LEGAL DUE DILIGENCE – A NECESSARY EVIL?

The Covid-19 pandemic has created the need for all businesses to adapt to the new normal in their practices. It is evident that the pandemic has a tremendous impact on the M&A deal flow across many sectors, even conducting Due Diligence (“DD”) is no exception. This uncertainty resulted in bringing new endeavours in the process of DD, as it is no longer as ‘usual’ but a new normal. However, this hasn’t changed the purpose of conducting DD, moreover, this has increased the scope of DD. Although, the factors in the process of DD differ from transaction to transaction with the basic purpose to assist the acquirer in acquiring the target and to determine various risks attached with the transaction. Therefore, the article aims to highlight some of the focus areas of Legal DD and its relevance in the current pandemic period and also bring out some issues which need to be considered during the DD process.

INTRODUCTION

To put it simply, a Legal DD (“LDD”) is a process undertaken by the parties in a transaction to decide if they should go ahead with their investment or deal or negotiate the terms and conditions of such a deal. LDD in a transaction seeks to provide important arrangements under the definitive agreements so that legal risks associated with the deal are brought under control.  No statute in India specifically defines the DD, however, there are some instances where the term DD has been discussed through its elements in the Indian Legal Jurisprudence. There are also judicial precedents that recognize the essential elements of the DD as a “duty of care”, “reasonable competence”, etc. Therefore, the concept of DD can be ascertained through various statutes and judicial precedents laid down by courts in India.

That said, The Hon’ble Supreme Court of India, in the case of Chander Kanta Bansal v. Rajinder Singh Anand stated that:

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 reasonable, 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”.

Even in the case of Kent RO System Ltd. v. Amit Kotak, the Hon’ble Delhi High Court recognizes the important elements of the Due Diligence as determining the scope of ‘vigilance’ as per section 79 of the Information Technology Act, 2000 read with rule 3 of Information Technology (Intermediaries Guidelines) Rules, 2011.

Further, the Securities Exchange Board of India (“SEBI”) Act, 1992 provides that due diligence should be exercised to prevent contravention by the companies. 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. Thus, DD is a “duty of care” and various Indian statutes dealing with economic matters provide to undertake a ‘particular standard of care’ through exercising DD.

THE OBJECTIVE OF LEGAL DUE DILIGENCE

The primary objective of LDD is to find legal risks and to evaluate these risks during a transaction. It will help to avoid any hidden liabilities in the future, which are based on a review of legal documents of the parties to a transaction. Following are the main objectives for conducting LDD:

  1. Confirming the title has good standing in the eyes of law.
  2. Analyze and assess the main legal risks.
  3. Identifying risk mitigation mechanisms.
  4. Understanding the Organizational Structure.
  5. Determining the value of the target entity.
  6. Ascertaining condition precedents.
  7. Making representations and warranties.
  8. Drafting legal definitive agreements.
  9. Ascertaining issues that are sensitive enough to be deal-breakers.
  10. Identifying legal factors affecting the integration of the business.

SELLERS/BUYERS LDD

Generally, the buyer side conducts LDD on the seller because of the maxim Qui Ignorance Non-Debuit Quod Jus Alieum Emit as it is not the responsibility of the seller for the risks that have been disclosed by the seller before entering into a deal. Therefore, the maxim denotes the importance of the DD as it reminds the parties to conduct DD before entering into a deal. Therefore, the buyer conducts LDD to have a sound understanding of the legal problems with the seller and to aid post-integration through efficient integration planning. However, on the other hand, the seller conducts LDD to enhance the seller’s negotiation power and to accelerate the pace of transactions. Thus, it is essential for the buyer and the seller to undergo the process of LDD.

DEFINING SCOPE OF LDD – DRAW UP THE LEGAL BOUNDARIES

The LLD process can take several days to several months, based on the nature of the transaction. Therefore, it is necessary to define the scope of the LDD based on the size of the transaction and the number of sector-specific issues that can arise in the long-run process. Moreover, looking into the current pandemic situation one needs to consider the risks associated with the Covid 19 pandemic as various unique areas have emerged which need to be investigated before entering into a deal. Moreover, the process of LDD can revolve around the following concerns:

  1. Verification of the current owner’s title.
  2. Analysis of corporate governance.
  3. Review of employment contracts.
  4. Key assets involved in the deal.
  5. Regulatory compliance.
  6. Post-integration risks.
  7. Material Litigation.
  8. Sectoral regulatory audit (review of compliance with the licensing, etc.).

LDD FOR OVERSEAS INVESTMENT TRANSACTIONS

In an overseas investment transaction, the scope of LDD is greater than the LDD in a domestic transaction because the buyer and seller have to comply with more compliance. Therefore, to conduct LDD for overseas investment transactions, it is important to understand what laws apply to such transactions. In India, any outbound and inbound transactions are governed under, inter alia, rules, and regulations:

  1. Foreign Exchange Management Act, 1999
  2. Foreign Exchange Management (Non-Debt Instruments) Rules, 2019
  3. Foreign Exchange Management (Debt Instruments) Rules, 2019
  4. SEBI (Alternative Investment Funds) Regulation, 2012
  5. Competition Act, 2000

Therefore, apart from general LDD, buyers, and sellers involved in an overseas transaction should consider the aforementioned acts and regulations before entering into a transaction.

FACTORS TO BE CONSIDERED FOR LEGAL DUE DILIGENCE

Following are the key specific areas of concerns involved in LDD:

  1. General Corporate Documents

It is essential to investigate the documents and records maintained by the targeted company since its incorporation. Documents such as Certificate of Incorporation, Memorandum of Association, Article of Associations, and other documents that are required to be maintained as per Companies Act, 2013 needs to be investigated to ascertain the legal standing of the targeted entity as it can pose legal risks on the transaction.

  1. Regulatory Compliances

It is also essential to check all the mandatory compliances provided in the Companies Act available with the Ministry of Corporate Affairs which will help to chalk out the condition precedent before the closing of the deal. However, with the given nature of the transaction, it is important to comply with the rules and regulations framed by other regulatory bodies such as SEBI, Reserve Bank of India, Insurance Regulatory and Development Authority, etc.

  1. Audit Reports and Financial Statement

It is important to review financial statements, as various statutes require filing and reporting of the financial statements which includes filing and reporting of income tax, goods and service tax, audit reports, etc. Reviewing such reports and statements may reveal various financial obligations and pending litigations of the targeted entity.

  1. Material Agreements

The investor needs to investigate various material agreements as they could contain obligations that would have significant adverse effects on the business of the targeted in the future. Moreover, it is also important to determine that the stamp duty is levied as per the requirement in India as nonpayment of the stamp duty affects the enforceability and the authorities may impose a hefty fine over the entity.

  1. Intellectual Property Rights

In today’s business landscape, various deals are entered to achieve inorganic growth by acquiring various intangible properties of the targeted entities such as Intellectual Property. Therefore, information related to designs, trademarks, patents, and the copyright of the target should be investigated to analyze legal risks associated with such rights.

  1. Labour and Employment Laws

India has extensive labour and employment laws and regulations that attract penalties for non-compliance. Therefore, with the given nature of the transaction, it is important to review that all the compliance is complied with.

  1. Real Estate

Transactions involving the transfer of real estate properties, often subjected to various legal risks. It is important to investigate that the target entity has sufficient authority or interests or rights vested in such property, any liens, litigation, easement, etc. exists on the property so transacted.

CONCLUSION

Whether it be Mergers and Acquisition or Private Equity or Venture Capital Deal, the buyer and seller should essentially conduct LDD, depending upon the nature of the business involved in a deal. Not only does LDD facilitate, inter alia, a smooth closure, but also helps to mitigate post-integration legal risks. Thus, it is the lack of LDD that destroys the deals.

Author(s) Name: Milendra Jain (Student, Indore Institute of Law)

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