Any responsible management will
require a comprehensive assessment of the possible legal risks related to the
corporate status, assets, contracts, securities, intellectual property, etc. of
the target company concerned before concluding any merger and acquisition
(‘M&A’) deal. Therefore, the process of legal due diligence assumes great
importance in a M&A transaction.
Meaning :
The expression ‘due diligence’
in a M&A transaction is used to refer to sort of an audit of a company’s legal,
financial, environmental and business affairs, and includes investigations into
the acquisition of the assets, risk analysis and general inquiries about the
company prior to entering into a contract. This process is undertaken by the
buyer before investing in a company, to ensure that the seller and the target
company have good title to assets proposed to be bought and also to know the
extent of the liabilities it will assume. Therefore, this data gathering process
forms an integral and critical part of the M&A process as it provides
information about the target’s business that enables the buyer to decide whether
the proposed acquisition represents a sound commercial investment.
Purpose :
Typically in an acquisition, the
purpose of legal due diligence is for the acquirer to check :
(i) the value of the assets
the seller is proposing to sell,
(ii) that the seller has
good title to the assets/shares free from all encumbrances,
(iii) that there are no
liabilities or risks that will reduce the value or use of the assets,
i.e., no third party has any right to use the assets,
(iv) applicable labour laws
and service contracts, etc.; and
(v) that there are no
existing or potential undisclosed liabilities that may adversely affect the
business of the target company and also evaluate disclosed liabilities.
The due diligence process helps
the buyer to properly evaluate the target company by investigating items that
either validate the offered price or items that diminish the company’s value and
its purchase price. The buyer may seek contractual protection from the seller in
the form of representations and warranties, but in practice, the protection
offered may be limited by disclosure and other contractual provisions. The
seller is required to disclose all relevant information relating to the target
to the buyer and often finds himself in a conflicting situation. On the one
hand, the seller wants to provide all relevant information to the buyer so as to
make the buyer comfortable with the seller’s offered price and on the other
hand, the seller does not want to reveal unnecessary information to the buyer,
for fear that should the deal not consummate, the prospective buyer may obtain
valuable commercial information and use to compete unfairly with the seller. In
the event of buyer’s breach, seller’s right to sue for damages and injunctive
relief may not be adequate protection or remedy, as such damages for breach may
be difficult to quantify and to enforce. Some prudent sellers require the buyer
and its advisers to enter into a confidentiality agreement.
Scope :
The scope of due diligence
review will depend on the purpose and nature of M&A transactions. For example,
acquisition of a company will demand extensive areas of inquiry than the
investigation made by a potential joint venture partner on the other joint
venture partners or inquiry made by a purchaser of shares in a company. The
extent of due diligence review is also likely to be governed by factors such as
available time, cost, the need to get the transaction done and the seller’s
sensitivity about the exercise.
In a due diligence process,
risks are identified and are borne by one or both parties and the parties will
negotiate the risks and the bargaining between the seller and the buyer will
relate to apportionment of the risks between them. The seller may give
warranties and indemnities with respect to risks that are identified, but more
often the seller is not aware of its problems until the buyer discovers it
during the due diligence process. However, representations, warranties and
indemnities from a seller covering a particular risk is not an adequate
substitute for carrying out the due diligence, because :
(i) warranties and
indemnities survive only for a few years by operation of law and contract,
(ii) warranties are often
qualified as to the materiality or the warrantor’s best knowledge,
(iii) indemnity claim have a
de minimis limit,
(iv) there is a time limit
in which the claim must be made usually within two to three years after
closing,
(v) sellers are more
cooperative prior to the closing as they need to close the transaction, but
are reluctant to address even the most valid warranty claims post closing,
and
(vi) by the time the
warranty claim is made, the warrantor may not be in existence or may not be
in a position to meet the claims.
The information obtained in the
due diligence review will place the buyer in a better position to assess the
risks and advantages of his investment and enable him to appropriately
renegotiate the terms of the acquisition. Therefore, a buyer not undertaking due
diligence would lose the opportunity to obtain more favourable terms of
purchase.
It must be noted that every due
diligence investigation depends on the quantity of data supplied by the seller.
The data may be sent to the buyer and its due diligence team to analyse at it
own offices or the buyer’s due diligence team is sent to the target’s office
where it is given access to the data room. It is necessary for the buyer to
support the data collection by securing representation, warranties an indemnity
from the seller, wherever possible, on those issues that are impossible for the
buyer to check and verify.The buyer usually requires that the seller warrants that the information supplied by the seller to the buyer’s due diligence team is complete and accurate. The seller more often would not war-rant those matters that would be known to the buyer during the course of due diligence process. In a situation where the due diligence exercise is limited, the buyer usually investigates key issues and may take the following precautionary steps to protect itself, such as:
i) secure appropriate representations, warranties and indemnities;
ii) consider negotiating a retention of the purchase price to cover potential claims;
iii) propose a price adjustment, if required;
iv) require compliance of certain conditions as a condition precedent to close of transaction, for example, obtaining of consents to the change of control from lender, etc.
Team conducting due diligence:
The legal due diligence team of a law firm usually consists of a partner, a senior associate, associates and paralegals (number of associates and para-legals will depend on the volume of documents to be reviewed). The senior associate is generally responsible for preparing the due diligence report for the client. The partner will be responsible for supervising the due diligence report and negotiating the acquisition agreements. The legal team prepares the legal due diligence questionnaire/ checklist and same is forwarded to the buyer’s personnel who after reviewing it will forward it to the seller. The legal team is constantly in touch with the buyer’s personnel to discuss issues arising out the due diligence review as the buyer’s personnel is the only person who will be able to make effective judgments as to the commercial importance and potential risk brought to light by the information revealed in the due diligence process.
Areas of legal due diligence:
The legal due diligence exercise will generally cover all of the areas listed below. This list is usually indicative and not conclusive and is tailored according to such factors as to whether the transaction is an asset purchase or share purchase and will also depend on the target’s industrial sector and size of the transaction:
i) Secretarial
ii) Real Estate
iii) Intellectual Property
iv) Litigation
v) Insurance
vi) Licences
vii) Employees
viii) Loans/Debts
ix) Material Contracts
x) Investments
xi) Environmental
xii) Competition
xiii) Other Laws
Gist of what the due diligence team investigates under the following heads are given below?:
Secretarial:
The investigation of corporate secretarial focus on the incorporation particulars, memorandum of association containing details about its objects, paid up capital, authorised capital, the number of shares issued, and the articles of association of the target containing provisions as to the directors, restrictions on shares, if any, shareholding pattern, etc. Under corporate secretarial, the register of members and directors and the minutes of meetings of the target are examined as well. Every company under the provisions of the Companies Act, 1956 is liable to maintain a register of members, register of charges and a register of directors to record and maintain minutes of all meetings of shareholders and of the board of directors held in the course of transacting business of the company. The target company is required to file records pertaining to their balance sheet and profit & loss account, annual return, consent of persons to act as directors, in case of increase of share capital/members, registration of resolution, creation/modification of charges, return of allotment, share transfer form, etc. with the registrar of companies. The due diligence team reviews all filings made with the registrar of companies. In case a company commits default in maintaining the said registers, or do not file their records with the registrar of companies in time, penal action may be initiated against the target company. The due diligence team besides examining compliance under the general provisions of the Companies Act, 1956, also gives particular attention to review compliances with provisions requiring government sanction.
Real Estate:
Investigation of real estate should delineate the immovable property held by the target, to whether it is leased, licensed or owned. If it is an owned property, the title of the target to such property must be ascertained. The due diligence team examines covenants attached to the transfer deed which may prohibit certain activities or may reserve easement rights and also assesses if there is a situation where the target may not have fully paid up the consideration or certain installments may be pending. In some cases, the target may not have obtained final deed of conveyance/sale deed in respect of the owned immovable property and there could also be outstanding dues pertaining to such property, namely, property tax, electricity and water charges, all of which needs to be checked. In case of leased and licensed property, one must check its capability to transfer the said property.
Intellectual property:
As regards the intellectual property, such as patents, designs, softwares, trade marks, careful assessment is required to ascertain whether they are owned and/or licensed by the target company and/ or licensed to the target company and whether they are registered or unregistered and whether they are in compliance with the relevant laws. The due diligence team examines whether there are any challenges, disputes or infringements of any registered and unregistered intellectual property rights licensed or owned by the target company. The due diligence team will also review pending applications related to intellectual property.
Litigation:
The due diligence team examines significant details of any disputes by or against the target company. Buyers may set a threshold in monetary terms to determine those litigation matters to be reviewed (for example, the buyer may not be interested in any claims for outstanding amounts from debtors below a certain figure). The diligence team may assess the contingent liability that the target may incur and examine the likely impact on the business of the target and details of any judgments given against the target and its assets as a result of litigation.
Insurance:
The investigation of documents relating to insurance would involve assessing the significant details of the insurance arrangements for the target company, such as whether there are any circumstances likely to give rise to a claim under insurance policies for the target company, whether insurance obtained by the target is valid, or whether the renewal of the policy is refused or premiums increased, whether there are any unusual terms in the insurance policies, and whether the target’s assets have been fully insured.
Licences:
The due diligence team must assess whether the licences or consents necessary to the operation of the target’s business, have been obtained, are valid and whether they are capable of being transferred/assigned to the buyer.
Employees:
With respect to employees and consultants of the target company, due diligence review would involve examination of service/employment contracts, letters of appointments, the executive and non-executive directors, consultants, key employees and managers have signed with the target company and the significant terms of those letters of appointments and contracts such as remuneration provisions, notice period for termination, any special payments on termination, term of contracts, absence of provisions on confidentiality, any restrictions during employment, restrictive covenants post-employment and confidentiality clause, etc.
The due diligence team inquires if there are any employees who have terminated or intend to terminate their employment in the period leading up to the transaction and examines the employee benefits such as share option schemes, bonus schemes, employee provident fund, gratuity, retirement benefits, etc. Investigation would also identify whether there are any trade unions / associations representing the personnel of the target company. The due diligence team makes inquiries about payment obligations to employees, whether relevant labour legislation has been complied with, whether there has been any strikes or litigation with respect to trade unions and employees or if there are any anticipated, industrial disputes or employment related litigation, involving the target company.
Loans:
Investigation with respect to loans would involve assessment of loans given by the target company to third parties and other members of the target group, whether there are any pending instalments or restrictive covenant in the loan documents that requires intimation to the lender in case of change in constitution of the target or whether the liability under the loan documents can be transferred to the buyer. The due diligence team also inquires if the seller has given any guarantees or indemnities in respect of the target and whether the target has provided any guarantees or indemnities for any other third party.
Material Contracts:
Evaluation of material contracts would include review of commercial agreements to which the target is party for example, any agency agreements, distribution agreements, share purchase agreements, licensing agreements and supply or purchase of goods agreements, hire-purchase agreements, etc. The due diligence team draws attention of the buyer to the relevant provisions in such agreements, such as obligations of the parties, termination provisions and effect of termination, change of control provisions, non-assignment provisions, representations and warranties, indemnities and guarantees, any other restrictive covenants.
Investments:
The due diligence team makes inquiries regarding any investments made by the target, including shares held in other companies, or fixed deposits or purchase of any other kind of instruments.
Environmental:
Environmental due diligence may be required in case of acquisition of a company which is a manufacturing company, or whose assets include land used for industrial processes. Environmental due diligence is conducted by lawyers or technical personnel who are experts in the field of environment. The environment due diligence team investigates potential responsibility for any clean-up and liability in relation to environmental damage. The investigation may range from a brief site visit to a more detailed survey involving detailed sampling of soil and ground water.
Competition:
The competition law is at a nascent stage in India, but the lawyer engaging in the diligence exercise is required to bear in mind the general competition law principles while reviewing the data of the target company. The due diligence team would need to seek information from the sellers to assess anti-competitive behavioural risks. Competition issues may have an effect on the acquisition value of the business or target, or may have an impact on the timelines for an M&A transaction. The analysis on competition issues is undertaken in consultation with lawyers specialising in competition law.
Other laws:
In case the target company is listed in any of the stock exchanges, the due diligence team would review all compliances the listed company is required to make under the Securities and Exchange Board of India Act, 1992, the Foreign Exchange Management Act, 1999 and other applicable laws.
Legal due diligence report:
The legal due diligence report is prepared by the buyer’s lawyers and addressed to the client-buyer, pursuant to the due diligence process of reviewing documents provided by the seller. The client may request for detailed form of report or just an executive summary summarising all the key findings of the legal due diligence review. The key findings in the executive summary will enable the buyer to consider issues for negotiations with the seller and help in deciding whether or not to proceed with the transaction. The description of key issues would include the change of control provisions in material contracts, prohibitions on assignment in material contracts, expiration of critical agreements, licences and registrations necessary for the operation of the target’s business, high-value on-going litigation matters, etc. Detailed reporting would include summary of all the documents reviewed in all areas of law.
