Due Diligence in M&A Transactions

Author: Ashish Kumar Karmakar, Dhubri Law College, Gauhati Univeristy

The New Economic Policy of 1991 brought prominent changes in the corporate world and made it easy to restructure companies. Corporate restructuring means to create a new structure by altering and modifying the company’s hierarchy, internal structure, finance and operation procedures which brings effectiveness and efficiency to boost profits and capital gains. It is not a new phenomenon in the corporate world. Corporate restructuring happens through various ways such as Merger, Demerger, Acquisition and Amalgamation. 

Merger and Acquisition both help to make a new structure of the existing company. Their contribution works for greater and optimal structure of the companies. Merger implies the combination of two or more companies to form a new entity which handed down all assets, liabilities and the entire business of the company that merged with another. Example of recent merger of companies i.e. HDFC Ltd. merged with HDFC Bank on 1st July, 2023 all employees of HDFC ltd. as on effective date becomes HDFC Bank ltd employees.

Acquisition implies to acquire or purchase the target company’s specific portion of assets, shares and even whole entity for a lump sum consideration on a going concern basis. It is a legal process of corporate restructuring and financial transactions where the assets as well as liabilities of two or more companies shall be invested into another company. Acquisition is a corporate phenomenon that can transform business structure in the highest possible way to attract customers nationally and globally. In case of acquisition the Identities of the shareholders cannot be guaranteed because it solely relies on transactional structure. Example of acquisition: Adani Green Energy Ltd acquired 100% equity shares of SB Energy India for $3.5 billion through a share purchase agreement in May 2021. SB Energy became a wholly-owned subsidiary of AGEL. 

1.  Horizontal Merger

2. Vertical Merger

3. Congeneric Merger

4. Conglomeration

5. Market extension or Product Extension Merger

6. Statutory Merger

7. Triangular Merger

8. Asset Purchase (1)

Before purchasing a car, what are the basic things we notice or are eager to know, such as price, model, benefits, maintenance cost, lifespan, etc. These are the foremost things that are going in our mind before purchasing a car is known as Due-Diligence. Due-Diligence is nothing but to gather information or re-checking detailed aspects for examination where the interest is appended.

Due-Diligence is a legal process of gathering information of an entity of merger and acquisition transaction. It is a detailed investigation as well as analysis to enter into a transaction with a company. The investigation shall be based on the company's financial, operational, legal and compliance aspects before investing in a company. Due diligence is often seen in merger and acquisition business transactions. It also helps in identifying potential risks, liabilities and opportunities in connection with the target company, which can rise to unforeseen difficulties shortly and also helps stakeholders to make informed decisions and develop risk-mitigating strategies.

The Purpose of Due-Diligence plays crucial roles to measure potential risks and benefits from the requested company. These are:

1. Acquainted with Legal risks: Review legal documents such as contracts, permits, licenses, and regulatory filings to identify the areas of legal risks as well as liabilities associated with the transaction.

2. Legal Compliance Verification: Verify that the company or business being considered complies with relevant laws and regulations, including environmental, labour, and tax laws.

3. Protection of IP: Evaluate the company's intellectual property portfolio and other assets to ensure that legal protections are in place to safeguard these assets.

1. Collection of Information: The information of the company’s data is gathered for the purpose of evaluation of its performance and understanding its core value.

2. Identify Strengths & Weaknesses: The SWOT (Strength, Weakness, Opportunities and Threats) analysis helps the business management to understand where the company is lacking and where it is strong enough.

3. Decision Making: To make informed decisions the stakeholder is required to access all the important as well as relevant information of the company.

Warren Buffet once said, “A sales pitch gives you the price, while due diligence gives you value.” (2) Due diligence becomes very prominent at each stage while a company goes into merger with another company and in another case when one company is acquired by another company. It confirms to the acquirer that all the relevant information is equipped to purchase the requested company. Due-diligence ensures that fair value is to be expected by both the parties in the Merger and Acquisition transaction.

A lawsuit was challenged by the shareholders in the year 2015 in which Delaware incorporated companies associated. It is considered to be one of the primary causes which reflect ineffective due diligence for its failure.

 Due diligence can be classified into various categories. 

1. Financial Due-Diligence: It verifies or examines financial statements, cash flows, assets, and liabilities of the requested company.

2. Operational Due Diligence: Examines operational aspects, including business processes, supply chain, technology, and HR practices.

3. Legal Due-Diligence: Reviews legal documents and contracts for risks, litigation, compliance, and governance.

4. Compliance Due Diligence: Assesses compliance with laws, regulations, and industry standards.

5. Commercial Due-Diligence: Analyzes the company's market position and prospects.

6. IP Due-Diligence: Assesses the quantity and quality of a company's intellectual property assets.

7. Technical Due Diligence: Examines the company's technological state, including its products, infrastructure, and IT staff.

Due diligence helps minimise the potential risk factor that exists in the investment of an entity. It allows the stakeholders to make informed decisions by examining potential issues, red flags and legal complications before entering into a deal. Due diligence allows the parties to negotiate the terms and conditions in which the parties are involved. The following are the benefits that can be assured by the due diligence process:

1. Risk Mitigation: Due-Diligence helps in reduction of risk in the early stage by discovering potential issues with the target company such as financial, legal, compliance, operational, IP risks, etc.

2. Effective decision making: Due-Diligence offers detailed insights of the decision making process by comprehensive research of the requested company.

3. Increased negotiation leverage: Negotiation leverage can be gained by getting the knowledge of strength and weakness of the requested company.

4. Regulation compliance: Is the requested company adhering to the relevant laws and regulations that are to be looked out in the areas of anti-money laundering and know your customer policies.

5. Valuation: Due-Diligence can provide the exact valuation of the requested company for merger and acquisition.

6. IP protection: The absolute ownership of the Intellectual Property lies with the requested company can be perceived by way of due-diligence which prevents infringement or violation or unauthorised use of Intellectual Property.

The Due-Diligence process involves a sequence of stages from planning to closing to deal with business transactions of the requested company. The stage brings the prominent perception towards merger and acquisition transactions. The stages are:

1.  Planning: It determines the scope and objectives of Due-Diligence investigation to make informed decisions towards investment.

2. Information request and collection: It requests information from the requested company and gathers relevant data, which ensures a smooth process of due diligence.

3. Information Analysis: It analyzed and examined the collected data of the requested company in order to identify potential risks, liabilities and opportunities with the transaction.

4. Preparation of report: It prepared a due-diligence report for summarising the findings associated with the requested company for initiating proposed actions and plans for the transactions.

5. Negotiating and Closing: It utilised the findings from collected data and information to negotiate the terms of the transactions with the requested company and finalise the deal.

Steps in Due-Diligence is a crucial role for merger and acquisition transactions with the requested company that every niceties have to be observed frequently during the research process and get a detailed view. The steps are:

1. Industry Research: During industry research, various factors such as market size, growth rate, competition, regulatory environment and customer behaviour are examined to gain depth of industry dynamics. It can be conducted through various reports such as market reports, trade publications, industry associations and interviews with industry experts.

2. Preparation of checklist: To develop a comprehensive due-diligence checklist or questionnaire to guide the information-gathering process such as nature of business, corporate records, regulatory filings or approvals, intercompany relation, financing loans or agreements, accounting records, litigation, etc.

3. Document review: The due-diligence team analyzes the collected information to identify potential risks, opportunities, and value drivers appended with the proposed transactions.

4. Due-Diligence Report: The DD report is based on findings and documents received from the requested company for merger and acquisition transactions. The DD report has some prominent sections such as Corporate information, Intellectual Property, Material Contracts, and Legal & Regulatory.

5. Requisition list: This is the list of particular documents and information that the acquirer requested from the company. It is a subset of the checklist and includes only those items that are deemed essential for the acquirer to make an informed decision of the proposed transaction.

6. Closure: It is the final step of the due-diligence process. When the due-diligence process is complete and negotiations are finalised, the acquirer and a target company sign a definitive agreement and the transaction is closed i.e. completion of acquisition process.

With the view of Merger and Acquisition transactions there are some comprehensive sources available for conducting due-diligence. The information and documents are easily available without approaching the requested company. For procuring information on the requested company, it is required to access online websites such as the MCA(Ministry of Corporate Affairs) portal, DPIIT(Department for Promotion of Industry and Internal Trade) portal, and NSE and BSE portals.

1. How do I access the MCA portal?

Type this website (https://www.mca.gov.in/content/mca/global/en/home.html), and you will be redirected to the MCA portal. Then click on MCA Services and you will get to see Document Related Service. Here you will get some details of the company by searching their names, CIN/FCRN, Registration Number and Country of Origin.

2. How do I access the NSE portal?

Type this website (https://www.nseindia.com) you will be redirected to the NSE portal. Here you will get to see some information about the company by searching their names.

Efforts of due-diligence bring significant queries to be addressed in Merger and Acquisition transactions. These are:

1. An overview of both the parties is in consideration for the Merger and Acquisition transaction.

2. Investigations of financial projections of the company such as audited statements, increase or decrease of margins, requirement of working capital, revenue recognition, capital expenditures, etc.

3. Intellectual property of the company is to be ascertained such as patent, copyright, trade secret, trademarks, etc.

4. Insights of the corporate structure of the company such as compensation for officers, directors and employees. It requires you to check the history of the CEO and CFO of the company.

5. Legal issues of the company, such as pending and settled litigation and their terms of settlement, claims, any government actions or proceedings, etc.

6. All the documents and corporate records of the company are to be reviewed such as charter documents, directors, officers, current shareholders and their voting deeds, compliance of issued securities with applicable laws and regulations acted upon.

7. Significant capability of the company is to be reviewed such as prominent subcontractors, monthly manufacturing, largest suppliers, etc.

No law says that due-diligence is a mandatory aspect of Merger and Acquisition transactions for the corporate restructuring process. It is not binding upon the companies to conduct due-diligence before investing into a company. It is for the satisfaction of the target company to do comprehensive research, investigation, analysis, inspection or examination before entering into the merger and acquisition transaction with another company. But due diligence is a legal process to scrutinise all the niceties of another company by signing a Non-Disclosure Agreement between the parties that the disclosing party’s confidential information remains safe. For this Non-Disclosure Agreement, both parties must maintain confidentiality and it gives the right to the disclosing party to sue at the time of infringement. There are no specific laws or enactments for governing and prosecuting legal due diligence. The Companies Act 2013 talks about due-diligence procedures of the companies involving merger and acquisition transactions.

1. The Companies Act, 2013 and SEBI have certain provisions in case of merger and acquisition transactions. It shall be the prior duty of the director to prioritise the needs and goals of the company. The US Supreme Court held the director in a case of Smith v. Van Gorkom, (2) legally liable to the stakeholders for assuring premium of 39-62% for the proposal of merger which exceeds market price limit. The court opined that the director should be cautious while conducting Board meetings for a prominent corporate transaction, i.e., the sale of the company.

2. It could be the worst scenario if the acquirer relies upon the target company by sending detailed information of the management at the time of the due-diligence process. In the case of Nirma Industries and Anr -Vs- SEBI, (3) it was held that to tackle potential risks and liabilities by way of due-diligence process, Nirma Industries was cognizant of abundant legal proceedings that can be initiated against the target company. It is under Regulation 27(d) of SEBI, 1997, that the Supreme Court of India opined that Nirma Industries should have taken caution for proper conduct of due-diligence before investing into target companies.

Challenges of due-diligence is not a new matter in the corporate restructuring process. It is a time consuming process for a company to conduct due-diligence thoroughly. It is not an easy task to perform, each and every niceties have to be checked properly with utmost care and caution before investing into a company.

1. When it comes to protection of confidential information and secret data of the requesting company with the help of an agreement, it becomes very hard to identify the risk associated because it restricts the disclosure of such information and data.

2. Unauthorised access of Intellectual Property may lead to dispute arising unliquidated damages. Hence the management is not permitted to share such sensitive information and data. It creates hurdles for the investor company to conduct due-diligence properly.

3. To conduct due-diligence requires separate experts for the different tasks to perform cautiously. For this the investor company has to spend lots of monies for Merger and Acquisition transactions.

4. Accurately assessing risks and potential liabilities which might occur shortly is a difficult task for the experts to perform effectively. Hence, the suggestion to invest shall be precarious for the investor company.

5. Sometimes, the wrong information is intentionally sent to the investor company, and it makes things very challenging to evaluate the information accurately.

Corporate restructuring transactions are influenced by the aspects of stringent due-diligence process. In every Merger and Acquisition transaction, there is a need for a proper due-diligence process. Due-diligence is a comprehensive process for investigation, analysis and examination of all the relevant information and documents. Due-Diligence has developed emerging technology to deal with cross-border transactions. For the growth and expansion of a business, mergers and acquisitions have a specific role for different kinds of transactions. Through a Merger and Acquisition transaction, the investor company can amplify territorial reach, which helps to attract more customers within a short period. The fundamental intent to conduct due-diligence is to identify the risks and opportunities associated with the transaction. Due diligence is not always successful in the corporate restructuring process due to inadequate information and data. It is always a challenging, costly and time-consuming task for every investor. Sometimes, due-diligence ends up paying a higher cost to the merging company.

1. References:

2. Types of Mergers & Acquisitions, Ansarada (2024), https://www.ansarada.com/mergers-acquisitions/types.

3. Sanya Suman, Due Diligence in M&A: Importance and Implications, LiveLaw (2024), https://www.livelaw.in/lawschool/articles/due-diligence-in-ma-importance-and-implications-252306.

4. Sanya Suman, Due Diligence in M&A: Importance and Implications [Nirma Indus. & Anr. v. SEBI], LiveLaw (2024), https://www.livelaw.in/lawschool/articles/due-diligence-in-ma-importance-and-implications-252306.

5. Shubhanker Jhingta, Due Diligence in M&A Transactions [Smith v. Van Gorkom], iPleaders Blog (2016), https://blog.ipleaders.in/due-diligence-ma-transactions/#Challenges_associated_with_conducting_due_diligence_in_india.