This article has been written by Brijesh Devi, pursuing the Diploma Programme in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
No matter what the scale of a transaction is, it requires some or the other kind of background checking from the seller as well as the buyer’s point of view. This background checking is done for various reasons the most common being to see that there are no commercial or operational contraventions or complications that might occur if this background check is not done. This sort of background check is known as due diligence. Due diligence is a process where investigation, verification, and/or audit of a potential transaction or investment is done to verify the financial and other relevant information during an M&A transaction or investment deal. Due diligence has to be done before a transaction between the buying and the selling party takes place. A transaction is likely to face difficulties (legal or financial) if no due diligence is conducted. Due diligence is an important process for both, the buyer as well as the seller. When a buyer/investor does a background check from the viewpoint of the seller then it is known as reverse due diligence. Due diligence gives the buyer confidence regarding the investment and assures the seller that their business is transferred in safe hands. The main objective of due diligence is to mitigate the risks by identifying any potential defects that can harm the transaction so that such transactions or defects can be avoided.
Types of due diligence
There are three basic types of due diligence conducted in a transaction – business, legal and financial due diligence. These are further classified into subtypes as per the requirement in a transaction.
Business due diligence
A business due diligence provides the context of the activities that the target company is indulged in. This type of due diligence provides the parties to the transaction with the records, assets, and operations of each other. Business due diligence can be further divided into operational, administrative, human resource (HR), intellectual property, and commercial due diligence.
Legal due diligence
Legal due diligence is done to ensure that the transactions are adhering to all the laws and frameworks applicable to the said transaction. Legal due diligence prevents any breach of law thereby preventing any penal or legal actions by the respective judicial authorities. Regulatory, compliance, and tax due diligence are a part of legal due diligence. Legal due diligence is conducted by lawyers and compliance professionals.
Financial due diligence
Financial due diligence is meant to seek verification of the finances shown by the target & acquiring party to one another. The financial due diligence involves audited and unaudited financial statements of recent as well as older years. This type of due diligence is conducted by financial analysts and other finance experts. Due diligence in international transactions and trade is very important as such deals attract scrutiny from different judicial authorities of the countries where the parties are involved from.
Need for trade-specific due diligence
International trade involves a lot of complexities financially and legally. To top that, language and cultural barriers are also very tough to crack. It is, therefore, necessary to see to it that the export-import, tariffs, financial laws, etc. aren’t breached. Trade-specific due diligence means fact-checking that all relevant international trade laws and other regulations are being complied with so that parties involved do not face any legal consequences for the same. Different kinds of trade take place globally and due diligence in each type of trade differs and is equally important. Well-conducted due diligence can provide a competitive edge over other competitors even in a new market.
International trade law & other aspects to consider before entering into an international trade deal
Trade can be classified as per its nature i.e., domestic and international. There are a lot more complex compliance and regulation involved in international trade due to the applicability of foreign laws. Before entering into an international trade deal here are a few things investors and investors should consider:
- Foreign trade laws
Every country has its own set of laws. Similarly, being involved in international trade with an organization of a foreign nation means both parties would have to follow laws from both countries in some way or another. Therefore, it is necessary to look up the relevant laws that might be applicable and check that they are adhered to and are there any ways to overcome a law that might prove to be rigid in some form.
- Licenses and permits
It is necessary to gain all the necessary licenses and permits for a trade deal to take place. Without proper licensing and certification, a trade deal cannot take place domestically as well. So, it is primary to hold the permits or there might be heavy penal actions which the defaulting parties will have to face if these permits are found to be improper.
- Tariffs & other tax implications
Some countries such as the US and UK put heavy tariffs on the import of foreign goods. Also, there are many other huge tax implications in these developed nations and these types of tax implications are comparatively very less on the exported items from their country. The idea behind these tax implications is to promote usage of material available in their markets itself and to promote export as much as possible.
- Treaties between the nations involved
It is important to consider the relationship between the home nations of the parties to the transaction and whether they are involved in any treaties. Sometimes the investors can save a lot of money on trade-related expenses if their nation holds a position of preferential origin in the treaty (if there is one) and even if no particular treaties are present only the relations between the nations might be sufficient to predict the deal.
- Customs valuation
After considering the laws, tax implications, etc the final part is to consider the custom valuation of the deal by the respected authorities. It is necessary to ask the question ‘Is the deal still worth it financially?’ If the answer to that question is yes then the deal can take place.
Conducting trade-specific due diligence; steps involved
There are different approaches to due diligence however the main task remains the same, to provide a thorough analysis relating to the financial, legal, and business aspect of the transaction. The most common steps in relation to conducting due diligence are as follows.
Step 1: planning & team building
The primary step in any business or transactional activity is planning. The importance of planning a deal cannot be stressed enough. A deal can’t succeed without a well-executed plan. For making a plan you need to build a team of experts who can help facilitate a transaction
- Hiring experts:
Organizations need to hire professionals who are well versed with the potential trade that can happen. These experts include but do not limit to accountants, compliance professionals, attorneys & financial analysts. Having a balanced team to make a plan of the transaction is of the utmost necessity.
- Financial/ investment planning:
After the experts are hired then the next part is getting them to work on the plan. The key elements of a transaction plan must include steps on how the investor organization can get financed and also include know-how on investment issues like proportioning the investment, when & how to invest etc.
Step 2: Researching
The second step while conducting due diligence involves a lot of research in various areas. These areas are as follows
- Industry research:
The first field that requires researching in due diligence is the complete industry in which the interest for investment is. Aviation, Pharmaceutical, Real-Estate, Technology are some of the industries where M&A and investment activities are increasing day by day.
- Market research:
The next part is researching the market where the potential investment is to be made. Market research is especially necessary when there is a plan to venture into a new or a foreign market. In market research, it is important to include a list of companies & organizations that are doing well or have the capacity to do well after investment support.
- Company/organization research:
After listing down the targets comes the time to research these organizations. Looking at the balance sheets, P&L accounts and other financial statements will give a clear idea of the company’s position. Similarly looking into their customer & market reach as well intellectual property and their management is also important.
Step 3: Analysing
The next step is analyzing all the information which is collected based on the industry, market, and organizational research. The procedure of analyzing is done in the following way;
- Reviewing the documents involved:
The first part of this step is to review all the required documents which are collected from the target. After reviewing the documents, the next step is to start jotting down all the information as soft & hard copies. This information is then stored in a virtual data room (VDR) which can be accessed by the authorized parties.
- Putting together the data and then evaluate:
All of the information that has been retrieved during the research has to be compiled systematically. After the compilation, this data is evaluated based on risk analysis (financial & legal).
- Analyzing the red flags:
After the data is put together and evaluated then it is time to analyze all the potential red flags that might harm the transaction in one way or another. If nothing can be done about these concerns then it is safe to turn back on the deal & if there is a way to overcome these red flags then the transaction can go ahead on the option of the investor.
Step 4: Presentation
The most important part of research is presenting the information gathered during the process. Since due diligence is research, presentation becomes the most important step of the process.
- Preparing the requisition list:
During due diligence, there are times where all the documents which are requested by the investor are not submitted to them, or the need to check some other documents is felt after the research and review by the hired professionals. In such cases, a requisition list is to be made and given to the vendor so that they get a clear demand of the documents that are further required to be submitted.
- Dividing the chapters of a due diligence report:
After compiling the data in the VDR it is time to divide this data collected into chapters so it is easy to understand the information. This is a much simpler form of data science.
- Presenting the due diligence report:
The final stage of due diligence in making the report of the complete background check that is done over time. The report is then to be presented to the hiring parties in a way that can be easily comprehended. Although there is no regulatory way of conducting due diligence the Securities Exchange Board of India (SEBI) under Schedule VIII of ICDR regulations has made it mandatory to include Executive Summary, Corporate Information, Loans & Finances, material Contracts, Litigation Matters, Human Resources, Insurance, Intellectual Property Rights, Annexures in a due diligence report for all expect capital market transactions.
The steps mentioned above can be involved in all types of transaction due diligence. The research and legal application however differ from industry to industry. 
Why is due diligence during international trade important?
In August 1993, a Canadian exploration firm named Bre-X began a drilling & exploration project at Busang, Indonesia near east Kalimantan (Borneo). Within a few months, the results indicated consistent gold mineralization. By 1997, it appeared that their project could contain up to 4% of the world’s gold reserves. This led to the rise of Bre-X shares and they became known globally. This project also led to the boom in exploration worldwide and Indonesia witnessed a gold treasure hunt.
Bre-X formed a partnership with a US mining company, Freeport-McMoRan, an operator in the Indonesian province of Irian Jaya, the world’s largest copper-gold mine during those times. Before making a firm commitment, the McMoRan sank several exploratory holes in Busang to get data. The results didn’t go well as no significant gold was discovered in Busang.
Afterward, in the late ’90s, Bre-X submitted a preliminary report made by Forensic Investigative Associates Inc. which stated that chief geologist de Guzman and a group of other Philippine geologists had the drill samples salted in the field before they were delivered to the laboratory. Gold of alluvial origin was substituted from a local gold panner. The apparent salting of the drills began after the first two drill holes had detected no gold in December 1993, and at that time the company had contemplated ending exploration.
This was one of the largest scams discovered that changed the entire conscience of global investors. Before this scam was unearthed (quite literally) the stock of Bre-X was valued at $6 billion (CAD). However, after this scam was revealed Bre-X lost $3 billion value instantly with shareholders holding them legally accountable for this act. Freeport-McMoRan had saved itself from a lot of hassle, to say the least by conducting a thorough background check before entering into trade with Bre-X.
This case is a classic example of why investors should conduct comprehensive due diligence before entering into a deal of any sort in any part of the world.
Conclusion
Due diligence is a way of background check made by an investor for assurance regarding the potential investment which will be made if the transaction is to take place. The risks, impediments, etc. once identified during due diligence can be avoided by the investor indemnifying or getting a warranty to the transaction. The same due diligence technique can work on different types of transactions subject to certain modifications depending on the trade and industry if the said transaction occurs. Organizations can avoid heavy losses if they conduct thorough due diligence on the investee/seller.
References
- https://corporatefinanceinstitute.com/resources/knowledge/deals/due-diligence-overview/.
- https://www.investopedia.com/terms/d/duediligence.asp#types-of-due-diligence
- https://cleartax.in/s/due-diligence#types.
- https://www.trade.gov/perform-due-diligence.
- https://ccbjournal.com/articles/international-trade-due-diligence-mergers-acquisitions-mechanisms-avoid-liability-unde.
- https://www.napier.ai/post/what-is-trade-compliance-and-why-does-it-matter.
- https://www.perkinscoie.com/en/international-trade-due-diligence-what-corporate-lawyer-s-should.html.
- https://www.forbes.com/sites/allbusiness/2014/12/19/20-key-due-diligence-activities-in-a-merger-and-acquisition-transaction/?sh=31a71a434bfc.
- https://www.mondaq.com/india/operational-performance-management/17241/legal-due-diligence.
- https://www.mbaknol.com/business-ethics/case-study-bre-x-scandal-the-6-billion-gold-fraud/.
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