INTRODUCTION
Due diligence is an act or exercise, performed before entering into any agreement or contract with another party. It involves investigation, audit, or review of a business, assets or a person before signing of the contract and aims to reduce the risk involved by making the decision as informed and calculated as possible through the use of a certain standard of care. In this article we discuss the various facets of the disclaimer clause and qualification clause, mapping the liability of an agency/law firm(s) undertaking the process of due diligence and follow up process that is used after it.
DISCLAIMERS IN A REPORT:
The collection, collation, and examination
of the findings of the investigation is called Due Diligence Report. It is
extremely important because it is concise and organized documentation which
eventually brings clarity and efficiency to the process of Due Diligence. A
report of due diligence consists broadly of four parts:
(i)
a disclaimer section;
(ii)
an executive summary of
the report;
(iii)
the report itself; and
(iv)
schedules.
According to the Black's Law Dictionary,
the term 'disclaimer' refers to "a statement that one is not responsible
for or involved with something or that one has no knowledge of it". Simply
put, it means that an individual is not legally accountable for something.
Disclaimers are added to the reports by
the agencies responsible for conducting the due diligence to shield themselves
from any professional liability arising out of the report. Practically, a
report of due diligence must consist of proper disclaimers stating the purposes
of and situations under which the report was prepared.
Generally, the legal review is made
according to the scope which has earlier been agreed upon and should be
specified in the report. The report only deals with a specified legal facet of
the target and is neither aimed to be nor should be understood as a legal
opinion on the contents therein.
No matter how carefully it is done, there
is a high possibility that certain problems might arise at the time of
conducting due diligence that might also require remedial actions, such factors
make it important for the disclaimer clause to be inserted in the report. Some
of those factors[1]
are:
1. Non
availability of information: Often, at the time of conducting due diligence
certain information might be hidden and could prevent drawing up of a complete
picture.
2. Unwillingness
of target company’s personnel in providing the complete information: Sometimes
the staff of the target company may prove to be not very cooperative and
unwilling to deliver the required information.
3. Providing
of incorrect information: If the information provided by the target company
staff is incorrect, it causes hurdles in preparing the report.
4. Complex
tax policies and hidden liabilities: Complex tax policies can generate hidden
tax liabilities that cannot be easily tracked.
5. Multiple
Regulations and its applicability: As new legislations come up, it might prove
difficult to ascertain its applicability for business and seeking a legal
opinion on it may be inexpedient or very costly.
6. Process
in providing data: Before data is made available for due diligence, it goes
through a number of checks and reviews which can slow down the due diligence
process.
7. Absence
of proper MIS: Lack of a proper MIS can make the process of due diligence
complicated.
General
Characteristics Of Disclaimers
1. Must
limit the scope to be used only by the client: This indicates that the report
is prepared only for the benefit of the client in a particular transaction and
must not be made available to any other party for their reliance;
2. Clearly
stipulate that the report is a derivative of the documents received by the
client. This indicates that unless otherwise indicated, the report is solely
prepared from the information gathered through the documents disclosed by the
target and any independent research was not carried out for the purpose;
3. Assume
that the given documents were supposed to have been properly executed. This
indicates that all the documents provided were executed and signed by the
parties to it and were true, accurate, complete and not misleading;
4. The
report also must contain the possibility of a future amendment acknowledging
the dynamics of business so that it provides for flexibility.
II.
QUALIFICATIONS, LIMITATIONS AND
LIABILITY IN THE REPORT:
The agency conducting due diligence may
declare any kind of reservation, adverse remark, or qualification at
appropriate places. Preferably, such qualifications, reservations, or adverse
remarks of the agency should be highlighted in italics or bold type in the
Diligence Report.
Regarding the matters on which the agency
could not form an opinion (due to insufficiency or information / data or other
reasons), a clear statement must be provided pointing out the fact that the
agency was unable to come up with an opinion and the reasons for the same. If
certain limitations either circumstantial or imposed by the company (like
certain books or papers being in the custody of another person or Government
Authority) reduce the scope of work to be performed, it must be indicated in
the report.[2]
In case these limitations make the agency unable to express their opinion, they
should state that:
“In the absence of necessary information and records,
he is unable to report compliance(s) or otherwise by the Company”.
Standard Qualifications in the Legal due Diligence
Report required to bypass liability[3]
One of the standard qualifications is,
when the due diligence report prepared, it is supposed to be limited to the
state of affairs as it was on the date the information was disclosed in the
data room, creating a limitation on the information. Then comes, assumption of
conformity to the originals of all documents submitted as copies It has to be
assumed that all the documents provided were executed and signed by the parties
to it and were true, accurate, complete, and conforms to the original document.
Another is, Reliance upon statements and communications received from
authorized officials of the target. Qualifications as to independent
investigations is also a standard qualification.
Limitations in
a DD Report
1. Since
the information received entirely depends on the data provided by the client,
its quality and quantity might cause potential risk of disclosure or
misrepresentation.
2. Limitation
on timing
3. Exposure
to unknown investors and also possible foreign jurisdictions
4. Even
if all the basic information is provided there might be some hidden risks as
the report relies on the analysis made by the person conducting due diligence. Here,
judgment of the person conducting the diligence is important.
5. Review
restricted to sanitized, vetted reports and interview with key employees- the
real dirt may be elsewhere (e.g. emails and other correspondences)[4]
Ascertaining The Liability
A.
in the case of
reliance requests:
In the case of financial acquisitions, the
financer of the acquisition may ask to review the due diligence report prepared
for the buyer. In such cases the law firm needs to remain cautious as exposing
the report to the financer could expose the firm to certain liabilities.[5]
Thus, the law firm should remain prudent
and take precautions while consenting to deliver or delivering the said
reports. First, the law firm should
make sure that the report of due diligence consists of proper disclaimers
stating the purposes of and situations under which the report was prepared. Second, before consenting to deliver or
delivering the reports, a law firm should:
1. be
satisfied as to the identity of the recipients of the report (e.g. their
reputation as a financial institution); and
2. come
up with proper terms and conditions that the recipients would have to accept
through a letter before getting access to the report.
Situation
I- Non-Reliance Letters
In this case, the recipient gets access to
the report on a non-reliance basis. In this case the law firm can request the
recipient to issue a non-reliance letter which means that the recipients, in
the letter, expressly acknowledge and consent to not rely on the report for any
purpose.
Situation
II- Reliance Letters
In a case where the financial institutions
want the report to be delivered to them on a reliance basis, the law firm has
to take certain steps to safeguard themselves from any future liabilities.
Apart from the steps mentioned above, the financial institutions should be made
to execute reliance letters that consist of proper disclaimers stating the
purposes of and situations under which the report was prepared and submit
various assumptions, limitations, and qualifications.
Ordinarily the conditions included in such
a delivery are:[6]
1.
The approval to use the
report for reliance by the financial institution will not create a relationship
of lawyer and client between the law firm and the financial institution;
2.
The liability of the firm
will be limited to a fixed amount and all claims against the law firm will only
be brought within a fixed period from the delivery of the report (e.g.- one
year).
3.
The law firm should deliberate
upon the applicability of laws and the forum to be approached so that in case
of a dispute they are not subjected to disadvantageous laws or jurisdiction.
B. Due Diligence
conducted through artificial intelligence:
AI undoubtedly brings many benefits, like
time and cost efficiency, and at times increased output which makes for a good
reason for law firms to adopt it in its due diligence process. However, there
are certain risks attached to it too. One of the major risks can be failure
of the software. The technical working of software as to its process of
getting results is only known to its developers and not the lawyers using it.
Thus, the lawyers should keep in mind that the software can create errors by
misinterpreting an ambiguous document or due to insufficient training of the program.[7]However,
due to the following risks attached to the use of AI programs which the law
firms should keep in mind while making use of them.[8]
This being said, there also arise certain
liabilities resulting from such failures. When a client appoints the law firm
to conduct due diligence for it, it transfers the risk involved to the
shoulders of the law firm by paying it for it. The hiring of a lawyer to make a
due diligence report carries with it a factor of insurance. Therefore, when
there is an error due to the use of AI, it exposes the law firm to liabilities.
An important question that arises here is that, does such an error bring
liability to the software manufacturer as well?
Keeping that aside and thinking just from
the law firm's perspective, there can be certain possible solutions to the
problem of liability of the firm. One of the solutions can be if the law firm
accepts the entire risk by taking out insurance. The law firm can also,
transfer the cost advantage accomplished through the use of the software to the
client who would in return bear the entire risk. In this case, the software
would also be chosen by the client. Another way of transferring the cost
advantage accomplished through the use of the software to the client can be
there. however, in this case, the software would be chosen by the firm itself
and the entire risk would also be borne by it. Here, the client can be made to
pay the risk premium as compensation. One easy way is if the law firm includes
a disclaimer excluding itself from any liability arising in such cases. As a
considerable amount can be saved from the use of AI software, it is quite
probable that the clients would be willing to accept such a disclaimer and
assume the entire risk itself.
III.
FOLLOW-UP
ON DUE-DILIGENCE
Even though the greater part of the
process of due diligence is carried during the implementation period, the
post-diligence period is also very essential as it involves the process of
making sure that an accurate assessment of the result of due diligence is done,
and ensures smooth conversion of the due diligence stage to the deal completion
stage and review. If the team conducting due diligence fails, the deal with the
target company falls through, and this part of the process is also recorded to
aid future deals.
An example of post diligence activity in
an M&A due diligence would include:
·
For the Buyer- Post
Merger integration and cultural adjustments;
·
For the
Seller-Termination of data room and ownership exchange.
Scope And Purpose
Of Follow-Up
Often, any non-compliance found during the
process of due diligence is fixed at the post-diligence stage. Among different
tasks arising out of the process of diligence are filing of a petition or an
application for the purpose of compounding of various offences or negotiating
the shareholders’ agreement, since the investors will be on a strong wicket and
may negotiate the price very hard.[9]
A “shareholders agreement” is only
executed after the rectifications are made following the reporting formalities.
Consistent follow-ups and a methodical review are required for making these
rectifications. Various clauses consisted in this agreement are:
representations and warranties, tag along and drag along rights, condition
precedents, and other clauses impacting the deal.
General
Precautions For Avoiding Hurdles At The Time Of Follow-Up
At the time of preparation of the report,
the agency that is conducting due diligence must make a final analysis of the
files that were produced through the entire process of due diligence. The
documents should also be put in a manner that they are readily available when
needed.
This is essential as the client can at any
point of time raise a question regarding a part of the report for which the
agency might need to refer to a document to explain it to the client. If such
an arrangement is not made at the time of the transaction, it is possible that
the counsel might not be able to find the documents when needed which would
make it impossible for him to recall the details of the negotiations.
Also, it might so happen that the client
does not produce certain documents required for the conduct of due diligence
even after requests from the agency. If these documents are provided
post-diligence, the report must contain a scope of amendment or provision of a
supplement report to include the essentials of the new document received.
Conducting
Post-Diligence Review: An Example Of
M&A Deal[10]
A thorough evaluation and review must be
made by the acquirer's management team of the results produced by due diligence.
Such a review begins when a presentation is made by the due diligence team to
the senior management team or the board of directors in certain cases as per
the process of decision making and hierarchy inside the company. After this, a
comprehensive assessment is made regarding the continuance of the acquisition.
In case the due diligence team finally
recommends abortion of the acquisition plan, the acquirer team must sincerely
and critically access the deal-sourcing process and analyse why the plan was
forwarded in the initial due diligence and must learn from the entire process.
To ensure that the knowledge gained from the experience does not go to waste
and is stored for future use, a member of the due diligence team must be made
in charge of knowledge management (KM) of the company. If the due diligence
results in the failure of the target company, another recommendation for such
acquisition should be made by the due diligence team regarding a similar
sector, keeping in mind the corresponding size to the senior management team of
the acquirer.
However, if the due diligence results in
the passing through of the target company, a proper follow-up review must be
carried on. Following thorough due diligence conducted by the due diligence
team in the premises of the company, the senior management must efficiently
look into the report to understand why the said acquisition was recommended. If
the acquirer is intimate with the risks involved, it would be easier to
mitigate them.
CONCLUSION
The general idea behind putting up a
disclaimer is to make the preconditions loud and clear and it is done to wave
off the professional liability and to avoid future risks, in this case, arising
out of the report. There are certain risks like- Non-availability of information,
the Unwillingness of the target company's personnel in providing the complete
information, etc, which make the presence of the disclaimer clause even more
important. There is also a need for standard qualifications to be inserted in
the report to bypass liability and further, the firm can even ask the recipient
for a reliance/non-reliance letter, ascertaining the liability.
Due diligence is an increasingly important
and common practice that also often consumes a lot of time and resources.
Artificial intelligence might help to solve this problem and increase
efficiency by reducing time and cost. Although exposed to certain risks, AI is
going to be the future of everything including Due Diligence and reduction of
risk is a big hurdle which both AI and Firms conducting Due Diligence face.
The process doesn't stop after successfully conducting the due diligence as it needs proper follow-ups and post diligence reviews to ensure better results. The earlier articles in the series have already analysed all the aspects related to due diligence, one cannot emphasize enough on how it is all about proper risk management, and in many cases, the risk is dynamic. Hence, proper follow-ups are extremely important to ensure the efficiency of Due Diligence.
[1] ICSI, Due Diligence and Corporate Compliance
Management (The Institute of Company Secretary of India, 2011), 282,
http://www.icsi.in/Study%20Material%20Professional/DUE%20DILIGENCE%20AND%20CORPORATE%20COMPLIANCE%20MANAGEMENT.pdf
[2]ICSI, Guidance Note on Diligence for Banks (The Institute of Company
Secretary of India, 2009), 6, https://www.icsi.edu/media/webmodules/pcs/GUIDANCE%20NOTE%20ON%20DILIGENCE%20REPORT%20FOR%20BANKS.pdf
[3] Pooja Patel, Path to successful M&A Transaction: An
effective legal Due Diligence (The Institute of Company Secretary of India,
2017), 4, https://www.icsi.edu/media/portals/72/year%202017/presentation/Legal%20Due%20Diligence%20-%20180217%20-%20Pooja%20Patel.pdf
[4]Id at 5.
[5] Project Committee, IBA Corporate and M&A Law Committee
Legal Due Diligence Guidelines (International Bar Association, 2018), 33,
file:///C:/Users/Pc/Downloads/Corp-MA-Legal-Due-Diligence-Guidelines-September-2018-FULL%20(3).pdf
[6]Ibid.
[7] Javier Tortuero, Artificial Intelligence and M&A Due
Diligence Current Trends (New York State Bar Association) 3,
http://www.nysba.org/Sections/International/Events/2017/Corporate_Wedding_Bells_CrossBorder_Mergers_and_Acquisitions/Coursebook/Panel_2/ARTIFICIAL_INTELLIGENCE_AND_MA_DUE_DILIGENCE_CURRENT_TRENDS.html
[8]Id
at 39.
[9] ICSI, Due Diligence and Corporate Compliance
Management (The Institute of Company Secretary of India, 2011), 12,
http://www.icsi.in/Study%20Material%20Professional/DUE%20DILIGENCE%20AND%20CORPORATE%20COMPLIANCE%20MANAGEMENT.pdf
[10]Kwek Ping Yong, Due Diligence in China: Beyond the Checklist
(Wiley, 2013), https://learning.oreilly.com/library/view/due-diligence-in/9781118469057/xhtml/Chapter08.html
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- To Read, Due Diligence: Need and Benefits by Anshul Ramesh and Avesh Harshan- PART-II , Click Here
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