The expressions “a stitch in time saves nine? and “better to be safe than sorry? can be painful truths for a purchaser of real estate where the appropriate due diligence was not carried out. The cost involved is relatively low when compared to the often significant purchase price and potential costs associated with unforeseen adverse findings.
The focus of this article is on commercial property transactions, however the principles involved can be equally important for residential purchases.
The fundamental purpose of a due diligence is to arm a prospective buyer with as much information as possible so they can ascertain whether the proposed deal stacks up in terms of the following:
- Whether the purchaser can achieve their intended purpose for the property whether that be to develop the site or simply achieve a particular income stream from existing leases and/or other arrangements.
- Whether there are any existing or potential problems with the property.
- Is the agreed price appropriate, bearing in mind the information gained and other costs involved?
The due diligence can be carried out either before or after the parties enter into a sale contract.
- Pre-Contract: A due diligence condition can be documented in a heads of agreement, in which case the due diligence period is usually tied to an exclusive dealing period. The heads of agreement will also often provide that the terms of the contract (and option deed, where relevant) be agreed during the due diligence period so that in the event the due diligence is ultimately satisfactory, the parties can then proceed quickly to sign unconditional (at least in terms of due diligence) documents.
- Conditional contract: The due diligence condition can be included the sale contract itself.
- Option deed: Option deeds are still very popular given the flexibility they allow, whilst at the same time providing the certainty of a binding agreement.
- If a put and call option deed is being used, the due diligence condition and associated rights of termination must be included.
- For a call option only, the option deed does not have to be conditional on a satisfactory due diligence as it is ultimately within the buyer’s control whether or not the sale proceeds. However, given that the buyer will almost always be conducting a due diligence prior to expiry of the call option period, the option deed should set out the buyer’s rights and seller’s obligations in relation to the buyer’s due diligence.
The due diligence clause should be drafted appropriately for the particular situation. Whilst the due diligence period, the scope of the condition and associated rights of termination are the critical elements that must be covered, consideration should be given to whether any other issues are relevant, for example:
- Rights to enter the land to carry out investigations
- An obligation on the seller to provide documents and information
- Warranties by the seller that information provided by them (where it cannot be independently verified) is complete and accurate
- An obligation on the seller to sign a consent to the purchaser’s application to Council
If the deal is to be conditional on the buyer obtaining a development approval (as opposed to the buyer simply making an assessment of the likelihood of obtaining the approval as part of its due diligence), it is recommended a separate condition be drafted which covers the appropriate issues. Different timeframes may also be required to allow for appeal periods.
The due diligence period must be long enough for the buyer to complete their investigations so the buyer should liaise with its lawyers and other consultants to determine a realistic timeframe.
If the buyer will be obtaining a full or standard town planning certificate, the due diligence period will need to exceed the statutory timeframes within which these must be provided (eg. a full town planning certificate takes 30 business days to obtain).
The importance of obtaining a full town planning certificate should not be underestimated by a buyer. If a property has, for example, unsatisfied development approval conditions or outstanding infrastructure charges, those problems will pass to the buyer with the land. If the buyer becomes aware of these issues during a due diligence, the buyer has the opportunity to either vary the terms of the contract (eg for an adjustment for the outstanding charges to be made at settlement) or to terminate the contact.
If the seller will not agree to a due diligence period exceeding the timeframe for the required planning certificate, an alternative is to have 2 timeframes for the due diligence – one which is for all matters other than the planning certificate, and a second which is limited to a satisfactory planning certificate. A seller of a property with no town planning problems should have no difficulty with that concept and will still get the benefit of knowing at an earlier date whether the sale is likely to proceed.
The legal due diligence is only one aspect of a thorough due diligence. Depending on the type of property and the buyer’s proposals and concerns, the buyer may also engage surveyors to check for encroachments, town planners for planning advice, engineers to check structural integrity and services, a construction company for development costs, bankers for financing options, environmental consultants for contamination checks and accountants to assess the feasibility of the project.
In more recent times, there are a number of businesses which now provide a “one stop shop? for the physical aspects of the due diligence.
Duty to carry out the due diligence
Even though most due diligence clauses provide that the buyer has an absolute discretion as to whether the results are satisfactory to them, the buyer cannot simply do nothing and then decide at the end of the due diligence period to terminate the contract. Buyers need to be aware there is an implied duty to actually carry out the due diligence.
Changing the deal
Once the due diligence clause is satisfied, the sale contract will usually provide the sale is on an “as is where is? basis with no rights of termination even where a significant problem is subsequently identified.
If the buyer’s investigations reveal an issue of concern but the buyer is still keen to proceed with the purchase if the issue is addressed by a contract variation (eg a price reduction), the buyer should raise this with the seller in sufficient time before expiry of the due diligence period and, if necessary, seek an extension. This is particularly important if the clause provides the due diligence is deemed satisfied if the buyer does not terminate by the end of the relevant period.
Buyers should value the importance of carrying out a thorough due diligence. Scrimping on it can be a false economy.