In the context of corporate acquisitions, the managing directors of the acquiring company are regularly faced with the question of the scope of the "due diligence," the review of the target company. Sometimes no due diligence at all is performed, such as in the context of a share purchase via the stock market. However, if the managing director makes the wrong decision regarding due diligence, it may lead to significant liability. The comments in this article relate to the managing directors of German limited liability companies but also apply to the boards of directors of stock corporations and generally to the management of limited partnerships that have limited liability companies as general partners. In the event the buyer uncovers risks that were unknown prior to the acquisition, or the business of the target company does not do as well as expected, the managing director may be reproached for potentially violating his duties of care in connection with the acquisition. Liability of the managing director is especially relevant when the purchasing entity does not have remedies available to it, as when the statute of limitations has run, there is a lack of solvency, or damage claims cannot be asserted against the seller (as is often the case when expectations regarding earning power are not met). In case of violations of the duty of care, the managing director is liable to the acquiring company for damages. Approval of the acquisition by shareholders (not the supervisory board, if any) or instructions issued by the shareholders in connection with the acquisition can exempt the managing director from liability only if the shareholders were adequately informed of any potential risks beforehand.
Duty to Perform Due Diligence?
The law contains only vague guidelines regarding the conduct of the buyer's managing director in a corporate acquisition. These guidelines provide that "the care of a prudent businessman is to be applied." The managing director is benefited by the fact that he has broad discretionary leeway. This includes knowingly assuming certain business risks, with the corresponding risk of making the wrong decision. In this context, the managing director is obligated to be thoroughly informed with the due care customary in the business regarding the basis for the corporate decision and the assumption of risks. Generally, in an acquisition setting, this means the company must have its own qualified employees perform due diligence as well as involve external advisors.
The managing director has the burden of proof that he did not violate his duty of care. If damages arise, he has to prove that he complied with his duty of care, that he could not comply with his duty of care through no fault of his own, or that the damages would have been incurred even if he had complied with his duty of care.
Scope of Due Diligence
In performing due diligence, questions arise as to its form and scope. There is no generally accepted standard in this regard. Today, it is customary to review the target company from a tax, economic, and legal perspective. However, further areas may also come under consideration, such as the review of potential environmental liabilities. The extent to which the information provided by the seller will be independently verified must also be decided. The Higher Regional Court of Oldenburg, for example, ordered a managing director to pay damages because he based a corporate acquisition on the profitability calculations prepared by the target company's management even though irregularities were evident, instead of conducting his own review of the calculations.
Regarding the managing director's discretionary decision as to the form and scope of the due diligence, circumstances may at times be taken into consideration that speak in favor of limiting the due diligence and possibly knowingly accepting risks:
- Time constraints. Time constraints may
justify limiting the scope of due diligence. In an auction
context, complying with the time frame set by the seller is
often a decisive factor for continued participation in the
auction process and therefore for achieving the
entrepreneurial goal of completing the acquisition. On the
other hand, timelines set by the company itself or its
supervisory board are not as imperative as they may sometimes
- Effort and expense. The costs and
human-resources expenditures have to be commensurate with the
economic value of the intended corporate acquisition for the
- Safeguarding against risks. In properly
safeguarding against risks, it is appropriate to assume risks
in cases in which a failed acquisition threatens the
buyer's very existence. Safeguarding against risks
can, for example, be served by creating a new limited
liability company to act as the buyer and borrower
simultaneously under the related acquisition finance
facility. For financial investors, accepting high risk is
practically part of the business model, and the risk of
individual bad investments is reduced by diversification
across an entire investment portfolio.
- Warranty claims. Due diligence, however,
should not be limited due to reliance on potential warranty
claims against the seller. When the decision regarding due
diligence is made, the details of the seller's
warranties are still uncertain. In the seller's
market that has prevailed over the last several years, buyers
were often prepared to accept far-reaching limits on
warranties, such as short limitation periods on claims or low
ceilings on damages. In addition, asserting warranty claims
may take many years and may ultimately fail due to the
seller's lack of solvency. On the other hand,
comprehensive due diligence is to be performed if no adequate
warranties may be expected, such as in the context of a
purchase from a bankruptcy trustee or if the enforceability
of any future warranty claims is doubtful.
- Increase in shareholdings. Often the
position is taken that due diligence does not need to be
performed in the context of the purchase of shares in a
company in which the buyer is already a shareholder. This
holds true, according to the principles set forth above, only
if the buyer has access to adequate and reliable information
regarding the company based on his prior shareholdings.
In corporate acquisitions, the managing director is advised to reach an informed decision regarding form and scope of due diligence by taking all material circumstances into account and carefully documenting the basis for the decision. This is especially true in exceptional cases in which the managing director decides against performing any due diligence.
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.