History and Background of Due Diligence
The essence of due diligence has been
present since ages for transactions between two or more parties for ensuring
transparency and legitimacy. The Roman
Law prescribed the concept of diligentia, with two subheads.[1] Firstly,
‘diligentia quam suis rebus’ or care which should be taken by a person for
managing is own affairs and Secondly, ‘diligentia exactissima’ or ‘diligentia
boni patrisfamilia’ the care which should be taken by the head of a family.
The legal maxims of Caveat Emptor and
Caveat emptor, which are also known to be originated under the Roman
Empire, connoted the identical principle of imposing a burden on the
buyer/seller to know about the information related to the transaction.[2]
The English Law distinguished diligence
into three degrees in the Seventeenth Century namely, Common or ordinary,
High or Great, Low or Slight.[3]
These were varying degrees of care a person can be imputed upon regarding the management
of their affairs taking consideration of their prudence. Although the term “due
diligence” has originated from the common law system in medieval England
after the Norman Conquest,[4]
however, its codification had taken place only under legislative enactments by
the United States, namely the United States Securities Act, 1933 (which
mentioned a process of ‘reasonable investigation’).
A. Due diligence in American
jurisprudence
The American laws on securities used to
impose huge liabilities on the dealers who used to sell securities or
properties to the public and the required Standard of Care was known as ‘due
diligence’. The US Securities Act[5],
in a provision which deals with the civil liabilities on account of false
statements and providing inadequate information to investors, connotes that the
statement should be made after a “reasonable investigation”.[6]
This phrase of a ‘reasonable investigation’
shares the essence of due diligence, and it provides a defence to any person
who deals with properties or securities and has taken every possible step to
ensure that adequate information is provided to the investor in the prospectus.[7]
B. The Indian scenario
Indian
jurisprudence has also accommodated due diligence in its legislator framework,
which makes it mandatory for the decisions related to business to undergo a
process of investigation, research and other precautionary steps. However,
there is no law or case law on Due diligence.
In the
Indian scenario, the most proximate concept associated with due diligence can
be of ‘Notice’, actual, constructive or imputed.[8] Various
Indian statutes adopt the essence of due diligence. Transfer of Property Act[9]
was probably the first legislation to do so when it provided for imputation of
notice from actual knowledge or wilful abstention from an enquiry or search, they
ought to have made.
This
imputation cast a duty on the person involved to enquire about the property
before making a sale, much like the U.S. legal framework in cases of
securities. In this case, the person buying a property is expected to act as a
reasonable man who conducts sufficient research and investigation to find out
about the title or ownership of the property.
Due
diligence has been adopted in many Indian legislations, whenever it involves a
commercial transaction involved. It is made mandatory in cases where the transaction
involves a lot of people, documentation, capital and property.
Mandatory
due diligence has been introduced under the SEBI Regulations[10]
and offshore offerings of security from American or other Global depositories.
Furthermore, many legislations such as Securities Contracts (Regulation) Act,
1956[11], Monopolies
and Restrictive Trade Practices Act (MRTP), 1969[12],
SEBI Act[13]
and IT Act[14],
have placed obligations to take care in case of economic matters.
However,
the Indian framework only places a standard of care rather than placing
statutory duty or consequential criminal liability for failure to exercise due
diligence.
What precedes Due Diligence
In every M&A transaction, the due
diligence forms an integral part of the transaction as it helps the parties to
make an informed decision after weighing the potential liabilities and
discrepancies.[15]
It ensures that the transfer of assets won’t bring unnecessary risks to the
shareholders. The purpose of due diligence is to measure the benefits and
liabilities of the transaction by enquiring all relevant information of past,
present or futures and assessing the prospects. This is usually done in three
phases starting with an examination of financial statements, assessing
management and operations and lastly, reviewing legal liability.[16]
i.
Self due diligence
The first step in any due diligence
exercise lies with the acquiring party where it is required to introspect and
determine the outcomes, it seeks from the due diligence exercise. Peter
Howson[17]
enlists the following questions which any acquirer should ask himself
before any due diligence exercise:
· What is the business strategy?
· How do acquisitions fit into the business strategy?
· How does the target fit the strategy?
· Have we carried out sufficient pre-acquisition planning?
· Are we sufficiently prepared for the due diligence exercise?
· Which areas are we going to investigate? Why?
· Do we know what we really need to know in each area of
investigation?
· Do we have enough time to complete the process? If not, what are we
going to do about it?
· Do we know where the synergies are going to come from? Have we tried
to quantify them in detail? What further information is needed?
· Have we worked out an adequate implementation plan?
· Have we explored all the consequences of the deal, for example the
effects on current operations, existing personnel, the industry and
competitors?
· Have we set material limits for the due diligence investigation?
· Have we explained the process to the seller?
· Have we agreed access to people and documents with the seller?
ii.
Environmental factors for a due
diligence process.
The
factors affecting the smooth execution of a due diligence process are mainly
threefold:
(i)
the external factors which affect the work;
(ii)
the internal restraints for the acquirer during the review process; and
(iii)
the nature of the entity being acquired.
Before
initiation of any due diligence process, these criteria need to be taken into
consideration and acted upon the acquirer in order to have a swift and
efficient review.
External Impediments: The ideal pre-condition for a due
diligence process includes having sufficient time for review, sufficient
resources and unhindered access to the company being acquired. If provided with
these factors along with a pre-emptive bid, the acquirers may participate in
the process directly without intermediaries in the process which is spread over
an expanded time period and the target company allows the disruptions due to
the detailed review. [18]
However, the ground reality is quite different. The acquirers get a
limited time for a review, in a very competitive environment where the target
company aims to work for its own benefit by the acquisition.[19]
Also, the target company employs various advisors who advice financially and
legally to extract a beneficial deal out of the acquisition. Various
constraints are put to give limited access to the information and avoid sensitive,
proprietary information. Further, the company management is mostly kept distant
from the review process.[20]
Limitations
of the acquirer – The acquisition does not take place in
isolation. The target company might have ongoing processes such as
restructuring, alliances, internal procedures, divestitures or other
acquisitions. The simultaneous processes also require similar access to to the
management and information, which causes delay and hindrances.[21]
Nature
of the target company – The nature of the company has
numerous impacts on the due diligence process of the company. For example, a
company at an early stage would have limited resources and experience of the
processes when compared to a large and mature company, which is well versed and
acquainted with the process.[22]
The latter would require less stimulation from the acquirer as they would have
established mechanism for execution of a due diligence process.[23]
iii.
Preliminary agreements for due
diligence.
Before initiating a due diligence process, the acquirer is made
to execute documents which include an agreement of confidentiality and also a
letter of engagement towards the consultant.[24] Apart from these, there
are several agreements necessary for a due diligence process.
C. Confidentiality Agreements
It is
essential to any M&A transaction that the information obtained during the
due diligence process remains confidential and not misused. It is also
essential that the information obtained during the process of due diligence is
used only to the extent of the due diligence process.[25] A
formal Confidentiality Agreement serves the purpose as it ensures clarity on
the information which cannot be shared and also acts as a deterrent for
disclosing it to a third party.[26]
D. Break Fees
Break
fees include failure cost agreements, termination fees et al., which imputes
the cost of failure of the consummation of the agreement for certain specific
reasons listed in the broken agreement. It places an obligation to the target
company to bear at least its own costs and contribute to the due diligence
costs.[27]
E. Exclusivity Agreement
Due
diligence is a lengthy process which requires the involvement of a huge amount
of capital, human resource and time of the involved parties.[28]
For this reason, it is essential to ensure that the target company is serious
about the deal and is not negotiating with other prospective acquirers.[29]
An exclusivity agreement serves this purpose and is quite common in the process
of acquisitions. FICCI, in its knowledge paper,[30]
had listed the following general terms:
i.
The duration of the
exclusivity period, A reasonable period should be fixed and maybe anything
from a few weeks to a few months, depending on the particular transaction.
ii.
An obligation on the
seller to immediately cease any ongoing discussions with a third party
regarding a possible transaction during the exclusivity period.
iii. An obligation on the seller not to solicit, initiate or enter
into any new discussions with third parties in connection with a possible
transaction. In this case, the definition “transaction” should include a full
range of possible transactions and not just the specific transaction that the
buyer has in contemplation.
iv. An obligation to not provide any confidential information
about the business/company to any other prospective buyer
iv.
Creation of a due diligence
team.
To
perform due diligence, the acquirer usually seeks retained consultants and
advisors who have in-house sources of expertise. The team includes people
having expertise in accounting and legal, for the financial review and
liability exposure. However, the team is not limited to that and also includes
management consultants, financial experts, environmental advisors, or any other
person having expertise.[31] The
Acquirer needs to ensure that the whole process is free from every conflict of
interest and the party directing the review should not have any connections
with the transaction.[32]
The conflict of interests include prior engagement with the company being
acquired, be in terms of auditing, consulting, bookkeeping, design, actuarial
services, brokerage services, legal services, or any other outsourcing
services.[33]Larger
companies usually choose to prefer a core team specialised on M&A and
Finance professionals supported by experts in specific areas such as financial
modelling and strategic planning. Whereas smaller organisations would prefer a
business manager and finance expert assigned as team leaders for guiding a team
assembled by a company consisting of both internal and external professionals.[34]
v.
Structure of the team
The due
diligence teams are usually divided based on the area of work and their
specific expertise. Each team would generally have a team leader who is
responsible for leading the team in the required direction and coordinate among
the team and also the other teams. There would be multiple levels of reviewers
to avoid any possible infirmity or anomaly.[35]
·
Finance/Accounting – Usually, the financial due diligence requires the maximum amount of
human resources due to the huge volume of data which need to be reviewed. This
number will be directly proportional to the size and complexity of the company.
This part of the team consisted of financial professionals, tax experts,
accounting and acquisition specialists.[36] Often,
independent accountants are also hired to increase manpower and have a second
opinion of a third party who has not been a part of the process.[37]
·
Business Development – The composition of this team will also be proportional to the size and
complexity of the enterprise. In those instances where the function exists, the
acquisition process in general, and the due diligence review in particular,
will significantly benefit from the participation of business development staff
seasoned in the organization’s strategic planning process and acquisition
justification efforts and experienced in managing due diligence reviews.[38]
·
Legal – The
legal team would be employed right from the commencement of the process, from
the drafting of contracts regarding confidentiality, non-disclosure and
exclusivity agreements. This team needs to be involved in the whole process,
assisting with the legal issues at every stage. They will provide the necessary
expertise to review legal documents and assess legal issues of all sorts during
due diligence.[39]
Besides, because they will also be intimately involved in negotiating and
drafting the purchase agreement, their participation will provide the knowledge
base to effectively address legal aspects of business issues that typically
emerge during final negotiations.[40]
·
Human Resources – The human resources team deal with the issues related to staff
management, compensation plans, change of control issues, and benefits
management, and treatment of staff. In, addition they strive to improve
cultural integration and diversity in the workplace during an acquisition.[41]
·
Information technology – the IT experts provide guidance in terms of the operations of the due
diligence which will take place with the help of technology. It includes product
support technology (particularly in technology-intensive businesses such as
software development, communications, financial services, and entertainment) and
its compatibility with that of the acquiring company.[42]
This would require substantial resources in terms of software, hardware and
personnel.
·
Sales and Marketing – This team would comprise of sales experts who would assess the
marketability of the business of the target company, its products and services,
and customer perceptions/relationships.[43]
The Sales team comprises of expert market reviewers with the expertise of
predicting the growth of the product, revenue strategies among other things.
vi.
Initial Preparation
According
to Paul Hilger[44],
In order to prepare for the due diligence process, the teams should be provided
with the following documents necessarily:
·
_The plan to create value or the organization’s functional equivalent
that outlines the assumptions about the transaction’s ability to enhance the enterprise’s
value
·
The approval document
presented to corporate management to justify the transaction and the
accompanying valuation model, including detail of projected growth,
profitability, and synergies
·
Information, such as
the offering document or other preliminary data, that may have been provided by
the seller or its representative
·
Company and product information,
such as promotional materials, that may be available
·
A copy of the
Information Request presented to the seller
·
The acquirer’s standardized
pre-acquisition checklist
In the
wake of being given the above records, the groups ought to be made mindful of
the procedure by the group heads and furthermore advised about the data found
in the above archives. The groups ought to be completely mindful of dangers and
openings related to the procedure, the goals of the procedure and the normal
result of the procedure. There ought to be agreeability and a benevolent domain
all together for the redistributed individuals with less experience. In
conclusion, the secrecy of the entire procedure must be focused on with each
part to maintain a strategic avoidance from any accidental disclosure.[45]
Prior to
starting the process, the due diligence agenda must be settled. The people with
essential duty regarding each team to be investigated ought to present their final
version of their part of the program to the people driving the team of the due diligence
survey. Group heads ought to assess its substance and give contribution
varying.[46]
They ought to guarantee that the targets set up for the individual teams will
challenge presumptions made in the arrangement to make esteem and instigate the
team reviewing to give noteworthy discoveries that can be used in the post due
diligence period of the acquisition.
The author of the post, Bodhisattwa Majumder is a law student at Maharastra National Law University and currently intern at Corp Comm Legal under Mr. Bhumesh Verma.
[1]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Edition; Tata McGraw Hill), 2010. 23-24
[2] “Some
thoughts on Due Diligence”, International Business and Commercial Laws:
Berg and Duffy, (1995). Available at http://www.bergduffy.com/Personnel/Articles/95ddartl.htm,
Accessed on 26th March, 2020.
[3]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Edition; Tata McGraw Hill), 2010. 22-23
[4]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Edition; Tata McGraw Hill), 2010. 22-23
[5]
Securities Act of 1933, Amended Through P.L. 115–174, Enacted May 24, 2018.
[6]
Section 11 (b) (3), of the US Securities Act of 1933.
[7] S.
Spedding, Linda. Due Diligence Handbook: Corporate Governance, Risk
Management and Business Planning, Burlington: CIMA Publishing, 2009, 9-10.
[8]
Charu Kumar, M, “Legal due diligence”, Mondaq,
Available in https://www.mondaq.com/india/Strategy/17241/Legal-Due-Diligence,
Accessed on 8th April, 2020.
[9]
Section 3 of Transfer of Property Act, 1882.
[10] Securities
and Exchange Board of India (Mutual Funds) Regulations 1996
[11]
Section 24 of Securities Contracts (Regulation) Act, 1956.
[12]
Section 53 of Monopolies
and Restrictive Trade Practices Act (MRTP), 1969
[13]
Section 27 of Securities and Exchange Board of India Act, 1992.
[14] S.278
B Information Technology Act, 1961
[15]
Chapter 6: Why Due Diligence, “Mergers and Acquisitions: The evolving Indian
Scenario”, PWC, Available at https://www.pwc.in/assets/pdfs/trs/mergers-and-acquisitions-tax/mergers-and-acquisitions-the-evolving-indian-landscape.pdf,
Accessed on 27th March, 2020, 22-23.
[16]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Editiob; Tata McGraw Hill), 2010. 6-7
[17]
Howson, Peter, “Commercial Due Diligence: The Key to understanding value in
an Acquisition”, 2006. 38-39
[18] “Due
Diligence: Investigation or audit of a potential deal or investment opportunity”,
Corporate Finance Institute, Available at https://corporatefinanceinstitute.com/resources/knowledge/deals/due-diligence-overview/,
Accessed on 29th March, 2020.
[19] Loev,
JD, David M. and CPA “Due Diligence Activities in Merger and Acquisition
Transactions”, American Academy of Attorney – CPAs, Available at https://www.attorney-cpa.com/articles/due-diligence-activities-in-merger-and-acquisition-transactions/,
Accessed on 30th March, 2020.
[20]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 113-115.
[21]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 115-117
[22]
Putz, Adam, “M&A 101: The role of due diligence in mergers and
acquisitions”, Pitchbook, Available at https://pitchbook.com/news/articles/ma-101-the-role-of-due-diligence-in-mergers-and-acquisitions,
Accessed on 26th March, 2020.
[23]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 115-117
[24]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Editiob; Tata McGraw Hill), 2010. 18-19.
[25] Mengus,
Dogan Baran. "Due Diligence Process in Mergers & Acquisitions and
Integration Problems.”, Available at https://pdfs.semanticscholar.org/3268/ae5d0f1248afeb70d5ac0113f403cb1fc713.pdf,
[26]
Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI
in collaboration with J Sagar Associates. Available at
http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on
3rd April, 2020. 51.
[27]
Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI
in collaboration with J Sagar Associates. Available at
http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on
3rd April, 2020. 51.
[28] Harper,
Pam. "Merging cultures." Executive excellence 19, no. 11 (2002): 7-7.
[29]
Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI
in collaboration with J Sagar Associates. Available at
http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on
3rd April, 2020. 51-53
[30] Id.
[31] “The
Panel on Audit Effectiveness: Report and Recommendations” (the “O’Malley
Panel Report”), Dated. 31, 2000. ¶5.6
[32]
Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”,
(2nd Editiob; Tata McGraw Hill), 2010. 21-22.
[33]
Categories of Non-audit services, Sarbanes – Oxley Act, 2002; available at http://www.sec.gov/rules/final/33-8183.htm.Accessed on 26th March, 2020.
[34]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 117-118.
[35] Iacono,
Mario Pezzillo. "Cultural due diligence as a proactive strategy of
organisational change: An empirical analysis." Social Science Research
Network (SSRN).
[36] Müller-Stewens,
G. "Wettbewerbsvorteil Corporate M&A." M&A-Review 2 (2003):
2003.
[37]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 96-97.
[38]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 97.
[39]
Broker, Brandons, “Due Diligence in Mergers and Acquisitions”, Business
Benefits Group, Available at https://www.bbgbroker.com/due-diligence-in-mergers-and-acquisitions/
[40]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 96.
[41] Lucks,
Kai. "Die Organisation von M&A in internationalen Konzernen." Die
Unternehmung (2002): 197-211.
[42]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 96, ¶2.
[43] Klingler,
Urs. "Performance Management." In Moderne Personalentwicklung, pp. 103-120.
Gabler, 2008.
[44]
J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation
approach”, Wiley Publishers. 112 at ¶1.
[45] Müller-Stewens,
G. "Wettbewerbsvorteil Corporate M&A." M&A-Review 2 (2003):
2003.
[46]
Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI
in collaboration with J Sagar Associates. Available at
http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on
3rd April, 2020. 51-53
- To Read, Due Diligence: A practical overview by Anshul Ramesh and Avesh Harshan- PART-I, Click Here
- To Read, Due Diligence: Need and Benefits by Anshul Ramesh and Avesh Harshan- PART-II , Click Here
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- To Read, [Expert Corner Series] Due Diligence: It's Process by Megha Kamboj & Monika Saini- PART-IV | Corp Comm Legal on Corporate Law, Click Here
- To Read, [Expert Corner Series] Due Diligence Checklist and What is to be done during Due Diligence by Riddhi Joshi- PART-V | Corp Comm Legal on Corporate Law, Click Here
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