Due diligence is an essential part of the mergers and acquisitions evaluation process. It goes without saying that the partners of the acquiring firm have strong financial analytical skills but there are additional factors to be taken into consideration. Recognizing these elements during the due diligence process will reduce the risk of a malpractice claim from the merged or acquired firm during the period of integration and the early post-transaction period.
The most important points to consider during the due diligence process are as follows:
- High risk or specialty areas of practice
- Industry and practice specialization
- Quality control
- Client acceptance and continuance
- Claim experience
High risk or specialty areas of practice
Target firms often possess a specialist skill or expertise in an area of practice or service a specific industry. CPA firm management typically seeks out merger candidates that employ professionals with specialized skills and experience in performing a particular service (e.g., litigation support) or serving a particular industry (e.g., entertainment).
Thorough research of the experience and qualifications of candidates is prudent. Request HR records such as resumes and independently verify educational backgrounds, and professional designations and specialist qualifications. An inquiry about any regulatory or disciplinary investigation or inquiry should be undertaken, and confirm with state boards of accountancy and professional associations to verify that all firm members are in good standing. Contact with prior employers may be required for recent hires of the candidate firm.
Specialist services or services to a high-risk industry performed by an acquired or merged firm can be a source of claims. This is exacerbated if the acquiring firm was not aware of these services or the services were inadequately and can be the catalyst for a frustrating de-merger.
The candidate firm’s technical materials that support specialty services should be verified as up-to-date. Review the quality control procedures and verify any specialist supervisory training. Consideration should also be given to the resources in term of training and maintaining technical expertise that the acquiring firm would require to supervise these services during the transitional period after the merger/acquisition.
Don’t place too much store in your ability to bringing a candidate firm’s quality control processes up to your firm’s standards. Evaluate and look for warning signs that staff is not complying with professional practices. Talk to Quality Control Managers in private. Avoid interference by Partners in QC issues. Be prepared to ask hard questions and dig deep. This is where malpractice claims arise. QC problems may not be an endemic issue but may be connected to a particular department or specific partner.
Client Acceptance and Continuance
This is a critical issue that goes beyond quality control and requires special attention. First, evaluate the candidate’s acceptance and continuation policies and procedures. Second, review the candidates existing client base to establish whether any current engagement require special attention or supervision. There may even be engagements that should be dis-engaged due to client or services risk.
You should make the execution of a merger or acquisition agreement conditional on your right to investigate the candidate’s compliance with its own quality control policies and procedures, including those that apply to client acceptance and continuance.
One regular mistake when reviewing a candidate’s client roll is to focus upon attestation. There are many activities that could generate claims. A few examples are:
- Aggressive tax positions.
- Reliance upon compiled financials by third parties.
- Poor supervision of low-level bookkeeping staff that manage client funds.
- Disinterested client management team or an absentee owner.
Such issues are components of complex due diligence protocol that must be adhered to when evaluating a target firm. Advice from consultants and various industry practice aids can provide useful assistance
It is imperative to consult with appropriately qualified and experienced legal counsel, and insist that your lawyer draft all agreements, including provisions addressing de-merger and ownership of receivables and work papers.
Copies of all business insurance policies, applications and loss runs for the candidate firm are crucial. This should include professional liability, cyber liability, general liability, directors’ and officers’ liability, Office Package and property, health, life, workers compensation, employment practices and any surety and crime bonds.
Review the policies with an insurance professional to coordinate with the acquiring firm’s protection and determine any coverage weaknesses and determine the need for changes for the combined firm. Evaluate any future changes in coverage pertinent to the needs of the combined firm to establish the adequacy of coverage of limits of liability, deductibles and self-insured retentions.
Understand how coverage operates and whether a difference in prior acts versus future coverage could result in a dispute. Develop a formula for the fair allocation of the claim deductible or uninsured risk between the partners before the transaction.
Consider an extended reporting period endorsement, which extends the time period of coverage for claims reported after a policy expires or is cancelled but only for wrongful acts that occurred prior to the expiration of the policy.
Understand all past claims made against the Candidate to see how this will impact future insurance record of the combined firm and determine how the deployment of risk management tools could have avoided or reduce the probability of future similar claims.
Ask for copies of all claims or potential claims papers against candidate and/or reported to its professional liability insurance carrier, and request a loss run from all professional liability insurers which coverage the past five years before the transaction. Interview management about the source of the claim, how was responsible, what the services were provided, and finally, what, if any, improvements or procedural changes could be made to the candidate. Establish the resolution of the claim or the maximum potential loss including insurer’s reserves. How did the claim impact client relationship and/or fees?
The risk of a malpractice claim for an merged or acquired firm is a very real problem. CPA Firms that consider the above suggestions will be better prepared to address the liability risks associated with this, and to concentrate on the more important task of the development and growth of their practice.
Jorgensen & Company are not attorneys and do not offer any form of legal advice. Consult with appropriately qualified local counsel for more assistance. Rickard Jorgensen is President & Chief Underwriting Officer for the CPAGold™ program and may be contacted at (201) 345 2440 or firstname.lastname@example.org