Canada: Due Diligence

You're thinking of acquiring a business and wondering whether it's worthwhile to do due diligence? Here is a summary of some considerations that will help you better understand the importance of that exercise.

1. Due diligence: a definition

First of all, the concept of due diligence can be defined as the process of evaluating and analyzing various aspects (legal, accounting, etc.) that are specific to the target business and its competitive environment. In other words, it is a process whereby the prospective buyer and its advisors scrutinize the 'pedigree' of the business. Naturally the process will vary from one transaction to the next depending on the size and nature of the target.

2. Asset purchase vs. Share purchase

Contrary to popular belief, it is incorrect to assume that due diligence is less important when purchasing assets than when purchasing shares. In both cases, a due diligence investigation will allow inherent risks in the business to be identified, and to confirm whether or not various hypotheses used to establish the sale price are valid (recurring revenues, business relationships, material contracts, etc.).

In this sense, the lawyer must make his client aware of the various caveats that may be involved in the contemplated transaction. For example, while in the case of an asset purchase the purchaser is theoretically not bound by the target's liabilities, an asset purchase may nonetheless represent the continuity of the target business for the purposes of Article 2097 of the Civil Code of Québec. The impacts of this are considerable:

2097. A contract of employment is not terminated by alienation of the enterprise or any change in its legal structure by way of amalgamation or otherwise.

The contract is binding on the successor of the employer.

The Quebec Court of Appeal has recently held moreover, in a lengthy and well-reasoned judgment, that there may be continuity of a business even where assets thereof were acquired through a trustee-in-bankruptcy1. That is definitely something to be mindful of!

A prudent and diligent purchaser will want to ensure that the target business has made all compulsory deductions at source and timely remitted all sales taxes to the appropriate fiscal authority. Failure to do so by the target could have disastrous consequences for the purchaser, as the State may have a deemed trust in all of the assets of the target to the extent it is a tax debtor.

While the list below is not exhaustive, the following aspects should be verified by the purchaser and its advisors:

  • all contracts binding upon the target;
  • books and records;
  • rights published in the Register of Personal and Movable Real Rights;
  • rights published in the Land Register;
  • judicial records (civil, penal and criminal);
  • occupational health and safety infractions and contributions;
  • federal and provincial tax status and history;
  • employment contracts, and
  • all other undertakings and obligations that could influence the sale price.

Searches should also be carried out with other government entities, depending on the nature of the target business. For this purpose a duly completed access-to-information request will have to be submitted.

3. Due diligence: an overview of the case law

Quebec courts have on numerous occasions stressed the importance of performing due diligence prior to the acquisition of a business. In the decisions canvassed below, the courts have emphasized the importance of the due-diligence exercise and reminded purchasers that failure to request relevant information about the business may constitute an inexcusable error with in the meaning of Article 1400 (2) of the Civil Code civil of Québec.

In its decision in Riccio v. Di Raddo2, the Court of Québec characterized the due diligence investigation into the various aspects of a business as an elementary precaution to be taken when acquiring a business. Not having done so constitutes an inexcusable error that does not vitiate the acquirer's consent. The Court accordingly found that the plaintiff's claim for damages had no merit, stating the following in that regard:

[44] Rita says that she never received the accounting documents proving the salon's annual revenues. However, Rita did not ask to see those documents before signing the contract. There was nothing forcing her to sign the deed of purchase and sale for the salon before having performed due diligence on the accounting records and revenues of the salon. Verifying the income generated by a business before acquiring it is an elementary precaution for anyone interested in going into that business. Rita did not ask for any evidence or guarantee of the salon's revenues. She preferred instead to rely entirely on Milena. She is however employed as an accounting clerk and should therefore appreciate the utility of accountancy. Rita committed an inexcusable error that in no way vitiates her consent.

...

[47] The evidence does not substantiate any misrepresentations on the part of Milena or Livia. It shows rather that Rita took no precautions to ensure that the salon's revenues were adequate, that its clientele was stable and the rent affordable. Her "blind faith" in Milena cannot justify not requesting information and documents necessary for running the business, such as financial statements or a list of clients. Failure to request such information is an inexcusable error for anyone wanting to go into business.

Chrétien v. Simoneau3 is a recent decision where the Court of Québec adopted the same position in dismissing the counterclaim of the defendants, who sought to be compensated for the plaintiff's failure to disclose all the debts of the target business before the transaction was consummated. The Court found, however, that their failure to do any due diligence constituted an inexcusable error:

[43] Nothing obliged the defendants to sign the deed of sale before doing due diligence on the financial statements of the business. The plaintiff did not pressure them into signing and the fact that the defendants blindly trusted him constitutes an inexcusable error on their part within the meaning of the second paragraph of Article 1400 CCQ.

...

[45] Since the defendants have not discharged their burden of proving that the plaintiff made misrepresentations to them, and considering that the plaintiff did not warrant the profitability of the business, and given the Court's finding that the defendants committed an inexcusable error by doing no due diligence whatsoever on the profitability of the business and the conditions necessary to maintain such profitability, the defendants' plea cannot succeed, nor can their counterclaim.

In short, in the two decisions canvassed above, the purchasers who had failed to do due diligence had not discharged their obligation to inform themselves. Consequently they did not succeed in establishing that their consent had been vitiated by misrepresentations on the part of the sellers.

In the matter of Soft Informatique Inc. v. Gestion Gérald Bluteau Inc.4, the purchasers sought to be indemnified because of a misrepresentation regarding a research & development tax credit originally in the amount of $930,357. Unbeknownst to the purchasers, the seller had since reached a settlement with the Canada Revenue Agency that effectively reduced the tax credit to a much smaller amount. The purchasers accordingly sued the seller for having led it astray.

The Court of Appeal concluded that the purchasers, despite their experience and degree of sophistication, were entitled to rely on the seller's representations. The reduction in the amount of the tax credit should have been disclosed:

[64] Things are not that simple. While the purchasers are sophisticated business people, there is a point where a party to a contract can no longer be criticized for not continuing to verify information, because of the climate of confidence that sets in and the representations and warranties that are given on both sides. That is the case here.

Because the purchasers had discharged their obligation to inform themselves, in particular by having done a due diligence investigation of the target corporation, the Court concluded that the seller's failure to disclose this situation was a breach of warranty entitling the purchasers to indemnification.

4. The satisfaction clause

Purchase and sale agreements often include a clause wherein the purchaser acknowledges having done a due-diligence investigation and declares being satisfied with the results. Can such a clause be prejudicial to the purchaser in the event that it makes a claim?

In the absence of any misrepresentation on the part of the seller, Quebec courts appear to be inclined to give full effect to the satisfaction declaration. By way of example, in the matter of 161251 Canada Inc. v. Monette5, the purchaser argued that the seller knew that a loss provision for the company's accounts receivable should have been included in its financial statements. The purchaser was claiming $257,607 for receivables that he had been unable to collect. The Superior Court found however that the seller had made no misrepresentation in that regard. Moreover, the purchaser had declared himself satisfied with the results of his due diligence investigation, and the offer to purchase did not include any provision for adjusting the purchase price for receivables that proved to be unrecoverable. The purchaser's counterclaim was therefore dismissed.

However, in instances where the seller does make misrepresentations, the satisfaction clause cannot be relied on to defeat a claim for a reduction in the purchaser's obligations, as was the case in the matter of Grégoire v. Brouillette6. While the plaintiff, who had acquired a pharmacy, had done due diligence before the purchase and declared himself satisfied with the results, the Superior Court held that his claim for a reduction in his obligations was well-founded. The seller had made misrepresentations about the size of his clientele and had engaged in unfair competition, information that could not have come to light during the purchaser's due diligence.

5. Conclusion

It is always advisable to do due diligence and to be advised by competent professionals who can adequately guide you through the various stages of a proposed acquisition. As the decisions canvassed above show, it is very difficult for a purchaser who deliberately chooses not to do due diligence to successfully argue in court that its consent was somehow vitiated. In this sense, while due diligence does involve additional costs, it is in our view an absolutely necessary exercise that can avoid a lot of complications for a prospective purchaser, regardless of the form the acquisition may take.

The authors would like to thank Marie-Michelle Savard for her contribution to this article.

Footnotes

1 Aéro-Photo (1961) Inc. v. Raymond, 2014 QCCA 1734

2 2010 QCCQ 6889

3 2015 QCCQ 7518

4 2014 QCCA 2330

5 2015 QCCS 579 (application for an extension of the deadline for filing factums granted, 2015 QCCA 985, and settled out of court)

6 2009 QCCS 5847 (appeal dismissed, 2011 QCCA 951)

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.

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