Concept and purposes of the due diligence in Spain

The concept

The notion due diligence comes from Anglo-Saxon Law and refers to the duty of precaution to be taken by any reasonable buyer or investor. It consists in an investigation procedure completed by a buyer or an investor of the object of his potential acquisition, before making his final decision.

In order to correctly understand the concept of due diligence, we have to keep in mind that some commercial transactions, because of their nature or importance, require a revision of the situation and projections of the business units concerned before their completion. The purpose is to collect as much information as possible in order to analyse the economic viability of the projected transaction, the reasonability of its conditions and its effects once the transaction is completed.

The purposes of due diligence are to:

  • Identify the inherent opportunities and risks of the projected transaction,
  • Identify the liabilities and the contingents which could eventually modify the selling price and/or increase the guarantees for which the seller remains obliged toward the buyer.

NB: Representations and Warranties (Manifestaciones y Garantias) are contractual agreements expressing the parties’ observations about the object of the contract (generally, the company sold), whose veracity and exactitude becomes contractually guaranteed. In case of a contractual failure by the seller, he may expose himself to penalties.

Keeping in mind that one of the purposes of due diligence is to identify the liabilities and the contingents of the company sold, the result of this investigation may affect the drafting of these contractual clauses (if the buyer decides to proceed with the acquisition of the company). Such clauses will be drafted in consideration of the risks detected during the due diligence. In this way, Representations and Warranties gives the buyer some security if he decides to buy the company, once the due diligence is completed.

  • Gives the seller or investor a higher level of security in his or her acquisition or investment.

The steps to be followed in order to carry out a due diligence in Spain

There is no precise rule as to the procedure to be followed when you are about to carry out a due diligence.

Nevertheless, in practice, the due diligence procedure begins once the buyer and the seller have, at least, concluded the beginning of an agreement which contains the essentials for the projected transaction of acquisition.

The beginning of an agreement generally consists of a letter of intent (carta de intención) relating the intention to acquire and to sell. This letter generally details:

  • The deadline to execute the due diligence and the seller’s obligation to give the buyer and his advisers the necessary documentation and information on the projected transaction.
  • A commitment of confidentiality of the buyer in respect to the information in his disposition.
  • The seller’s promise not to negotiate and not to conclude the projected transaction with a third party while the deadline of execution of the due diligence is still running.

Any transaction which involves an important financial investment (acquisition of a company, a stake of meaningful participation or of a substantial part of its shares, etc.) is necessarily a risk to the buyer. Such risks consist of, for example, inaccuracies of the accounts and the financial situation of the company, the existence of burdens which could affect its shares, the incorrect assessment of value of its shares and the existence of hidden liabilities.

So, a first approximation of the concept of due diligence may be referring to a legal and countable revision of the object of the projected transaction. Such revision will be effectuated towards a detailed investigation of the different aspects of the company’s activities in order for the buyer to better know what he is about to acquire.

Once this detailed investigation is completed, the buyer will be able to decide whether or not to proceed with the projected acquisition.

1st hypothetical:

The buyer decides to acquire, once the due diligence is carried out. Therefore, a final agreement will be concluded between the buyer and the seller. The final agreement will detail the guarantees for which the seller remains obliged towards the buyer. Then, the projected transaction will be executed.

2nd hypothetical:

The buyer finally decides not to acquire the company because of new factors discovered during the due diligence procedure which compromises the economic viability of the transaction.

Nota bene: A judgment of the Provincial Court of Madrid on 20 March 2012 states that a potential buyer or investor should not find himself liable for ending pre-contractual relationships in these hypotheticals.

Furthermore, it is well established by the courts that the mere breach of pre-contractual negotiations does not lead to a right to receive compensation, even if there was a breach to the good faith principal or an unjustified breach of the negotiations.

Nevertheless, the potential buyer is obliged to pay compensation to the seller if he decides not to proceed with the acquisition of the company when:

  1. There exists a legitimate and reasonable expectation about the conclusion of the projected transaction.
  2. There is no justification for breaching the negotiation (the due diligence did not make new factors appear which could have compromised the economic viability of the transaction).
  3. Real damage to the seller has resulted from the breach of negotiations.
  4. There is a causal relationship between the breach of the negotiations and the damage suffered.

Inés Ducom  & Nicolás Melchior

More articles about due dilligence:

The importance of due diligence in business transfer operations

Terms and phases of the due diligence as part of a business transfer

This article is not considered as legal advice

Having graduated with a Law degree, Nicolás Melchior specialises in real estate, commercial contracts and ICT law in Spain. Working languages: Spanish, German, English and French. For any query Contact Nicolás Melchior