Legal due diligence

Author: | Published: 12 Jul 2001
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The term 'due diligence' has now been internationally accepted to include a broad spectrum of investigative procedures in relation to an acquisition of a company's shares or of assets in a commercial context, a joint venture project, a financinge transaction, the issue of securities and other general pre-contractual inquiries. Today, due diligence has become a sophisticated and intricate process requiring very special skills on which the most delicate business decisions are founded.

The practice of conducting a due diligence investigation is of comparatively recent origin in India. It was more or less imported into India by foreign investors and their legal and financial advisers after the economic liberalization reforms of 1991. Over the past decade, however, the concept and procedures for the conduct of a due diligence investigation relating to every aspect of the business and affairs of the target organization have been well accepted in India.

What is due diligence?

In India, there is neither a statute nor any case law to define or interpret the term "due diligence". The concept of due diligence is closely associated with the doctrine of notice – actual, constructive or imputed. Under section 3 of the Transfer of Property Act 1882 "a person is said to have notice" of a fact when they actually know that fact, or when, but for willful abstention from an enquiry or search they ought to have made, or gross negligence, they would have known it. In relation to transactions concerning immovable property, Indian law 'presumes' notice of an instrument registered in accordance with the provisions of the Indian Registration Act to be effective from the date of registration: notice of title of any person who is in actual possession of immovable property and the notice to the agent in the course of business to which that fact is material.

Recently, mandatory provisions have been introduced for the conduct of due diligence under the Securities and Exchange Board of India (Mutual Funds) Regulations 1996 and offshore offerings of securities by Indian companies through American or global depository receipts (ADRs/GDRs).

Due diligence is the process of obtaining sufficient reliable information about the business entity to help to uncover any fact, circumstances or set of conditions that would have a reasonable likelihood of influencing a business decision or the valuable making of an offer of a considerationa price to complete the transaction.
Significance of due diligence

Competitive forces in the seamless global economy have lead many organizations to transform themselves, change ownership or to transfer their assets through acquisitions, mergers and divestments. With respect to any acquisition, the principle of "caveat emptor" continues to hold paramount significance. This makes it incumbent on any party to exercise suitable precautions before undertaking any venture. The investigation enables an acquirer in to minimizing its exposure to many problems and pitfalls that can arise during and after the acquisition.

The decisions such as whether to make an investment, whether to choose one joint venture partner or another, whether to lend finance to a borrower for a project, what disclosure should be included in an offer document for issue of securities whether listed on a stock exchange or otherwise, whether a party to an agreement is capable of performing its contractual obligations – these and several other vital decisions depend on due diligence.

Thus, the whole purpose of the exercise is to correct any knowledge imbalance and obtain information superiority, ascertain the risks in any transaction, negotiate those that are open to bargain and to apportion those which are not, and avoid the disappointment, displeasure and immense loss and abortive cost on the "discovery" of undisclosed risks.

Findings from the exercise of due diligence can often be quantifiable into a value amount, and may lead to a purchase price adjustment or modification to the terms and conditions of the agreement that are beneficial to the acquirer.

Duty of care

There are many Indian statutes dealing with economic matters (eg section 53 of the Monopolies and Restrictive Trade Practices Act 1969, section 24 of the Securities Contracts (Regulation) Act 1956, section 27 of the Securities and Exchange Board of India Act 1992, and section 278B of the Income Tax Act 1961) that contain a standard section on offences committed by companies. This section has the following proviso that is useful to note in this context:

"Provided that nothing contained in this sub-section shall render any such person liable to punishment if he proves that the contravention took place without his knowledge or that he exercised all due diligence to prevent such contravention."

This connotation of the phrase "all due diligence" is not too far away from that of "due diligence". The jurisprudence that has evolved in interpreting "all due diligence" is likely to be applied to "due diligence".

The term due diligence does imply a particular standard of care. In the Indian context, ordinarily there is no positive statutory duty on the part of the buyer to exercise due diligence. There is also no criminal liability for a failure to exercise due diligence.

Tools of due diligence

Due to the complexity of international commercial transactions and the application of a variety of laws, regulations and jurisdictional limitations, no one single analytical method can be used for every due diligence investigation. One of the tools is a list of subjects on which the target company can be questioned, in effect to do a health check about the risks of that business. Another tool is the representations and warranties that the seller can be asked to make in the commercial contract. The third method is to review, in an integrated manner, the financial analysis of the seller's business with the analysis of the legal risks that are associated with the transaction.

Managing risks through due diligence

In a merger or an acquisition the following risks may arise:

  • the political risk associated with the countries in which the target operates;
  • the accuracy and sufficiency of disclosure in the past financial accounts of the target;
  • the continuity of the targets, key personnel, suppliers and customers after the acquisition;
  • the good and clear title to the assets – whether the assets of the targets are worth the value that, the target attributes to them; and
  • whether there are any existing liabilities that may manifest themselves in the future to prevent or restrict the business operations or performance of the target.

Limitations on the representations, warranties and indemnities given by the Seller

It is an accepted fact that representations, warranties and correlated indemnities in contracts suffer from the following limitations :-

  • their validity is restricted only to a few years;
  • there may be a ceiling on the seller's or borrower's financial liability under the contract;
  • disputes may arise in interpreting and quantifying the damages; and
  • their enforcement may be difficult in certain cases.

Conventional due diligence procedures

There are two basic types of procedures regarding due diligence: a) presentation of predetermined data by the seller/target company in a 'data room'; and b) data provided in response to the acquirer's questionnaire.

The 'data room' method has been successfully used for disinvestments by the tender route. By this process, the seller is able to maintain ensure that all the bidders are treated fairly and that they are given access uniformly to the same data or information. Hence, uniformly of the information and documents supplied to all bidders is maintained. Any discrimination in the supply of information or documents could vitiate the bidding process. This applies more to disinvestment by the central or state government or government companies, which can be subjected to judicial review under the provisions of the Constitution of India.

The other methods are more prevalent in one- to-one negotiations.

Apart from legal duties, in what transactions does the concept normally arise?

In India, due diligence is being used to an increasing extent in transactions where the buyer or lender is an overseas multinational corporation and is being advised on the transaction by lawyers from its home country. In transactions between parties both or all of whom are Indian, due diligence is an extension of the traditional concept of 'investigation of title' with a few refinements that are necessitated by local law.

Market practice and client expectations

Almost invariably, the same lawyers do the due diligence and advise on the transaction. By retaining the same lawyers to perform both these functions, the clients expect to receive the best possible advice, comfort and security. The purpose of the due diligence exercise, apart from the legal imperatives that may require it to be undertaken, which practically do not exist in India, is therefore to provide the best measure of security to the client with regard to the target company's capacity, the legal validity of its business operations, the legality of the documents produced by it for inspection and other relevant legal issues.

Another major motivating factor is the evaluation of the price that the client is likely to pay for the acquisition, the amount of the price to be set aside in an escrow account, the conditions of such escrow and the proper appreciation of the risks to which the client may be exposed by entering into the transaction. If the subject matter of the transaction is the financing of a large 'greenfield' project, a due diligence report prepared by a specialist lawyer can provide invaluable help to the client in evaluating the risk factors that are or can be associated with the business of the borrower. Since almost all acquiring companies are professionally managed, it is logical for them to seek outside professional legal advice on these issues. It would be very imprudent for them to enter into a major transaction without the benefit of skilled professional advice. A Due diligence report prepared by a skilled lawyer can be effectively used to negotiate the vexed question of the representations and warranties to be included in the sale and purchase or financing agreement, the disclosures that inevitably qualify, some, if not many of them and the amount, if any, to be set aside in escrow and on what conditions.

Asset purchase versus share acquisition

Undoubtedly, the acquisition of assets is the preferred option from the purchaser's perspective. This would obviate the taking over of inheritance of any unforeseen liabilities. The scope and nature of the due diligence is also limited in the case of purchase of assets per se.

In relation to the acquisition of shares, the purchaser has the benefit of the continuity of business and contracts. The due diligence investigation in such cases will have to focus on the conditions in the licences, registrations, approvals or contracts of the target company which may impose restrictions or limitations due to change of control provisions. The purchaser will have to also ascertain that the agreements are fully assignable to ensure a seamless transition.

There may a third eventuality where the business, together with the assets and employees (such as in the case of a demerger or spin-off), is acquired by the purchaser. Here, it would be of utmost importance that the 'workmen' are given the benefit of continuity of service and that the compensation offered to them by the acquirer is not less favourable than that received prior to acquisition. This is a very sensitive issue for the Indian trade unions, which usually have a say in case of most substantial demergers or transfers of an undertaking.

Contents of the due diligence report

The due diligence report normally contains information pertaining to:

  • company information;
  • corporate capacity;
  • directors, their interests and conflicts, if any;
  • accounts;
  • statutory compliance with the applicable regulations;
  • personnel;
  • compliance with the Industrial Disputes Act 1947, the Payment of Bonus Act 1965, the Payment of Wages Act 1936, the Payment of Gratuity Act 1972, the Employees Provident Funds and Miscellaneous Provisions Act 1952, the Employees State Insurance Act 1948, and the Local Shops and Establishments Act; as well as with any industrial settlement, award, judgment or order in any labour dispute or litigation; recognized trade unions; retrenchments, lay-off and voluntary retirement schemes; and share options, share incentive, profit sharing or other incentive schemes for employees; pension, retirement, provident fund, superannuation and gratuity schemes;
  • share capital;
  • shareholders;
  • licences, permits, approvals and specific statutory compliances;
  • intellectual property rights – identifications of all patents, trade marks, copyrights, industrial designs, all other forms of registered and unregistered intellectual proprietary rights or other form of monopoly or property rights used or owned by the target company and rights granted to third parties;
  • industrial property – know-how, trade secrets;
  • infringement of third-party rights;
  • assets – immovable and movable property;
  • exports and imports, compliance with laws;
  • litigation – judicial, quasi-judicial, arbitral and other administrative proceedings;
  • taxation issues – income tax, customs, excise and sales tax;
  • insurance – quality of insurance cover;
  • contractual liabilities and commitments; and
  • environment-related issues – compliance with law, social issues, and the rehabilitation of people likely to be ousted by large natural resources projects, eg a reservoir for a hydroelectric project.

It should be noted that even if the acquisition is one of shares in a greenfield company, it may still be necessary to do a due diligence investigation under all or some of these headings intp the affairs of the promoter of the company, especially if that promoter is going to transfer any of its assets to the new company.

Practical issues

Managing the due diligence process

1. Initial parameters – management will require a preliminary evaluation of the areas of key importance for the success of the transaction, eg key employee retention would be critical to the acquisition of many service firms.

2. Selecting due diligence teams – the core team for the conduct of the due diligence should consist of:

  • management representatives of the acquirer;
  • legal counsel;
  • valuation adviser;
  • chartered accountants (CPA)/merchant bankers;
  • technical consultants.

This stage will also involve the coordination plan among the team members, and allocating responsibilities and functions. Usually, all external counsel are required to execute confidentiality agreements before commencement of the assignment.

3. Preparing and executing preliminary investigation – the objective of the preliminary survey is to identify deal-breaking issues upfront before money and other valuable resources are committed to a detailed investigations. Some of the critical issues that may emerge during this exercise are:

  • concealment of facts and figures;
  • insufficient internal controls;
  • non-compliance of or adventurous interpretations of contracts, legal provisions, accounting principles, policies or standards;
  • employee retention and core management succession;
  • contingent liabilities;
  • statutory non-compliance;
  • industrial sickness (erosion of net worth); and
  • legal proceedings.

4.Detailed due diligence – the success of the investigation to make a well-informed decision would lie in a well-planned, integrated and coordinated detailed enquiry procedures.

5.Certification of completeness of disclosures – the due diligence team should obtain a declaration or certificate from the target company confirming the completeness of the disclosed information and documents, and that no material data has been withheld by the target.

Inter-relationship with representations and warranties conditions precedent etc – representations, warranties and the disclosure letter

Nearly all well-drafted commercial contracts include a detailed list of representations and warranties. The seller or the borrower may, if they wish, qualify these representations and warranties in as a disclosure letter. There is a great deal of obfuscation about this disclosure letter. In a sense, the acquirer or lender has no control over the extent and nature of the qualifications made in the disclosure letter. In strict legal theory, the disclosure letter is like a counter-offer which the lender or purchaser may or may not accept. If they accept it in whole or in part, the disclosures in it become embodied in the contract and are binding on both the parties. If they reject it, there is no contract all. The parties are left to renegotiate the transaction or to abandon it. It is for this reason that a good due diligence investigation report by a specialist can be of critical assistance to the client during the final stages of the negotiation of the transaction. The client can use it to reassess the price or the short or long-term risks that are attendant on the transaction. They can thus renegotiate the disclosure letter to their advantage.

Conditions precedent

The conclusion of the detailed due diligence inquiry can assist the draftsperson in setting forth precise conditions, subject to fulfilment or accomplishment of which the transaction may be completed. This would primarily include any statutory approvals, consents, registrations, declarations and, filings that should be procured before the parties can complete the transaction.

Interaction between disclosures and due diligence

There is a lot of confusion between the obligation imposed by a contract on the seller to make certain representations and warranties, and the right of a purchaser to conduct a due diligence investigation in respect of the subject matter of those representations and warranties. Sellers often protest at the double imposition, the obligation to respond to questions and to provide information during a due diligence investigation, and the contractual obligation to make representations and warranties that may cover the same ground. But the two are quite different and their purposes are not the same. They are therefore compatible with each other. If a seller wishes to exclude any representation or warranty, they should include the relevant facts in their disclosure letter and if the buyer accepts the disclosure, the seller will not be liable on that representation or warranty.

Advice and opinion issues

Identifying 'bankability' issues

In India, the problem of the 'bankability' of licences awarded by the Department of Telecommunications to a successful bidder after a laborious tendering process was resolved when the Department proposed a draft of a tripartite document among the Department, the licensee and the bankers advancing project finance to the licensee. By this tripartite agreement, the Department recognized the right of the bankers to "assign" the licence to operate the telecommunications service to another person in the event the original licensee defaulted in their obligations under the licence or under the project financing agreements.

Nature of opinions to be given on disclosed documents

The role of a lawyer who conducts a due diligence exercise is to advise the client on the validity and enforceability of all the documents that are disclosed to the lawyer during the investigation. His or her opinion has to relate to their legal validity and on whether the purchaser or lender would have any concerns with them if the transaction were closed. A due diligence opinion is not really a legal opinion, it is a statement regarding the lawyers' knowledge about the information gathered based on the lawyer's participation in the preparation of the transaction documents.

How to cover approvals requirements, the regulatory regime and other local law issues

The best approach for a lawyer who is conducting a due diligence investigation on behalf of a client in a foreign country is to retain a competent lawyer of that country to conduct a part of the exercise there, and to give a report to the home country lawyer. In addition, at or before the closing, the latter should be asked to give a written opinion on these and other issues.

Dealing with the need for renegotiation

One of the recognized ways to deal with the problem of renegotiation is to insert a condition precedent in the memorandum of understanding or agreement for sale that is entered into between the parties prior to the start of the due diligence exercise, stipulating that the closing shall be contingent on the successful completion of the due diligence investigation and on the purchaser or lender being satisfied with its outcome.

Evidence to prove questions of fact

If the due diligence exercise discloses certain facts or documents that need to be recorded and which the seller or borrower is required to accept as binding, the best way to accomplish this result is to include them in an appropriate clause (or, better still, in a representation and warranty) in the final sale and purchase or financing agreement, or to have the seller or borrower make a declaration on oath affirming those facts and agreeing to be bound by them.

Challenges in conducting due diligence

No enquiry can be without hurdles. These may be of various kinds, such as:

  • insufficiency of basic data;
  • road-blocks to obtaining or sharing proprietary information; and
  • confidentiality/secrecy covenants may prevent disclosure of material documents.

Some of the minor issues include language barriers, travelling to remote locations, or people who are not enthusiastic about or are unaware of the proposed transactions.

Professional project management of the due diligence process can however overcome these problems.

The benefits of a professional due diligence exercise include:

  • accuracy of warranties and representations;
  • a 'big picture' of the vision of the target company and its future earnings;
  • SWOT analysis of the target company;
  • identification of deal-breaking issues and formulating business solutions to resolve them; and
  • smooth transition of the merger – the cultural shocks can be considerably softened with a focused, well-communicated and firm plan.

Do's and don'ts for the best results of a due diligence

There are certain steps that can be taken to ensure best results:

  • determine the objectives and clear strategies;
  • form groups of personnel for project management, data management, core due diligence team and support team;
  • lay down the terms of reference for each group and formulate procedures for a clear allocation of responsibilities;
  • observe an integrated approach for the due diligence process and rely on technical consultants' expertise wherever necessary;
  • use appropriate technology for the collection, analysis, indexing and retrieval of data;
  • store the data in electronic form which makes it portable, capable of being transferred to and accessed from remote locations, and providing a single point access to the entire transaction team;
  • never hesitate to ask questions or seek clarifications;
  • do not avoid plant visits on account of inconvenience – the on-site conditions contain a wealth of information which would be never be available on paper;
  • never put off the due diligence until after the transaction is completed; and
  • do not over-react to the media reports; however, do not ignore them.

Due Diligence

Little & Co.
Central Bank Building
Mahatma Gandhi Road
Mumbai-400 023
Tel: 91 22 265 2739
Fax: 91 22 265 9918