In this blog post, Sakshi Samtani, a student of K.C. Law College, Mumbai, who is currently pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses the actions that can be taken pursuant to a due diligence report. 

When a company is acquired or undergoes a merger, a significant transfer of power and responsibility takes place to the hands of the new owners. To minimize the risk and liability on themselves, a due diligence report is carried out. The commercial term ‘due diligence’ has evolved over a period. The report is a detailed investigative process in the form of detailed research. The report includes a study of collections, review, and appraisal of business information, financial information, legal information and identification of the state of affairs, liabilities and exposures of the firm being acquired or undergoing the merger, otherwise also known as the target entity, etc. It is applicable when a company’s shares or commercial assets are acquired; a joint-venture project is initiated, in the case of financial transactions and issuance of securities along with other general pre-contractual inquiries. It is important to remember that the due diligence report occurs only after the term sheet has been drawn out and executed. During the process of a merger or acquisition for big companies and multinationals corporations, a lot of money, a lot of documents and a lot of people are involved and to minimize each of their risks, a due diligence report is further encouraged. The risks and liabilities mentioned include, but are not limited to, non-compliance issues, tax claims, the credibility of the brand and its products, etc. For example, a company that is in the midst of a merger but has evaded tax in the past still faces a liability, which would now be the responsibility of the acquiring firm. In most cases, the due diligence report would serve to dissuade a firm from proceeding with this merger. Thus, the report saves both companies a huge waste of time and resources.

However, in the case of a discrepancy or non-compliance with laws being found after the due diligence report is carried out, the investing firm or individual may decide to invalidate the transaction or be at free will to lower the agreed upon price of the transaction. In other cases, the investor may choose to protect himself and his company with specific indemnity warranties and representations or may request for insurance that covers liabilities such as product liability, environmental risk and various other risks that may arise. A venture capitalist or investor may choose to invest conditionally in a company based on a successful due diligence report that claims that all issues and internal matters of the company have been discovered.

Due diligence illustrates a specific standard of care. In India, there is no positive statutory duty requirement on the part of the buyer or investor to carry out due diligence, nor is there any liability of facing a criminal penalty for failure to execute due diligence.

When conducting a due diligence exercise, it is important to note that Company Law compliance of the company can be scrutinized for the previous three years. The Tax and environmental records of the firm over the previous seven years can also be taken into consideration during this examination. This amount of time for a due diligence process over which one may look back at records is very vital.

The importance and significance of due diligence are increasing over time. Multiple official statues in India recognize their vitality. An introduction of compulsory regulations and provisions for carrying out due diligence have been put in place through Securities and Exchange Board of India (Mutual Funds) Regulations 1996 for foreign contributions by Indian firms. These are done through global depository receipts or American depository receipts.

The process of Due Diligence may be carried out for multiple purposes and in multiple fields for various reasons. The kinds of due diligence extends far beyond just legal due diligence to financial due diligence, factory due diligence, tax due diligence, technology due diligence, labor due diligence and environmental due diligence, amongst several others. Firms or investors or both may choose the kind of due diligence they wish to carry out based on the industry or market in which they are involved in, or with. For example, a company looking to acquire a construction company in all probability may choose to carry out a labor due diligence, especially if there has been unrest from relevant labor groups or unions or there have been complaints in the past with relation to the treatment of workers.

At the onset of a due diligence process, certain documents and information are requested in connection with a potential acquisition of the Target Business of the Company looking to be acquired or invested in. All references to the company and its Target Business refer to the firms’ direct and indirect subsidiaries. All the documentation requested must be provided either as original copies or certified true copies that are duly signed by authorized personnel of the Company, to validate their authenticity for the acquirer.  These documents and information will also be updated during the due diligence process and must be subsequently dated at each update.

One of the most important document groups that are looked into is the company’s corporate books and records. This would include the company’s Memorandum of Association, Articles of Association, its Certificate of Incorporation, minutes of the board of directors meetings, details of the firm’s assets, various registers such as Register of Investments and copies of audited financial statements, etc. The company’s government compliances and filings must also be scrutinized during a due diligence review. The documents for these would include but are not limited to notices relating to violation or infringement by the company of any Indian or foreign laws, the firms anti-bribery and anti-corruption policies, government permits and licenses, and a list of all the laws affecting the operations, and everyday running’s of the Target Business.

Acquirers or Investors would also like to assess the debt and loan situation of a company they may be interested in. During the due diligence procedure, they may request for details of lenders, debtors and creditors along with the time span for the existence of debts for the Company. Along with this, relevant communications that have been documented, copies of agreements and a list of payments that are yet payable by the company are a few of the documents that may also be requested.

For business and material agreements; all joint venture collaborations, partnerships, trademarks and licensing agreements relating to the Target Business must be made evident. Copies of all contractual agreements of the company must be shared, which includes lists of their top suppliers, distributors, technical collaborators, franchise agreements, advertising contracts and a lot more.

For joint ventures, a due diligence report is vital when a new partner comes on board with an existing business for such a business venture. However, when new businesses are being formed to facilitate a new joint venture, there is not much need or scope for a due diligence procedure to be carried out.

When an irregularity is discovered, pursuant to the due diligence report, the actions taken to regularize, rectify or invalidate these irregularities are added to the ‘conditions precedent,’ also called CPs. Fulfillment of this is a pre-condition to the investment being brought in.

To determine the importance of the risks, liabilities and deficiencies and the subsequent attention that needs to be given to them, every due diligence process must have a materiality threshold. In most cases, the lawyers exercise their judgment concerning materiality threshold, however, for larger transactions and business dealings, the parties or investment bankers have a say in the matter. It is also understood that the materiality threshold is dependent and varies with the extent of the transaction and kind of investment.

Materiality thresholds are maintained lower for strategic investments where due diligence reports are exercised extensively and intricately. On the other hand, the materiality threshold is maintained comparatively higher for venture capitalists or private investors who are concerned purely with the financial investment. In most of these cases, a limited due diligence is carried out. Moreover, while investors look to protect themselves while investing through warranties and indemnities from the company and its promoters, the majority shareholders and management also face similar financial risks as the investor. However, it is them, the management and majority shareholders who are at risk of losing a lot more in the case of a crisis and hence, they too take adequate measures to prevent materialization of those risks.