Diligence long overdue.

The rush to join in today's frenzy of M&A transactions has some companies viewing due diligence as a necessary evil - and giving the process short shrift. Yet, cutting corners can destroy a merger, thwart strategic gains from the deal, and plunge a company into costly, distracting, and potentially ruinous litigation.

As a young associate at a large law firm working on one of my first M&A transactions, I was shocked to see how our client, a sophisticated merchant banking firm, pushed on all the professionals to "get the deal done." About three months after the closing, I was asked to share my recollections of the deal with a senior litigation partner of the law' firm, who told me that our client had discovered an "inventory problem" at the acquired company. I subsequently learned that the "inventory problem" involved finding out that a significant number of paint cans - the company was a manufacturer of paint - in finished goods inventory contained water instead of paint.

Even as a young associate, it seemed to me that this "problem" could have been identified prior to the closing with some prudent due diligence and coordination with the various accounting firms involved in the transaction. My experience since then suggests that in all too many M&A situations due diligence is viewed more as a necessary evil than as an integral - and potentially beneficial - part of the process.

The 1997 merger of HFS with CUC International to form Cendant Corp., for example, was announced with great hoopla. However, as a result of CUC's inadequate financial controls, Cendant was forced to report that net income had been inflated by $500 million over three years.

Earlier this year, Michael Ovitz, the former president of Walt Disney Co., invested $20 million to take control of Livent. It was only after this expenditure that Ovitz and his associates apparently discovered accounting irregularities in the company's records that contributed to Livent's bankruptcy filing and the possible loss of Ovitz's investment.

These cases are unusual in that fraud was, or may have been, involved. More typical situations involve pre-existing environmental conditions, tax liabilities, litigation, and agreements that can stifle a company's strategy for a deal because they bar it from acting in an intended manner, or impose a hidden cost. In a mammoth deal, such as the $75 billion Exxon/Mobil merger, there are thousands, or tens of thousands, of commitments and agreements. There are dozens of environmental risks related to production, refining, and distribution that should be checked. There are existing lawsuits, some with and some without merit, that need analysis.

Until these have been examined, Lee Raymond of Exxon and Lucio Noto of Mobil can't know whether Exxon/Mobil can achieve the intended cost savings of $2.8 billion annually and whether Exxon/Mobil can actually reduce its work force by 7.3 percent, or 9,000 jobs. The companies can't even know whether their cultures will mesh synergistically or clash and prevent bold action. Such was the case, for example, at Pharmacia & Upjohn, until a new CEO, Fred Hassan, put a stop to arguments between Swedish and American employees of the merged companies.

Due diligence is risk management. Risk management calls for judgment and analysis. The trade-off in a merger or acquisition is how much risk a CEO is prepared to assume in closing a deal versus the risk of not getting a deal done. There is no easy answer, but far too often the urge to "close" a deal can fog judgment and lead to unnecessary risk assumptions.

Although the cost of due diligence is one hurdle, the psychological capital already invested by the CEO and management group in the deal can be an even greater obstacle. The seller emphasizes its desire for the quick development of an operational and financial structure that will lead to the speedy completion of the sale. Because of the time and effort expended to effect the merger or acquisition, not-too-subtle pressure, often from major investors, is placed on anyone or anything endangering its fruition - including due diligence.

But this pressure must be overcome if the CEO is to be successful in his or her M&A activity. Since the margin of error for survival in M&As is thin - and getting thinner - due diligence should start even before negotiations are underway. What's more, beginning the process early on could head off a long, costly effort to unwind a transaction that should never have been entered into in the first place.

Ideally, good-faith negotiations between lawyers for the two parties should take place at every step along the way. And for the buyer's lawyers to be able to negotiate most efficiently - on the purchase price, on the structure of the transaction, on the allocation of risk between the parties for liabilities and other contingencies, and on other significant terms - a vast store of data ought to be forthcoming from due diligence. That data will eventually be the basis for both the purchase agreement and the closing documents.

At the heart of legal due diligence is a document and information request to the company being acquired from the law firm representing the acquirer. Although this checklist can be tailored to the specific situation - expanded or reduced depending on the company and the details of the deal - certain basics are always covered to facilitate the review. These include:

Significant Agreements

No acquisition should be completed without a study of the material agreements contained in the records of the company to be acquired - everything from vendor contracts to real estate leases, financing arrangements. and joint ventures.

In a recently completed acquisition of a middle-market manufacturing business, the acquirer had great plans to identify and put in place an operating plan to reduce certain costs, including cost reductions related to the renegotiation of certain vendor agreements. To cut costs, the acquiring firm decided to review all vendor contracts internally instead of having them reviewed by outside counsel. Unfortunately, the firm did not focus on the "evergreen" and notice provisions of certain of these contracts, anti closed the deal without being able, in the short term, to use the leverage of an expiration or termination date in its vendor contracts to obtain price concessions.

For example, due diligence in the acquisition of a large, publicly traded retail chain involved reviewing hundreds of leases to ascertain if landlord consents were needed prior to the consummation of the transaction. Since most of the leases had "change of control" provisions that necessitated landlord consent, obtaining such consents was made a condition to the acquiring firm's closing obligations. When all the required consents were not forthcoming, the acquiring firm successfully negotiated a reduction in the purchase price to cover the risk of closing without obtaining all consents and the possibility of increased rentals under such leases.

Litigation

It's essential to be aware of any litigation, arbitration, or regulatory proceedings concerning the company being considered for purchase. With the magnitude of jury awards these days, it's foolhardy to attempt a merger or acquisition without assurances that a court elate stemming from a third-party lawsuit won't follow the closing.

Of course, it's no longer surprising - if it ever was - for corporations to be sued by individuals and institutions for allegations ranging from product liability matters to securities litigation to environmental-related injuries to libel and slander. Since it's difficult, if not impossible, to leave existing or potential litigation behind in an acquisition transaction, a prudent acquirer should fully analyze and evaluate such risks. Nothing can turn off a buyer's enthusiasm for a particular acquisition faster than the thought of inheriting a never-ending securities class action or mass product liability case involving thousands of individual plaintiffs. Imagine trying to buy a tobacco company in today's environment. Or a chemical company that manufactures a dangerous substance.

In recent years, litigation over intellectual property (IP) rights has proliferated, which underscores the importance of understanding a target's IP portfolio. One of the simplest legal documents - often taken for granted - is a standard form of Nondisclosure, Proprietary Rights, and Inventions Agreement that most newly hired employees of high-tech and other companies are asked to sign. Yet, in many target companies with significant IP portfolios, this documentation is nonexistent or incomplete. In such cases, whether the target company really owns the IP is questionable. And that uncertainty could prove fatal to the success of the acquisition or the valuation placed on the target company. Usually, these problems are curable; however, they are better dealt with prior to the closing than afterward.

Compliance with the Law

Legal due diligence involves a careful analysis of the target company's history of compliance with applicable law. Since legislation and regulations may affect the operations and profitability of many companies, acquirers shouldn't finalize a transaction without evaluating compliance. We live in a regulated society, with government involved in an ever-increasing number of business issues - securities, antitrust, employee relations, environment, tax, manufacturing, and advertising standards, etc. Failure to comply with any one law or regulation could have a significant impact on the success of a transaction.

Several years ago, our firm discovered that an acquired company probably violated the Robinson-Patman Act in that it had different pricing structures for different customers. Our client was very anxious to proceed and asked us to fully analyze these risks, from both a legal and financial point of view. As there is no way to "cleanse" this risk, and in a merger transaction, the buyer assumes this liability, in the end the client decided to close the transaction without attempting to negotiate a new purchase price.

In another situation, a due diligence analysis ended up killing a transaction that the client desperately wanted to pursue. Early on in another diligence analysis, the acquiring company learned that a seller of a significant private business had, over the years, developed an "inventory bulge." In short, the seller had been hiding taxable profits in inventory from the scrutiny of his accountants and the IRS. The actual size of the "inventory bulge" was approximately 40 percent of the company's net worth at the time. Needless to say, the seller insisted on a stock transaction so that the buyer, our client, would take on the underlying tax exposure. After many meetings in an attempt to solve the problem, our best recommendation was to either go to the IRS with the seller and work out a long-term payout or terminate negotiations. When the seller was unwilling to confront the IRS, negotiations were terminated.

Environmental Risk

Possible exposure to environmental risk and liability is currently the single most worrisome part of the due diligence process for many corporate acquirers. If an environmental analysis reveals contamination to land or buildings, the worth of the target company could be sharply depressed until the circumstances are resolved. Furthermore, the purchaser may be responsible for cleaning up any contamination left at the facilities by the previous owners.

Litigation involving environmental issues has become a new American growth industry, causing corporations contemplating an acquisition to be extremely wary of becoming defendants in legal actions seeking personal injury-related damages.

In a recent acquisition, our firm was called upon to analyze contingent liabilities related to environmental lawsuits that were pending against the target company. The number of lawsuits was in the hundreds, but the settlement pattern suggested that each of the suits could be settled for hundreds of dollars. Furthermore, the target business was not a primary offender but was a small contributor to the problem. The client negotiated a risk-sharing arrangement with the seller of the business covering a multi-year post-closing period, which, at the time, seemed like a perfectly reasonable approach.

Unfortunately, shortly after the closing, with tort reform legislation picking up momentum in several large industrial states, the plaintiff's bar began to actively solicit individuals who were exposed to this particular environmental hazard in the workplace. Before long, what had been a fairly manageable liability issue turned into a nightmare as the number of cases reached into the tens of thousands all across the country. Needless to say, the risk-sharing arrangement, while adequate during the original five-year, post-closing period, turned out to be insufficient to deal with a problem of this magnitude. Over a period of approximately two years, our client was successful in renegotiating the terms of the risk-sharing arrangement to its satisfaction, but not without beginning litigation against the seller and enduring some fairly unpleasant meetings.

The legal elements of due diligence are obviously not the only ones to be taken into consideration when an acquisition is in the offing. Accountants, consultants, investment bankers, and others have an important role to play during the period between the contract signing and the closing - and even before. In addition to fulfilling their respective technical functions, they should interview senior officers of the target company, discuss the deal with its customers and suppliers, and check the references of the target's key personnel. These parties work together with the lawyers as an acquisition team to provide the best intelligence and counsel to the client so that the thrill of the chase does not overwhelm good business sense.

But the final decision whether to make the acquisition or not belongs to the CEO. He or she must select the appropriate individuals to serve on the team and make certain that every aspect has been carefully analyzed and evaluated. If not, he or she should insist on widening the scope of the due diligence to focus on the additional issues to be dealt with - yen if they should break, rather than make, the merger. Deals would hardly ever get done if companies spent unlimited time doing due diligence. Yet when a company doesn't take advantage of the process of due diligence, there's a real danger of adding still another unsuccessful deal to the lengthy list of mergers and acquisitions that have not met the test of time.

All of the perils that may lie ahead should be identified, contained, or avoided before the deal is executed. Foresight, not hindsight, is the responsibility of those charged with making mergers happen.

Lawrence G. Graev is a partner of O'Sullivan Graev & Karabell, LLP, a New York law firm with expertise in offering legal and business advice in complex financial and business transactions.