M&A Technology Due Diligence Update 2014

by Bennett Jones LLP
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Technology Risks Have Changed: Know What To Look For

The perfect storm created by the intersection of (on the one hand) the dramatic increase in the business use of cloud computing, open source software, prolific social media, the emergence of Big Data, wireless mobile devices (including for Board meetings), and the alarming increase in cyber security attacks (of many kinds), with (on the other hand) rapidly increasing IT corporate governance duties, expanded regulatory scrutiny concerning data security, privacy, anti-spam and corporate governance (OSC, SEC, OSFI, critical infrastructure regulators, and many others), increased audit awareness and sensitivity for IT risk, emerging shareholder activism, consumer rights (from e-commerce rights to privacy), and the growth of class action litigation…. all require a more specialized and comprehensive approach to technology risk due diligence for M&A transactions in 2014.

According to leading pundits and reports, the M&A compass seem to be turning in the right direction. Earlier this year, Forbes Magazine's article, "6 Reasons 2014 Will be a Strong Year for M&A Activity"1 identified historically low interest rates, a healthy stock market performance and a large inventory of private equity owned companies as some of the reasons why M&A activity will (and has begun) to get stronger in 2014. Similarly, the Financial Times' article, "Expectations Rise For a Rebound in M&A"2 predicted that an upswing in M&A transactions can only be closer due to "increased confidence and emboldened chief executives with strong balance sheets to spread their cash piles on buying growth." Bloomberg News' corresponding predictions in their recent article, "M&A Boom Seen in 2014 as Drug Hunt Spurs Biotech Deals" included this quote of Jeff Stute of JPMorgan, "We see M&A in the health-care sector being up materially in 2014 at all size levels and across all subsectors. Buyers and sellers will get comfortable with the new reality of where assets are priced".3 The Financial Post's David Pett cited various sources for the prediction that, " Canada’s M&A market is expected to rebound this year…as stronger equity prices and more positive market sentiment drive the value of deals in the country higher"4, and in particular CMC Markets Canada's confidence about increased Canadian M&A, "particularly in the mining and energy sectors".5 That refrain was echoed in the recent Wall Street Journal's article, "Global Mining, Metals M&A Activity to Pick Up in 2014"6. Although both 2014 articles in Canadian Lawyer Magazine, "Brighter Outlook For M&A"7 and "Mining M&A Primed"8, cite numerous reasons for a changing M&A landscape, perhaps the most poignant insights for developing growth in M&A transactions might be found in the April 1st article, "6 Reasons U.S. M&A Activity Will See Strong Growth This Year"9:

US M&A activity is picking up steam. Deal volume in the first quarter of this year was the highest since 2007 (in dollar terms)…. Moreover, M&A transaction volume growth for both large and middle market firms is poised to accelerate this year (because)…US corporations currently hold record amounts of cash…the market has recently rewarded companies that are doing deals by giving them higher valuations…financing costs are still quite attractive…macroeconomic environment in the US should support M&A activity…(and with US stock market strength) companies will be using their shares as "currency" to do deals.

M&A Technology Risk: Due Diligence In The Perfect Storm

Regardless of how accurate the pundits' predictions are for a 2014 M&A upturn, one thing is certain – the nature and use of information technology that all corporations depend upon, across all sectors, has radically developed and transformed since 2008. Even though a profound global recession may have stunted the growth of commerce generally, the corporate use and deep reliance on emerging information technology has vastly expanded into new dimensions of business capabilities, efficiency and reliance. However, those developments have also created vast new territories of potential, and highly dangerous, business risk. The agglomeration and use of so-called Big Data, the detailed harvesting of personal information related to an individual's online activities, the increasing reliance on cloud computing, the quickly expanding business use of social media, escalating cyber security threats, the unstoppable trend to process business data outside the enterprise through so-called Software as a Service ("SaaS") or cloud computing structures, and the exploding use of wireless mobile computing devices for business (from placing highly confidential Board of Director information on tablets, to smart phone business apps) – there is absolutely no doubt that increased business efficiency also comes with a very onerous, "risk management" price.

That transformed technology landscape is not the only reason why highly acute and specialized technology risk due diligence is required for M&A transactions. Just as the technology landscape has drastically changed since 2008, so too has the onerous and penalizing nature of the laws, regulations, corporate governance standards, and accountability for the harm that may be caused by the risks of such emergent technology, for example: a cyber attack or unauthorized intrusion; an employee's cyber harassment of another employee, or an employee's disclosure of confidential business information, through social media; a broad Internet cyber attack against the company's reputation;10 the inadvertent but wrongful digital dissemination of persons' personal information (for example, employee health records or customer credit card numbers); the implementation of a web-enabled shared service IT service across affiliates that does not comply with regulatory security requirements; the misuse of, or failure to protect, the security of personal information; or, the wrongful export of data or communications to (or through) an export restricted jurisdiction – to name only a few.

In a very real and practical sense, the current requirements for highly specialized and comprehensive "technology risk" due diligence in M&A transactions now arise in a perfect storm where transformational technological risks intersect with highly onerous legal duties, regulatory compliance requirements, and a developing culture of consumer protectionism (including class actions), corporate governance accountability, and stakeholder activism.

Regardless of the industrial sector (from mining to manufacturing), the inherent technology risks associated with M&A transactions have never been higher than in 2014. Today, if you are a utility enterprise who operates critical infrastructure, the secure and safe operation of your IT system is now considered a matter of national security. If you are a public company whose failure to keep up to date with your onerous technology corporate governance duties results in a damaging IT failure, you may quickly face angry shareholders, a myriad of persistent and demanding regulators, and very concerned auditors who have alarming, if not dire, business risk warnings. Otherwise, if you were to inadvertently release highly confidential information about a large number of your customers, employees, patients, or shareholders by hitting the wrong "send button", – you may have to defend yourself against a very large and aggressive class of plaintiffs with exorbitant compensation demands.

Technology Due Diligence For M&A Transactions

In addition to all of the many other normative and traditional technology related due diligence investigations that are necessary for M&A transactions11 (such as IP ownership, maintenance and support services, existing use and license rights compliance, risk management practices, and general IT risk/liability assessments), the following are more focused considerations to be cognizant of when addressing the more recent technology risks that are discussed above:

  • to what extent is SaaS, ASP or cloud computing relied upon, and what are the relevant facts (security requirements, risk allocation, from what jurisdiction(s) are the services provided, operational specifications, are there service audit rights and have they been exercised, history of breach/failures, etc.); review all third party IT service contracts and arrangements to assess performance compliance and the business risk profile (e.g., is personal information or confidential business information being processed or stored);
  •  to what extent does the company's interests in selling or commercially exploiting proprietary software rely upon (or include) so-called open source software (in any of its variable licensed forms) and tools;
  • are there security programs for employees with IT control, including: screening and background investigations; data access controls based on employee seniority and "need to know basis"; existence of an employee assistance program; is there a whistle blowing policy; is there mandatory manager holiday leave; and, are there random operational IT audits;
  • history of all cyber security incidents, including: cyber attacks; hacking; communications interception; disclosure of cyber attack response and damage assessment; data loss or corruption; incidents of any unauthorized access (viewing, reproduction, transmission); any virus contamination; and, incidents of employee sabotage; information concerning preventative and corrective actions, and related IT enhancements (and testing);
  • records of IT security assessments, investigations, continuous improvement, quality assurance and best practice governance, including independent third party expert opinions; internal testing; ethical hacking programs; protocols for so-called "supply chain integrity" of all IT goods, which is essential since unauthorized IT (and data) access may be secured by prior embedded instructions or devices in the IT rather than by external hacking or intrusion;
  • use of social media (and online publishing of all forms) by employees and/or for business purposes; existence of corporate social media use policies; employee "corporate secrets" training; related corporate IT/cyber policies; assessment of corporate digital practices, and regulatory compliance; reputational protection programs; history of any claims, complaints, litigation arising out of social media use (including cyber harassment); online brand and reputation assessment;
  • use of wireless mobile IT devices; how pervasive and for what information; used in what jurisdictions; disclosure of related security controls (encryption, password, etc.); security breach incident history, including lost/stolen devices;
  • does the target rely upon shared service IT infrastructures, where any back-office operations across affiliates or related companies have been consolidated into a single service provider; what services (IT, HR, finance, supply chain, etc.); is there an "arm's length" (a fair market value) inter-company contract in place; what is the oversight for compliance and risk management; and,
  • technology corporate governance assessment; are there policies, practices, procedures; oversight activities, projects or reviews; the use of specialized technology and security experts; IT risk management programs and conduct; overall IT legal and regulatory compliance programs; is there disaster recovery and contingency planning; are there regular compliance reviews and corrections; history of regulatory reviews or interventions; audit notes or assessments.

In addition to all other undertakings involved in a normative technology risk due diligence review for M&A transactions, the following materials, documents and information (in addition to traditional sources) should also be reviewed and considered in the context of the emerging technology risks discussed above: IT corporate governance policies and required procedures; cyber security "incident" response action plans (including detection, reporting, management escalation, document (evidence) retention, "SWAT expert" contact list, litigation defense, reputation management, public relations, government relations and regulatory compliance); all cyber incident regulatory reporting files; IT contingency and disaster recovery plans, including redundancy and testing programs; all related IT service and infrastructure contracts (including SaaS, ASP, outsourcing, cloud computing, open source licenses, hosting and all other material IT contracts); information related to IT contract compliance, including service performance audits, claims and disputes; history of cyber incidents of all types, both internal breaches and external threats; any internal and third party cyber or IT reports or assessments concerning IT and cyber security preparedness; and, a comprehensive review of the target company's unique regulatory and commercial risk exposure related to IT and cyber liabilities.

Notes

  1. Jeff Golman, January 13, 2014, www.forbes.com
  2. FT Reporters, January 14, 2014, www.ft.com
  3. M. Tirrell and D. Welch, January 10, 2014, www.bloomberg.com/news, although Mr. Stute expressed some reasonable cautionary qualifications and his comments should only be considered in the full context of Messrs. Tirrell's and Welch's article.
  4. D. Pett, January 29, 2014, www.business/financialpost.com
  5. Ibid, per Colin Cieszynski, market analyst at CMC Markets Canada
  6. A. MacDonald, London Bureau, Wall Street Journal, February 2, 2014 www.wsj.com
  7. J. Brown, February, 2014 edition, pages 43-45, www.canadianlawyermag.com
  8. A. Davis, March 2014 edition, page 18, www.lexpert.ca
  9. April 1, 2014, www.soberlook.com
  10. The work by one of Canada's leading defamation and reputation (cyber libel) lawyers, David Potts, in the highly specialized field of cyber attacks on a company's reputation, is particularly instructive and insightful, www.cyberlibel.com
  11. The recent or emerging technology developments are not intended to be exhaustive. They are provided in addition to all of the many other normative and traditional technology due diligence issues and concerns that must be determined, considered and risk assessed in the course of an M&A transaction.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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