This article is written by Aswathy, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.
Table of Contents
Introduction
M&A transactions have the power to alter the future of an entity and put it on a track of growth if the acquirer/target is chosen rightly. On the contrary, if the wrong choice is made, it would adversely affect the acquirer’s growth and its stakeholder’s profits and can even lead to their decline. Therefore, such deals must be traversed with ample precautionary measures and this is where the importance of the due diligence process comes into the picture.
The main object behind the process of due diligence is to minimize risk or allocate identified risk in another direction so that the risks get nullified, or in the cases of M&A deals the risks are to be resolved in a time-bound manner so that it won’t adversely affect the acquirer company post-acquisition. In some cases, some risks identified may be so dire that they may become a deal-breaker. Therefore conducting a proper due diligence process is one of the most important stages in the life cycle of a deal. Due diligence can be financial due diligence, business due diligence or legal due diligence. We shall analyse and look into the legal due diligence process and identification of red flags.
What are red flags?
During legal due diligence, risk factors related to key legal issues are identified through thorough scrutiny and identification of red flags. While conducting legal due diligence, a “Red Flag” is essential knowledge that appears to be contradictory or irregular to the legal norm or potential liabilities of the target company that may, if left unaddressed, may later come as surprise risks or dangers to the acquirers. It is an alert or a signal that the company could be faced with a potential legal issue. Red flags can be identified in a variety of contexts. During legal due diligence, red flags mostly relate to non-compliance of laws, ongoing litigation, outstanding liabilities, etc.
Different types of red flags
While conducting legal due diligence, one may come across and identify various different types of red flags. Following are the types of red flags to keep an eye out for :
1. Non-compliances
This is one of the main focus areas during legal due diligence, and assessing the compliance level of a company is a meticulous process. Compliances essentially cover all the relevant and applicable provisions of various statutes, regulations and rules that the company is required to comply with. For an Indian business entity, this includes compliance of:
- Companies Act 2013 – Compliance with this Act can be determined from the charter documents of the company, i.e the Memorandum and Articles of Association, maintenance of the meeting minutes record, minutes of the meetings of the board, maintenance of statutory registers and share certificates etc. Non-compliances should be noted and assessed.
- Labour laws – The company has to be in compliance with all central and state-level labour laws that are applicable to it. This includes the acts like the Employees State Insurance Act 1948, Payment of Gratuity Act, 1972, the Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013 etc. and compliance with applicable provisions of these acts. While conducting labour law due diligence, one must also check whether returns to be filed under various labour welfare and employee benefit laws have been filed in a timely manner.
- Licenses and permits – For smooth conduct of the business of a company, licenses and approvals are necessary. Licenses are permits required by companies differ according to the nature of business undertaken by the company. These include the license to conduct business or in case of a regulated business, registration with the regulatory authority, an IEC in case of import-export business, tax-related registrations and trade licenses etc.
- Intellectual property rights (IPR) – IPR is one of the major assets of a company and due diligence should include checking the statutory compliances involved in the licensing and assignment of any intellectual property.
- Environmental law – Compliance with provisions of environmental law acts and regulations must also be reviewed. This includes obtaining environmental permissions for business where necessary and also environmental license in the case of manufacturing or hazardous industries.
- Tax laws – Compliance with provisions of tax laws like the Income Tax Act 1961 and the Integrated Goods and Services Tax Act, 2017 etc.
2. Violations
Another important facet to look into is whether the company has violated any laws or rules and regulations which are applicable to it. Violations of certain laws can attract hefty penalties and even attract imprisonment. These include company law violations, labour law violations, environmental licensing violations etc. Tax law related violations such as tax evasions and tax fraud are also some areas that should be carefully looked into and assessed during the red-flagging process.
3. Liabilities
It should be checked whether the company has any continuing or impending financial liabilities arising from loans and advances, or borrowings from financial institutions or other companies or persons. Further, facility agreements entered into and sanction letters issued as part of such borrowings should be scrutinised with a focus on key clauses like the terms of repayment and breach of terms clause. There can also be a contractual liability, arising from agreements entered into by the company during the normal course of business. These include supply contracts, service contracts, maintenance contracts etc. One should record the rights and obligations arising from such contracts as these could have an impact on the proposed transaction or on the future operations of the business.
4. Litigation
As part of the due diligence process, all litigation to which the target company is a party should be reviewed. In case the target company has numerous litigation matters, then the material litigation matters have to be determined. The opinions of legal counsels handling these matters must also be taken into account.
How to identify a red flag?
The process of due diligence consists of looking into the legal aspects of the business, which involves careful inspection of the entity’s legal records, registers, contracts, licenses etc. Once one has access to the documents or the data room of the company, the documents or records can be bifurcated into various subheads for ease of analysis. All of the documents can be categorised into the heads of :
- Corporate records,
- Licenses and permits,
- Intellectual property,
- Loans and advances,
- Material contracts,
- Human resource.
Once the records have been categorised, each of the records in each category must be reviewed as against their legal requirements and standards to be met, and any laws that the particular document has to comply with or any liabilities that arise from it should be noted in order to identify a red flag.
For identifying corporate non-compliance, corporate records of the company have to be assessed. In order to efficiently pinpoint issues, one must have statutory knowledge of the Companies Act, corresponding rules, forms and notifications as applicable to the company. Whenever non-compliances are identified, they must be flagged and their consequences must be assessed in the light of the corresponding statutory provisions.
While conducting due diligence on documents related to loans and advances, the facility agreements, sanction letters and executed contracts must be carefully reviewed. In the case of documents related to borrowings, it is very important to take note of the change of ownership or control clause, which may state that the lender’s consent may be required in order to consummate the proposed transaction. Any such clauses which may affect the proposed transaction or the future of the target company must be red-flagged. Contracts that would have a direct impact on the revenue of the company are called material contracts. While reviewing these contracts, one should make note of duties and liabilities, reps and warranties, novation, assignment, and change of control clause in order to determine whether the consent of the other party is required for the proposed transaction and also how the transaction will affect the material contract. One must also review IPR related clauses that may be present in business agreements like a distribution agreement or a service agreement. Any such key findings must be flagged.
While reviewing the important litigation matters of the company, one must determine the total value of such litigation and the impact that it may have on the target company if it were to not succeed in the case. Statutory provisions invoked in the litigation, as well as the costs claimed by the litigants or the penalty, fine or imprisonment consequences, must be identified and all these possible adverse consequences must be red-flagged.
Case study: Significance of due diligence and red-flagging
In the case of Nirma Industries & Anr. v. Securities Exchange Board of India, Nirma sought to withdraw an open offer made by it as per the Takeover Regulations on the ground that the target company’s promoters had committed fraud and embezzled money. One of the important principles from the Supreme Court ruling, in this case, is regarding the obligation of buyer’s due diligence. The Court pointed out that due care and caution must be exercised both in the light of the interpretation of Regulation 27(d) of the Takeover Regulations and as per the obligations of an investor. Corporations must ensure that proper due diligence is performed on the target company.
Another case wherein the ignorance of red flags and lack of proper due diligence led to a write off of an astonishing $580 million dollars was the 2012 Caterpillar Inc. acquisition of ERA Mining Machinery Limited. The acquisition was for around $653 million. As the team at Caterpillar was simultaneously working on a far bigger deal it was looking to close, the due diligence on the current deal was rushed through. There were enough red flags before the acquirer; Siwei’s parent company, ERA Mining, was listed on China’s Growth Enterprise Market (GEM) index, and it was said to be “designed to accommodate companies to which a higher investment risk may be attached.” Yet another red flag was when the company disclosed, even before the due diligence began, that the company was cash-strapped and had multiple short term liabilities due; and it further recorded a net loss of $2 million in 2011. It was only a few months after the closing of the deal that Caterpillar’s team noticed discrepancies in the inventory records of Siwei. This led to the exposing years of forgery and fraudulent accounting that was going on at the company. As a result of this, the deal had to be written off. If only the due diligence process was more rigorous and thorough, this could have been avoided by Caterpillar.
Conclusion
Due diligence is, without a doubt, a demanding and time-consuming process. Because there are so many variables, it is complicated and intricate. The line of questioning used for gathering information may at times appear to be negative, intruding, and frequently misinterpreted. However, this will ensure that the process is exhaustive. Although a stressful and tedious process, it must be overcome if the transaction is to be completed successfully, especially considering the high stakes involved in most deals, as can be observed from the above case studies. The margin of error in such high-value deals are very thin and therefore the red-flagging process during the legal due diligence must be conducted methodically with maximum precision in order to avoid any risks for the buyer/investor.
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