{"id":43,"date":"2018-12-28T01:33:52","date_gmt":"2018-12-28T01:33:52","guid":{"rendered":"https:\/\/davidlewislaw.com\/?p=43"},"modified":"2018-12-28T01:40:11","modified_gmt":"2018-12-28T01:40:11","slug":"due-dilligence","status":"publish","type":"post","link":"https:\/\/davidlewislaw.com\/?p=43","title":{"rendered":"Due Dilligence"},"content":{"rendered":"\n\n\n
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DUE DILIGENCE OR WHAT YOU DON\u2019T KNOW CAN HURT YOU<\/b><\/span><\/p>\n

Due diligence is like sweeping a field for mines.\u00a0 Not quite as dangerous, to be sure, but you never get thanked for the ones (i.e. the problems) that you find.\u00a0 The purpose of this article is to provide to buyers a brief summary of some do\u2019s and dont\u2019s and hopefully some useful checklists, which follow each section, and to both sellers and buyers a few practical hints.\u00a0 To keep the reader (not to mention the writer) awake, each subject is headed with an example of a particularly nasty example of what might crawl out from under that particular rock or an (in)appropriate witticism.<\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 1.\u00a0\u00a0 <\/span>Overview; or Any Idiot Can Spend $100,000 on Due Diligence Legal Fees<\/span>. Like a good tailor, the smart investor needs to know how much due diligence is . .\u00a0 . well, due, at the very outset.\u00a0 This is because the key to understanding due diligence is that it never starts later than when the purchase agreement is negotiated.\u00a0 How much is enough is largely a matter of experience, but in general it is determined by the nature of the project and of the investment.\u00a0 For example, a review of income history is more significant for an office building than for a hotel that you\u2019re converting into condominiums.\u00a0 One size never fits all.<\/span><\/p>\n

Of course, we all want Italian tailoring at K-Mart prices.\u00a0 You won\u2019t find it, but sometimes you\u2019ll get the opposite.\u00a0 Be very careful of costs; law firms thrive on due diligence because it is one of the relatively few tasks that can profitably be delegated to young and inexperienced attorneys.\u00a0 You know how much is enough; they don\u2019t.\u00a0 It is always possible to identify more questions to ask, so that if the instruction is just \u201cprotect me,\u201d then the process is open-ended. The client must decide, as a business matter, the boundaries of its due diligence program.\u00a0 Not to worry; if you don\u2019t, I guarantee you\u2019ll never make the same mistake again.<\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 2.\u00a0\u00a0 <\/span>The Contract Negotiation; or The Relationship is Always Strongest on the First Date<\/span>.\u00a0 In the contract negotiation, the first key due diligence issue is to get the seller to produce copies of the documents.\u00a0 If the seller merely gives you the right to rummage around its office and make your own copies, it\u2019ll be harder to prove later on that a document was not produced.\u00a0 Second, the buyer\u2019s approval period should not run until the last<\/i> document is produced.\u00a0 Third, the buyer must have the right to disapprove any matter in its sole discretion.\u00a0 Practice hint<\/i>: it\u2019s a good idea to add an omnibus right to approve \u201cthe suitability of the property for Buyer\u2019s investment purposes\u201d \u2013 this enables a justification-free \u201cout\u201d should the buyer wish to walk from the deal.\u00a0 Fourth, get all the access and inspection rights that you are going to need.\u00a0 Some sellers are wary of allowing invasive or destructive testing, which may be essential for the buyer.\u00a0 Remember, the best chance of getting what you need is right at the beginning, when the parties are most co-operative.\u00a0 Well, maybe the date analogy isn\u2019t quite accurate.<\/span><\/p>\n

Checklist (for contract clauses):<\/i> <\/span><\/p>\n

Seller must produce all documents<\/b><\/span><\/p>\n

Approval period runs from delivery of last document<\/b><\/span><\/p>\n

Sole discretion<\/b><\/span><\/p>\n

Omnibus right<\/b><\/span><\/p>\n

Access and inspection rights<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 3.\u00a0\u00a0 <\/span>Leases; or Oh, You Mean the Tenant Has the Right to Buy the Building Too?<\/span>\u00a0 Leases are the keystone of all income producing properties.\u00a0 You must see every one, together with all extensions, modifications and side letters.\u00a0 If there is one thing that you are going to review yourself, let it be the leases; a close reading is essential not only to spot what is there (e.g., rights of first refusal, rights of offset, landlord obligations, dependent covenant clauses) but what is not, such as incomplete operating pass-through provisions.\u00a0 You really must review the leases yourself; leaving it to a third party is very dangerous, because especially in large projects, it is simply too easy to overlook something important.\u00a0 Remember that any lease ambiguities can sometimes be clarified in the estoppel certificates. \u00a0\u00a0<\/span><\/p>\n

Checklist:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/i><\/span><\/p>\n

All Leases – entire copies plus any addendum or riders.\u00a0\u00a0\u00a0\u00a0 <\/b><\/span><\/p>\n

Rent Roll(s) showing all tenants, rents, escalations, commencement dates\/expiration dates, option terms, security deposits, and tenant status.<\/b><\/span><\/p>\n

Management company reports<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0 4.\u00a0\u00a0 <\/span>Tenant Files; or No-One Knows the Building Like the Tenants<\/span>.\u00a0 There may be no issues in the leases or even raised in the estoppel certificates, but you\u2019ll always learn a lot by looking at the tenant correspondence files.\u00a0 These are a mine of information about management, operation and ownership issues in the building, and tenant payment history.\u00a0 Even better, go and talk to the tenants . . . unless the purchase agreement contains a confidentiality clause (in which case access to the tenant correspondence files is all the more important).<\/span><\/p>\n

Checklist:<\/i><\/span><\/p>\n

Tenant correspondence files<\/b><\/span><\/p>\n

Tenant interviews<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 5.\u00a0\u00a0 <\/span>Insurance; or How Come No-One\u2019s Willing to Insure Me?<\/span>\u00a0 Depending on how old the building is, insurance policies can be a very valuable resource.\u00a0 The seller should be required in the purchase agreement to obtain for the buyer a copy of the insurance company\u2019s most recent risk assessment for the building, together with a claims history.\u00a0 This can reveal anything from leaking roofs to uneven paving.<\/span><\/p>\n

Checklist:<\/i> <\/span><\/p>\n

Insurance Policy; including all riders, risk assessments, and disclosure affidavit for carrier<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 6.\u00a0\u00a0 <\/span>Physical; or You Mean it Isn\u2019t Supposed to Lean Over Like That?<\/span>\u00a0You need to check out: seismic; soils; building structure; mechanical and system components (e.g. plumbing, electrical, elevator, HVAC).\u00a0 Find out how big the building actually is; some markets are notorious for having floor areas that get bigger each time a lease is signed.\u00a0 Thorough inspections can almost be guaranteed to find some defects or problems, so that buyers often use the due diligence process as a tool for renegotiating the price.\u00a0 This may be particularly true where the buyer is using either in-house inspection teams or independent contractors with whom they do repeat business.\u00a0 Seller\u2019s practice hint:<\/i>\u00a0 try to get a \u201cno nickel and dimes\u201d clause in the purchase agreement (e.g., individual defects costing less than $X to correct, or defects in the aggregate costing less than $Y, will be deemed acceptable).\u00a0 Also, provide that if the buyer terminates the agreement for a \u201cdue diligence\u201d reason, then it must provide copies of its reports as a condition to the return of its good faith deposit; it\u2019s a valuable \u201cpackage\u201d for the next buyer.\u00a0 Buyers\u2019 practice hint:<\/i>\u00a0 if the seller asks for this, require reimbursement for the cost of the reports.<\/span><\/p>\n

Checklist:<\/i> <\/span><\/p>\n

Measurement of usable and rentable size of the building.<\/b><\/span><\/p>\n

As-built plans and specifications. <\/b><\/span><\/p>\n

Engineers (soils, geotechnical, electrical, plumbing, HVAC, elevator, roofing).\u00a0 <\/b><\/span><\/p>\n

Access to, and availability of additional, telecommunications services.<\/b><\/span><\/p>\n

Utilities – adequacy, availability of any desired upgrades, physical connection arrangements.<\/b><\/span><\/p>\n

Utility bills: Water, Sewer, Gas, Electric (at least two years of monthly statements). <\/b><\/span><\/p>\n

All recent appraisals, engineering reports, environmental reports.<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 7.\u00a0\u00a0 <\/span>Financial; or I Didn\u2019t Realize that Andrew Fastow Was on Day Release.<\/span> You must see a financial operating history of the property. An examination of rent rolls, payment histories, and credit files of existing tenants can be very helpful.\u00a0 The expense side of the ledger is just as important, as it will show aberrations such as unusual spikes \u2013 or troughs \u2013 in spending.\u00a0 <\/span><\/p>\n

Checklist: \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/i><\/span><\/p>\n

Annual profit and loss statements (P&L\u2019s) 3 – 5 years<\/b><\/span><\/p>\n

Monthly P&Ls (1-2 years)<\/b><\/span><\/p>\n

Balance sheet (3 years)<\/b><\/span><\/p>\n

Rent Roll including term, deposit, and payment history <\/b><\/span><\/p>\n

Tax returns- 3 years<\/b><\/span><\/p>\n

Bank statements showing deposits for last twelve months<\/b><\/span><\/p>\n

Complete audit of building operations (operational audit).<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 8.\u00a0\u00a0 <\/span>Environmental; It Used to be a WHAT?<\/span>\u00a0 No due diligence inquiry can omit environmental analysis; even an empty field can have pesticide residue or storage tanks on or under it.\u00a0 Generally, the first step is to conduct a \u201cPhase One Assessment\u201d, which usually comprises a visual inspection and an analysis of federal, state and\/or county records to establish past and present uses of the property.\u00a0 If justified by the findings of the Phase One Assessment, a buyer may wish to obtain a \u201cPhase Two Assessment\u201d report, which may include subsurface drilling and sampling, monitoring, well installation and sampling, ground penetrating radar, and asbestos and lead sampling.\u00a0 Sometimes the Phase Two Assessment may also include an investigation of special environmental concerns, such as “sick building,” lead paint, electromagnetic fields, poisonous insulation, and other “problem” building materials.\u00a0 Some states have specific environmental review procedures.<\/span><\/p>\n

Checklist: \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/i><\/span><\/p>\n

Phase One Environmental Report<\/b><\/span><\/p>\n

If recommended, Phase Two Environmental Report<\/b> <\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 9.\u00a0\u00a0 <\/span>Service Contracts, or Piggy Properties Gets Paid for all Lease Renewals and Moron Management Has an Annuity<\/span>. The buyer needs to review all service agreements.\u00a0 This would include any agreements for trash removal, landscape maintenance, parking lot operation, window cleaning, and so on.\u00a0 Most service contracts are terminable on fairly short notice, but there are some major exceptions.\u00a0 The main ones are property management agreements, which sometimes have long termination notice periods, billboard agreements and, for some odd reason, elevator maintenance contracts.\u00a0 As noted above with respect to leasing, a potentially significant area of exposure is for the payment of brokerage commissions on the exercise by tenants of renewal options or other rights under their leases.\u00a0 Because service agreements can be binding on buyers, it should be possible even in an \u201cas is\u201d deal to obtain a representation from a seller that it has not entered into any service agreement which it has not disclosed to the buyer.<\/span><\/p>\n

Checklist:<\/i> all agreements which relate to the ownership, management, operation, leasing and maintenance of the building.<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 10.\u00a0\u00a0 <\/span>Title and Survey; or Roadway?\u00a0 What Roadway?<\/span>\u00a0 This is a task normally undertaken by the buyer\u2019s attorney.\u00a0 The seller should be required to deliver (or more accurately, to cause the seller to have the title company deliver) copies of all title records.\u00a0 It\u2019s a good idea to ask the title company to plot the easements, as it makes it easier to review the survey when it comes.\u00a0 Buyers should obtain ALTA extended coverage insurance under the 1970 form of policy, as this does not include an exception for creditors\u2019 rights or an arbitration requirement, which were introduced in later versions.\u00a0 A close review of all documents is essential, even of existing loan documents when the loan is not being assumed.<\/span><\/p>\n

Checklist<\/i>: ALTA title report, legible copies of all exceptions, and survey.<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 11.\u00a0\u00a0 <\/span>Litigation; or Why Can\u2019t We Close Without Aunt Jane\u2019s Signature?<\/span>\u00a0 Pending litigation may affect the seller, any of its constituent entities, or the property itself.\u00a0 In addition to getting representations in the purchase agreement, a litigation search can and should be obtained.\u00a0 Some claims can reveal defects in the building while others may go the very ability of the seller to deliver title (for example, where a group of heirs own the property and disagrees as to key elements of the deal \u2013 i.e., the \u201cGrubby Group\u201d syndrome).<\/span><\/p>\n

Checklist<\/i>: litigation search (state and federal courts).<\/b><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0 12.\u00a0\u00a0 <\/span>Governmental; or You Mean That Shack is a Historical Landmark?<\/span>\u00a0 It\u2019s probably a good idea to check the status of the building with local authorities to see whether there are any specific issues with it.\u00a0 Examples are zoning, historical landmark designation, special licenses (e.g. liquor), air rights, certificates of compliance and Americans with Disabilities Act issues.\u00a0 This review should include an analysis of whether, even if the building satisfies these requirements on an existing basis, it will continue to do so if any contemplated renovations or expansions are carried out.\u00a0 Sometimes an existing building is \u201cGrandfathered\u201d under existing rules or regulations, so that once an expansion project is underway the building will have to be brought up to code to remain in compliance.\u00a0 <\/span><\/p>\n

Checklist<\/i>: check local authority records and indexes.<\/b><\/span><\/p>\n

Conclusion:<\/b>\u00a0 There are no hard and fast rules for due diligence.\u00a0 It\u2019s a daunting combination of heads-up batting and sheer drudgery, but it\u2019s worth every penny and every hour.<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n","protected":false},"excerpt":{"rendered":"

DUE DILIGENCE OR WHAT YOU DON\u2019T KNOW CAN HURT YOU Due diligence is like sweeping a field for mines.\u00a0 Not quite as dangerous, to be sure, but you never get thanked for the ones (i.e. the problems) that you find.\u00a0 The purpose of this article is to provide to buyers a brief summary of some … Read more<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"tpl-no-header-footer.php","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[],"_links":{"self":[{"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/posts\/43"}],"collection":[{"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=43"}],"version-history":[{"count":1,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/posts\/43\/revisions"}],"predecessor-version":[{"id":44,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=\/wp\/v2\/posts\/43\/revisions\/44"}],"wp:attachment":[{"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=43"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=43"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/davidlewislaw.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=43"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}