This article has been written by Anupam Bhaduri pursuing Diploma in Merger and Acquisitions (PE and VC transactions) from LawSikho.
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Due diligence is the precursor of all corporate merger and acquisition transactions taking place between two companies or entities. A due diligence report singularly holds the answer to the most important questions in a transaction- “Is the transaction worth the money? Are there any risks that the investor/buyer is unaware of?” Due diligence can be effectively summarized as a process employed by companies to verify, investigate and audit a potential venture or investment opportunity.
This is done to verify every information that surfaces during the deal involving an investment process or merger and acquisition transaction. The impediments or risks identified can then be adequately noted down in the due diligence report in the form of a warranty or indemnity in the transaction documents. This will alert the acquirer of the potential risks. In situations where the risk does arise at some point in the future, the indemnity clause will provide for the target making good the loss suffered to the acquirer.
A brief overview of real estate due diligence
All due diligence regarding the purchase of stocks or assets will entail some form of real estate assets. In instances where the real estate in itself is not a key driver for the transaction to take place, the requirements for the due diligence may be less strict. However, it is still advised that one should conduct the necessary physical, financial and operational due diligence on the target company’s real estate assets as they often are critical to the deal. It has been perceived often that the investor company faced an unknown liability in the form of real estate assets that had not been properly managed.
Importance of real estate in due diligence
Conducting real estate due diligence owes its importance to the constant fluctuations in the values of real estate. This has, in turn, heightened the risks and the potential impact it can have in the deal. Hence the due diligence conducted on the real estate assets can question the very feasibility of the transaction itself. It is thus important for the investing company to perform scrutiny into the title, the legality of the constructions in question, the permissions obtained, if any, encumbrances involved with the properties, and every other additional information that affects the nature of the transaction. Hence, a real estate due diligence would primarily seek to resolve the rights of the seller or lessor, the ownership rights, charges, mortgages, acquisitions and litigations or any other restrictions attached to the property.
Ms Alicia Albury, a partner at Maddocks on this regard states that every transaction plan must adapt to the local jurisdiction of the transaction. However, on a broad spectrum, the due diligence should typically focus on the presence of accurate title deeds, zoning, resumption proposals, taxation records, proper mutations and any non-compliance notices if applicable. Any agreements entered into by the seller with any third parties must also be accounted for. Care should be taken to verify information from the seller that only the person selling the property shall have access to. The seller shall also be made accountable if the buyer faces unseen damages due to the concealing vital information relevant to the transaction.
Depending upon the need of the transaction taking place, the real estate due diligence can cover a period preceding about three decades. The period of the title search is extended to determine the constraints like limitation periods apply for the dispossession of the property by the local authorities or the government which is thirty years. The due diligence conducted thus provides significant stress on the confirmation that no vested rights are applicable that could dispossess the present owner of the property.
Key components of real estate due diligence
Any typical due diligence for real estate involves the tracking of title ownerships, encumbrances and state laws that are applicable to the real estate property. A list of the components required to be verified is provided below:
Tracing of ownership: The title documents of any real estate property can be acquired in the following manner:
- In scenarios where the title document of the property is acquired by the purchase or sale of the same, the beneficiary of such transaction can have the registered sale deeds verified. Any other document that provides substantial effect to the transferability of the real estate property can also be verified in the process.
- If the property in question is acquired through a gift deed, all one needs to do is verify the registered deed of gift satisfying the transfer of title of the property to the beneficiary. In case of an inheritance or where the property is obtained through a will, one needs to examine whether the document is in violation of any statute, local or central in nature.
- Properties that are acquired by virtue of lease are to be verified against rights conferred to the parties, lease deed and all other documents regarding the compliance of transferability of the property.
Authority to actually transfer the title of the property: An important aspect to verify is whether the person or organisation is actually empowered to effect the legal transfer of title deeds to the new owner. In order to ascertain that the immediately preceding title rights are in order, the due diligence report must accommodate the khatiyan numbers, jamabandi records, mutation certificates and tax receipts. Further, the previous owner must qualify legally to sell the property, i.e., he must not be minor or a person of unsound mind.
Charges levied over the property: It is of utmost necessity to inspect the charges of the property before the transaction is finalised. It is important to verify whether the property is mortgaged to a foreign investor or a bank or some other financial institution. The relevant documents regarding this can be obtained from the Register of Charges. Further, if any charges are created by a company, a CHG-1 form can be filed with the Register of Companies, which shall be inspected and an encumbrance certificate shall be procured accordingly.
Transfer within a reserved category: It is observed in certain cases that the local statute mentions that a property owned by a person from a reserved category can only transfer his title to another person from a reserved category. Due diligence conducted for tracing previous title deeds would prevent the buyer/investor from violating the provisions of any such local legislation.
Leasing or sub-leasing: In India, leaseholders are provided with lands by the government for agricultural purposes. Hence, care should be taken while conducting a real estate due diligence to verify whether the sub-leasing of the land is for agricultural or residential purposes.
Performing construction on the land: The due diligence process must accommodate the legality of any construction being carried out. Care should be taken to ascertain that all permissions have been obtained from the government and the specific local laws have been followed. Only then can the development deed be executed. The nature of the property in question should also be verified. In the case that the land is found to be agricultural in nature, the parties are supposed to file for the Change of Land Use from that particular State Government.
Government and other regulatory body approvals: The real estate due diligence conducted must positively examine, and verify the approvals obtained. A requisition checklist should be prepared and every approval sanctioned from the government or other state regulatory bodies must be accounted for. Absence of such approvals are a big red flag for a real estate centric transaction and an indemnity clause must be accommodated to protect the investor/buyer from any damages suffered in the future.
Process of acquisition: The laws in relation to acquisition in India prevents the original owner from being alienated from his rights. Hence, due care should be taken while conducting the due diligence to confirm that the property in question is not tied to any acquisition process. This is important because in an acquisition has been made by the government and subsequent transaction was carried out without the knowledge of a previous acquisition, the transaction is void ab initio and hence is not legally enforceable.
Publication of relevant information: It is wise for the investor to publish a notice in at least two local newspapers which have a wide circulation. This is done in order to be on the safe side and not face any unregistered transactions.
Upon careful observation, it can be inferred that legal due diligence plays an important role for an investor, individual or foreign, in any transaction pertaining to real estate for its sale, purchase, lease or mortgage. It is thus prudent to probe and consider every information related to the property that bears significance for the transaction in question. It is also advisable that all documents, namely, but not limited to title, encumbrance certificates, government and other regulatory permissions and insurance policies are properly scrutinized.
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