Do the Due (Diligence)
Updated: Sep 30
This article was published in The Daily Record on September 22, 2020 - Download the Reprint
“Do. Or do not.” - Yoda
In most corporate acquisitions and commercial real estate purchase transactions, the buyer contracts for the right to conduct due diligence. In a corporate acquisition, due diligence involves the buyer’s comprehensive appraisal of the business being purchased, to establish its assets and liabilities and the accuracy and completeness of the seller’s financial information. In a commercial real estate transaction, the buyer must thoroughly inspect the fundamentals of the property in order to reduce or mitigate financial uncertainties, and the buyer’s lender will require an encompassing due diligence process to ensure that the property that will serve as collateral for the loan justifies the amount of financing sought.
A prospective buyer of commercial real estate can perform due diligence before signing a contract, but it is often the better practice to include due diligence provisions in the purchase contract, because the seller is then contractually obligated to provide specified information and give the buyer physical access to the property. A seller’s failure to provide that information or allow that access would give the buyer grounds to terminate the contract. Moreover, due diligence provisions usually give the buyer the right to terminate the contract without liability (and recover its deposit) if the due diligence process generates negative information about the property. At minimum, the seller could seek to negotiate a reduction in the purchase price based on any such negative information.
From the seller’s perspective, the existence of a buyer’s contractual right to conduct due diligence as to the physical condition and appraised fair market value of the property should relieve the seller from having to give any warranty as to the property’s physical condition or its economic viability.
Typical due diligence provisions in commercial real estate contracts require the seller to deliver to the buyer documents such as: contracts, leases, rental agreements and other agreements related to the property; prior engineering reports, environmental reports and appraisals; and instruments concerning easements, rights of way and other restrictions on or interests in the property. Most due diligence provisions also give the buyer a certain amount of time to complete its physical inspections and any other due diligence it may wish to perform, including but not limited to environmental and other engineering inspections, studies and investigations, and appraisals. They also require that the seller give the buyer access to the property to conduct an appraisal and any environmental, engineering and structural studies and investigations.
Once the seller contracts to allow due diligence, the buyer has sole control over decisions about what property inspections and other financial analyses, investigations or appraisals will be done, and, ultimately, whether the transaction will go forward. For example, during due diligence on the sale of commercial rental property, the seller must effectively “open its books” and its property to the buyer; any denial of specified information or physical access to the property by the seller would raise a red flag that could well justify the buyer’s cancellation of the contract.
At the same time, a buyer’s contractual right to conduct due diligence provides substantial protection to the seller in the event the buyer develops post-closing remorse and sues to try to recover on fabricated damage claims based on alleged problems with the property. New York retains the doctrine of caveat emptor, which imposes no liability on a seller for failing to disclose information regarding the property when the parties deal at arm’s length, unless there is some conduct on the part of the seller which constitutes active concealment; mere silence alone is not actionable.
In addressing, and dismissing, claims of breach of contract or fraudulent inducement arising from real property transactions, the New York Courts regularly hold that claims of misrepresentation will not lie if the representation allegedly relied upon by the buyer was not a matter within the peculiar knowledge of the seller, and could have been discovered by the buyer through the exercise of due diligence. When a buyer has a contractual right to conduct due diligence, but fails to exercise that right in whole or in part, it cannot establish justifiable reliance on any alleged representation by the seller. Moreover, when the buyer is given access to the property and performs property condition assessments, environmental investigations and similar inspections as part of its due diligence, and then proceeds to a closing, the seller may not claim justifiable reliance on any oral representation of the seller concerning the physical condition of the property when that physical condition was not peculiarly within the seller’s knowledge and the buyer had the means available to ascertain the truth or the real quality of those representations.
If you have any questions regarding the issues discussed above, or if you have any other Litigation concerns, please contact the Underberg & Kessler attorney who regularly handles your legal matters or Tom Knab, the author of this piece, here or at (716) 847-9104.