This article is written by Arnaz Pestonji who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (including PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Due Diligence is a detailed investigation or inquiry made into the affairs of a business entity (known as the “target company”) by an individual or a business entity who intends to acquire, merge or make a strategic or financial investment in such entity. The main purpose of conducing a due diligence process is to discover, quantify and mitigate the risks and liabilities associated with the proposed transaction and assess the value of the target company. The type of due diligence depends upon the nature of the transaction and can be in the form of a legal due diligence, financial due diligence, property due diligence, information technology due diligence or environmental due diligence.
The term due diligence is not defined under the Indian law but derives its recognition from the principle of “caveat emptor” which means that a buyer must beware. A duty is cast upon the buyer to exercise reasonable precaution, obtain necessary information from the seller and to make an informed decision before entering into a transaction.
While considering a merger or an acquisition (“M&A”) transaction, the buyer, acquirer or investor, as the case may be, will have limited knowledge pertaining to the target company other than what is available in the public domain. Due to which, the buyer will appoint legal and financial experts preferably lawyers, chartered accountants, or merchant bankers to conduct a due diligence process on its behalf. Similarly, the seller may also carry out a due diligence process on his own company to be able to ascertain fair market value, rectify any non-compliances and thereupon have an upper hand in negotiations.
Process of Due Diligence
Ideally, careful planning, detailed review, verification and analysis, and a great deal of preliminary work is undertaken in a due diligence process. The due diligence team of the acquirer is entrusted with significant responsibility to review the company’s compliance history, discover any legal impediments, verify financial information, identify red flags and mitigate any irregularities that can hinder or obstruct the proposed deal or create any substantial implications upon the acquirer after execution of the transaction.
At the conclusion of the due diligence process, the acquirer will determine whether to enter into the transaction after reviewing the recommendations provided in the due diligence report. The acquirer may end up pursuing a risky transaction if the recommendation provided in the due diligence report is incorrect. Safeguards are drafted in the transactional documents in the form of representations, warranties or indemnities to protect the acquirer against any existing and potential liabilities of the target company. However, if the due diligence process itself fails to detect substantial issues, the transactional documents may not contain corresponding safeguards.
Inadequate Due Diligence Process
In a due diligence process, vast amount of information is to be reviewed. The legal due diligence team typically analyses the charter documents, material contracts, employment agreements, real estate documents, corporate compliances, tax compliances, financial documents, insurance contracts, labour law compliances, intellectual property rights and any litigation proceedings by and against the target company.
There are high chances of mistakes or miscalculations being committed if due care is not adopted. The due diligence team may; fail to undertake prior approval of third parties or government authorities to proceed with the transaction; fail to discover non-compliances of the target company; ignore discovered information which is relevant; overlook expiry or non-transferability of certain licenses; fail to detect potential liabilities; over-value or under-value assets or securities of the target company; overlook non-transferability of intellectual property rights; or neglect mismanagement or fraudulent practices undertaken by the target company.
The outcome of the entire transaction heavily relies on a due diligence process. Any error, omission or oversight committed during a due diligence process can have disastrous effects. Sometimes, the structure of the transaction is altered based on recommendation received from the due diligence report. Once the M&A transaction is complete, the acquirer gains a substantial stake in the target company and becomes responsible for the target company.
Consequences of inadequate due diligence
In the past, many high staked M&A deals have resulted in absolute failures on account of inadequate due diligence process. When a business entity proceeds with a transaction without conducting a due diligence exercise or based on an inadequate due diligence exercise, the ramifications can be severe. Following are the consequences of an inadequate due diligence process:
Financial Consequences
Post-acquisition or merger, all financial risks of the target company are passed to the acquirer. Due to inadequate due diligence process, the buyer may be heavily penalized and can be made financially liable for the past non-compliances of the target company under sector-based laws, foreign investment laws, companies’ law, competition laws, SEBI regulations, RBI guidelines or any other applicable law. Since M&A transactions are generally exorbitantly priced, a failed acquisition or merger can negate the value of the proposed transaction and can even result in financial ruin of the acquirer.
In 1998, a German company Daimler Benz merged with Chrysler Group for a value of $36 billion. However, the merger was not successful and the value of Chrysler fell to $7.4 billion after a couple of years. According to various experts, Daimler failed to conduct a proper due diligence process which resulted in over-valuation of the target company.
In September 2008, UAE based Etisalat acquired 45% stake in the Indian telecom operator Swan Telecom (renamed as Etisalat DB) for $900 million. A year later, the Supreme Court of India revoked 2G licences awarded to Swan Telecom due to impropriety in obtaining the licences. The due diligence process carried out by Etisalat failed to detect any impropriety in obtaining telecom licenses. Etisalat faced significant financial losses of upto 827 million dollars and later took an exit from the company. Thereafter, Etisalat issued legal proceedings against the promoters of Swan Telecom (renamed as Etisalat DB) on the grounds of fraud and misrepresentation.
In 2011, US based company, Hewlett-Packard carried out only six hours of due diligence on the finances of the British software company Autonomy before buying it for £8bn, in a deal that ended in disaster and a $5bn (£3.8bn) fraud case. HP failed to notice the accounting improprieties during the due diligence process and was sued by its shareholders for negligence in missing red flags and not performing adequate due diligence related to Autonomy purchase. The former CFO Cathie Lesjak of HP later admitted that not only did she never read the preliminary due diligence report prepared by accounting firm KPMG, no further due diligence was conducted.
Legal Consequences
A due diligence process may take into consideration existing ligation proceedings by and against the target company but may overlook potential litigation proceedings that may arise in the future. There may be cases wherein the representatives of the target company may not disclose relevant information in relation to potential litigations. If any party including government authorities or third parties launches action against the target company post-merger or acquisition, the acquirer will be subject to unpleasant legal battles and proceedings despite having no participation in any non-compliance, irregularity or fraudulent activity committed by the target company. Thus, a stringent due diligence and a thorough investigation into the litigation background of the target company is very important. Extensive exposure to tax related litigation, litigations by disgruntled management or shareholders, labour disputes, consumer disputes, environmental litigations can affect the functioning of a company and create a significant dent in the company’s finances. A company which is mired in a series of legal proceedings may eventually affect its business operations and hinder its corporate growth.
In the case of Nirma Industries and Anr. v. Securities Exchange Board of India, Nirma Industries sought withdrawal of an open offer under Regulation 27(d) of the Takeover Regulations on the ground that the promoters of the target company had committed a fraud and had embezzled funds. Nirma Industries applied to SEBI to allow the withdrawal of the open offer. The Supreme Court however rejected all the contentions of Nirma Industries and held that an investing company is responsible for its own decision to invest and should carry out appropriate diligence. The Court stated that Nirma Industries were aware of various litigations, the plea of ignorance of litigation and dangers of investment was thereby denied.
In June 2008, Japanese company Daiichi Sankyo paid $4.6 billion and acquired a 64% state in Indian drug making company Ranbaxy Laboratories Limited. After a couple of months, the United States Federal Drug Administration (USFDA) banned 30 generic drugs manufactured from three of Ranbaxy’s units in India citing gross violation of approved manufacturing norms, forgery of documents and fraudulent practice. Daiichi initiated legal proceedings against the former promoters of Ranbaxy for allegedly concealing facts and supressing regulatory issues with USFDA during the due diligence process. In 2016, Singapore arbitration tribunal ordered the promoters to pay around $525 million to Daiichi in damages on grounds of fraudulent misrepresentation and concealment of material facts. The arbitral award was later upheld by the Delhi High Court after being challenge by the promoters in India.
Conclusion
A well-conducted due diligence process is an integral part of a successful M&A transaction. Negligence or any form of inadequacy in this regard will have detrimental effects upon the M&A transaction. A failed M&A transaction will cause severe financial and legal hardships and damage the reputation of the parties to the transaction
With a view to avoid any inadequacy in a due diligence process, it is necessary that the process is carried out by persons having requisite skills and competence. A competent due diligence team that has a systematic approach will ensure that the risks associated with the transaction are detected and are not passed on to the buyer.
It is pertinent to note that the Indian courts are hesitant to award damages or grant reliefs to persons who wilfully ignores any discovered information. It is thus essential for the parties to refrain from being overly enthusiastic or emotionally vested in a transaction that can cause the parties to ignore any negative information and cloud their judgment.
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