A. INTRODUCTION:
Legal due diligence is the investigation process that is carried out on a target company after the preliminary stage of negotiations are over with regards to a prospective deal. The objective of the legal due diligence is to identify the pros and cons, which tend to help understand the opportunities or threats associated with the deal. As a result of the legal due diligence, it may happen that the terms of the deal which were agreed upon during the initial phase of negotiations seek to be renegotiated or the deal might be declined. Legal due diligence is an opportunity to understand the target company by getting access to its confidential information and documents. These documents and information aid in identifying the associated risks and the ways in which those risks could be mitigated.
B. DIFFERENT PERSPECTIVE OF LEGAL DUE DILIGENCE:
Legal due diligence enables a company to come to a nuanced understanding of the prospective deal and take business friendly decisions. Therefore, what the businesses usually do is, after the preliminary stage of negotiations are completed, they ask their legal team to conduct legal due diligence. Notwithstanding, the difference in scope due to different scenarios or deals, the below mentioned are the kinds of legal due diligences that are typically conducted.
1. Investor perspective of due diligence:
An investor opts for a legal due diligence before making an investment as it desires to study the finance, assets, employee, partners, suppliers, customers, legal information etc. of the target company. In the process if the investor identifies risks in its investment, then a mitigation plan is developed to reduce the liabilities or else it may also happen that the investor declines the potential investment.
2. Vendor perspective of due diligence:
Vendor due diligence is usually conducted suo-moto by the companies in order to prepare themselves for a possible fund raise in future. This diligence is very beneficial for the companies as it helps them identify the gaps in the compliances and take necessary steps to rectify the same. It is really helpful when an external diligence is done by an prospective investor as it reduces the time of the investor to get the diligence done and also the costs of the company as the investor may not again do a detailed diligence and rather only get a limited diligence done on the company.
C. COVERAGE OF A LEGAL DUE DILIGENCE PROCESS:
Before going into the coverage part of the due diligence process, it is important to mention here that when a legal due diligence is taken up, the first and foremost thing is a requisition list which is in Q&A format or a list which lays downs all the documents and information that is required for a legal due diligence to be conducted. The provision of all such information and documents can be done by setting up a data room or uploading them digitally. Further, the coverage of a due diligence is discussed below:
1. Corporate:
The forms filed by the company under the Companies Act, 2013 and other incidental corporate related information of a company is readily available on the Ministry of Corporate Affairs website and the same can be accessed by doing a public inspection. Upon such download the basic incorporation details of the company, the authorized share capital and paid up capital of the company and shareholding pattern of the company can be viewed.
The shareholders agreements that are executed by the company with its shareholders shall be reviewed to confirm if there are any consent requirements for any future fund raise by the company and its promoters, then those issues shall be highlighted so that the company and the promoters take proactive actions for obtaining consents/waivers as required under the shareholders agreement.
In our experience, we have usually observed that the share certificates issued by the target company are not in complete compliance with the provisions of the Companies Act, 2013. As the share certificates determine the shareholding of a shareholder in a company, to ensure its validity it must be ensured that it is appropriately signed as per the provisions of the Act and also must be adequately stamped as required under the stamp act of the respective States.
The target company shall also ensure that the minutes of the board meetings, minutes of shareholders’ meetings are maintained in the requisite manner and are held at such intervals as prescribed under the Act. The filing of forms with the Registrar of Companies, compliances under Foreign Direct Investment Regulations, Annual Return on Foreign Liabilities and Assets under Foreign Exchange Management Act, 1999 is verified while doing the diligence.
If there are any related party transactions, then the details of those transactions have to be verified and if there are any risks associated with those transactions that might be faced by a company shall all be mentioned in the report in an informative manner.
2. Material contracts/ Commercial contracts/ Employment contracts:
The contracts that have been executed by the company with its various stakeholders have to be reviewed in depth. It has to be ensured that the contracts are properly drafted, and the key clauses are in place. Further, the key issues/liabilities are identified in connection with the obligations of the target company with respect to clauses such as change in control, indemnity, termination, prior consent requirements under various scenarios, which depends upon case to case basis. The target company shall ensure that the contracts must be adequately stamped in accordance with the state specific laws to reduce the red flags in the due diligence report.
3. Borrowings:
The companies often procure loan facilities for business developments or for any other purpose for ensuring better business operations, which may be in the form of an overdraft facility, term loan facility, cash credit facility etc. In the executed documents covenants like security, interest, interest on delayed payments and other important covenants also have to be reviewed. If any other documents are executed by the company such as letter of hypothecation etc., such documents shall also be thoroughly looked into.
The purpose for reviewing borrowings related documents of a company is to identify the liabilities associated with those borrowings for a target company. If there are any risks or liabilities which are identified, the same have to clearly mentioned in the report and the ways in which those risks or liabilities can be mitigated shall also be mentioned. Further, these borrowing documents also lay down the requirement of obtain of prior consent before any fund raise or any other corporate restructuring and the same shall be highlighted in the diligence report so that the Company can take appropriate steps to ensure the compliance of the lending documents.
4. Licenses and consents:
The smooth operations of a company can take place when the target company has acquired all the requisite licenses and consents under all the applicable laws. The requirement of licenses under applicable laws in India depends upon the location of and the nature of business of the target company which the target company is required to obtain, however some licenses such as trade license, shops and establishment licenses, NOCs from fire department of the respective State are some of the licenses which are usually mandatorily required for any business. Few of these licenses are renewable every year and therefore the Company should ensure that the same is done as and when due.
During the process of legal due diligence, the target company is generally asked for the copies of the licenses obtained and the target company shall ensure that it obtains all the applicable licenses which are valid as on the current date. The target company shall further ensure that it complies with all terms and conditions mentioned under the licenses, failing which the due diligence report marks the penalties under applicable laws which the target company may face upon non-fulfillment of the conditions.
Further, with respect to taxation, PAN, TAN, professional taxpayer registration, GST have to be mandatorily complied with and have to be obtained by the company.
5. Litigation:
The target company would be required to disclose if there are any pending litigation to which the company is a party. In the event of any alternative dispute resolution procedure or litigation has been either initiated by or against the target company, the details of the proceedings would be recorded so that the target company or the investor, as the case may be, have an assumption with regard to liabilities/costs that the target company might be possibly liable for upon the closure of the proceedings.
6. Labour Laws Compliance:
HR compliance is another important aspect of the legal due diligence. Compliance of labour laws is very essential for a company as employees play a vital role in the company’s operations. To begin with, the target company is required to disclose the number of employees working in the company so as to determine the applicability of labour laws as compliance of couple of laws depend on the number of employees employed by the target company. The target company is asked to present their HR policies and leave policy that has been implemented in the company, and all other documents so that it may be established or concluded the abidance of the applicable labour laws and state rules by the target company. It is well-known that non-compliance of the provisions of applicable labour laws along with state rules may attract penalties and disciplinary actions from the authorities and this chapter helps the target company to identify and mitigate the same to a large extent.
7. Intellectual property:
Intellectual property has become one of the most important assets a business has which adds value to the business and the target company in terms of brand and goodwill, which is why IP due diligence is covered as a part of LDD. IP due diligence is essentially an audit to assess the intellectual property developed by the target or licensed to, a company, business or individual. The intellectual property may be registered or pending for registration or un-registered and the same shall be captured in the diligence report.
8. Property:
It is a well-known fact that property is a high factor asset which adds huge value to the company. Under this coverage, the prospective investor tries to evaluate the property, whether it is owned or leased and attempts to scrutinize all, or specific parts, of the legal affairs with regard to a property with a view of uncovering all legal risks involved in the proposed transaction and to provide the buyer an extensive insight into the nature of the property and risk/costs involved in the proposed transaction. Due Diligence often improves the buyer’s position by pointing out the risks involved in purchasing the property and ensures that necessary precautions in relation there to. In case of leased property, the target company is asked to disclose all the lease agreement that the company has executed for using various properties for the requirements of the company. Further, the key issues/liabilities are identified in connection to the obligations of the target company and also with respect to clauses such as term, notice period, rent, security deposit, termination, increments. The target company shall ensure that the lease agreements must be adequately stamped and registered in accordance with the state specific laws to reduce the red flags in the due diligence report.
9. Insurance:
Insurance is another important part of the legal due diligence process. It helps in evaluating the coverage of risks. The target company has to disclose if they have obtained any kind of insurance policy, which are evaluated to analyse the coverage and the value of the insured. Further, the key issues are identified in connection with the term and validity of the policy.
D. HOW IS LEGAL DUE DILIGENCE HELPFUL FOR THE INVESTORS?
Deals or transactions are often coupled with various kinds of uncertainties and risks. A good and healthy company attracts good investors and the investors also evaluate the health of the target company, which helps them in evaluating the true valuation of the target company. In other words, the lesser red flags in the legal due diligence report, the more is the confidence of the investor.
However, the key issues/liabilities are identified during the course of the legal due diligence from the documents/information that is provided by the target and the way forward is negotiated by the target company and the prospective investors. Following are some of the conclusions that comes out after the legal due diligence process:
1. Determination of valuation of a company:
As everyone is aware, that any investor putting in monies into a company would first get a legal diligence done and in the event that there are a lot of red flags in terms of legal compliances, then not only will that delay the closing of a deal but will also have an adverse impact on the valuation of a company. The purpose of the diligence is to identify the risks/liabilities that are involved with respect to a target company. by accessing its financials, and other legal documents of the company. The same has to be analyzed, which will determine the risk/liabilities involved and ultimately determine the valuation of the target company.
2. Conditions Precedent and Conditions Subsequent:
Condition precedent describes an event or condition to be fulfilled prior to the investor investing into the Company. The condition precedents are the outcomes of the findings of a diligence report and whatever can be corrected prior to the investment by the investor shall be complied by the company and the promoters. Apart from condition precedent, there may be certain condition subsequent which may be required to be complied with by the company and the promoters within a specified time period after investment by the investors into the company.
3. Representation and warranties:
Representations and warranties are assurances given by the parties. Any transaction document will have the representations and warranties of the company and the promoter with regards to the business operations and compliances by a company. Depending on the outcome of the diligence the investor may ask for certain specific representation and warranties. Further, the companies usually provide a disclosure letter which lays down certain existing non-compliances by the company and the same are exceptions to the representations provided by the companies.
4. Indemnity:
Indemnity means making good for the loss. Upon completion of diligence the investor shall seek indemnity from the company and the promoters for the existing non-compliances and also specific indemnity may be sought by the investors on certain critical matters.
E. CONCLUSION:
Due diligence is a process which aids investors and companies to verify, investigate and understand the compliance level of the target company in depth by analyzing all the information and documents provided by the target company and then identify the risks involved in the deal. Legal due diligence process ensures that strategies are made to mitigate the issues so that it gets easier for the parties to negotiate a deal.
Authors: Prashant Jain, Co-Founder & Partner; Abhishek Gupta, Associate; Jaisis Das, Associate
Disclaimer: The content of this article is intended to provide a general guide to the subject matter. For any queries, the authors can be reached at (i) prashant@samistilegal.in (ii) abhishek@samistilegal.in (iii) jaisisdas@samistilegal.in.
