This article has been written by Milendra Jain pursuing a Diploma in Merger and Acquisitions (PE and VC transactions) from LawSikho.
Table of Contents
Are you familiar with the maxim Qui Ignorare Non Debuit Quod Jus Alienum Emit? No? Let me enlighten you! This means “let purchaser beware, who ought not to be ignorant that he is purchasing the rights of another”. The phrase denotes the importance of Due Diligence (“DD”) as it reminds the buyer/investor to complete their DD when entering into deals.
With the Covid 19 pandemic, it is evident that the healthcare sector is growing at a great pace and the world has seen a trend to invest in and enter the healthcare sector, pharmaceuticals, and life science. As per the S&P Global Market Intelligence reports the aggregate transaction value for healthcare M&A was five times in the first quarter of 2021 compared with the year-ago period reaching up to USD 101.8 billion. Moreover, India has also seen a surge in M&A deals in the healthcare sector which is expected to reach USD 372 billion by 2022. That said, there are nuances that how Due Diligence will play out across the healthcare sector in this pandemic with unforeseen circumstances. In this article, the author is going to discuss why DD is important for a successful closure? what legal and regulatory material risks can be prevented through DD during healthcare M&A? and what is healthcare M&A.
Closing a deal is an easy part, but what comes first is DD as it can be the most time-consuming and tedious aspect of a transaction. DD can be referred to as an investigation of a potential investment that adds significant value to the transaction by showing red flags and ensures that the proposed transaction is safe to proceed with or not. DD enables an entity to undertake these transactions from an informed point of view. DD is used by both the buyer and seller to determine the worth of the business before the negotiations begin. Generally, it is for the buyer to make sure that it knows what it is investing in and to uncover the possible relevant elements which might be critical for the success of the M&A, and to know more about what it is buying.
Moreover, DD is getting access to data from the other side in the form of various documents, to ascertain risks that could be deal-breaking. DD can be structure into three steps as follows:
- Preliminary DD
- Detailed DD
- Final DD
Tools for conduction DD are the documents made available in the Physical Data Rooms or Virtual Data Rooms. These data rooms consist of several important documents to be kept for review in order to communicate issues through DD Report to the acquire. However, due to the amidst pandemic, the DD process has undergone a change as it shifted the process to Virtual Data Rooms.
Statutory consideration of due diligence
No statute defines the term ‘DD’. However, there are judicial precedents that recognize the essential elements of DD as ‘duty of care, ‘exercising reasonable competence’, etc. The Hon’ble Supreme Court of India, in the case of “Chander Kanta Bansal v. Rajinder Singh Anand”, stated that:
“The word “due diligence” has not been defined in the code. According to Oxford Dictionary (Edition 2006), the word “diligence” means the careful and persistent application of effort. “Diligent” means careful and steady in application to one’s work and duties, showing care and effort. As per Black’s Law Dictionary (Eighth Edition), “diligence” means a continual effort to accomplish something, care; caution; the attention and care required from a person in a given situation. “Due diligence” means the diligence reasonably expected from, and ordinarily exercised by, a person who seeks to satisfy a legal requirement or to discharge an obligation. According to Words and Phrases by Drain-Dyspnea (Permanent Edition 13A) “due diligence”, in law, means doing everything reasonably, not everything possible. “Due diligence” means reasonable diligence; it means such diligence as a prudent man would exercise in the conduct of his own affairs.”
Further, the Security Exchange Board of India (“SEBI”) Act, 1992 provides to exercise all due diligence to prevent the commission of contravention. Also, the SEBI (Issue of Capital and Disclosure Requirement) Regulation, 2009, mandates the lead merchant banker to exercise DD, before the opening of public issue. Due diligence in healthcare deals
Conducting DD in the acquisition in a healthcare sector includes all the ordinary legal, corporate, and financial due diligence activities, but also includes unique areas of inquiry:
- Covid 19 DD
With the advent of the Covid 19 pandemic, various unique areas have emerged and which is need to be investigated before entering into a deal as follows:
- Production and Labour Force
- Raw-Material Sourcing
- Healthcare Delivery
- The demand of Life Saving Drugs
2. Corporate Structure and Disclosure DD:
DD generally reviews the legal liabilities in regards to the corporate structure of the targeted company as “whether the entity is duly incorporated under the laws of the state or not?” and “whether the entity has made adequate disclosures under the securities law of the state or not?”. Moreover, it is necessary to investigate the matters of the targeted entity as all the compliance has been made under the corporate and securities law considerations, in order to prevent future legal risks.
3. Healthcare Regulatory compliances and Licensing DD:
The healthcare sector is highly regulated by various Authorities in India under different business models in the healthcare sector and it is essentially important to ensure that the targeted company has complied with all applicable laws governing sub-sectors of the healthcare sector. Furthermore, it is also essential to review that the targeted entity has obtained permissions and licenses for sector-specific considerations.
Following are some mandatory regulatory compliances in the healthcare sector:
- Drugs and Cosmetics Act, 1940 ;
- The Clinical Establishment Act, 2010;
- Pharmacy Act, 1948;
- National Medical Commission Act, 2019;
- Central Drugs Standard Control Organization;
- Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2020.
4. Tax DD:
It is also necessary to ensure that the targeted company has complied with the provisions of the Income Tax Act, 1961 and Goods, and Service Tax, as tax DD explores any income tax liabilities and uncovers potential tax benefits which the targeting company is not availing. This reduces the risk exposures associated with the business transaction to be carried out.
5. Financial DD:
Financial DD includes reviewing financial statements and audit reports, targeted entity’s debt structures, potential liability, revenues, and value of assets, in order to assess financial risks and opportunities. Financial DD is important, as it fully investigates the financial health of the targeted entity which is an important consideration in the valuation of the targeted entity. Following are some common valuation techniques:
- Discounted Cash Flow Method
- Comparable Transactions Method
- Economic Value-Added Approach
- Net Asset Valuation
- Principal Valuation Approaches – International Valuation Standards
6. Contracts DD:
Generally, it includes reviewing all material contracts and commitments of the targeted entity which could raise certain red flags, or yellow flags, or green-flag. However, the pandemic has raised more importance of the DD of the contracts as it puts more focus on the issues pertaining to force majeure, termination, and dispute resolution.
7. Litigation and Malpractices DD:
Generally, it includes reviewing litigation history and any judicial, quasi-judicial, arbitral and other administrative proceedings are pending against the targeted entity. However, malpractice will be the primary focus of any healthcare litigation due diligence.
8. Risk Management DD:
With the Covid 19 pandemic, DD is essential to ascertain specific sectors which are prone to the pandemic. In order to mitigate uncertainty and risks, Investors should be mindful regarding risk transfer mechanisms through Representation and Warranty Insurance and the policies governing such mechanisms.
9. Labour and Employment DD:
The healthcare sector can be an employee-heavy sector, therefore it is essential to investigate various documents and agreements with employees and to evaluate compliance requirements with the various labor laws.
10. Solvency DD:
Reviewing the solvency of the targeted entity is necessary as it identifies potential liabilities of the targeted entity. It will also be necessary to assess the impact of the pandemic on the target’s financial status and determine any solvency risk.
11. Intellectual Property (“IP”) DD:
Healthcare IP assets can come in form of trade secrets, copyright, trademarks, and patents. Healthcare companies, especially pharmaceutical and biotech companies, often deal with various forms of intellectual property, including patents. So, it is important to review the targeted entity’s rights and obligations attached to certain IPs in order to evaluate the value of such IPs.
12. Anti-Trust DD:
It is important to ensure compliance with the Competition law during DD, as it will review that the transaction undertaken would have adverse appreciable effect or abuse of dominant position and to seek approval from Competition Commission of India if the transaction qualifies as a combination.
By conducting DD on the target company, the buyer company gets a detailed understanding of the target companies business module, and thus the buyer company is better able to ascertain a fair purchase price.
Due diligence report
The final product of DD is a thorough report that summarizes the process and supplements of the decision-making. The most important part of the report of the DD is the ‘Executive Summary’, to be delivered to the executives of the company. However, the DD report stating summary/recommendation is translated into transactional documents in the following ways:
- Condition Precedent
- Condition Subsequent
What is Healthcare M&A?
The object and definition of Healthcare vary from person to person. However, when Healthcare M&A is referred to as a transaction in the healthcare industry as it is about a sale or purchase or an investment in a business in various categories under the healthcare sector as recently AstraZeneca acquired a drug developer Alexion for $39 billion. However, there are various sub-sectors in the healthcare industry in which various deals could take place as follows:
- Healthcare Services
- Healthcare Technology
- Medical Devices
Despite the Covid-19 pandemic, India has seen significant growth in the healthcare sector and is expecting to witness various M&A coming into the space. Having said that, in a highly regulated market, healthcare deals require deep-dive investigation for a successful closure. Besides, it helps to avoid several material risks. After all, the information that is discovered during diligence is critical to a deal’s success. Healthcare companies require significant investment to bring products to the market in such cases DD provides a high level of security in the sector. A DD investigation will depend largely on the specific requirements of the buyer and the transaction in order to assess the value of the deal. Lastly, it is the lack of DD, which destroys the deals.
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