Due diligence review, which is frequent in acquisition transactions, basically refers to an examination of the target company prior to the buyer's acquisition. This term originates from Anglo-American legal system, and Swiss-Turkish doctrine has yet to generate a new term and thus uses the term “due diligence” in their legal terminology.
The main purpose of due diligence is to rectify the information asymmetry between the parties. At the beginning of negotiations, the buyer’s knowledge of the target company is usually limited to the publicly available information, and this puts buyers at a disadvantage in certain aspects of the transactions such as contract drafting and making appropriate offers. Due diligence review eliminates these concerns and provides an equal negotiation stance for the buyer.
The due diligence review is usually conducted before an acquisition. Even though such review is not directly regulated under Turkish law, it has a direct effect on seller’s liability. According to the Turkish Code of Obligations No. 6102 [“TCO”] art. 222, the seller is not liable for the defects buyer knows or is able to know at the time of the contract’s conclusion.
However, this provision is not mandatory, meaning that the parties may agree otherwise. Indeed, in practice, the effect of due diligence on the seller's liability is frequently regulated in share purchase agreements.
What is Due Diligence?
Due diligence in corporate acquisitions can be defined as the buyer’s elaborate examination of the target company, whose shares the buyer plans to acquire, prior to the transaction. During this process, an assessment of the target company’s financial and legal status is made through a review that includes but is not limited to the company’s assets, loans, accounts, contracts, and pending lawsuits. Essentially, this review can be conducted prior to or after the share purchase agreement or after the closing. However due to the fact that due diligence review is almost always carried out before the signing in practice, our article focuses on due diligence review conducted prior to signing of the share purchase agreement.
The Effect of Due Diligence to the Share Purchase Agreement
After the due diligence review, the buyer can identify the problems, setbacks or shortcomings of the target company. These may be issues that can be resolved or eliminated before the closing, or they may be potential risks that may arise in the foreseeable future. For example, problems regarding an incomplete certificate may be rectified and the respective certificate may be obtained. Or it may be possible to put subcontracted workers on the company's payroll, who are legally considered to be the company's own employees. However, a lawsuit to which the target company is a party, cannot be resolved in a short while. Such problems must be considered during contract negotiations and covered in the share purchase agreement.
Shortcomings identified by the buyer that can be remedied promptly are usually agreed as closing conditions, that is to say that the seller undertakes to remedy the said shortcoming before closing. In above mentioned examples, the seller undertakes to obtain the incomplete license or put the subcontracted workers on company payroll. It is possible to regulate other matters as closing conditions, as well. For instance, if the target company has guarantees in favor of sellers, these may be requested to be removed at closing or immediately thereafter. Finally, if the problem is of a nature that cannot be resolved in a short period of time and it contains considerable risk in the future, they are likely to be regulated under seller’s liability as per the share purchase agreement. The said risk may be directly accounted for in the purchase price, or it may be left on the seller to indemnify the target company or the buyer pursuant to seller’s warranty, or the risk may be shared between the parties.
The Effect of Due Diligence to Seller’s Liability
Due diligence conducted before the sale contract limits the seller's liability as per TCO art. 222. The seller can no longer be held liable for defects that the buyer knows or should have known within the scope of due diligence. In fact, the seller’s warranties cannot be relied on regarding the defects buyer knows, thus the buyer may only ask the seller to be liable for any damage that may occur in the future due to that said defect. On the other hand, it is possible for seller to give warranty that there are no defects that the buyer should have known.
In short, the seller shall not be liable for any defects the buyer learned or should have learned -unless they give warranties that such defects do not exist- during the due diligence review.
Therefore, it is vital that the due diligence review is conducted with utmost care, considering the seller can avoid liability by claiming that the defect should have been known from the information and/or documents they disclosed during the due diligence review, but the buyer’s consultants did not notice the said defect. The fact that the buyer knew or should have known about the defect must be proven by the seller; however, since it is difficult to prove this issue, it is recommended that the matters that the buyer knows or should know to be regulated in the contract. In any case, keeping a copy of all information and/or documents provided during the due diligence review would be a good strategy on the seller’s side, since they may not be able to access those after the closing.
In practice, the effect of due diligence to the seller’s liability is an important issue during the negotiation phase. The seller aims to confirm all of the information and documents provided during the review is known to the buyer through putting a clause in the share purchase agreement. This strategy called the general disclosure concept, poses a clear risk for the buyer, especially in case of a review process with a multitude of information and documents.
On the other hand, the buyer would like to include all matters that relieve seller of their liability in the agreement. In this scenario, the parties draft a disclosure letter as an addendum to the contract that identifies all of the issues for which the seller will not be liable for.
According to the TCO art. 222, the seller will not be liable for the defects the buyer knows or should have known. Thus, the information and documents disclosed during the due diligence review, which is extremely frequent in M&A practice, may lead to non-liability of the seller. In such cases, disputes may arise regarding various issues, such as the scope of seller’s liability and the defects that could have been understood from the disclosed documents. In order to avoid these problems after the acquisition, it is recommended that the seller and the buyer mutually determine the disclosed matters and agree on the liability regime in the contract.
By Zahide Altunbas Sancak, Partner, Guleryuz Partners