Due Diligence in Employee Ownership Transactions

What does the term “due diligence” mean?
Due diligence essentially is the process of investigating if there are any potential problems that could make a transaction problematic. Generally, the buying party (such as the ESOP trustee) requires due diligence work to uncover potential problems in the company whose stock is being bought. Examples of difficulties due diligence could uncover include (but are not limited to) unclear titles to property, undisclosed liens on assets, by-laws that prohibit certain kinds of sales, environmental liabilities, improper accounting methods, and a failure to conduct a thorough business analysis of a proposed transaction.

Is due diligence legally required in an employee ownership transaction?
There is not a statutory requirement for due diligence. However, a failure to perform it in cases where it may have turned up critical information could lead to lawsuits by parties to the transaction. For instance, participants might sue an ESOP fiduciary who bought stock in a company that had a large, undisclosed environmental liability.

What alternatives are there to doing due diligence?
One alternative, of course, is to do nothing and take the risk. Frankly, this is usually what is done. Although there have been few resulting problems, the risk is very much there; a major ESOP lawsuit (Reich v. Valley National Bank, the “Kroy” case) concerned these very issues. A mid-point solution is for the seller to warranty that there are no problems, thus shifting some of the potential legal exposure to the seller (normally, the employer company and its board where employee ownership is involved). The trustee could still be sued, however, for not pursuing the matter further. Warranties would be somewhat parallel to having a company’s books reviewed instead of audited.

What areas does due diligence cover?
Generally, due diligence investigations look at accounting practices, corporate by-laws and other documents, laws and regulations that could affect a transaction, the status of assets, pending litigation or regulation issues, and a company’s general business practices and financial conditions. This is a broad list of possibilities that could entail weeks or months of work, but the idea is to look specifically for problems that can impede a transaction.

Source: National Center for Employee Ownership (NCEO)

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