This article on how to conduct a legal due diligence is written by Rakesh Gupta pursuing M.A. in business law from NUJS, Kolkata.

INTRODUCTION

‘The mistake is thinking that there can be an antidote to the uncertainty.’[1] In a current global corporate scenario, where a lot of transactions are taking place at a speed light, the uncertainty level is at its peak. No one can forecast what will be the government’s policy towards the company which may have an impact on it, or what would happen if key personnel resign from the company, or if the company loses its investor. Anything is possible at any time. No one can predict the future. For these above-mentioned reasons, every corporate industry should conduct a legal due diligence and be prepared for any unpleasant surprises before getting into any merger & acquisition deal. In this article, we are going to discuss what is legal due diligence? Why it is done? And how it conducted?

LEGAL DUE DILIGENCE –MEANING AND CONCEPT

Due diligence has been used since the fifteenth century in the literal sense “requisite effort.” Centuries later, the phrase developed a legal meaning, namely, “the care that a reasonable person takes to avoid harm to other persons or their property”; in this sense, it is synonymous with another legal term, ordinary care. Due diligence is the research and analysis that an organization needs to perform while preparing for any business transaction such as corporate merger or purchase of securities etc. It’s an investigation of a business or person prior to signing a contract, or an act with a certain degree of care.  As per dictionary definition, due diligence is “the care that a reasonable person exercises to avoid harm to other person or their property.” In plain English, it simply means doing your homework.

For a layman, the term ‘Due diligence’ means the reasonable verifications and precautions taken to identify or prevent foreseeable risks.[2]. In  legal terms, due diligence is “ a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent person under the particular circumstances; not measured by any absolute standard but depends on the relative facts of the special case.” In the words of Crilly’s Due Diligence Handbook, it is a process whereby an individual, or an organization, seeks sufficient information about a business entity to reach an informed judgment as to its value for a specific purpose.[3]

In any acquisition process where the buyer company needs to know whether they will be able to recover the returns against their investment, they’re making to buy the company. To know this, the company needs to conduct a detailed and an in-depth investigation of the obligations of the company including its debts, leases, pending and potential lawsuits, distribution agreements, compensation agreements and the likes.

In R v Steinberg, Ontario judge Harris wrote:

“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 legislations the words all due diligence import an area of precaution sufficient to prevent the foreseeable, but not the unforeseen, the unexpected, the unknown, or the unintended.”

LEGAL DUE DILIGENCE – WHY?

In today’s corporate world, legal due diligence is not just a mere task to be undertaken during Merger & Acquisition deals, it’s a necessity as in these deals  not only the assets are transferred but also the liabilities associated with such assets is transferred. The value of the company that is being merged or acquired cannot be understood without knowing all the relevant legal issues under consideration which makes the process of legal due diligence more necessary.  Regardless whether the transaction of buying a business as an asset purchase, a division purchase, a company stock purchase, or a corporate merger, one must conduct legal due diligence on the target company. By conducting legal due diligence on the target company, buyer company get the detailed understanding of the target companies business module and thus buyer company being better able to ascertain a fair purchase price. Buyer Company is also been able to identify any surprise business liabilities for which it might become liable after becoming the business owner. 

Any companies main agenda for undertaking legal due diligence is to minimize the risks, assigning the uncertain risks in other direction so that the risks factor is reduced and shareholders value is maximised. Legal  due diligence is also important because, depending on the outcome of the whole process, the buyer company may want to incorporate certain seller obligations in the deal agreement ( like clearing any liens on the assets of the business, obtaining required third party consents, etc.).

LEGAL DUE DILIGENCE – THE PROCESS

There are different types of due diligence such as business due diligence, financial due diligence, special due diligence, accounting due diligence and the legal due diligence. This article deals primarily with the legal due diligence part. Due diligence basically means using common sense, doing your homework and thinking things through before investing time and money in an opportunity.

Let’s assume that one company is planning to buy out its competitor who wants quit from the industry. The competitors business is quiet alluring to the buyer company because of its position in an area of town where the reach of Buyer Company is difficult. But before finalising the deal to buy the target business the buyer company need to perform legal due diligence.

• Does the proposed business have healthy cash flow?
• Can one establish the flow of revenue stream after looking at the books?
• Correct and Fair value of Assets (tangible or intangible) and Liabilities?
• Is there any hidden assets or liabilities?
• Reliability of Financial projections and what multiple is it placing on those earnings?
• Does Company have all the Documents in proper order?
• Does company have any tax dues?
• Does Company have given out or taken any property on lease? Does Company have the proper lease documents and when those lease ends?
• Does Company have taken any insurance policy and whether its documents are in order?
• Does Company maintain proper employee’s files including salary and benefits?

The above mentioned list contains some questions, answer of which a buyer company always try to get before getting into any merger & acquisition deal. By conducting the process of legal due diligence the buyer company can get the above answers. The above is the very short list for legal due diligence. Below we will discuss the process off conducting legal due diligence in detail:

STEP -1

According to Justin Levy, Partner at Winston & Strawn, “the buyer should always hire the specialized services of a legal advisor or a consultant as this process is in itself complicated wherein both business and the industry issues need to be understood and one would be certain that the right questions are being put up and the probable risks are uncovered”.  Therefore every company who needs  to do legal due diligence could contract with professional experts/ consultants to conduct legal due diligence such as lead investors, corporate/business development staff, legal staff (attorneys), financial staff (accountants), loan officers, investment bankers.

STEP -2

RESEARCH INFORMATION

For any legal due diligence process to be successful, both the parties’ i.e. Buyer and Seller must cooperate with each other to understand the bigger picture first. Before entering into any legal agreements, the buyer needs to go through following legal documents:

• A list of Subsidiaries of the Company whether directly or indirectly related.
• Memorandum and Articles of Association and Certificate of Incorporation
• Minutes of meetings of the Company’s stockholders or members, board of directors, or any committee thereof, for the last 3 years.
•  All agreements between stockholders or members of the Company relating to management, ownership, or control of the Company.
• Capitalization of the Company showing the number of authorized shares of each class or series of capital stock, the number of issued and outstanding shares of such stock, and the record owners of such shares.
• All documents entered into with respect to or related to any prior financings or equity issuances of the Company, including, but not limited to, Stock Purchase Agreements, Stockholders Agreements and Registration Rights Agreements.
• All correspondence and agreements between or among the Company and the directors or officers of the Company relating to indemnity, employment, loans, or advances.
• Stock books, stock transfer ledgers, and other stock records of the Company.
• A list of options, purchase rights, and warrants issued by the Company specifying the name of the holder, the number of options, rights or warrants issued, the date granted, the option or purchase price, and the position of the holder with the Company, together with copies of option, right or warrant agreements.
• An address list of the locations of all land, buildings, and other improvements either leased or owned by the Company.
• All material governmental permits, licenses or authorizations, and related correspondence, of the Company.
• Other than customer contracts, any agreements with any federal, state, or local regulatory authorities to which the Company is a party.

Apart from the above mentioned list the buyer company also needs to focus on some more points:

Contracts and Agreements:

     Various Business Contracts:

The buyer company should review all major distributor, supplier and customer agreements, all confidentiality and non-compete agreements, all intellectual property agreements (licenses into and out of the company), and all equipment leases.

    Real Estate Agreements: 

Buyer company needs to review all real estate leases entered into by the target company (whether as a tenant or a landlord), purchase agreements, surveys (if a long term lease or fee owned), title insurance policies (if fee owned); buyer company should ascertain whether any consents are needed for the contemplated business sale (or merger) transaction, how much the rent liabilities are, whether there are sufficient term(s) remaining on the lease(s), among other things.

   Insurance Agreements:

The buyer company must review all insurance policies carried by the target business to determine if the present coverage is adequate for the business as it is conducted (or plans to be conducted).

   Licenses and Permits:

The buyer company should check whether the target company required to maintain licenses and permits with the local and state authorities (such as a liquor license or other operating permit)?  If so, the buyer company must take all copies of such licenses and permits and determine which licenses may require the seller’s obtaining prior consent for the contemplated sale or merger of the business. 

Detail list of all Assets and Liabilities:

The buyer company must be sure what the target company owns and owes regardless of whether the transaction is in form of an asset purchase or a stock purchase. The target companies’ assets may include cash, securities, inventory, equipment, intellectual property (copyrights, trademarks, patents, and other proprietary rights), notes and accounts receivables, real property (leased and owned). 

Liabilities may include bank debt, employee benefits and bonuses earned and not yet paid, pending and current lawsuits, licensing violations, etc.  The buyer Company should receive the list of all employees and their current salaries. It shall also identify which employees are key to a successful transition and continued operation of the business.

One of the major problems of locating and managing the hidden assets and liabilities has to be tackled intelligently by the buyer company as there are certain assets and liabilities in every company which do not appear anywhere in the balance sheets such as the unregistered lands, assets held by a nominee, unregistered intellectual property, contractual rights and obligations. To find out such assets and liabilities, the buyer company or its hired professional needs to investigate the historic financial records, and internal announcements. The public registers should also be searched for in the process not only with the current company name but also with its former name. If possible, the current personnel of the company should be interviewed to know the company better.

Customer Grievances:

In today’s digital world it is very easy to find on internet if there is any negative publicity or customer complaints about the target company.  The internet is a powerful tool for viral marketing and unfortunately, for flaming a business. No company wants to buy a business that has such a negative image and has negative consumer awareness. The customers’ complaints on the internet should also be searched for as it would lead to know the good and the bad of the company in a better way.

STEP -3

THE ANALYSIS

As the buyer company or its hired professional completes Step – II of the legal due diligence process, they must now analyse all the findings in a systematic way. It is advised to quest for any ‘casus belli’ or any questionable or a suspicious document found in the process of investigation to its root. All due diligence questionnaire must be prepared highlighting all the key areas that are needed to be examined. In this way, the core areas which are to be investigated and examined can be highlighted giving a better picture. The purpose of filling the questionnaire is to help the company or the hired professional make sure that all the major areas of the legal due diligence are considered.

The time process of legal due diligence normally varies depending upon the size of the target company. It can take place for a few days, for a smaller target company to a several months if the target company is big and has more complicated transactions. The process of legal due diligence ends when the buyer company is adequately satisfied and had analysed all the relevant documents and issues related to the target company and is able to understand the market fairly well. Every buyer company would try to complete the due diligence process before carrying out the primary agreements with the seller company.

STEP -4

THE ANALYSIS REPORT

An analysis report of the legal due diligence findings needs to be presented to the buyer company by the hired professional that carries out the investigation. As the buyer company would be unfamiliar to the legal nomenclature, the analysis report should be presented in the easiest and the most user-friendly way. For smaller deals, the analysis report could be presented in the verbal form if buyer company agrees with it, while for the big deals involving more financial resources, the legal due diligence findings should be presented in a detailed memorandum format listing all the documents investigated, key issues discovered and the solutions thus suggested for resolving the issues. The buyer company should specifically convey to its hired professional advisor about his priorities and expectations from the said deal in order to get a more streamlined analysis report highlighting the main concerns and keeping them at a priority.

Tips & Warnings

• Always have a very good knowledge of own business practices, financials and inventories. Only then can a buyer company be confident in the due-diligence priorities you set for exploring a potential investment.
• Always look out for the opportunity to determine where one can save money. Business opportunities involve their own costs. Saving money (where possible) in conducting due diligence will contribute to the potential for a successful transaction.
• In any Merger & Acquisition deal, when it is determined what information and materials will be necessary to conduct legal due diligence, the buyer company should ask about the benefits and costs of each. Some information may at first seem desirable but prove to be too challenging or expensive to obtain. Recognizing this before beginning, will increase the chances for productive legal due diligence.
• Don’t focus solely on how a business or product has performed historically. Due diligence that ignores the future potential to be derived from the investment will have too narrow a focus to support sound due-diligence practices.
• Relying on traditional financial, legal and environmental data when conducting due diligence is insufficient. Although vital components of due diligence, these traditional data sources alone do not adequately predict long-term success in an investment. Consider a more multi-disciplinary approach involving business strategy, corporate culture, information-technology operations and human capital.
• One-third of due diligence investigations uncover serious problems in a potential business investment; problems that essentially become “deal breakers” that end further consideration.

LEGAL DUE DILIGENCE – THE CONCLUSION

It’s a hard truth that the whole process of legal due diligence is time consuming, troublesome, annoying and most of the times expensive. Legal due diligence, although a very hard and tedious process but once the buyer company conducts it and get the results, they become sure whether proposed investment in the target company would be a good, wise and profitable decision or not. Above all, the buyer company gets a clear picture as to how the company needs to run as all the grey areas related to the target company is known and also the working in the market.

Not only this, the analysis report which the buyer companies hired professional personnel prepares during his process of investigation also helps in drafting the merger and acquisition agreement and the related ancillary agreements. The information derived from such details investigated report will be useful in assigning the risk while drafting the company’s warranties, its pre-closing promises and the post-closing indemnification rights of the buyer.

In this article, the concept of legal due diligence and how it is conducted is highlighted from the point of view of the buyer company. In some Merger and Acquisition deals, where the seller company accepts consideration other than money, it may happen that he performs his part of legal due diligence too.

Thus if anyone is willing to enter into any business transaction of Merger and Acquisition, one would know what he needs to do and go with his legal due diligence process which would give him a clear picture about his future with the subject company.

In the end, in the words of Jeffrey Weiner, “eternal vigilance is more likely to be the price of successful deal making, and performing adequate, if not excellent, due diligence—the path to salvation”.[4]

 

[1] Quote, David Levithan, The Lover’s Dictionary.

[2] Duhaime’s Legal Dictionary.

[3] WILLIAM M. CRILLY, DUE DILIGENCE HANDBOOK (American Management Association, 1998).

[4] Jeffrey M Weiner, Due Diligence in M&A Transactions, 2010 Edition.

LIST OF WEBSITES REFERRED

http://duediligencedataroom.com/IP-Due-Diligence-Checklist.html

http://www.loylaw.com/uploads/8/2/7/8/8278277/acquisition_due_diligence_checklist.pdf

https://www.merriam-webster.com/dictionary/due%20diligence

http://www.gecapital.eu/en/docs/GE_Capital_Overview_Due_Diligence.pdf