REPRINTS FROM
E-DD
DISORDER
M&A DUE DILIGENCE IN THE E-INFORMATION AGE
BY HOLLY K. TOWLE
A fundamental commerce shift from
bricks-and-mortar to clicks-withoutborders has changed the rules of due
diligence.
As our economy has moved from
“goods” to intellectual property and information, due diligence has changed
to include reviews for open-source
software and its potential “viral” effect. Yet, while intellectual property
matters dominate the headlines,
“Non-IP/Electronic” due diligence, or
E-DD, focuses on issues arising from
doing business electronically and information that tends not to enjoy intellectual property protection.
The importance of due diligence
reviews is no secret. An investigation may reveal risks that lurk below
the surface, and only the foolhardy
acquirer skips this step. When computer information is created, collected, held, used or discarded, E-DD
is essential. Here are a few key due
diligence questions for the e-information age.
Is the acquisition agreement wording outdated?
Most agreements focus on tangible “property” concepts, yet items
important in an information economy are not tangible. Some are not
even “property.”
As intellectual property rights
became as or more important than
brick-and-mortar assets, wording
of acquisition agreements shifted
from focusing on tangible property—
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“sales,” “ownership” and “title”—to
dealing with “licenses” and intangible intellectual property rights.
But another shift beyond IP is
necessary. If a target entertainment
company is sending computer “robots” to gather ticket prices from
Internet auction sites, the gathered
facts are not protected by copyright,
so getting an assurance that the target is not “infringing” misses the
mark. The target could be “trespassing,” however, and E-DD would have
used language to capture that kind of
difference.
Exactly what E-DD laws are we referring to?
Assume a buyer wants to send
e-mail promotions to post-merger
customers. This makes the target’s
customer list a valuable asset in the
deal. These days, having customers
is not the same as being able to send
marketing e-mails to them. If E-DD
ignores this, the buyer may end up
paying for something it is not really getting, specifically the ability to
send e-mails to the full list.
In another example, new state laws
require customer notice upon breach
of information security. ChoicePoint
Inc. made news in February 2005
when the company provided notice
that it had been duped into selling
the personal information of almost
145,000 people. ChoicePoint made
this disclosure under a 2003 California law (recently followed by about
20 states), more than eight months
after the breach occurred.
Had ChoicePoint been an acquisition target during that period, asking
during E-DD whether it had suffered
any security breaches might have
elicited important information.
Let’s put the potential acquisition
risks into perspective: ChoicePoint
stock lost 1.3% the day after the announcement, fell nearly 14% the next
week and, as of June 2005, was still
down more than 12% from the day
of disclosure, according to The Wall
Street Journal.
Won’t a representation regarding
compliance with all applicable law
solve all of this?
No. Many of the new laws do not
require anything, so they cannot be
violated—they simply create material consequences if the law is ignored.
Thus, a target could accurately represent that it is not in violation of law
while still being at risk under those
laws.
To illustrate, assume the target has
a Web site where customers make
contracts. Those contracts are electronic records and several state and
federal laws will affect them simply
because they are electronic (that is,
these laws do not exist for paper records).
For example, under federal law,
e-records may be denied legal effect,
validity or enforceability if they do
not meet certain federal rules. There
is no “violation” of law if the rules are
not met—the records simply become
susceptible to challenge. Worst case,
the target might not have the enforceable or valid contracts that it thinks
it has—instead, it may have contracts
and records that are subject to challenge because that is a consequence
of, but not a requirement of, not
meeting the new e-rules. Had the acquirer sought a specific representation regarding electronic records and
done some E-DD regarding them, it
might have paid less for the contracts
or added “fix e-records and procedures” to its post-merger to-do list.
What’s best, due diligence or a
mere representation?
E-DD liabilities and issues tend
to create an affirmative need to investigate instead of relying on representations in acquisition agreements.
REPRINTS FROM
In modern practice, a mismatch between privacy policy text and practice may present greater liability or
reputational risk and business disruption than many issues examined
in traditional due diligence. Review
is necessary, not mere assurances.
E-DD is a “tip of the iceberg” is-
sue, and addressing every new law
and concept would be prohibitive.
But E-DD commensurate with the
circumstances, risks and the target
company’s business is a new necessity. This includes updating acquisition agreements and taking another
look at the focus of existing due dili-
AS FEATURED IN
REPRINT FROM DECEMBER 12, 2005 PP. 25
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gence. ■
Holly K. Towle is a partner in the Seattle office of Preston Gates & Ellis
LLP, head of the firm’s Electronics in
Commerce practice and the author of
“The Law of Electronic Commercial
Transactions.”