The economic liberalization of 1991 brought with itself certain practices like conducting legal due diligence which hitherto did not form a part of the traditional practice in India. Although the practice of conducting legal due diligence is recent, neglecting the same can pose a threat to the strategic gains expected from a deal and can push the company into costly litigation. Due diligence is a programme of critical analysis that companies undertake prior to making business decisions in areas such as corporate mergers/acquisitions or major product purchases/sales. It is an attempt to provide business owners and managers with reliable background information on proposed business deals, whether the deal in question is a proposed acquisition of another company or a partnership with an international distributor, so that they can makeinformed decisions as to whether to go ahead with the business action.
The precise origin of “due diligence” is lost in the mists of time. However, Black’s Legal Dictionary defines due diligence as “the diligence reasonably expected from, and ordinarily exercised by, a person who seeks to satisfy a legal requirement or to discharge an obligation”. Traditionally, due diligence has involved a process of discovery that is relevant in key business transactions, as well as operationalactivities. Due diligence has become the norm in decision-making as regards: n Joint ventures
Lawyers often come up with facts that prove to be the basis for the buyer to renegotiate the deal to its financial advantage. Studies suggest that about two third of M&A deals fail after the transaction is closed and as a result, brings loss of value for the buyer. However, a significant number of deals do not close because of issues uncovered by legal due diligence in particular. Prudent lawyers from all over the world recommend improving the buyer’s odds by taking legal due diligence as seriously as other parts of the deal. In cases of cross-border deals, where physical and cultural distances make problems harder to see, the buyer’s reluctance for legal due diligence might prove very costly. Providing a short executive summary dealing with the main legal risks and opportunities in doing a deal from the buyer’s commercial point of view would always be helpful. Also, an assessment of the likelihood of those risks materializing and the costs that would be incurred is to be made.
Investigating the indebtedness of the target and subsidiaries, including a review of loan agreements, notes, mortgages and security agreements becomes a crucial factor in many deals. Conducting legal due diligence in such cases would mean including any off balance sheet financing arrangements and the use of Special Purpose Vehicles where there is recourse to the target. Apart from this, it also involves:
Every business is exposed to various kinds of risks. Some risks are macro in nature over which the company does not have any control, whereas other risks are internal and micro. Due diligence is a process of conducting a macro audit of all the risks that a company is exposed to. Needless to say, legal due diligence is a very important aspect of risk management where risk compliance is ensured and at the same time minimization of risk is also taken care of.
How far does a buyer wish to go in the due diligence process depends in part on how much time the buyer has and how much money it has to invest in the company it wishes to buy. This would depend on the status of the company in the community, the number of years it has been in business, whether it has been audited by a major firm for some years and any other factors that help to establish the basic stability of the firm, such as longterm customer retention. Further, the due diligence of a company can vary depending on the type of the company.
The due diligence work required for the acquisition of a large, diversified, global company in a highly regulated industry is obviously far more extensive than the work involved for a firm in a relativelyunregulated sector. It also matters as to whether the firm is privately or publicly held. Also, the type of transaction can limit the due diligence effort, since stock purchases trigger more due diligence responsibilities than do asset purchases.
While requesting information from the parties, obtaining the following documents becomes desirable:
As far as questions of compliance are concerned, the question to be determined is whether the business complies with generally accepted standards of corporate governance. In particular, what has to be seen is whether all charges on the company’s assets have been properly recorded and filed at the Registrar of Companies (ROC). Further, obtaining details of all licences or consents, permits or authorities, required to carry on business would be desirable.
As far as the legal structure of a company and its subsidiaries is concerned, the following details would be imperative:
Financial and legal due diligence are the pillars on which an acquisition primarily depends. Pursuant to due diligence, we analyse the economic feasibility of the transaction. The scope of legal due diligenceis to ascertain the following:
The rationale of ascertaining the above is to enable the acquirer to analyse (i) legal risks and liabilities likely to be carried over after acquisition; (ii) whether the representations, undertaking and warranties given by the company are true and correct; (iii) any other risks associated from the business, financial, legal and other perspectives. Further, it also helps in identification of legal issues in the transfer of shareholding & management control, including determining whether the consent of lenders, if any, for the changed shareholding and management is required. By way of this exercise the acquirer can make an informed decision whether they should acquire the company and the manner in which the deal should be structured.
While carrying out due diligence, we commonly encounter that the statutory and other records of most of the Indian companies are not properly maintained. Further, most of the promoter driven Indian companies do not have a full fledged legal department due to which it becomes difficult to obtain complete records and information pertaining to the company. Secondly, except the online records available under the Companies Act, 1956, there is no centralised department where all the information pertaining to the company is available as a result of which it becomes difficult to corroborate the information provided by the company specifically with respect to litigation, FEMA, tax & IP. Consequently, the lawyers generally have to rely upon the information provided by such company.
Legal due diligence involves “thorough” investigation of reliability of information provided. However, the usual market practice is that, we often get it done from an outsourcing agent i.e. a legal consultancy. At times, there might be highly technical issues involved where the expertise of the consultancy firm in the said area might be questionable. Hence, it is ideal to have one or more technical experts who can work hand-in-hand with the legal due diligence team.
Litigation is an important aspect to consider while conducting a legal due diligence as it determines the stability of the company and the risks involved therein. It would comprise the following:
Often, the legal and financial records of many small private companies are extremely limited and in some egregious situations are totally non-existent. In such a situation, the due diligence investigation should be expanded in an effort to obtain the information necessary for a reasonable valuation of the legal and financial position. At a minimum, the buyer will want to conduct a more thorough investigation regarding the nature of thereceivables and the customers owing the debt.
The information obtained in the legal due diligence process is also helpful for both the buyer and the Target company in drafting and negotiating the merger or acquisition agreement and related ancillary agreements. This information will be particularly helpful in allocating risk when drafting Target company’s representations and warranties, pre-closing assurances; and the buyer’s post closing indemnification rights. Further, the target company will need to prepare a disclosure schedule, to be delivered at the time the primary transaction agreement is executed. This document discloses exceptions to the representations and warranties made by Target company in the agreement. The information gathered in the legal due diligence process will be helpful for Target company in preparing the disclosure schedules. In addition, if the transaction includes a securities component, this information will be useful in drafting a disclosure document that may need to be delivered to the buyer.
In the legal due diligence process the parties will attempt to identify everything that must happen before the transaction can close. For example, the buyer in relation to the Target company will focus closely on:
The presentation of legal due diligence findings is only a relevant issue for the buyer. The buyer will normally expect his legal team to present legal due diligence findings promptly and in a user-friendly format. For small deals or cost-sensitive buyers, the presentation may take the form of a verbal conversation. On the other end of the spectrum, for large complicated deals, it is not unusual for legal due diligence findings to be presented in the form of a memorandum that describes all documents reviewed, analyzes the key issues discovered and recommends various solutions. Many buyers simply ask for a bullet-point list of key issues identified in the legal due diligence process. The point is that, if one is a buyer, he should make his expectations clear and communicate it with the legal team regarding any cost sensitivities and the format in which hewould prefer the legal due diligence findings to be presented.
The due diligence process involves relationships between parties that involve trust and confidence. There is a duty of disclosure of all material facts and this also applies to relationships that are uberrimae fides, ie, one of utmost good faith. This obligation of utmost good faith can also be imposed contractually by a buyer and a seller in a corporate transaction. The parties can expressly contract to create a duty of utmost good faith and thereby place a duty of disclosure of all material facts.
The remedies for breach of the duty of disclosure by the seller in the case of real property transactions fall into two categories flowing from the type of breach:
Where the non-disclosure relates to a substantial defect, the buyer will be entitled to rescind the contract before the completion of the transaction, or closing. They may alternatively seek a reduction in the purchase price.
The failure to disclose a matter in relation to the type or tenure of the seller’s title or a misleading physical description of the property in the particulars of sale deeds to liability in mis-description rather than non-disclosure.
Although it is not mandatory to conduct a legal due diligence, in an emerging economy like India, the major purpose of conducting a legal due diligence is to identify deal-breaking issues before money and other resources are committed to detailed investigations. The legal due diligence specialists have to focus on crucial issues like concealment of facts and figures by the party and place a check on noncompliance of or adventurous interpretations of contracts and other legal provisions. A legal due diligence report should not be about an executive summary and a long content report within various legal areas. Ideally, it should contain a clear prioritization of the most important findings, advisors’ comments thereto and recommendations on how to address such findings. Cutting the long story short, the legal due diligence report should be a tool for the potential acquirer to make the legal and commercial decisions on how to address key findings. It would be apt to conclude with the old adage: “It’s better to prevent and prepare than to repent and repair!”
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