Don't ignore electronic due diligence: potential acquirers would do well to apply sophisticated electronic methods to quickly search email and other electronic data for lurking liabilities.

When a company is rumored to be a takeover target, bad things can happen. Top executives may accept job offers with rival companies, taking key employees with them. Sales managers and account executives may send out resumes and make copies of confidential customer information. R & D scientists may copy proprietary data, fearing their jobs may be at risk. Sales staff, hungry for last-minute commissions, can hype sales results or sell at deep discounts. Senior executives who may have been massaging the numbers or overseeing aggressive accounting methods can delete incriminating email and documents.

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If the acquirer carries out traditional due diligence and focuses primarily on checking sanitized, vetted reports and interviewing key employees, it may completely overlook the candid, liability-laden statements that are crucial to understanding the target, warts and all. If problems surface after the merger is completed, followed by a sharp drop in the company's stock price, an influx of class-action lawyers will follow. And you can be sure that these lawyers will seek disclosure of the email and other electronic records that should have been weighed by the acquirer and its advisors in the due diligence process.

Why will these class-action lawyers be so successful at digging up the dirt? Because modern plaintiffs' lawyers have become adept at electronic data discovery. They know how to cut through the mass of irrelevant and redundant data and go right to the negative and incriminating stuff. They can recover email and other electronic data considered lost or destroyed when someone pressed "delete."

The ability of powerful and sophisticated search tools to review masses of data quickly and thoroughly, coupled with savvy sampling techniques, is changing what a party conducting diligence can and should know using "reasonable care." The due diligence standard is defined by case law. Typical is a federal court's holding that an underwriter conducting due diligence must show that it "did not know, and in the exercise of reasonable care, could not have known, of [the] untruth or omission" of the investor disclosure in question (Software Toolworks Sec. Lit., 50 F.3d 615 (9th Cir. 1994)).

The level of diligence that is "due" is measured, in part, by what material liabilities may lurk. An exhaustive search for every potential source of liability is neither feasible nor legally required. It would be prohibitive, in terms of money and time, to search a company's entire electronic record. But slighting the electronic record can result in charges that a company and its advisors failed to fulfill their duty of due diligence.

Let's look at a hypothetical diligence effort. Suppose that a target company has been accused of bribing foreign officials in violation of the Foreign Corrupt Practices Act. The buyer may feel that it can quantify the potential fines, but if the industry is sensitive to such scandal, the buyer may want to look deeper to determine the pervasiveness of the alleged misconduct. The target's management may not know if the accusations are true, and employees could be busy covering their tracks.

The target, the acquirer, or both, could engage a third-party electronic data expert. There are cogent reasons for doing so:

* The target does not want to reveal too much in case the deal falls through, or jeopardize the integrity of its intellectual property and trade secrets, especially if the suitor is a rival.

* The expert can neutrally carry out the parties' agreed instructions.

* The expert can provide valuable advice on matching the scope of the diligence to the circumstances of the deal, and can also suggest sophisticated sampling techniques to help the parties refine their search.

* The expert can expedite the process of locating, collecting, processing, searching, hosting and delivering the data.

How a search is conducted depends on the deal. If misconduct is suspected, a review of metadata (authors, revision dates, prior versions, etc.), as well as "deleted" data, which can often be restored, may be in order. However, this type of review can quickly become very costly and is normally not justified.

Here are steps that our hypothetical target company could take to search its electronic data in response to the buyer's request for more information:

1. The parties consult with a third-party expert to set search parameters, such as key people and dates, and agree on the scope of the investigation.

2. A comprehensive survey of the target's data identifies sources of potentially relevant data, such as email, office suite applications, corporate and other customized databases, hard drives and network shared data.

3. Based on this survey, potentially relevant data is collected from sources such as file servers, backup tapes, hard drives and removable media.

4. In some cases it may be necessary to restore backup tapes or legacy data or to recover data thought to have been deleted. In restoring and reviewing such data, it is critical to weigh the cost against the potential benefit.

5. The process culls extraneous or duplicate data, such as non-user program files and email strings, significantly reducing the amount of data to be further processed.

6. One or more searchable databases are created from the remaining user data.

7. The target and its attorneys, or perhaps the independent expert, search and review the data.

8. The target synthesizes and reports the data, and the methods employed to obtain the data, to the acquirer in an agreed format.

9. If the acquirer finds the report or methodology inadequate, the target can decide whether to reveal more information or modify methods. If it refuses, the acquirer can decide whether to accept the data as reported, demand representations or warranties, refine disclosed risk factors, or walk away from the deal.

In our hypothetical case, several questions will be raised in the electronic due diligence process. Is there a repository for tracking the status of foreign contracts? Does the target's sales staff share contact information that may shed light on who has contacted persons suspected of receiving payments? If the misconduct is potentially pervasive throughout the target, what other individuals are in a position to have taken part?

A variety of tools can be used to search vast quantities of electronic data. Some go beyond traditional Boolean searching to include enhancements like a built-in thesaurus, natural language and fuzzy searching. Some tools group documents containing closely related subjects. Other so-called "artificial intelligence" search engines look for specific topics rather than specific words, locating documents with related semantic content and then prioritizing the results.

The effort put into carefully planning a search is just as important as the tools used to carry it out, and involves several important steps. An evaluation of the issues to be investigated is necessary to create effective search criteria. Data must be meaningfully sampled in order to test and refine the search and generally validate the process. Once key data is located, appropriate follow-up is necessary, such as considering again the search methodology, and perhaps examining the metadata of important documents for further search criteria.

With an array of available search engines and methods for searching vast quantities of data, an optimal approach to electronic due diligence is necessary. The issue is not what is possible, but what is practical and reasonable in the context of closing a friendly merger or securities offering. The initial planning effort, centered on completing the task on time and within a budget, is critical to effectively applying the available tools.

In addition to risk reduction, electronic due diligence provides two other key benefits. First, the war room goes digital. The data can be accessible via the Internet 24/7 in a searchable format. Paper documents can be scanned, coded and stored electronically. A target talking to several suitors can establish varying levels of access. Instant flagging, notation and folder creation are possible. This more efficient, less expensive review format lowers transaction costs and invites more bidders.

Second, electronic due diligence simplifies post-merger data integration. One key to a healthy merger is a swift and rational integration of data systems. The survey can involve a review the target's data, particularly old backup tapes; those that serve no useful purpose should be recycled. In future litigation, those tapes may require restoration at great expense simply to confirm that they contain irrelevant information. It doesn't make sense to acquire useless and potentially liability-laden backup tapes.

No doubt, many financial executives and their advisors will feel reluctant to apply what they view as novel and unnecessary techniques that are overly intrusive and possibly impolitic. But before dismissing electronic diligence, they should address the following questions:

* Would your company, your shareholders or your client benefit, through reduced risk, refined disclosure, broader representations and warranties, or more efficient pricing, from the information that may result from insisting on applying these methods?

* If the acquirer and its advisors ignore the opportunity to dig deeper into areas of concern, have they met their respective duty of due diligence?

* Do the risk factors in your disclosure highlight the matters that you could have explored on a deeper level utilizing these techniques?

* If the target's advisors fail to reasonably search the electronic record, have they fully provided the records to be produced in response to the due diligence checklist?

* Does the acquirer and its advisors want a shareholders' class action suit to be the event that gets them focused on what may be in the email they decided not to review? You can be sure that if trouble ensues, the class action attorneys will now demand that email in discovery.

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Careful planning and the use of appropriate tools and techniques enable all parties to take a deeper look into a range of issues. Companies may want to:

* Review email to and from major customers and suppliers.

* Uncover candid evaluations of a key product shared among the designers.

* Determine who authored and who revised a key spreadsheet, and perhaps why.

* Confirm whether key intellectual property has been appropriately safeguarded.

* Review email and sentiments concerning key regulatory events.

* Locate expressions of anticompetitive sentiments.

* Find statements made in connection with the resignation of audiors.

* Explore transactions with affiliates.

* Confirm the independent business purpose of complex deal structures.

David K. Thornquist ([e-mail]) is an attorney and a consultant for Data Discovery Direct (DDD), a division of SPI Technologies.