Due Diligence Procedure in Private M&A

A collection of data on how any due diligence process of M&A is conducted in India along with the tools and methods used for the same.

Introduction
 
The term Due Diligence implies the process of undertaking reasonable verifications and precautions in order to identify and prevent any potential risk which may arise in the future. Mainly, it is the process of evaluation of business deals diligently from several areas before arriving at any conclusive decision regarding the same.
 
The meaning of this term can be said to be synonymous with research, investigation and precaution. Due diligence is one of the most necessary steps performed by an individual to avoid causing harm to any other person or property. This process is more of an investigative made for the evaluation of assets and liabilities, and furthermore, this process also looks into the potential commercial as well as the economic value of the Company or firm wherein such due diligence is required.
 
If we look at it from the point of view of an M&A transaction, Due Diligence is basically a tool which enables the buyer with reliable and complete background information on the proposed deal and this also helps in uncovering any potential liabilities or discrepancies thereby enabling such a buyer to make a more concrete and informed decision about the transaction. As of today, several methods of conducting due diligence exist depending upon the area or the scope of coverage such as Financial Due Diligence, Legal Due Diligence, Commercial Due Diligence and Tax Due Diligence. Several other diligences may also be performed in areas such as IT and human resources as well.
 
It is also worth noting that due to COVID 19 there are several procedural hurdles faced by the professionals to conduct a smooth due diligence. Due to COVID-19 almost all countries are in lockdown mode or few countries are operational with strict movement restriction. The physical meetings, site visits and inventory checks becomes a challenging task. The specialised due diligence exercises such as verification of title to lands and environmental due diligence have to deferred. In case of M&A due diligence the buyers are focusing on business continuity plan of the Company which includes the short term and long term financing arrangement to mitigate the COVID 10 crisis. Further Insurance policies of a target company should be analysed to ascertain the possibility of mitigating any losses through existing insurance policies, such as coverage for business interruption and losses due to force majeure events. Also, it is important to assess if the company’s workforce is covered by a comprehensive group health insurance policy that covers healthcare costs. 
 
Methods of performing Due Diligence

The importance of performing Due Diligence prior to any business agreement or transaction cannot be reiterated enough for the safety and security of both businesses. Thus it is also very important to know the method via which such Due Diligence may be conducted. Since most commercial transactions are highly complex in nature, whether they are local transactions or international ones, there can never be one standard method of performing such Due Diligence. Following are the most commonly used methods for conducing due diligence:
  • Questionnaire - This method is effective in checking out the basic details of any target organization. Whether it is to check its general well-being or the financial health, potential risks involved etc.
  • Representations and Warranties - Another method is the representations and warranties method through which the seller can be asked to make certain warranties in the commercial contract, for the future safety and security of the company.
  • Review - 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 which could be associated with the transaction.
Processes involved:

Any of the above mentioned methods of conducting Due Diligence need to be done in a systematic manner through which one team can analyse the information collected properly. This is usually done through the following processes:
  • A presentation of the predetermined data by the seller or the target company in a ‘data room’.
  • The data provided in response to the acquirer’s questionnaire:
 
  1. While using the Data Room method, a large amount of data is presented to interested parties in order to study and value the same and get its due diligence conducted. This process involved the presentation of a large amount of data. This method has been successfully used for disinvestments by the tender route and through this process, the seller is able to maintain and ensure that all the bidders are treated fairly and are provided with the access uniformly to the same data or information. Hence, all such information is supplied uniformly to the sellers along with the necessary documents within a Data Room. In case of any discrimination in the supply of information or documents, the same could result in nullification of the bidding process. This applies more to disinvestments by the central or state government or government companies that can be subjected to judicial review under the provisions of the Constitution of India.
 
  1. The second method involves the presentation of a questionnaire which is put to the target company and on that basis further one- to-one negotiations are done. After this, a Due diligence report is prepared by lawyers that can be effectively used to negotiate any vexed question of the representations and warranties which is to be included in the sale and purchase or financing agreement, the disclosures that inevitably qualify and the amount, if any, to be set aside.
Management of the due diligence process

Prior to conducting a due diligence process, it is important to have a plan ready as to who will be responsible for the conduction of such due diligence. This can be summarised I the following manner:
  1. The Initial parameters – Every management requires a preliminary evaluation of the areas of key importance for the success of any transaction which could involve the continuity of the targets, key personnel, suppliers and customers after the acquisition.
  2. Selection of the due diligence teams – The main team for the conduct of the due diligence should comprise of the following:
  • The management representatives of the acquirer/buyer.
  • A legal counsel.
  • A valuation adviser.
  • A qualified chartered accountants (CPA) or a merchant banker.
  • A team of technical consultants.
At this point, the coordination of a plan shall also take place wherein all the team members decide over the approach for the said Due Diligence. This means the allocation of responsibilities and functions. Mostly, all external counsels are required to execute confidentiality agreements prior to commencing such a process.

3. Preparing and executive preliminary investigation: The main objective of such a preliminary survey is to identify any deal-breaking issues upfront before any money or other valuable resources are committed to anydetailed investigation processes. Certain aspects which might emerge at this stage have been provided below:
  • Any concealment of facts and figures.
  • A lack of or insufficient internal controls.
  • Any manner of non-compliance of or adventurous interpretations of contracts, legal provisions, accounting principles, policies or standards.
  • The employee retention and core management succession.
  • All contingent liabilities.
  • Any statutory non-compliances.
  • Any form of industrial sickness such as the erosion of net worth.
  • Any on-going or pending legal proceedings.
4. Due Diligence Report – The whole aspect and its subsequent success of such a due diligence report depends entirely upon making a well-informed decision which can only be the result of a well-planned, integrated and coordinated detailed enquiry process. Generally there are 2 types of due diligence report practiced by the professionals know as long form due diligence report which comprises of the briefs regarding the nature and type of all the documents received whether they are in compliance or non compliance  and the other type of due diligence report is known as red flag due diligence report which only provide the potential risk and non compliance exist in the company.

5. The Certification of completeness of all disclosures – Once all the tasks are successfully completed, the due diligence team must acquire the declaration or a certificate from the target company which confirms the completeness of the disclosed information and all documents, and also that no material data had been withheld by the target company.

Contents of the due diligence report

Every report of Due Diligence must comprise of the following details of the target company:
  • The basic company information.
  • The corporate capacity of the company.
  • Information pertaining to the directors, their interests and conflicts, if any.
  • Details of the financial accounts.
  • material contracts of the Company with its stakeholders like customers, suppliers, lenders, or in relation to real property, to understand the key terms, and any restrictions, requirements of consent, intimation or otherwise that are relevant for the proposed transaction;
  • Details of the Immoveable property
  • Details of Intellectual Property Rights
  • Details of Insurance policy obtained by the Company.
  • Details of pending or threatened litigations involving the company, including proceedings or investigations by regulators;
  • All statutory compliances along with the applicable regulations.
  • Details regarding all the personnel in employment with the company.
  • The 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. This must also be accompanied with any industrial settlement, award, judgment or order in any labour dispute or litigation, the recognized trade unions, any retrenchments, lay-off and voluntary retirement schemes, share options, share incentives, profit sharing and any other incentive schemes for employees. Further the details of pension, retirement, provident fund, superannuation and gratuity schemes are also required to be provided.
  • Total share capital.
  • Information on all the shareholders.
  • All licenses, permits, approvals and specific statutory compliance.
  • The intellectual property rights which is the 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.
  • All industrial property along with any trade secrets.
  • Any infringement of third-party rights.
  • All the assets whether immovable or movable property.
  • The exports and imports, compliance with laws etc.
  • Any litigation including judicial, quasi-judicial, arbitral and other administrative proceedings.
  • Any taxation issues which includes income tax, customs, excise and sales tax.
  • Details pertaining to insurance and the quality of the insurance cover.
  • Any and all Environment-related issues such as compliance with the law, social issues and the rehabilitation of people likely to be ousted by large natural resources projects.
  • Ancillary documents, including those pertaining to information technology, and insurance policies obtained in connection with the business, etc.
However, the content/scope of the due diligence depends upon the sector in which the company operates. For example if a company is a hospital, the licenses and approvals obtained by the company along with their operational, environment and sector law compliances are key to the due diligence. On the other hand, if the company is engaged in the services sector, the material agreements entered into by it, would be important. Further, many investors also engage advisers to conduct anti-money laundering, bribery and corrupt practices-related due diligence.

In order to obtain significant advantage in a competitive bid scenario, many buyers relying upon the representation and warranties insurance on a regular basis. However it is worth noting that these insurance products are expensive and provide protection with certain terms and conditions.

Therefore, every due diligence report is a detailed document comprising of various aspects of the target company right from its incorporation to its labour law issues and dynamics, the history of the company with share markets along with all environmental issues or taxation details. Thus the process of due diligence is a long a detailed process conducted by any able lawyer.