This article is written by Srishti Khindaria, from Amity Law School, Delhi, and Shubhanker Jhingta, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from

What is an M&A?

Mergers and Acquisitions (M&As) have become a common phenomenon throughout the country ever since the introduction of New Economic Policy (NEP) of 1991 which lead to liberalization and the opening of Indian markets to the foreign ones.

The merger is a combination of two companies, where one company merges itself into the other and loses its identity, while the other prominent company gains greater importance and consolidates itself with or absorbs the other company.The term ‘amalgamation’ has been used synonymously with a merger in The Companies Act, 1956 and both these terms are used interchangeably, but both are not precisely defined.

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In an acquisition, there is an acquiring company and an acquired company. The acquiring company purchases the interest of the acquired company’s shareholders. Thus, a merger is an arrangement through which two or more companies are brought together, and their control is vested in one company. Here both companies pool in their interests. While in an acquisition the ownership of one company is bought in tangible or intangible assets by another company in ways such as purchasing the controlling interest in share capital or the voting rights. In a highly competitive environment globally, mergers and acquisitions have turned out to be one of the fastest ways for companies to gain a competitive advantage.

What is due diligence?

Due diligence refers to any reasonable person/business entity must take before entering a legal contract or business transaction. Performance of thorough due diligence before any investment or acquisition is made by the business is a fiduciary duty entrusted with the officers of companies

Due diligence is a through and through examination of all the critical aspects of business. Every aspect of the business must be examined through due diligence- financial, operational, tax, commercial, tax, IT, integrity, social, environmental, health and safety, regulatory, etc. It is seen as a comprehensive appraisal of the business by a prospective buyer to evaluate the assets and liabilities and other factors of business.

Role of due diligence in M&As

Mergers and Acquisitions involve a reasonable amount of due diligence by the buyer as before committing to the transaction it essential for the buyer to know what it will be buying and what all obligations it will assume with the purchase, the nature, and extent of liabilities of the target company, litigation issues, intellectual property issues, etc. This is particularly important in the case of private companies where the target company has not yet been subject to the scrutiny of the public and where the buyer has very little ability to obtain information that it could ordinarily obtain from public sources.

Thus it can be said that the basic function of due diligence in any merger or acquisition is to assess the potential risks involved in the proposed transaction by inquiring into all relevant aspects of the business to be purchased in its past, present and predictable future.

The four core areas of due diligence in a merger transaction are as follows;

  • Financial statements review: This is done to confirm in the balance sheet the existence of assets, liabilities, and equity, and analyze the income statement of the company to determine its financial health.
  • Management and operations review: This is done to determine reliability and quality of financial statements, and to gain a sense of contingencies which exist beyond the financial statements.
  • Legal compliance review: This is done to review and check for potential legal problems that could arise in the future stemming from the target company’s past.
  • Document and transaction review: This is done to ensure that the paperwork of the deal is in proper order and that the transaction structure is appropriate.

In 2008 Bank of America’s acquisition of Countrywide Financial for about $4 billion serves as a perfect example as to why due diligence is important.[1] Countrywide Financial has been a key player in subprime mortgage market through the 21st-century real estate boom.

 A subprime mortgage refers to those mortgages which are given to borrowers who have less than perfect credit score. Analysts discover years after the deal took place a lack of oversight on the part of employees and brokers- who had financial incentives in the way of commissions backing their actions- who pushed through mortgage approvals on overvalued properties that the borrowers may have trouble repaying.

Subprime mortgages held by major financial institutions such as Lehman Brothers, Countrywide Financial and Bear Stearns, in the form of securities. However as these securities had no market price and were illiquid, the firms were not able to value them on a market-to-market basis and subsequently went on to value them for many times their actual worth. Countrywide Financial too had a large inventory or such securities on its books, and they were valued using spurious methods.

When Bank of American acquired Countrywide Financial, while conducting due diligence, its officials failed to recognize that these subprime securities where worth much less than stated and as a result along with the $4 billion purchase price there was over $40 billion attached as a liability that Bank of America was unaware of.

Another example to showcase the importance of due diligence would be that of the deal between Dai-Ichi Sankyo and Ranbaxy. Initially, Dai-Ichi Sankyo paid Ranbaxy $4.6 billion for 63% of its share however late wrote down the acquisition’s value by $3.6 billion. The reason being that they were never fully aware of the extent of the Food and Drug (FDA) Investigation into Ranbaxy when it was asked to shut down all its pending and future drug applications from its Ponta Sahib plant in 2009. The first-to-file atorvastatin which was the greatest attraction for Dai Ichi was fraught with many problems. As Dai-Ichi failed to conduct adequate due diligence, they ended up suffering huge losses.

“Only Fools Rush”

Why is due diligence important for any M&A transaction?

Though a slightly time-consuming process due diligence is essential before any M&A is undertaken. And the companies entering into an M&A must make sure it is conducted in a proper manner as it is essential to investigate the affairs of business as a prudent person would.

The other advantages of Due Diligence are as follows;

  • It helps assess the risks and opportunities that shall be present in the proposed transaction and reduces the risk of unpleasant post-transaction surprises.
  • It confirms all material facts of the business and that the business is exactly as it appears without any discrepancies.
  • Due diligence helps create a relationship of trust between two otherwise unrelated parties.
  • It helps identify potential deal killers and defects in the target business that help avoid bad business transactions.
  • It helps gain information which would be useful for valuation of assets, indemnification and also negotiation processes.
  • It also helps verify that the target business has bene complying with norms of the industry and identify potential “red flags.”
  • Lastly, due diligence also helps in analyzing the target before a controlling interest is acquired in it.

As it has been said, “Due diligence is not judgment making it just bringing out all facts to the fore.”[2]

Steps involved in due diligence

Commercial transactions are usually complex in nature, therefore, it is very difficult to come up with a single analytical method for performing due diligence. However, there are a few tools that can help us with the same. 

Tools of due diligence

One of these methods involves preparing a questionnaire for the target company, which helps us in identifying the risks involved in the business of the Company and also gives an overview of the General and Financial health of the Company.

Another way is to ask the Seller to make Representations and Warranties regarding the conduct of business in a contractual agreement.

The third method involves reviewing the financial analysis of the targeted company’s business, analyse and identify the legal risks associated with the same.

Procedure concerning due diligence

There are two ways of conducting due diligence:

  • In the first method, the seller Company presents predetermined data to the Buyer in a data room.
  •  The Second method involves analysing the data provided by the Seller in response to the questionnaire.

In the Data Room method, the Potential bidders are supplied with large amounts of data, which is then studied and valued. Each Buyer is presented with the same amount of data and information and any discrimination in the supply of information or documents may end up vitiating the whole process. Therefore, in this method, due diligence is conducted on a large amount of data and information provided by the Seller/target company.

In the questionnaire method, negotiations are done on a one to one basis based on the answers supplied by the Seller Company. A due diligence report is prepared by the lawyers based on these answers and further negotiations can be done based on this report.

Initially, the buyer sets up a team of legal and financial experts. This team consists of investors, lawyers, accountants, personal consultants, and other service providers based on the business your company is involved in.

In the next step, the due diligence team gathers all the material information and documents. Once the confidentiality agreement is signed between the parties, the due diligence team can request the seller company to provide the necessary documents. The objective of this preliminary survey conducted by the team is to identify some critical issues like statutory non- compliance, concealment of facts and figures, pending legal proceedings, any imbalances in internal controls of the company, and so on. As a result of this preliminary survey, the buyer is able to identify any potential risks and deal breakers issues before money and other resources are committed to the target company.

If there is any problem during the review process, the team will decide on abandoning the deal altogether or modifying their offer. The team can hold meetings with the seller company to address any grievances on time. A certificate of completeness of disclosures should also be obtained from the target company stating the authenticity and completeness of documents provided, and that no material information has been withheld by the seller company. If the buyer is satisfied with the information, it can proceed with the transaction and send a purchase agreement to the seller company for approval.

Elements of due diligence

Financial due diligence

Financial due diligence is considered to be one of the most important types of due diligence. It aims to ensure that the financials provided by the target company in the Confidentiality Information Memorandum are accurate. It also involves an analysis of major customer accounts, analysis of profit margins, and inspection of internal control procedures. The Company’s order book and sales pipeline order are also examined,  to make better projections.

Intellectual property due diligence

Intellectual property assets are considered to be some of the most valuable assets in possession of a company; these intangible assets are what differentiate a company from its competitors, vis-à-vis the products and services they provide.  Therefore, it is important that a due diligence review is conducted over some items like a schedule of patents and patent applications, schedule of copyrights, trademarks, pending patent clearance documents, and any pending case against the company in regard to intellectual property.

Taxes due diligence 

Due diligence concerning tax liability involves a thorough review of all the taxes the target company is under an obligation to pay and ensuring their proper calculation. Furthermore, the status of any pending tax-related cases also needs to be examined.

Customer due diligence

Customer Due diligence is essential to a transaction as it provides the buyer company with a close look at the target company’s customer base. It involves an examination and review of the following:

  • Top customers of the company, customers who are indispensable to the company regardless of their current spending with the company.
  • The current credit policies, service agreements, and insurance coverage.
  • Customer Satisfaction Score and a list, with explanations of any important customers lost by the target company in the past three years.

Legal due diligence

In any acquisition, a company wants to avoid acquiring any unwanted legal liabilities from the target company. Legal due diligence, therefore, includes a review and examination of the following:

  • The Memorandum and Articles of association of the company.
  • Minutes of Board meetings of the preceding years.
  • Shareholder Certificates issued to important management personnel of the company.
  • All the material contracts and agreements to which the company is a party to.
  • Copies of all credit agreements, bank financing agreements, licensing, and franchise agreements.

These are some of the key elements of due diligence that need to be kept in mind before entering into a mergers and acquisition transaction. Additionally, diligence in antitrust and regulatory issues, insurance, material contract and employee management issues are some other key areas where due diligence is required.

Is due diligence mandated by indian law?

Securities and Exchange Board of India and several provisions in the Companies Act, 2013, cast an obligation on the director to act in the best interests of the company. He is supposed to exercise due care and skill while doing the same. In the case of Smith v. Van Gorkom, the Court held the directors personally liable for approving a merger proposal which assured shareholders a premium of 39-62% over market price, The US Supreme Court opined that the directors failed to exercise reasonable care and also stressed on the fact that the Board participation needs to be carefully planned and structured when a decision has to be taken regarding a major corporate transaction such as the sale of the company.

In Nirma Industries and Anr v. Securities Exchange Board of India, the Supreme Court opined that under Regulation 27 (d) of the SEBI, 1997, an investor Company needs to ensure that appropriate due diligence is carried out regarding the target company before investing. The Court stated that Nirma Industries were aware of various litigations, the plea of ignorance of litigation and dangers of investment was thereby denied.

Challenges associated with conducting due diligence in india 

  • In most transactions, there are confidentiality and secrecy covenants, which prevent the disclosure of any material data or information.
  • In case of a distressed M& A transaction, the investor company is dependent on the IRP, COC, and the management for providing basic data and information. This may lead to a discrepancy in information being shared, leading to disputes. 
  • A correct assessment of the contingent and past liabilities and making recommendations for the same, make the task of a due diligence expert difficult.
  • Due diligence requires a variety of experts; therefore, the procedure can end up being an expensive one for the acquirer.
  • In many transactions, there is also insufficient basic data provided to the acquirer, which makes the procedure challenging.

How to effectively undertake due diligence exercise

Before making the last move, it is essential to keep the following things in mind to effectively undertake due diligence:

  • Firm and clear strategies and a well-defined objective are one of the fundamentals of an effective due diligence exercise.
  • Allocate clear responsibilities and formulate procedures for the personnel involved in data management, project management, and core due diligence team and so on.
  • Have an integrated approach towards the due diligence process and seek the expertise of technical consultants whenever necessary.
  • It is also expedient to store the data in electronic form, which makes it easier to transfer to and being accessed from remote locations. 
  • Use the latest technology for retrieving, analysing, and reviewing data.
  • It is important to deal with the media reports, although paying too much attention should be discouraged.
  • On-site visits should be encouraged; the on-site conditions give a firsthand view of the prevailing scenario which can never be available on paper.
  • Lastly, there needs to be a continuous dialogue between the acquirer and the target company and there should be no hesitation in seeking clarifications.
  • Conclusion
  • A comprehensive due diligence process is essential for the success of any merger and acquisition transaction. The fundamental purpose of due diligence is to validate assumptions on identification and valuation of risks. It must be ensured that the scope of investigations is tailored to the nature of the transaction. Due diligence is of utmost importance and it cannot be emphasized enough that most deals fail due to nothing more than inadequate due diligence due to which the buyer ends up overpaying or experiencing major integration problems or assuming unknown liabilities.






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