In this article, Shreya Mazumdar, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses the possible red flags during a legal due diligence exercise.

Introduction

The term due diligence is closely related to the doctrine of notice. Section 3(6) of Transfer of Property Act, 1882 states that a person is said to have notice of a fact when he actually knows the fact, but for wilful abstention from an inquiry or search which he ought to have made, or gross negligence, he would have known it.

It means a person shall be deemed to have a notice of any fact if his agent acquires notice to act on his behalf in the course of business.

Due diligence came into the limelight in the case of Mergers & Acquisitions. It means whenever there is a merger or acquisition, the buyer should always take proper care and find out all the legal the other details of the company. In the said case the host company before entering into the contract or agreement with the other company must find out the detailed information about it.

Due Diligence

  • Due Diligence refers to precautions or reasonable verifications taken by a company to identify and prevent foreseeable risks. Due diligence is a part of the merger and acquisition, mainly the buyer does a due diligence to check whether the target company will give him a profit or not.
  • It is a part of the acquisition or the merger where the buyer company goes on a detailed investigation or research to identify that they can get good valuable returns on this deal.
  • In this process, the buyer’s company will come to know about the details of accounts, debts, sales, profit margin, leases, pending or past legal suits, compensation agreements, distributions agreement of the target company.

R v Steinberg

In the above case the Ontario judge Harris said that 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, unexpected, unknown, or unintended.

Legal due diligence exercise

  • Legal due diligence exercises can identify issues which affect the structuring of transactions, disclose weaknesses, or risks in the underlying business. Identifying those issues give a chance to the interested parties to fix any issues discovered before they cause problems in:
    • Price according to the perceived risk
    • Seek additional contractual
    • Insurance protection, or
    • In extreme cases decide to walk away.
  • Legal due diligence is a set of checks, usually done by the advocate or lawyer who represents the buyer. This is done to satisfy the lawyer of the buyer that the business is not experiencing any litigation cases or legal charges.
  • The lawyer reviews the contract with:
    • Customers
    • Suppliers, and
    • Employees to uncover any potential or immediate risks to the smooth operation of the business.

Example of legal due diligence

An American client wants to acquire six companies (hereinafter known as the target company) for this purpose he has to enter into the contracts with all the companies. The legal due diligence cannot be done by him alone, he will give his documents for review to a company who handle such documents. The company will summarize all the documents, arrange it in a systematic way and after the due diligence report has been made they can ultimately make the purchase decision.

Red Flags during legal due diligence

Red flags refer to the problems, difficulties or issues.

A buyer with legal due diligence faces a lot of problems. The are various red flags during this process are given below:

No Contracts

If there is no contract between the business and its staff, clients or suppliers then there will be no legal or formal obligation on the other party to perform the said promise or agreement.

Company- Middle of a Litigation

During a Merger or Acquisition, it is very necessary to check whether the company is in middle of any litigation case or not. If it is in the middle of any litigation then the buyer may pay only the cost of litigation personally.

Void management team

Many buyers prefer acquisitions with experienced management teams that can help the buyer’s business to grow after the deal is closed. In due diligence process, some buyers may discover that a company’s leadership or management team isn’t prepared to manage the business in the previous owner’s absence.

Before marketing the company for sale, the seller may realize that his business management team is weak which may not attract or impress the buyers. It becomes a void management team when a seller appoints wrong persons in the management team.

Losing customers

When a buyer wishes to purchase a company he may do the following things:

  • Asses or interview the clients
  • Asses or interview the customers of the company.

It was done to know the vendor-customer relationship, interviewing the client can also help in knowing the reaction of the client when there is a change of ownership.

There are many clients who back out when there is a change in ownership may be because of the trust issue. This is one of the most important red flags during the legal due diligence exercise as a company run only because of its customers.

If while assessing, the buyer finds that the customer may withdraw due to the change in the ownership and has even informed about the same to the owner or seller and the owner did not disclose this fact to the buyer then in such case the buyer can finish the contract due to the dishonest behaviour of the owner.

Labour Law Violations

The buyer before mergers and acquisitions should review the seller’s employee benefit plans as well as he should ensure his own current and past personnel policies. This means the buyer has to take care of both the employees of the company he is acquiring and the policies he is following in his own company, e has to keep the balance between the both.

A buyer may discover potential liabilities that are due to the employee rights violations by the owner. A certain violation can result in penalties that can amount to several millions of dollars. A buyer needs to protect himself from such a huge debt, especially if it is due to the negligence of the previous owner.

Troubling legal past

This is basically related to the second point which discusses the situation when a company is in middle of any litigation. The difference between the two is that the second point talks about the present scenario but this point emphasizes on the past cases of the company.

The manager at the company or even the owner could have a hidden criminal past or have faced allegations of fraudulent behavior before joining the business. Such findings can make a buyer question the integrity of the company and its leadership.

Governing Documents

Review of Target Company’s governing or constitutional documents like:

  • Article of Association
  • Memorandum of Association
  • Charter
  • Shareholders Agreement, etc.

Review these documents. Governing documents is one of the most difficult red flags during the exercise of legal due diligence.

Conclusion

Due diligence can uncover a wide variety of potentially damaging issues. It is important for buyers to work with their legal and financial advisors to assess each due diligence concern and evaluate their impact. Due diligence is an important factor in merger and acquisition as it has a lot of significance. One should always try to overcome the red flags or the difficulties faced during the legal due diligence exercise and carry on the work.

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