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As a result of several converging factors, the exercise of some level of due diligence with regard to a company’s electronic record may be unavoidable. This article will consider the impact of electronic discovery on due diligence practices, and examine whether, and to what extent, an investigation of the electronic record is desirable, or even mandatory. The implications extend to due diligence in mergers and acquisitions, securities, financing and other transactions. Consider the converging factors in this field. Electronic discovery is widespread. Discovery of electronic records in litigation is rapidly growing in prominence. Litigators are becoming adept at conducting electronic discovery since a party improperly responding to electronic discovery requests can face severe sanctions and a party failing to seek electronic documents may forgo key evidence. Experts and tools make e-discovery feasible. A burgeoning industry of experts and software developers has devised tools and methods for effectively conducting electronic discovery. These methods make it possible to search quickly a vast quantity of electronic records. The electronic record is rife with liability. The electronic record, particularly e-mail, has emerged as a clear source of corporate liability. There are many examples of regrettable e-mail statements serving as key evidence in civil, regulatory and criminal actions. But leaving aside the more egregious, headline-grabbing statements, candid communication is the lifeblood of an efficiently run company. E-mail is spontaneous. It is precisely the unguarded nature of e-mail that makes it the focus of litigators seeking the “smoking gun.” And it can provide parties conducting due diligence with the clearest statements about a company’s products, prospects, risks and more. Due diligence requires the exercise of reasonable care. The standard to be met in the conducting of due diligence is defined by case law. One representative case held that an underwriter seeking to shield itself by utilizing the due diligence defense must show that it “did not know, and in the exercise of reasonable care, could not have known, of [the] untruth or omission.” Software Toolworks Sec. Lit., 50 F.3d 615, 621 (9 th Cir. 1994). Tools and methods are changing what one can learn while exercising reasonable care. As the tools, methods and expertise have improved in the electronic discovery realm, making it more practical to sift through a company’s vast electronic record, and as the liability-laden statements found in the electronic record become more prominent, an inevitable question arises: Can parties conducting due diligence claim to have met the standard required if they fail to investigate a company’s electronic records? What a party can know using reasonable care is being redefined by tools and techniques that are making diligence with respect to electronic data reasonably doable. A typical investigation Consider the typical investigation of an acquisition target. The war room is filled with financials, reports, minutes, agreements, regulatory communications and other papers. These papers are fully vetted. Senior management answers questions to the best of its knowledge. Areas of concern get more attention and analysis. Hard-pressed managers will remind their attorneys that they can’t know everything that has been said and done in the company’s name by everyone under their watch. In the seminal due diligence case, Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968), the court wrote that it is not “sufficient to ask questions, to obtain answers which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete.” Id. at 696. The electronic record is vast, and the time and money available to conduct due diligence are limited. Investigating the entire electronic record is neither feasible nor legally required. But after initial diligence has narrowed the scope, the relevant electronic record is vastly reduced. In an era of voluminous e-mail, it is doubtful that the managers themselves are aware of the e-mail created by subordinates residing on the company’s servers. These are some instances when relying on management responses and ignoring the electronic record may be particularly risky: The company’s intellectual property (IP) is a significant asset. If a company’s valuation is largely IP-based, certain questions naturally arise. Has the company adequately protected its critical information from unauthorized access? Has permissible access been analyzed for otherwise suspicious activity, such as unusual copying or transmission? Since all of this can be readily investigated, is it reasonable to ignore doing so? A company is highly regulated. Suppose, for example, the subject of the due diligence inquiry is a pharmaceutical developer with significant value based on drugs in varying stages of clinical trials. One would want to know whether the company collects and shares information concerning these trials in internal group folders. Additional questions would include: Does the Food and Drug Administration (FDA) liaison staff similarly share information internally? Have these messages been evaluated? If significant value is tied to one or two drugs, would sampling and reviewing the e-mail of certain key individuals provide a more candid view of the drug trials or competing products, or the likelihood of FDA approval? Specific risk factors are contemplated. If a concern has risen to the level that it needs to be included as a risk factor in the disclosure, or that specific representations and warranties are being sought, will these statements serve as a road map for plaintiffs’ lawyers of matters that could have been explored by sifting through the electronic record? Can the risk described be further understood, at a reasonable cost and within a reasonable amount of time, by exploring the company’s electronic information? A lawsuit can be reasonably anticipated. If a shareholder suit challenging your transaction is expected post-announcement, it is virtually certain that the lawyers will immediately seek discovery of electronic records, particularly e-mail. Plaintiffs’ lawyers know that complying with a sweeping electronic discovery request is expensive and one-sided. No company would want a shareholders’ class action to be the event that focuses its attention on what may be in the e-mail that someone conducting due diligence decided not to review. Red flags are waved. Certain events, such as the untimely resignation of a company’s auditors, a change in accounting methods or insider stock sales raise concerns. The greater the ability to define key events, dates and people and to focus on those events during due diligence, the greater the likelihood that the electronic record will reveal candid explanations. Rumors of a merger swirl. If word of the merger is out, bad things can happen to the target. Key people that are an important asset of the target start to float r�sum�s and line up co-workers to take with them. Employees copy customer lists and proprietary data. Salespeople conduct fire sales. Anyone who has been engaged in improprieties may be busy hitting the “delete” key on his or her computer. With little to lose, employees may take actions that do serious harm to the value of the target. Uncovering this kind of activity would normally require a broad effort. Creatively applying search techniques and tools in your due diligence can simplify the effort and bring useful information to light. Learning a new approach Most corporate practitioners are unfamiliar with the steps involved in investigating the electronic record of a company. First, a third-party expert is likely to be called in to assist with scoping, such as defining key people and dates. The company’s data are surveyed to identify potentially relevant types of data, such as e-mail, office suite applications and customized databases. These data are collected from source media such as file servers, backup tapes, hard drives and removable media. It may be necessary to restore backup tapes or recover temporary or deleted files, although it is critical to weigh the costs and time constraints of doing so against the potential benefits. Next, extraneous or duplicate data, such as nonuser program files and e-mail strings, are removed, significantly reducing the amount of data to be processed. Searchable databases are created from the remaining user data. Finally, the collected, culled data are searched and reviewed. The company synthesizes and reports the results, including the methods employed, in an agreed format. If a party finds the report or methodology inadequate, the target or issuer can decide whether to reveal more information or modify its methods. If it refuses, the acquirer or underwriter must decide whether to go forward on that basis. There are several reasons for engaging an electronic discovery expert to assist with the investigation. The issuer or target will probably insist on an independent expert. A company does not want to reveal too much should the deal fall through, or jeopardize the integrity of its IP and trade secrets, especially if the suitor is a rival, or the underwriter has deep industry connections. A neutral expert can carry out the parties’ agreed-upon instructions, and provide valuable advice on matching the scope of the diligence to the circumstances of the deal. Finally, an expert can expedite the process of locating, collecting, processing, searching, hosting and delivering the data. There are various tools that can be used to search vast quantities of electronic data. Some go beyond traditional Boolean searching to include enhancements like a built-in thesaurus, natural language and fuzzy searching. “Artificial intelligence” search engines look for specific topics rather than specific words, locating documents with related semantic content, measuring how closely each document relates to a topic and then prioritizing the results. The effort put into planning a search is just as important as the tools used to carry it out, and involves several important steps. An evaluation of the issues to be investigated is necessary to create effective search criteria. Data must be meaningfully sampled in order to test and refine the search and generally validate the process. Once key data are located, appropriate follow-up is necessary, such as consideration again of the search methodology, and perhaps examination of the metadata of important documents with an eye toward refining search criteria. With an array of available search engines and methods for searching vast quantities of data, an optimal approach to electronic due diligence is necessary. This requires an understanding not only of the available techniques and tools but also the environment in which diligence is being conducted. The issue is not what is possible but what is practical and reasonable in the context of closing a friendly merger or securities offering. The initial planning effort, centered on completing the task on time and within a budget, is critical to applying the available tools effectively. Leaving aside risk considerations, there is an equally compelling economic argument for conducting some level of electronic data diligence: The further investigation should result in more efficient pricing. Is the seller or issuer being asked to accept a discount due to nominally unquantifiable perceived risks? If yes, those risks might be reduced, and the price correspondingly increased, if a search of the electronic record confirms that the perception is unwarranted. Would the buyer achieve a better price if further risks were exposed? In the case of a powerful buyer and an eager seller, the buyer may be able to compel an extensive review of the record. The added expense may be more than offset by the reduced price arising out of revealing further liabilities. Added benefits In addition to risk reduction and more efficient pricing, electronic due diligence provides two other key benefits in an acquisition. First, the old-fashioned war room can now go digital. The data can be accessible via the Internet 24/7 in a searchable format. Paper can be scanned, coded and stored electronically. A target talking to several suitors can establish varying levels of access. Instant flagging, notation and folder creation are possible. This more efficient, less expensive review format lowers transaction costs and invites more bidders. Second, electronic due diligence simplifies post-merger data integration. A key ingredient to a healthy merger is a swift and rational integration of data systems. The survey can involve a review of the target’s data, particularly old backup tapes. Backup tapes that serve no useful purpose should be recycled. In future litigation, those tapes may require restoration at great expense simply to confirm that they contain irrelevant information. It doesn’t make sense to acquire useless and potentially liability-laden backup tapes. What one party perceives as highly desirable, the other may consider unwarranted. Of course, in the context of closing a friendly deal, the investigation must be reasonable. However, all parties need to understand the manner in which these matters are now litigated, the methods that make this type of investigation possible and how these methods are reshaping due diligence. David K. Thornquist is an attorney and a consultant for SPI Technologies Inc. He can be reached at [email protected].

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