCE IN AN AGE OF INTERNATIONAL TERRORISM 327

❏ Have any assets become impaired as a result of the business disrup- 1 tion? Did the target have business interruption insurance? 2 2. For those targets indirectly affected by terrorism 3 ❏ Has the target’s industry been adversely affected? What steps, if any, 4 has the target taken to replace lost revenues or to decrease its costs? 5 Have any discount pricing measures been implemented? If so, with 6 what prospective outcome? 7 ❏ If revenues have decreased, and such decreases are expected to con- 8 tinue, have any assets been impaired? Are there assets whose recov- 9 erability is not assured, and if so, have appropriate accounting adjust- ments been made? 10 ❏ If the target had made recent investments or acquisitions and good- 11 will was generated, has the goodwill (or other intangibles) generated 12 from such acquisition been impaired, and is an impairment adjust- 13 ment required? Consider whether the financial projections prepared 14 in conjunction with any investment have been made obsolete by the 15 events of 9/11 and thereafter. 16 ❏ Is the target company considering any workforce reductions or any 17 other operational measures, such as plant or office closings, which 18 may be accounted for using a restructuring charge? 19 ❏ Is the target company considering any security enhancement measures 20 that will require additional capital investments? If so, what is the likely 21 impact of such investments on the target’s operations and liquidity? 22 ❏ Has the target recorded any unusual, one-time increased revenues resulting from the events of 9/11? Consider nonrecurring revenues. 23 For example, companies in industries used to remove the debris from 24 the World Trade Center would have received substantial payments, 25 which should be considered one-time opportunities. 26 ❏ Does the target own any products, patents, or other assets that ter- 27 rorism or its consequences may have caused materially to increase or 28 decrease in value? 29 30 LEGAL DUE DILIGENCE 31 The events of 9/11 and those that have followed (such as anthrax by mail) 32 and may follow add to the risks to be explored, uncovered, and evaluated 33 in due diligence on inbound and outbound transactions. Among the risks 34 calling for close scrutiny are the following: 35 36 37 328 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 1. Insurance 2 ❏ Was there adequate insurance in place for a target directly affected 3 by the events of 9/11 to recover its losses? 4 ❏ Have claims been timely and properly notified to the insurers? What 5 has been the response thus far from the insurers? ❏ 6 Do existing insurance policies (casualty and business interruption, in particular) make acts of terror an exception? If so, what is the avail- 7 ability and cost of policies specifically designed to cover such an 8 exposure? 9 ❏ Is acts-of-terror coverage sufficient to cover reasonably foreseeable 10 terror scenarios (e.g., evacuation and temporary idling of facilities 11 due to bioterror, such as happened at post office facilities)? 12 13 2. Other material agreements 14 ❏ In the event of a terrorist incident affecting the target or its contrac- 15 tual counterparties under material agreements to which the target is 16 a party, to what extent does the wording of the agreements excuse 17 performance by either party? Examine “force majeure” and “com- 18 mercial impracticability” provisions, considering also any mandatory 19 provisions of relevant decrees under applicable foreign law. ❏ To what extent would “material adverse change”/“material adverse 20 effect” clauses in pending agreements be triggered by a terrorist event? 21 ❏ Has the target or any of its contractual counterparties invoked or 22 threatened to invoke any such provisions excusing performance? 23 ❏ Do notice provisions in any material contracts provide for notices to 24 be sent to the World Trade Center or other destroyed or interrupted 25 locations? Check that notices sent on or about 9/11 were subse- 26 quently effectively given. 27 28 3. Real estate, raw materials, and finished goods 29 ❏ What do provisions in real estate and equipment leases (and pending 30 purchase or sale contracts) say about complete or partial destruction 31 of the structure or equipment or its temporary unavailability? Will the 32 target be compelled to return to the property or continue to use the 33 equipment upon repair or replacement, or can it enter into long-term 34 replacement arrangements? 35 ❏ Does the target have adequate security arrangements in place at 36 each of its facilities? Is there a centralized security policy on a world- 37 CROSS-BORDER DUE DILIGENCE IN AN AGE OF INTERNATIONAL TERRORISM 329

wide or national basis, taking into account the heightened security 1 called for at higher-profile facilities (e.g., where hazardous materials 2 are used, power plants, etc.)? 3 ❏ Are security arrangements in compliance with applicable laws (e.g., 4 freedom of speech; avoidance of potentially unlawful screening 5 based on race, national origin, or religion)? 6 ❏ Have the target’s products, or the raw materials used by the target, 7 been made subject to any special security-related rules, surveillance, 8 or transport or use requirements (e.g., crop-duster aircraft; materials 9 usable in explosives)? 10 11 4. Management, employees, agents, customers, and suppliers 12 ❏ Do the target’s employment and contracting procedures and record 13 keeping (e.g., end-user certificates) ensure that it properly knows its employees, agents, customers, and suppliers? If not, should reviews 14 be conducted? 15 ❏ Have there been any government or law enforcement inquiries about 16 the target or any employees, agents, customers, or suppliers, and has 17 the target prepared for such inquiries (taking into account applicable 18 rights of privacy and contractual confidentiality obligations, as well as 19 disclosure obligations)? 20 ❏ Does the target suspect that any employees, agents, customers, or 21 suppliers may be connected with terrorist organizations or activities, 22 and if so, have any remedial steps been taken? What steps? 23 ❏ Have operations been affected by departure of military reservists, and 24 have applicable regulations been followed as to their tenure, bene- 25 fits, and other rights? 26 ❏ Have applicable regulations been followed in connection with chari- table solicitations by well-intentioned employees, as well as by the 27 target itself? Check that the target is not making donations to pro- 28 scribed charities or permitting fund-raising by them on the premises. 29 ❏ Is the target subject to the USA Patriot Act, and if so, is the target in 30 full compliance with this new anti-money-laundering legislation? (It 31 requires, among other things, that U.S. financial institutions having 32 certain accounts for non-U.S. persons establish “appropriate, specif- 33 ic, and where necessary, enhanced due diligence policies, proce- 34 dures, and controls that are reasonably designed to detect and report 35 instances of money laundering through those accounts.”) 36 37 330 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 5. Pending legal and regulatory matters 2 ❏ Have lawyers or other professionals involved in the target’s current 3 legal or regulatory matters been directly affected by the events of 4 9/11 and thereafter? If yes, have any necessary original documents 5 been lost, or has the progress or prospects of the matter been mate- 6 rially affected? ❏ Has the terror risk itself affected the prospects for any sought regu- 7 latory approvals? 8 9 TAX DUE DILIGENCE 10 The tragedy of 9/11 has clear and immediate implications for the tax due 11 diligence process. Among them are the following: 12 13 ❏ As a result of the President’s or the IRS’s federal disaster declarations 14 for five New York counties and Arlington County, Virginia, the need 15 to obtain details by the regular due date for each taxpayer claim for 16 relief from performing any of the filing or payment obligations set 17 forth in the six items listed below 18 t Filing any income, excise, harbor maintenance, alcohol and 19 tobacco, or employment tax return 20 t Payment of any of such taxes, including installments due thereon 21 t Contributions to a qualified retirement plan 22 t Filing a petition with the Tax Court or for review of a decision 23 rendered by the Tax Court 24 t Filing a claim or instituting a suit for tax credit or refund Any other act specified in a revenue ruling, procedure, notice, 25 t announcement, news release, or other guidance published in the 26 Internal Revenue Bulletin 27 ❏ The need to obtain details concerning original books and records, 28 financial information, tax return reporting information, or other rele- 29 vant tax due diligence data lost or missing as a result of the 9/11 fed- 30 eral disasters, without regard to the taxpayer’s location, including the 31 following: 32 t Nature of items missing 33 t Existence of backup data 34 t Degree of difficulty to replace 35 ❏ The need to obtain details of any 9/11 claimed casualty loss deduction. ❏ 36 The need to obtain details of any unresolved insurance matters exist- 37 ing as of the tax return filing claiming a casualty loss deduction. CROSS-BORDER DUE DILIGENCE IN AN AGE OF INTERNATIONAL TERRORISM 331

❏ The need to obtain details of any secondary data sites for tax-related 1 information existing prior to or installed after 9/11, including the fol- 2 lowing: 3 t Site location 4 t Breadth of data 5 t Degree of detail 6 Security of data t 7 Results within the past twelve months of testing secondary site t 8 for reliability 9 PEOPLE AND ORGANIZATIONAL DUE DILIGENCE 10 11 Before 9/11 fewer than 30 percent of U.S. corporations had terrorism 12 response plans and more than 40 percent had no policies to deal with 13 potential employee Internet sabotage, although nearly that many had expe- 14 rienced such acts in one form or another. In the people/organizational due 15 diligence effort, the team should ask the following key questions: 16 17 ❏ Is there a corporate security officer, and if so, to whom does that per- 18 son report? ❏ Has the target evaluated the impact of September 11 on employee 19 morale and the ability to successfully recruit attractive new hires? 20 ❏ What steps has the target taken to evaluate the risk of terrorist attack 21 and, in the event of such attack, to reduce its risk, including the fol- 22 lowing: 23 t Cessation of operations in or near areas likely to be subjects of 24 attack 25 t Use of contractors in high-risk areas 26 t Workplace security awareness programs 27 t Regular surveillance reports on potential terrorist threats 28 Evacuation procedures t 29 Increased security measures such as guards and executive pro- t 30 tection 31 t Evaluation of expatriate risks such as kidnapping of executives and their families 32 ❏ Is there a disaster succession plan in place for key management? If 33 yes, does it include backup corporate authorizations for important 34 banking, regulatory, and securities matters? 35 ❏ Is there a disaster contingency plan for the target and its units (per- 36 haps modeled on pre-existing Y2K contingency plans)? 37 332 DUE DILIGENCE FOR GLOBAL DEAL MAKING

1 INVESTIGATIVE TECHNOLOGY IN DUE DILIGENCE 2 Companies do business with all sorts of people, including some they really 3 know nothing about other than the name such persons claim to have. These 4 persons may be visitors, the cleaning lady, or even some employees. Since 5 9/11, corporations are increasingly focused on the flight-manifest analogy: 6 He gave me his name, but do I know the real identity of the person who just 7 walked into my conference room? Confirming that people have the identi- 8 ties they claim is as important as patting them down for weapons. There are 9 still Class A buildings where one can get through the “security check” in the 10 lobby by signing in as “Superman.” Often people suspected of engaging in 11 harassment are questioned, causing companies to ask “How did we ever 12 hire that person?” In the personnel file search that follows, often it is dis- 13 covered that a background check was performed but revealed nothing 14 wrong, because the putative harasser gave false identifiers. Thus, persons 15 on either side of the due diligence negotiating table may properly ask the 16 following questions: 17 18 ❏ Has there been adequate assessment of the risk that either company 19 could be hiring or doing business with people associated with ter- 20 rorism? 21 ❏ Have steps been taken to confirm the identities of people with whom 22 the company comes into contact? 23 ❏ If something went wrong with a particular individual with whom the 24 company comes in contact, could the company readily document the 25 person’s identity in order to follow up? 26 ❏ Has the target taken adequate precautions to ensure that unvetted 27 people do not have access to its facilities? ❏ 28 In unstable parts of the world, has the target satisfied itself that the 29 employment agencies it uses are free from terrorist influence and that such agencies check for unsavory ties in the backgrounds of the 30 people they recommend to be hired? 31 32 33 34 35 36 37 1 2 Index 3 4 5 6 7 8 Abbey Healthcare, 255 income taxes, 122–123 9 accounting due diligence losses, provisions for, 125 10 See also financial due diligence; off-book transactions, 126 11 generally accepted accounting related-party transactions, 12 principles (GAAP) 126–127 13 certified public accountants, rela- research and development expen- 14 tionship with independent, ditures, 122 120–122 active investing, 23–24 15 checklist, 134–148 activist groups, 315 16 closely held companies, 115–116 adjacency, 24–25 17 common mistakes, 102–103 due diligence for, 41–42, 50 18 data processing systems, 131–132 Alidata, 305 19 defined, 101 Allen, James, 25 20 discontinued operations, 116–118 American National Can (ANC), 39 income taxes, 122–123, 130–131 Anglo-Saxon due diligence, 4, 257 21 integrity and qualification of Angwin, Duncan, 35 22 employees/management and, antitrust, 173–177, 206 23 119–120 AOL, 26, 27, 36, 44 24 inventory accounting methods and Archer-Daniels-Midland, 175–176 25 taxes, 217 Asea Brown Boveri (ABB), 13–14 26 management, pressure on, 102 asset acquisitions need to address all issues, 103–104 checklist, 243–244 27 procedures, 114–133 employee benefits and, 217–218 28 restructurings, 114–115 foreign subsidiary shares as part of, 29 statutory, regulatory, and legal 220–222 30 requirements, 127–128 indebtedness, 231–232 31 terrorism, effects of, 326–327 nonfederal taxes and, 224–228 32 accounting issues, considerations in post-acquisition issues, 232 evaluating structuring, 230–231 33 barter transactions, 125–126 target’s operations and structure, 34 employee stock plans, 124 212–216 35 environmental issues, 124–125 taxes and, 212–232 36 going concern issues, 123–124 transfer pricing, 222–224 37

333 334 INDEX

1 valuation, 229–230 Canada, discontinued operations in, 2 verifying numbers, 106–108 117 asset reappraisals, 110 Canadian Registration of Personal 3 ASTM (American Society for Testing Property Obligations Act, 186 4 and Materials), 170 Canal Plus, 72 5 Astra, 64 capabilities, analysis of, 17 6 AT&T, 256 capacity, analysis of, 87–88 7 Audi, 72 Carnegie, Andrew, 155 8 Australia, discontinued operations in, Carrefour, 73 116–117 Casino, 73 9 Austria, discontinued operations in, Cendant, 156–157 10 117 Central Bank, 127 11 AutoTrackXP, 307 certified public accountants, relation- 12 ship with independent, 13 background checks, 307–310, 120–122 14 320–321 CFO Magazine, 73 Bain & Co., 13, 21, 44 checklists 15 Bain Capital, 23–24 for accounting/financial due dili- 16 Balanced Scorecard method, 259 gence, 134–148 17 Banana Republic, 59 for investigative technology, 18 bank accounts, 195–196 320–322 19 barter transactions, 125–126 for legal due diligence, 191–207 20 Bay Networks, 25 for operational due diligence, Ben & Jerry’s, 254, 255, 266 75–99 21 benchmarking, 16 for organizational due diligence, 22 competitor, 31–32 295–302 23 best demonstrated practices (BDPs), 16 for strategic due diligence, 48–50 24 Best Foods, 254 for tax due diligence, 241–251 25 Biotech LLC, 229–230 check-the-box election, 214, 239 26 BMW, 59, 69–71 Chrysler Corp., 10, 59, 69–71, 261, Börjesson, Rolf, 39–40 268 27 Bower, Joseph L., 26 Cisco Systems, 25, 43 28 brands, operational due diligence Citibank, 66 29 and, 59–60, 83 Citicorp, 25, 36 30 Bridgestone, 68–69 Citigroup, 25 31 British American Tobacco (BAT), 14 Clayton Act, 174 32 Brooks Brothers, 59–60 closely held companies, 115–116 Broughton, Martin, 14 commercial review. See strategic due 33 Burrelle’s Information Services, 306 diligence 34 business definition matrix, 29, 30 communication 35 Business Week, 156–157 corporate culture and, 264 36 Mercer Management study, 2 indicators of external corporate, 37 Campeau, 27 270 INDEX 335

indicators of internal corporate, 296–297 1 271–272 culture 2 patterns and processes, 267–270, corporate, 65–68, 96–99, 3 297–298 263–265 of results, 167–169 national, 261–263 4 communication problems, 150–151 customers 5 translators, use of, 162–163 analysis of, 16, 28, 32–33, 48, 49 6 company operational due diligence and, 7 analysis/growth opportunities, 28, 58–59 8 33–35, 48–49 9 price elasticity, 32–33 Daimler-Benz, 10, 59, 69–71, 261, competition, 10 268 10 analysis of, 16–17 DaimlerChrysler, 59, 66, 67, 70–71, 11 benchmarking, 31–32 255 12 dynamics, 31 data processing systems, 131–132 13 market map, 31 data room, use of, 163 14 positioning, 28, 31–32, 48, 49 Dean Witter, 17–18, 66, 268 15 Computer Associates International debt-to-equity ratios, 231–232 Inc., 177 decision making, corporate culture 16 controlled foreign corporations and, 264 17 (CFCs), 246 defensive due diligence, 154 18 Coopers & Lybrand, 66 deferred taxes, 111 19 copyright issues, 178–180 Denmark, discontinued operations in, 20 corporate culture, 65–68, 263–265 117 21 checklist, 96–99 Deutsche Telekom, 61 corporate structure checklist, Diageo, 26 22 241–242 discontinued operations, 116–118 23 corporate values, 265 disputes, investigating, 316–318 24 costs DLJ, 67 25 of achieving adjacency, 41–42 documents, legal review of, 165–167 26 analysis of, 15–16, 48 due diligence 27 CourtLink, 317 See also under type of cross-border transactions defined, 3–4 28 operational due diligence and, integrating efforts, 11–12 29 52–53 what constitutes financial, 7–9 30 strategic due diligence and, 22–23, what constitutes legal, 6–7 31 35–36 what constitutes operational, 9–11 32 success matrix, 45, 46 who is involved in, 4–5 33 cross-selling, 41–42 types of, 4 CSFB, 67 Dun & Bradstreet, 306 34 cultural differences, 35–36 DuPont, 26 35 cultural factors, organizational due duties, organizing and delegating, 36 diligence and, 261–265, 164–165 37 336 INDEX

1 80/20 rule, 214, 220, 233, 237 generally accepted accounting 2 Electronic Data Systems (EDS), 261 principles (GAAP) Emerson, 25 checklist, 134–148 3 Employee Retirement Income common mistakes, 102–103 4 Security Act (ERISA) (1974), data processing systems, 131–132 5 7, 218 defined, 101 6 employees, 10 documents to be requested from 7 benefits and asset acquisition target company, 134–145 8 issues, 217–218 inbound transactions, 109 benefits and share transfers, income issues to be evaluated, 9 236–237 146–148 10 benefits checklist and taxes, income taxes, 122–123, 130–131 11 247–249 industry practices, 129–130 12 checklist, 94–96, 247–249 information needed, 135–137 13 integrity and qualifications of, management, pressure on, 102 14 119–120 need to address all issues, 103–104 inventions of, 178–180 organizational due diligence and, 15 legal due diligence and, 202–203 279, 281, 282–283, 299–300 16 operational due diligence and, outbound transactions in devel- 17 65–68 oped countries, 110–113 18 organizational due diligence and, outbound transactions in emerging 19 270, 272–275, 298 countries, 113–114 20 stock plans, 124 procedures, 104–114 terminating, without liability, terrorism, effects of, 326–327 21 188–189 verifying numbers, 106–109 22 environmental issues, 124–125 what constitutes, 7–9 23 documentation on, 141–142 financial professionals, role of, 5 24 legal due diligence and, 169–173, financial statements, 111, 195, 243 25 200–201 Fine Papers, 60 26 escheat, 148 Firestone, 68–69 estoppel certificates, 165–166 Foreign Corrupt Practices Act, 318 27 European Commission, 36 foreign tax credits (FTCs), 219, 221, 28 European Union, 5, 6, 173, 227 237–238, 246–247 29 executives. See management France, discontinued operations in, 30 Exon-Florio procedures, 182 117 31 FrozFood, Inc., 223 32 Federal Trade Commission (FTC), Fulltext Sources Online, 305 312 33 Federated, 27 Gap, The, 59 34 feedback, cultural differences and, Gartner Group, 23–24 35 263 GE Capital, 25, 73 36 financial due diligence GE Lighting Tungsram, 253 37 See also accounting due diligence; General Electric (GE), 25, 27, 36, INDEX 337

45, 155, 173, 253–254, 257, IBP, 153, 168, 169, 256 1 261, 269 inbound transactions, 2, 109, 127, 2 generally accepted accounting princi- 157, 173–175, 184, 207, 327 3 ples (GAAP) income taxes, 122–123, 130–131, industry accepted and, 128–129 146–147 4 generally accepted accounting princi- industry dynamics and trends, 29–30 5 ples (GAAP), differences industry practices, financial reporting 6 between U.S. and Colombian and, 129–130 7 asset reappraisals, 110 inflation, accounting for, 112 8 deferred taxes, 111 information systems, 278–279, 9 financial statements, basic, 111 280–281, 299 inflation accounting, 112 information technology (IT) and 10 pensions, 112 communications, operational 11 prior period adjustments, 112–113 due diligence and, 57, 61–62, 12 revenue recognition, 113 64–65 13 General Motors (GM), 26 checklist, 90–93 14 Germany, discontinued operations in, legal due diligence and, 202 15 117 insurance, 154, 205–206, 328 Gillette, 17 Intel, 25, 43 16 Glaxo Wellcome, 24, 27, 64 intellectual property (IP), 63 17 going concern issues, 123–124 checklist, 90–93 18 golden parachutes, 236 concerns about, 315–316 19 Grand Met, 26 legal due diligence and, 177–182, 20 growth opportunities, 33–35 202 21 Guinness, 26, 261 intellectual property holding company (IPHC), 223 22 HardwareCo, Inc., 223 International Accounting Standards 23 Hart-Scott-Rodino (HSR), 155 (IAS), 116 24 Harvard Business Review, 24, 52, Internet, use of, 166–167 25 59, 64 intranet sites, 163–164 26 Harvard Business School, 13 inventory account methods, 217 27 Homedco Group, 255 inventory analysis, 80, 198 Honeywell, 6, 27, 36, 45, 155, 173 investigations/investigative technology 28 Hong Kong Securities and Futures background checks, 307–311, 29 Commission, 313 320–321 30 Houlihan Lokey Howard & Zukin, 2 of business practices of target com- 31 HSR, 174, 177 pany, 311–318, 321–322 32 Hubbert, Juergen, 69 checklist, 320–322 33 human resources (HR), 291–294, follow-up, 311 302 how to use, 304 34 human-rights groups, 315 terrorism, effects of, 332 35 hybrid entities, 230–231 Italy, discontinued operations in, 117 36 37 338 INDEX

1 James Mintz Group, 303, 313 searches/investigations, conduct- 2 Japan, discontinued operations in, ing, 165–167 117 legal due diligence, risk exposure 3 J. Crew, 59 areas in 4 Johnson & Johnson, 267 antitrust, 173–177 5 joint ventures, 211–212 environmental, 169–173 6 intellectual property, 177–182 7 Kaplan, Robert S., 259 litigation, 183–185 8 A.T. Kearney, 261 national security implications, KKR, 27 182–183 9 Kozlowski, Dennis, 73 security interests of creditors, 10 KPMG, 2, 53 186–188 11 Krekel, Tig, 59 terminating employment and mar- 12 keting relationships without lia- 13 labor relations, 203–204 bility, 188–189 14 languages clause, 150–151 legal professionals, role of, 5 Lauren, Ralph, 59 legal requirements, financial/account- 15 laws, documents showing compliance ing issues and, 127–128 16 with, 137–138 Leschly, Jan, 24, 64 17 lawyers, assigning, 160–164 Lexis, 317 18 leadership styles, differences in, Lexis-Nexis, 166 19 268–269 liability, successor, 207 20 legal due diligence limited liability companies (LLCs), avoiding missed opportunities, 215–216, 226 21 157–158 limited liability partnerships (LLPs), 22 checklist, 191–207 226 23 defined, 149 litigation 24 importance of, 149–150, 155–157 exposure issues, 184–185 25 insurance against risks, 154 investigating, 316–317 26 language and legalese problems, legal due diligence and, 205 150–151 process and timing issues, 27 purpose of, 151–153 183–184 28 terrorism, effects of, 327–330 loans, 196–198 29 timing of deal and, 158–160 Loral, 256 30 what constitutes, 6–7 losses, provisions for, 125 31 legal due diligence, elements of effec- Lycos, 72 32 tive assigning qualified personnel, machinery/equipment, review of, 33 160–164 86–87, 198–199 34 communicating results effectively, management 35 167–169 analysis of, 94–99 36 organizing and delegating duties, background checks, 307–310, 37 164–165 320–321 INDEX 339

integrity and qualifications of, NameBase, 310 1 119–120 national security issues, 182–183 2 profiles of key, 273–274 negotiations, 258–259, 295 3 management information systems Netherlands, discontinued operations (MIS), documents needed for, in, 117–118 4 142–143 new products/services, 9 5 Mannesmann, 61 newspapers, use of local, 305–306 6 manufacturing New York Times, 68 7 operational due diligence and, 57, Nexis, 304 8 61–62 nexus concept, 225–227, 228 9 organizational due diligence and, Nortel Networks, 25 288–291, 301–302 Norton, David P., 259 10 market(s) Norway, discontinued operations in, 11 analysis, 28, 29–30, 48, 49, 78 118 12 demands, 9–10 13 organizational due diligence and, off-book transactions, 126 14 286–288, 300–301 Office of Foreign Assets Control, 314 15 peculiarities of local, 35 Office of Thrift Supervision (OTS), market map, competitor, 31 313 16 Marks & Spencer, 59–60 operational due diligence 17 Matsushita Electric Industrial, 62, checklist, 75–99 18 71–72 contents of, 57–58 19 MCA, 71–72 cross-border issues, 52–53 20 McDonald, Mackey, 52 designing, from a strategic per- 21 memorandum of understanding spective, 53–54 (MOU), 156, 159, 191 examples of what can go right, 22 Mercedes-Benz, 255 72–74 23 mergers and acquisitions, statistics on, examples of what can go wrong, 24 1–2 68–72 25 Mergerstat, 1 framework for, 75–76 26 Merrill Lynch, 68 terrorism, effects of, 325–326 27 Mexico, discontinued operations in, validating and integrating other 117 efforts, 54–57 28 Microsoft Corp., 43, 174 value-creation process, 58–62, 29 mission, 265–267, 297 76–90 30 Mitchell, Mark L., 157 value-creation process, support for, 31 Monsanto, 64 63–68 32 Morgan, J. P., 155 what constitutes, 9–11 33 Morgan Stanley, 66, 268 operational professionals, role of, 5 Motorola, 256 organizational due diligence 34 checklist, 295–302 35 RJR Nabisco, 27 communication patterns and 36 Nader, Ralph, 315 processes, 267–270, 297–298 37 340 INDEX

1 composition of, 256–257, 295 PriceWaterhouse, 66 2 cultural factors, 261–265, pricing, 79 296–297 prior period adjustments, 112–113 3 employee issues, 270, 272–275, Private Eye, 306 4 276, 298 private investigators, use of, 163, 5 functional areas, 278–294 303–304 6 mission, vision, and values, privatization, affects of, 120 7 265–267, 297 process flow analysis, 84–85 8 negotiations, 258–259, 295 product analysis, 77 performance measures, 259–260 Profit from the Core: Growth 9 prior experiences, role of, Strategy in an Era of 10 257–258, 295 Turbulence (Zook and Allen), 11 strategic objectives, 254–255, 295 23, 25 12 structure, 275, 277–278, 299 Public Access to Court Electronic 13 terrorism, effects of, 331 Records (PACER), 317 14 types of deals and, 255–256, 295 public records, international, OSHA, 201 304–305 15 outbound transactions, 1, 4, 110, public securities issuance transactions, 16 113–114, 127, 167, 173–175, 154 17 184–188, 204, 327 purchase multiples, 19, 20 18 outsourcing, 82, 85, 92, 286 19 Quaker Oats, 66 20 Pascal, Blaise, 35 quality control, 87 Peckar, Peter, 2 21 pensions, 112, 236 raw materials, analysis of, 88–89 22 performance measures, 259–260 regulatory issues, 36 23 Pfizer, 24 financial/accounting issues and, 24 Pharmacia AB, 64, 268 127–128 25 Phase I and II studies, 170, 171–172 investigating, of target company, 26 physical plant, review of, 86 312–315 PIERS (Port Import Export related-party transactions, 126–127 27 Reporting Service), 318 research and development 28 Pillsbury, 26 analysis of, 93 29 Platinum Technology International expenditures, 122, 216–217 30 Inc. (PTI), 177 Reserve Bank of India, 313 31 PLM, 39 restructurings, 114–115 32 political environment, impact of, Reuters, 25 132–133 revenue recognition, 113 33 Polo, 59 rewards, cultural differences and, 34 Port Import Export Reporting 262–263 35 Service (PIERS), 318 Rexam, 39–40 36 Possessions Tax Credit, 219 risk 37 price elasticity, 32–33 analysis, 85 INDEX 341

corporate culture and, 263 W.H. Smith, 41–42 1 Roth, John, 25 SmithKline Beecham (SKB), 24, 27, 64 2 Rothmans, 14 Snapple, 66 3 Rover Cars, 59, 69 Sony, 62 Royal Ahold, 73 South Africa, discontinued operations 4 in, 118 5 sales, 10, 80–82, 281, 284–286, 300 Spain, discontinued operations in, 6 SalomonSmithBarney, 66 118 7 scale, 24 staffing analysis, 276 8 due diligence for, 37–41, 49 statutory requirements, 9 Schrempp, Juergen, 71 financial/accounting issues and, Charles Schwab, 25 127–128 10 scope, 25 Stertz, Bradley, 70 11 due diligence for, 43, 50 stock plans, employee, 124 12 Seagram, 26, 71, 72 strategic alliances, 256 13 Sears, 17–18 strategic due diligence 14 SEAT, 72 assessing findings, 45–47 15 Section 338, 238–239 checklist, 48–50 securities company analysis/growth oppor- 16 filings, 195 tunities, 28, 33–35 17 holdings, 195–196 competitive positioning, 28, 18 Securities and Exchange Commission 31–32 19 (SEC), 121, 127, 128, 313 cross-border complexities, role of, 20 Securities Commission, Italian, 313 22–23, 35–36 21 security customer evaluation, 28, 32–33 interests of creditors, 186–188 defined, 18 22 national security issues, 182–183 market analysis, 28, 29–30 23 self-image, corporate culture and, terrorism, effects of, 324–325 24 263 value, achieving, 18–22 25 sellers, authorization of transaction strategic planning 26 by, 193 capabilities, analysis of, 17 27 September 11 events, 323–332 competition, analysis of, 16–17 services, operational due diligence costs, analysis of, 15–16 28 and, 57, 61 customers, analysis of, 16 29 share compensation plans, 236–237 importance of, 18 30 shareholders, legal issues and, strategic rationales 31 192–193 active investing, 23–24 32 share purchases, 108–109 adjacency, 24–25, 41–42 33 checklist, 242 evaluating, 36–37 structuring, 238–239 scale, 24, 37–41 34 taxable, 232–239 scope, 25, 43 35 Skoda, 72 for top ten acquisitions, 27 36 Slim-Fast Foods, 254 transformation, 25–26, 44–45 37 342 INDEX

1 strategy state and local, 147 2 need to understand current, 14 tax-free exchanges, 239–240 planning, 14, 15 terrorism, effects of, 330–331 3 reviewing, 15–18 transactional, 227–228 4 supply chain, analysis of, 62, 88–90 transfer pricing, 222–224, 245 5 Sweden, discontinued operations in, withholding, 219, 235–236 6 118 terminating employees/marketing 7 Switzerland, discontinued operations relationships, without liability, 8 in, 118 188–189 Terra Networks SA, 72 9 Taken for a Ride: How Daimler- terrorism, 323–332 10 Benz Drove Off with Chrysler Tesco, 73 11 (Vlasic and Stertz), 70 third-party consents, 165–166 12 tax due diligence/taxes time, cultural differences and, 262 13 asset acquisitions and, 212–232 Time Warner, 26, 27, 36, 44 14 capital franchise, 147 trade-journal searches, 306 checklist, 241–251 trade secrets, 178–180 15 compliance versus planning, transactional taxes, 227–228 16 209–210 transfer pricing, 222–224, 245 17 consolidated returns, 235, 247 transformation, 25–26 18 coordination, 210 due diligence for, 44–45, 50 19 credits, 219, 221, 237–238, translators, use of, 162–163 20 246–247 Travelers Insurance, 25, 36, 66 deferred, 111 Tungsram, 253, 257, 269 21 80/20 rule, 214, 220, 233, 237 Tyco International Ltd., 6, 73 22 employee benefits and, 217–218, Tyson Foods, 153, 168, 169 23 236–237, 247–249 24 exercise and transfer, 147–148 Uniform Commercial Code (UCC), 25 income, 122–123, 130–131, 186 26 146–147 Unilever, 254–255, 261, 266 international federal, 216–220 United Kingdom, discontinued oper- 27 inventory accounting methods ations in, 118 28 and, 217 United States, discontinued opera- 29 joint ventures, 211–212 tions in, 118–119 30 legal due diligence and, 204–205 Universal Studios, 71–72 31 nexus concept, 225–227, 228 Unsafe at Any Speed (Nader), 315 32 nonfederal, 211, 224–225 Upjohn, 64, 268 personal property (ad valorem), 33 148 value(s) 34 red flags, 312–313 achieving, 18–22 35 reserves, 233–234 corporate, 265–267, 297 36 saving methods, 229–232 value-added tax (VAT), 227–228 37 share purchases and, 232–239 value-creation process, 58–62 INDEX 343

checklist, 76–90, 324 1 support for, 63–68 2 Verizon, 62 3 VF Corp., 52 vision, 265–267, 297 4 Vivendi, 72 5 Vlasic, Bill, 70 6 Vodafone, 61–62 7 VoiceStream, 61 8 Volkswagen, 72–73 9 Wall, The, 42 10 Warner-Lambert, 24 11 Waterman, 17 12 Welch, Jack, 45, 155 13 withholding taxes, 219, 235–236 14 World Class Transactions: Insights 15 into Creating Shareholder Value Through Mergers and 16 Acquisitions (KPMG), 53 17 18 Yacimientos Petroliferos Fiscales 19 (YPF), 120 20 Yamaichi Securities, 68 21 Zeneca, 64 22 Zook, Chris, 23, 25 23 ZZZZ Best, 317 24 25 26 27 28 29 30 31 32 33 34 35 36 37 1 2 3 About Bloomberg 4 5 6 Bloomberg L.P., founded in 1981, is a global information services, news, 7 and media company. Headquartered in New York, the company has nine 8 sales offices, two data centers, and 87 news bureaus worldwide. 9 Bloomberg, serving customers in 126 countries around the world, 10 holds a unique position within the financial services industry by providing 11 an unparalleled range of features in a single package known as the 12 BLOOMBERG PROFESSIONAL™ service. By addressing the demand 13 for investment performance and efficiency through an exceptional combi- 14 nation of information, analytic, electronic trading, and Straight Through 15 Processing tools, Bloomberg has built a worldwide customer base of cor- 16 porations, issuers, financial intermediaries, and institutional investors. 17 BLOOMBERG NEWS®, founded in 1990, provides stories and 18 columns on business, general news, politics, and sports to leading newspa- 19 pers and magazines throughout the world. BLOOMBERG TELEVI- 20 SION®, a 24-hour business and financial news network, is produced and 21 distributed globally in seven different languages. BLOOMBERG 22 RADIOSM is an international radio network anchored by flagship station 23 BLOOMBERG® WBBR 1130 in New York. 24 In addition to the BLOOMBERG PRESS® line of books, Bloomberg 25 publishes BLOOMBERG MARKETS ™, BLOOMBERG PERSONAL 26 FINANCE ®, and BLOOMBERG WEALTH MANAGER®. To learn 27 more about Bloomberg, call a sales representative at: 28 Frankfurt: 49-69-92041-280 São Paulo: 5511-3048-4506 29 Hong Kong: 852-2977-6900 Singapore: 65-6212-1100 30 London: 44-20-7330-7500 Sydney: 612-9777-8686 31 New York: 1-212-318-2200 Tokyo: 813-3201-8910 32 San Francisco: 1-415-912-2970 33 34 For in-depth market information and news, visit the Bloomberg website at 35 www.bloomberg.com, which draws from the news and power of the 36 BLOOMBERG PROFESSIONALTM service and Bloomberg’s host of media 37 products to provide high-quality news and information in multiple languages on stocks, bonds, currencies, and commodities.