Canadian companies, and in particular those engaged in the resource sector, have looked, for many years, beyond national borders to expand their businesses. In recent years, rising commodity prices and an ever increasing scarcity of attractive domestic prospects have combined to fuel an explosion in international financings and acquisitions. Concurrently, monumental geopolitical forces have been at work. The collapse of the Soviet Union in the 1990s, the economic emergence of both China and India, and the relentless forces of globalization have opened up new frontiers for Canadian companies in Eastern Europe, Russia, Africa, the Middle East, Asia and Latin America. As a result, Canadian businesses are now pursuing opportunities in jurisdictions that, even ten years ago, could not or would not have been seriously considered. Political, economic and other risks that were considered unmanageable in the past are now seen more as an inevitable part of the landscape of international transactions.
Thus, the increased appetite for international transactions is readily understood. The reality for Canadian companies, both public and private, choosing to expand internationally is that the capital required to complete international acquisitions and financing is not unconditionally available. Debt or equity financing for international projects brings with it certain prerequisites, and, above all, a strong aversion for uncertainty. Identifying, reducing and quantifying uncertainty or risk in the context of a proposed financing or acquisition is what due diligence is all about. But due diligence and risk management is fundamental to all transactions, domestic or foreign. What differentiates the due diligence required for international transactions from that normally conducted in domestic transactions?
Due diligence in international transactions may be best described as domestic due diligence on growth hormones. Almost overnight, a small, peripheral issue can be transformed into a massive, pivotal problem that consumes the entire due diligence team. The mere fact that one or more key components of an international transaction involve unfamiliar territory (be it geographical, political, legal, cultural, linguistic and economic differences) is problematic enough. However, the addition of today’s demanding business climate to an already novel environment creates a formidable challenge for companies struggling to get comfortable with the international transactions they are contemplating.
This paper does not purport to be an exhaustive review of international due diligence, nor is it intended to be a comprehensive "how to" guide for the conduct of due diligence for international transactions. It will instead attempt to highlight for the reader the critical due diligence issues that generally arise in international financings and acquisitions and suggest some practical ways of addressing these issues. Finally, although the paper is focused on international financings and acquisitions by Canadian-based companies in the energy sector, many of the issues discussed and the suggestions made in the paper have broader application.
Due Diligence in an International Setting
"Due diligence" refers to the investigation of the business, legal and financial affairs of an entity or asset carried out by interested parties and their advisors in connection with a wide range of transactions, including public or private financings, acquisitions of shares or assets, and the establishment of partnerships, joint ventures or other strategic alliances. As international transactions, by definition, transcend national borders, they inevitably present "translation difficulties" for the parties involved. These translation difficulties go far beyond language.
International financings and acquisitions routinely involve fundamental conflicts between the political, legal, economic, social and cultural norms of the host country and those of the "investor" country or countries. These disparities are exacerbated when, as is often the case, the host country is a developing country with an emerging market economy, while the acquiror or investor is domiciled in a highly developed and regulated market economy. The gulf between host and investor nations has widened in recent years, with the trend toward increasing regulatory scrutiny and transparency in more developed countries (especially in North America and Western Europe) that tend to be the primary exporters of capital. All of this means that the investigation, analysis and risk assessment process known as "due diligence", which characterizes every transaction between buyer and seller in a market economy, becomes immensely more complex in an international environment.
There are numerous textbooks, articles, journals and checklists which deal with the myriad issues regularly arising in international transactions. Rather than attempting to catalogue all of the potential due diligence issues here, we thought it would be instructive to demonstrate how fundamental the issues can be in an international transaction by briefly reviewing the risk factors commonly appearing in the offering and other disclosure documents prepared by public companies seeking to finance their international operations. In a recent prospectus, potential investors in an international energy company were asked to reflect upon a wide array of risks to their investment including:
- Interpretation and application of the laws and regulations of the countries in which the Corporation operates can be uncertain and could adversely affect the Corporation.
- Crime and governmental or business corruption could significantly disrupt the Corporation’s ability to conduct its business and could materially adversely affect its financial conditions and results of operation.
- There are political, economic and other risks relating to the countries in which the Corporation currently operates or may operate in the future.
- Relinquishment obligations under applicable legislation and the terms of Production Sharing Contracts may adversely affect the total amount of the Corporation’s prospective resources.
- The Corporation must comply with the regulatory regimes of the countries in which it operates, and such compliance may result in increased expenditure.
- The Corporation’s production may be constrained by production or export quotas.
- The Corporation faces foreign exchange, interest rate and inflation risks.
- US holders of Common Shares and the Corporation may be subject to sanctions imposed by the US government if the Corporation decides to pursue operations in countries subject to US economic sanctions.
- The Corporation could face significant liabilities under environmental laws.
- Joint ventures entered into by the Corporation could lead to additional costs.
- The Corporation could be subject to labour or other unplanned production disruptions.
- Future litigation could adversely affect the Corporation’s business, results of operations or financial condition.1
Admittedly, offering documents are designed to be defensive in nature and accordingly, the risks attributable to the issuer’s operations tend to be exhaustive if not overstated, but the fundamental point remains. International transactions present a number of challenging barriers to entry for companies seeking to complete such transactions without accepting some level of risk far beyond what would be domestically palatable.
Having established that due diligence in international transactions is different than domestic due diligence and that the differences can be extraordinarily complex, what can be done about it? Assuming that abandoning the proposed transaction is not an alternative, the following discussion presents some suggestions gleaned from experience which may assist international venturers and their advisors in: (i) understanding and mitigating the risks of a proposed transaction; (ii) evaluating the information obtained; and (iii) using the information obtained through the due diligence process for the transaction being considered.
The Planning Process
- Timetable and Working Group
- Engaging Local Counsel
- Retaining Other Consultants and Experts
- Face-to-Face Meetings
- Establish Communication Protocol
- Contingency Plans
- Request for Disclosure
- Sources of Information
- Integrating Technology
- Keep Records and Identify Documents
- Use of Information Gathered
- When is Enough Enough?
Effective due diligence for international transactions begins with an understanding of the proper scope of the investigation. Does the proposed transaction represent a client’s initial foray into the host country, or has it been successfully operating its business there for several years? Clearly, in the former case, the due diligence undertaken needs to be much broader and more comprehensive. All members of the due diligence team will need to spend more time educating themselves and their clients about the business environment in which the transaction is taking place. There are additional implications of being a "first timer" in a host country or region: the timetable for completing the transaction should be significantly expanded and the team’s reliance on local expertise will be heightened. Nothing can be assumed in such a transaction and an acquiror must review in detail the very basics of conducting business in the country, such as the taxation and regulatory system, for the transaction to have a reasonable chance of success.
The scope of the due diligence is also heavily impacted by the nature of the proposed transaction. International acquisitions in host countries tend to fall into one of three categories: (i) the direct acquisition of rights from the relevant government agency; (ii) the acquisition of interests through the negotiation of an investment, production-sharing or other similar agreement with the host country; or (iii) the acquisition from a third party (by purchase, sublease or joint venture) that currently owns an interest in the target assets.2 Again, the focus of the team’s due diligence efforts will be strongly influenced by the type of international acquisition or financing being contemplated. If, for example, the transaction being considered is a public equity financing, the norms and expectations of the investor country are of paramount importance. In this situation, the due diligence process is driven by what the capital market in the investor country needs to support the transaction. If, for example, the capital market in the United States is critical for the success of the financing, the underwriters may require a special antifraud opinion from legal counsel at closing, which will dramatically affect the scope and intensity of the due diligence process.
The importance of organization in international due diligence cannot be overstated. To be effective, large, multinational due diligence teams need to be managed with close to military precision. Generally speaking, the management role for the due diligence effort in an international transaction will fall to the financial advisor or its counsel. The manager or co-ordinator may change as the transaction proceeds, but it is critical that this individual be a skilled and persistent communicator, who is able to devote sufficient time and attention to the role. Organization begins with the preparation of a detailed timetable, which will serve as a road map for the transaction from beginning to end and which will identify critical tasks and assign responsibility and target dates for completion of each stage of the transaction. Clearly, there is an art to the preparation of such timelines, but they need to have enough detail to demarcate key milestones in the transaction which will, in turn, alert the due diligence team to the deadlines they will face in terms of gathering and analyzing information. Often the careful preparation of a detailed transaction timeline will serve to highlight an overly aggressive date for completing the transaction. This is a common complaint of lawyers and other advisors, however, clients are better able to assess the merits of such complaints and the risks of proceeding too hastily if they can see, clearly outlined in the timetable, a series of critical deal elements piled up against unduly optimistic completion dates.
As the timetable is being constructed, a comprehensive working group list with all pertinent contact information should be prepared. In complex international transactions, the working group (once all the lawyers, accountants, engineers and other advisors are added) is often enormous and it tends to expand as the transaction progresses. Although it sounds banal, continual updating and maintenance of the working group list is essential. There is nothing more frustrating than having difficulty communicating (or worse, failing to communicate) with working group members at critical times in a transaction because of gaps or inaccuracies in the working group list. This is particularly true in international transactions where multiple time zones and local holidays intervene at the most inopportune times.
At the initial stages of a planned international transaction, the retention of local counsel must be considered. As mentioned previously, the due diligence team’s reliance on local expertise will depend on the nature of the proposed transaction and the acquiror’s experience with operations in the host country. Local counsel are an invaluable resource to the due diligence team that has little knowledge of a given area; they really serve as interpreters of laws, customs and business practices in the host country. As local counsel generally appreciate the sometimes unstated expectations of the acquiror or investor, they are often better able to advise the due diligence team on the feasibility of the transaction timeline as it develops. In many developing countries, laws can appear to be conflicting and may not have been judicially interpreted; and they may also be applied in a manner that, to foreigners, appears arbitrary or capricious. For example, in Nigeria, it would appear from a reading of the Petroleum Act that commercial oil production cannot occur until an oil prospecting license is approved by the petroleum ministry for conversion to an oil production lease. However, the actual practice in Nigeria is very different and commercial production from oil prospecting licenses is quite common pending conversion.
If the due diligence issue involves a question of status or capacity, the conventional practice would be to approach the relevant government agency or partner in the host country for the pertinent consents, approvals or other assurances. In many countries, such an inquiry could at best, yield an incomprehensible response and, at worst, a tax audit or some other unwelcome investigation of the affairs of the target company. For all of these reasons and many which one would never anticipate, the retention of local legal counsel is a critical component of effective due diligence in international transactions.
A typical international acquisition or financing in the energy sector will require external accounting, engineering, environmental, tax and financial advisory expertise. International accounting and engineering standards differ in many respects from Canadian GAAP and NI 51-101 and significant efforts must be made by the due diligence team to ensure the experts are aware of the standards to be applied and the proper methodology to be used in translating the data. Clearly, there is a premium attached to experts who have working experience with the different systems.
A relatively new addition to the due diligence team on international transactions is the global investigative consultant. Such consulting firms may be engaged by the acquiror or, in a financing, the underwriters to gather personal and business information about the participants in a proposed transaction and practical intelligence regarding the conduct of business in the host country. Such information is sometimes referred to as "reputational due diligence"3 and serious consideration should be given to engaging such expertise during the planning of the due diligence process, particularly where the acquiror or investor lacks experience operating in a host country, or the business and political environment of the host country appears to be highly unstable. Given that energy and mineral resources are distributed throughout the world without regard to political boundaries, some level of instability is often unavoidable in international transactions. As such, it is highly likely that a global investigative firm will be retained to provide information to one or more parties in an international transaction. Extreme care and attention needs to be devoted to the process of engaging such consultants; an ill-defined mandate, or indiscrete or inappropriate methods of collecting, assessing and disseminating the intelligence can easily derail the entire transaction. Moreover, unqualified experts may not only waste valuable time and resources, but may also reach conclusions that are more indicative of their lack of knowledge and judgment concerning operations in the host country than anything else.
Although much can be accomplished in the world of international business without physically meeting the key participants in a transaction, or attending on site to review the key assets involved, comprehensive and effective due diligence cannot be conducted without such meetings and visits. The alarming collapse of YBM Magnex International4 illustrates the importance of on site asset inspections; face-to-face meetings among the transaction’s participants often provide insights that are not conveyed by electronic correspondence or conference call. Organizing such meetings in international transactions can be exceedingly difficult, time consuming and expensive; accordingly, they must be incorporated into the detailed timetable for the transaction at the outset.
The most finely crafted transaction timetable is an absolute waste of time and effort if it is largely ignored once the transaction gets underway. A large, multinational working group will quickly lose direction and imperil the transaction unless those who are assigned responsibility for certain tasks (and target dates for completion) in the detailed transaction timetable are able to regularly communicate their progress (and their challenges) to the entire working group. If the due diligence team encounters unforeseen delays or difficulties, the detailed timetable can be refined and adjusted accordingly. Weekly conference calls for the entire working group (supplemented as required by discussions with smaller working groups) are invaluable tools for the due diligence process and the transaction itself. It is important that all key participants hear first hand how things are progressing. The fear of having to explain one’s inability to complete an assigned task to the entire working group instills a powerful sense of discipline in all of the transaction’s participants. It is amazing how much tends to be accomplished on the eve of a regular conference call to review outstanding matters on a proposed transaction.
This sounds like an oxymoron, but international transactions involve so many uncontrollable variables that the timetables on which they are constructed should be as flexible as possible. The due diligence team will constantly encounter obstacles and roadblocks caused by the vagaries of the host country’s political, legal, economic and social framework. Simply obtaining the visas, permits and immunizations necessary to allow team members to enter the host country can lead to problems and delays. In addition, local bureaucrats may be in no mood to perform even routine tasks on a "rush" or emergency basis. The solution to such problems will require creativity, adaptability and invariably, time. Generally speaking, clients tell their advisors time is a luxury they do not have. Unfortunately, effective due diligence in international transactions demands time and careful planning; without adequate time, the due diligence will be compromised and the risks of completing the transaction inevitably increase.
Gathering the Information for Due Diligence
As due diligence is an investigative process, the investigation usually begins with the purchaser’s counsel (or in the case of a financing, underwriter’s counsel) providing to the vendor a list of documentation required for review. This request for disclosure ("RFD") is merely the beginning, especially in international transactions. Consents, transfer approvals and certificates of status which are customary in domestic transactions may be unusual or unavailable in international transactions, depending on the legal and regulatory framework of the host country. Accordingly, it is advisable for the purchaser’s counsel to ensure local counsel is engaged quickly to ensure such counsel is informed about the proposed transaction and involved in the preparation of the RFD. If certain "standard" due diligence documentation will be difficult or impossible to obtain, the due diligence team will be so advised and will be able to develop another strategy to obtain the desired information. It is incumbent on the vendor and its counsel (similarly supported by local expertise) to identify potential problem areas upon receipt of the RFD. Nothing positive develops from a situation where the vendor fails to provide documents listed in the RFD, and then fails to advise the purchaser that more than oversight or laziness is involved in such failure to produce. Again, to belabour a point previously made, this type of miscommunication in the due diligence process is much less likely to occur if both sides of the transaction are represented by experienced, local counsel.
Like the detailed timetable, the RFD needs to be continually refined and updated as the investigative process and transaction itself roll on. All members of the working group should be informed continuously of the status of document production, review and analysis. As well, documents produced should be identified by the parties and any further action arising out of the production and review must be recorded with follow up responsibility and a target date for completion assigned.
The RFD forms the backbone of the due diligence process; depending on the nature of the transaction, the investigative effort is normally supplemented by management questionnaires and interviews for personal and business information at various stages of the transaction. At all times, counsel on both sides of the transaction will be heavily involved in framing the questions asked and the responses provided in such supplementary materials.
While the RFD is underway, it is important, particularly for the purchaser, to gather as much pertinent information as it can about the target assets and the implications of doing business in the host country. There is a vast array of information readily available on the Internet and in Canada, the Department of Foreign Affairs and International Trade as well as local Canadian embassies are valuable and reliable sources. The annual CIA World Factbook provides useful background information on all countries as do the various country briefings prepared by the U.S. Department of Energy and publications such as The Economist. The U.S. Department of State and several of the large, multinational accounting firms have extensive publications on the financial, tax and other aspects of doing business in many foreign countries.5 One resource which is often overlooked in conducting due diligence for international transactions is the business consortium operating either in the domestic or host country. "Business consortiums are organizations, such as chambers of commerce, trade-specific alliances and institutions, professional associations, councils, federations and unions that build networks among existing businesses operating in the same geopolitical market."6 To use a local example, organizations similar to CAPP, SEPAC or the Calgary Economic Development Authority in the host country can be valuable sources of information for an energy company considering an entry into a foreign jurisdiction by acquisition. Learning from the experience of others is generally the fastest way up the learning curve for a company trying to grasp the practical realities of doing business in the host country. The fiscal regimes of foreign jurisdictions are often unbelievably complicated and the rules and regulations are frequently open to interpretation, if not in a total state of flux. The very recent experience of Ivanhoe Mines in Mongolia is a classic example of how quickly the political winds in a host country can shift and how profoundly these unpredictable shifts can impact future business operations and enterprise value.7 Understanding the rules of the game as it is played in the host country will allow the due diligence team to focus on the critical aspects of the RFD and to know where and when to seek further clarification of the initial responses.
Because of the imposing barriers to entry, international transactions tend to be more ambitious in size and scope than their domestic counterparts. Ambitious projects spell complexity and for lawyers and the due diligence process in general, they also spell trouble. Trouble usually arrives in the form of a massive, sometimes unintelligible array of documentation that makes one doubt whether the proposed transaction can be completed on time. Technology is no panacea for international due diligence, but it is difficult to imagine how an effective process could be managed without it.
The working group on a recent international financing included participants from Geneva, Lagos, London, New York, Dallas, Toronto, Calgary and Hong Kong. Organizing conference calls, meetings or any form of communication other than electronic was a logistical nightmare. With the benefit of prior experience, a virtual data room was established in the initial stages of the financing to allow working group members to access critical due diligence documents and to post, for immediate review, revised draft documentation as the financing progressed to closing. It is difficult to conceive how the project would have been completed on a timely basis without the technological assistance provided. There are a number of "virtual data room" products being marketed today and the search, retrieval and identification capabilities of the software programs they employ are continually expanding. The time and money invested in acquiring and effectively integrating technology in the due diligence process (including the training of the intended users) will be repaid not only in the quality of the due diligence but in the speed and ease of concluding the transaction itself.
Wrapping up the Process: What to do with What’s Been Learned
For posterity and future litigation (hopefully not!), all of the materials produced in the due diligence process must be organized and identified. In international transactions, official translations of documents in the language of the governing jurisdiction may be required. Given the sheer volume of documentation common in international transactions, the task of organizing and storing the due diligence material in a form that is readily retrievable will be much simpler in situations where the proper technological tools were utilized when the due diligence was conducted.
The information obtained in the due diligence process is used for the same purposes in all transactions, domestic or foreign. Among other things, effective due diligence assists legal counsel in structuring the transaction and confirming issues of ownership and associated rights and obligations. In addition, the information gathered will inevitably change the representations, warranties, covenants and indemnities included in the documents recording the transaction. But in international transactions, it is arguable that the educational role of due diligence data is also of fundamental importance. Ideally, the purchaser emerges from a well designed investigative process with a better understanding of what is being acquired and what to expect in conducting its business in the host country. In the case of an international financing, the underwriters should exit an effective due diligence process with a full appreciation of the unique risks associated with the business being financed and better protection against litigation should one or more of the risks identified by the process adversely affect the business.
Many would argue that lawyers never know when enough due diligence is done on a particular transaction and it is always the client who has to step in and either close or abandon the transaction. Admittedly, there is some truth to this, particularly in the realm of international transactions where the risks are undoubtedly more vexing and intense. Although the question is clearly rhetorical, it is probably safe to conclude the due diligence when even the most risk averse member of in a large, multinational working group (and there always at least one that achieves this distinction) begins to cavalierly dismiss new and exotic issues being raised by other team members for discussion or debate.
The more serious answer to the question reveals something fundamental to the conduct of due diligence in international transactions. In a carefully constructed investigative process for a sizeable international transaction, there will be no shortage of information for an acquiror or investor. In fact, there will be a blizzard of information and opinion available on all aspects of the proposed transaction from a sometimes bewildering array of experts. The real challenge in international transactions is to separate reliable and important intelligence uncovered in the due diligence process from information of lesser credibility and significance. Separating truth from fiction in an unfamiliar environment requires judgment from the entire due diligence team and such judgment must be exercised at every step of the due diligence process. Fittingly, the decision to conclude the information gathering process for an international transaction is also an exercise in judgment, and this judgment will be based on the level of risk management achieved by the process.
A cursory review of Calgary-based companies operating internationally underscores the increasing importance of understanding and constructing effective strategies for the conduct of due diligence in an international setting. Today’s landscape reveals Addax Petroleum in Nigeria and the Middle East; Niko Resources in India; First Calgary Petroleums in Algeria; Calvalley and Western Oil Sands in Iraq; Valkyries in Russia; and Nexen in Yemen, to name only a few energy companies with an international focus. The world may be getting smaller but it definitely is not getting any simpler. Perhaps the best approach to international due diligence is summed up by the phrase "Never Assume Anything." In the end, that’s not a bad credo for due diligence at home or abroad.
* First presented at Insight Information's conference on Advanced Due Diligence: Effective Strategies for Conducting Legal and Financial Due Diligence - June 19-20, 2006 in Calgary, Alberta.
** Mr. Ferguson is a Partner in the Securities and Mergers & Acquisitions Group of Fasken Martineau DuMoulin LLP ("FMD") in Calgary, Alberta. Mr. Klym is an Associate in Corporate Finance with RBC Capital Markets. The authors gratefully acknowledge the assistance of Brenden M. Hunter, Student-at-law at FMD, in the preparation of this paper. The views expressed, however, are solely those of the authors.
1. See Supplemental Prep Prospectus of Addax Petroleum Corporation dated February 8, 2006 under "Risk Factors" at page 125.
2. Jerome J. Bensing, et. al., "Due Diligence in Foreign Countries: The Landman’s Role" (1997) 43 Rocky Mt. Min. L. Inst 21 at p. 21 – 26.
3. See Samuel Porteous, "Reputational Due Diligence Can Really Pay Off", The Lawyers Weekly 18(41) March 12, 1999.
4. See, for example, Stephen Schneider, "Money Laundering Through Securities: An Analysis of Canadian Police Cases" (2004) Aspen Review of International Business and Trade Law 169.
5. Phillip R. Clark and Lisa M. Bain, "International Project Due Diligence - What the Lawyer Can Do to Really Protect the Client’s Deal" (1999) 45 Rocky Mt. Min. L. Inst. 15, for a good compendium of the vast array of information available on various websites.
6. Christopher Jay Walker, "Due Diligence and Local Business Consortiums: The Untapped Resource in Transnational Business Expansion", 6 The Tennessee Journal of Business Law 179.
7. On May 15, 2006, Ivanhoe Mines issued a press release regarding the surprise introduction of a windfall profits tax by the Mongolian government. The response of the stock market to these unexpected developments was swift and punishing.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.