DUE DILLIGENCE
The
mistake is thinking that there can be an antidote to the uncertainty. In a
corporate world, where a shed load of transactions take place at a light
blazing speed, the degree of uncertainty achieves its highest form. This is so
as no one knows how the government’s policy towards the company might affect
it, or what would happen by a key personnel’s resignation from the company, or
if the company loses its top notch investor. Anything is possible at anytime.
For these above mentioned reasons, every company should conduct a legal due
diligence and be prepared for the unpleasant surprises (if any) before entering
into any merger & acquisition deal.
What
exactly does this term mean?
For a layman, the term ‘Due diligence’ means the
reasonable verifications and precautions taken to identify or prevent
foreseeable risks. It is the process in which an action is arrived at
before consummating it. Legally speaking, due diligence is “ a measure of
prudence, activity, or assiduity, as is properly to be expected from, and
ordinarily exercised by, a reasonable and prudent person under the particular
circumstances; not measured by any absolute standard but depends on the
relative facts of the special case.” In the words of Crilly’s Due Diligence
Handbook it is a process whereby an individual, or an organization, seeks
sufficient information about a business entity to reach an informed judgment as
to its value for a specific purpose.
It is that part of the acquisition wherein the
buyer company needs and demands to know whether they will be able to get the
returns for as much investment they’re making to buy the company. For this, the
company would carry on a detailed and an in-depth investigation of the
obligations of the company including its debts, leases, pending and potential
lawsuits, distribution agreements, compensation agreements and the likes.
In R
v Steinberg, Ontario judge Harris wrote:
“To require the steps taken by the company to absolutely prevent these occurrences under any
circumstances whatsoever would go beyond due diligence, and
would make the company a virtual insurer against any
error. I do not think that was the intention of the legislation; the words all due diligence import
an area of precaution sufficient to
prevent the foreseeable, but not the unforeseen,
the unexpected, the unknown, or the unintended.”
Why
Legal Due Diligence?
In today’s globalised world, legal due diligence is
not just a task to be undertaken during M&A, but also stands as a necessity
as M&A deals have the power not only to transfer the asset value but also
the liabilities associated with that asset. This further means that the value
of the company that is being brought cannot be understood without keeping in
mind all the relevant legal issues under consideration which makes the process
of legal due diligence all the more necessary. It is therefore considered to be
a critical component of all the transactions in this 20th century.
The main agenda for which undertaking due diligence
is necessary is to minimize the risks, allocating the risks in another direction
so that the risks gets nullified and thereby maximizing the shareholder value.
By carrying out a proper due diligence, the risk factor related to the key
issues that would be discovered later is reduced as a thorough scrutiny of the
business is already conducted which gives a better idea for ascertaining the
fair purchase price as well as helps to know the ups and downs of the subject
therefore saving the money as well as the time that is involved in the whole
deal process.
For a buyer, the due diligence process attempts to
reveal the facts and the potential liabilities of the company under
consideration thus saving them from the instability as well as surprise risks
and dangers. There are many processes involved in the due diligence including
the business due diligence, special due diligence, accounting due diligence and
the legal due diligence. This article deals primarily with the legal due
diligence part.
The
Process
In a legal due diligence, the buyer company mainly
focuses on two key subjects. The first is to determine the current status of
the company. Determining the current position holding of the company to be
brought up is the most intrinsic part of the legal due diligence as it sets a
base for knowing the future of the company to a large extent. It very
comprehensively helps in understanding that what exactly the buyers are buying
as well as to lay out a plan for future projects related to it.
Secondly, a good legal due diligence should be able
to tell about the consequences of the business as well as the ways to make the
consequences favorable for the buyer company. The advisor will carry out a
cost-benefit analysis to understand the impediments on the acquirer and the
pros and cons of the transaction.
·
Step
I- The Plan
According to Justin Levy, Partner at Winston &
Strawn, the buyer should always hire the specialized services of a legal
advisor or a consultant as this process is in itself complicated wherein both
business and the industry issues need to be understood and one would be certain
that the right questions are being put up and the probable risks are uncovered.
Hence, the first step in this process should be to hire the professional legal
services which would plan and strategize the whole process of the
investigation.
·
Step II-The Research
For a
successful legal due diligence process, both the buyer as well as the seller
needs to cooperate together in helping each other to understand the broader
picture first. Before the parties enter into legal agreements, the buyer party
needs to go through the company’s accounts and data. If the company under
consideration is a public one, the buyer can easily go through the governmental
reports of the company whereas in case of a private company the buyer must ask
the seller to show him with the summaries including the audits, balance sheets,
websites et al. Particular attention on the legal due diligence should be paid
if the company under consideration is a small one as they are not
professionalized from a legal perspective. This is so as they do not have the
infrastructure and the resources as much as the larger companies have. Another
point to be considered is in respect to the deals with the regulated
industries. One must have to be really cautious as they have stringent rules
and it is very important to understand these industries and advise the client
appropriately in helping him the mitigate the high risk factor.
Once
all the legal documents which would include the incorporation document,
shareholders warrants, any outstanding warrants, licenses & permits, the
process should move on to the further task of inspecting all the litigations
concerned with the subject company. It is a major task as it establishes a firm
overview of the outstanding risks that the buyer company would have to deal with
as well as forms a ground for a better understanding of the market.
The
assets and the liabilities of the business should also be known. The target
companies assets like cash, securities, inventory, intellectual property
(copyrights, trademarks, patents, domain names, and other proprietary rights)
as well as the liabilities like bank debt, licensing violations, bonuses earned
and yet not paid should be paid a thorough investigation in the process. The
list of all the employees as well as their current salaries should be keenly
scrutinized in order to know the way the company pays its people.
After
this, the major problem of locating and managing the hidden assets and
liabilities has to be tackled as there are certain assets and liabilities in
every company which do not appear anywhere in the balance sheets such as the
unregistered lands, assets held by a nominee, unregistered intellectual
property, contractual rights and obligations. For reviewing this, the historic
financial records, internal announcements and the likes need to be
investigated. The customers’ complaints on the internet should also be searched
for as it would lead to know the good and the bad of the company in a better
way. The public registers should also be searched for in the process not only
with the current company name but also with its former name.
If
possible, the current personnel of the company should be interviewed to know
the company better.
·
Step III- The
Analysis
After
the company has cleared stage II of the legal due diligence process, the buyer
with the help of their advisors need to analyze all the findings in a proper
systematic way. It is always advisable to chase the ‘red flags’ or any
questionable or a suspicious document found in the process of investigation to
its root. Preferably a due diligence questionnaire must be prepared
highlighting all the key areas that are needed to be examined. In this way, the
main areas which are to be examined can be highlighted giving a better picture.
The purpose of filling the questionnaire is to help the researcher make sure
that he has considered all the major areas of the legal due diligence.
The
duration of the process of legal due diligence normally varies depending upon
the size of the company under consideration. It can take place for a few days,
for a relatively smaller company to a several months if the company is larger
and has more complex transactions. The process of legal due diligence then ends
when the buyer is fairly satisfied and had analyzed all the relevant issues
related to the company and is able to understand the market fairly well. Every
buyer of the company would try to complete the due diligence process before
carrying out the primary agreements with the seller party.
·
Step IV- The
Presentation
Lastly,
the legal due diligence findings need to be presented to the buyer by the
counsel/advisor that carries out the investigation. As the buyer would be
unknown to the legal terminology, the report should be presented in the easiest
and the most user-friendly way. For small deals, the presentation should
preferably be presented in the verbal form while for the big deals involving
more financial resources, the legal due diligence findings should be presented
in a memorandum format listing all the documents investigated, key issues
discovered and the solutions thus suggested for resolving the issues. The buyer
should explicitly convey to its advisor about his priorities and expectations
from the deal in order to get a more streamlined report highlighting his main
concerns and keeping them at a priority.
Conclusion
Legal
due diligence, although a very complicated and tiresome process but once the
buyer undertakes it and get the results, he can be sure whether his investment
in the company would be a good decision or not. To top it all, the buyer gets a
clear picture as to how he would need to run the company as he knows all the
grey areas related to the company as well as the working in the market. Not
only this, the memorandum which the buyer’s counsel prepares during his process
of investigation also helps in drafting the merger and acquisition agreement
and the related ancillary agreements. The information thus derived will be
useful in allocating the risk while drafting the company’s warranties, its
pre-closing promises and the post closing indemnification rights of the buyer.
Thanks to his worthy investigator and legal advisor.
In this
article, the concept of legal due diligence is highlighted with respect to the
buyer. In certain cases, where the seller accepts consideration other than
money, it may happen that he performs his part of legal due diligence too.
So, the
next time one enters into any business transaction of M&A, one would know
what he needs to do and go with his legal due diligence process which would
give him a clear picture about his future with the subject company.
In the
end, in the words of Jeffrey Weiner, eternal vigilance is more likely to be the
price of successful deal making, and performing adequate, if not excellent, due
diligence—the path to salvation.
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