Legal Due Diligence in Mergers and Acquisitions
In the face of increased competition, many companies consider mergers and acquisitions (M&A) as a superior way of strategic production and market diversification. Research shows that mergers and acquisitions usually do not accomplish the desired goals and it is always challenging for the management to achieve a successful M&A. Numerous studies have come to a conclusion that due diligence in the preparation phase of a transaction constitutes one of the key success factors of M&A.[i]
While going for M&A, it is imperative for a buying company to investigate and collect necessary information about a target company to have a complete understanding of the value and risks associated with it. This is done by conducting a thorough due diligence to elicit all the relevant information about the transaction including financial, legal and commercial to figure out whether to move forward with the acquisition process and at what price and terms.
In large business transactions such as M&A which involve huge sums of money and resources, it is vital for a business entity to make an informed decision and in order to do that, a thorough due diligence is required to be conducted and which is why it is regarded as one of the most critical phases of the M&A processes.[ii]
The role of due diligence in M&A is to support the valuation process, place the buyer in a better position to negotiate, inform the planners of post-merger integration and test the accuracy of representations and warranties contained in the merger agreement.[iii] Ideally, a thoroughly conducted due diligence evaluates all aspects of the target company including, but not limited to, financial, legal, commercial, organization and human resources, environment, culture, and ethics.
Among these, legal due diligence is one of the most important areas of focus in the due diligence process, especially while going for M&A as it greatly determines how, or if, a deal will move forward. For a successful M&A, legal due diligence must access the following dimensions of the target company:
ORGANIZATIONAL AND CORPORATE STRUCTURE
The buyer will be concerned with all the relevant corporate documents and the legal structure of the company including all its branches and subsidiaries. A careful review of the organizational documents and general corporate records including capitalization of the target company is done.
Information under this head includes memorandum and articles of association, validity of issuance of securities, all shareholder agreements, documents evidencing securities such as options and debentures, contracts in which directors, key managerial personnel, promoters and controlling shareholders are interested in,[iv] details of secured loans and secured lenders of the company, provisions in the articles of association that may affect the transaction such as right of first refusal or first negotiations in connection with a sale of the company or its business[v], list of current directors and officers.
Contracts are the foundation of value for the business. Before entering into a business relation with another company, it is pertinent to examine its contracts to get information about the rights and obligations of the company. The contractual documents are used to elicit information like validity and enforceability of the contracts, provisions regarding novation and assignment, rights and obligations of the company, disclosure requirements and confidentiality restrictions and the provisions regarding material breaches.[vi]
Review of all the material contracts and commitments of a target company is one of the most critical components of a legal due diligence, A variety of contracts are reviewed including partnership or joint venture agreements, model sales or manufacturing contracts, bank line of credit agreements,[vii] security and pledge agreements, mortgages, guarantees, repurchase obligations, surety contracts and similar arrangements, limited liability company or operating agreements, customer and supplier contracts, past acquisition agreements, license, royalty and franchise agreements and contracts the termination of which would result in a material adverse effect on the company.[viii]
LEGAL OWNERSHIP OF ASSETS
It is essential to review all the properties owned by the target company or otherwise used in the business. This involves review of both real and intellectual property of the company. Review of real property includes investigating into title of the property, registration of the title, operating leases, deeds of trust and mortgages and other interests in real property.[ix]
Intellectual property portfolio of a company predominantly determines its value and relevance to the combined company. In order to ensure that there are no inherent ownership issues and no conflict of interests, a number of documents are reviewed including ownership and registration of the intellectual property, patent licenses held by the company, any trademarks, trade names or service marks, any copyrights and rights of the company or third party relating to the intellectual property.[x]
In any given transaction, it is extremely important to know whether the company is involved in any pending litigation or if there is a scope for litigation in future. Thus, it is necessary to review pending, threatened or settled litigation, matters in arbitration, or regulatory proceedings involving the target company, litigation settled and the settlement terms, claims threatened against the company and any pending or threatened governmental proceedings against the company.[xi]
It is extremely important to review the existence, validity and adequacy of licenses and permissions under various statues and regulations (including under environmental law), any action initiated or noticed received in the past or present against the company in relation to breach of conditions of any license and any other licenses necessary for operation of business.[xii]
GOVERNMENTAL REGULATIONS, FILINGS, AND COMPLIANCE WITH LAWS
It is pertinent to understand the extent to which the target company is subject to and is in compliance with regulatory requirements, including by reviewing any pending or threatened investigations or governmental proceedings, any notices received from any government agencies, documents showing deficiency in compliance with regulatory standards of the company, any report on the burdens and costs of regulatory compliance including labour and other state and local regulation and information regarding any cancelled or terminated licenses or permits of the company.[xiii]
It involves a review into conditions of employment, labour or employment contracts, statutory or contractual obligations of the company related to employment, engagement of contract labourers in the company’s business, existence of unions, disputes, if any, with unions, union or collective bargaining agreements, any pending or potential charges of unfair labour practices against the company, information regarding any pending or threatened labour disputes and any other labour disputes.
ANTITRUST AND REGULATORY ISSUES
Antitrust and regulatory scrutiny of acquisitions is on the rise in recent years. It is pertinent to analyze any potential antitrust issues that the deal may present. In order to assess the antitrust or regulatory implications of a potential deal, various activities are undertaken including analyzing scope of any antitrust issues, looking for if the target company is a competitor of the buyer company, working out any limitations imposed by the company on timing or scope of diligence disclosures, and finding out if the company has been involved in any prior antitrust or regulatory investigations or inquiries.[xiv]
Analyzing and evaluating the legal position of a company are the foremost objectives of legal due diligence. It delves into liabilities and obligations of the target company which may have an impact on the value of the firm. There is no gainsaying the fact that legal due diligence is a meticulous process but it ultimately provides the buyer with insights on imminent legal risks associated with the business of the company.
The ultimate purpose of conducting a thorough due diligence is to identify any ‘deal breakers’, if any, or any ‘deal diluters’ and if it can be mitigated or eradicated, or any ‘deal cautioners’ which helps the buyer in taking a calculated risk in connection with the transaction.
For an efficient M&A, preparation and organization of a company sets forth an important prerequisite for its successful implementation as it facilitates a professional investigation of the possibilities for any added value creation. Legal due diligence is an indispensable process which deals with investigation and collection of information on a target company to look for any legal risks or impediments associated with it. In order to gain insight on legitimacy and viability of a company and to understand the advantages, disadvantages and risks associated with a decision, legal due diligence is an unavoidable process in any M&A transaction.
ENDNOTES [i] Sladana Savovic, Due diligence as a key success factor of mergers and acquisitions, Actual problems of Economics,424,425(2013),https://www.researchgate.net/publication/281647947_Due_diligence_as_a_key_success_factor_of_mergers_and_acquisitions. [ii] Alen Sacek, Due Diligence in Mergers and Acquisitions in Emerging Markets: Evaluated Risk Factors from the Academic and Practical View, 11, Journal of Modern Accounting and Auditing, 363 (2015), http://www.davidpublisher.org/Public/uploads/Contribute/55dac3151b597.pdf. [iii] V. Bhagwan et al. , A Systematic Review of the Due Diligence Stage of Mergers and Acquisitions: Towards A Conceptual Framework, 29(3), South African Journal of Industrial Engineering, 217, (2018), https://www.researchgate.net/publication/328885677_A_systematic_review_of_the_due_diligence_stage_of_mergers_and_acquisitions_Towards_a_conceptual_framework. [iv] Mitigate Risk with this Acquisition Due Diligence Checklist, LexisNexis, https://www.lexisnexis.com/en-us/products/lexis-diligence/ctr/due-diligence-checklist.page. [v] Richard D. Harroch et al. , 20 Key Due Diligence Activities in a Merger and Acquisition Transaction, Forbes (Dec. 19, 2014, 01:09 PM), https://www.forbes.com/sites/allbusiness/2014/12/19/20-key-due-diligence-activities-in-a-merger-and-acquisition-transaction/#378f822d4bfc. [vi] Rajnish Sharma, Due Diligence Process: Steps Involved in Legal Due Diligence, https://www.academia.edu/4339812/Due_Diligence_Process_Steps_involved_in_legal_due_diligence_Issues_Description. [vii] Supra note 4. [viii] Harroch et al. , supra note 5. [ix] Id.
[xiii] Harroch et al. , supra note 5.
[xiv] Harroch et al. , supra note 5.
ABOUT THE AUTHOR
This blog has been authored by Raushan Kumar, who is a 2nd year B.A., LL.B. (Hons.) student at Damodaram Sanjivayya National Law University, Visakhapatnam.
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