Legal Due Diligence: An Overview

Legal Due Diligence is carried out to gain a legal perspective on the target company and check that acquiring such a company does not land the acquirer in legal trouble. It involves a broad spectrum of investigative procedures in furtherance of the acquisition of the target company’s assets or shares, a JV project, a major financial transaction or other general pre-contractual enquiries. 

Legal Due Diligence is usually carried out by lawyers. The target company supplies the lawyers with the relevant legal documents and information requested by the buyer. The lawyers check whether or not there are any legal problems based on the documents supplied to them. The lawyers usually demand documents related to the key contracts entered into by the company, a list of patents and other intellectual property documents, employment agreements, insurance coverage, real assets held by the company, and pending lawsuits against and initiated by the target company.

Legal Due Diligence becomes extremely important in cross-border transactions, which require specialised expertise in the foreign jurisdiction’s legal framework and specific rules and regulations regarding such transactions. Additionally, familiarity with the labour laws, differences in the taxation structure, land ownership laws etc., becomes crucial. This makes it extremely important for the acquiring companies to seek professional help from professional consultants to carry out cross-border transactions. These professional consultant companies collaborate with local professionals in order to gain a better understanding of the local business environment and the legal framework. These local professionals allow the acquirers to gain an understanding of the political, cultural and economic aspects related to the business deal.

After reviewing the legal documents supplied by the target company, the lawyers, along with the consultants, prepare the legal due diligence report for the acquirer. The report is a summary of the information reviewed from the documents supplied and also mentions the documents sought by the lawyers, which the target company failed to supply them. The report also mentions about the detection of the false documents provided.

The role of the lawyers and consultants does not end here; it extends till the closing of the deal, where the lawyers draft the terms and conditions of the agreements. 

What is Legal Due Diligence?  

Legal Due Diligence is the process of scrutinising the legal affairs of the target company in order to protect the buyer/investor from incurring legal risks which may arise after the acquisition of the target company. Legal Due Diligence revolves around going through the legal documents of the company to find legal risks related to the legal status, ownership structure and agreements, legal commitments, intellectual property etc. of the company. Legal Due Diligence provides the buyer with relevant information about any unsecured legal risks related to the acquisition of the target company thereby increasing his bargaining power at the negotiation table.

How is the exercise of Legal Due Diligence undertaken?

The lawyers and consultants use the following means to undertake an exercise of legal due diligence:

1. Questionnaire: One way of going about Legal Due Diligence is to prepare a questionnaire to be filled out by the target company to check the general and financial health of the company along with the risks involved in the company’s business side of things.
2. Representations and Warranties: The other way is to check the representations and warranties that a seller can be asked to make in the contract.
3. Review of financial analysis: Another way of conducting legal due diligence is to review the financial analysis of the seller’s business and juxtapose it with the analysis of the legal risks that are associated with the proposed acquisition.

Steps involved in conducting Legal Due Diligence

Generally, a legal due diligence exercise can be conducted in two ways. In the first way, the target company furnishes the information sought by the lawyers from the buyer’s end which is stored in a data room. Here, the interested parties submit a mammoth amount of data for the layers and professionals to conduct due diligence. In this process, the bidders are ensured fair treatment. This process is generally applicable to the disinvestments made by central and state government companies.

In the other method, a questionnaire is shared by the buyer with the target company and on the basis of their responses, one-to-one negotiations take place between the companies.

Components of LegalDue Diligence Report

Every report prepared as a result of performing a Legal Due Diligence exercise should contain the following components reflecting the lawyers’ and consultant’s opinions about various legal aspects of the target company’s business:

• Legal identity of the company;
• Corporate capacity of the company;
• Information on the target company’s directors and their conflict of interests, if any;
• Preparation of Accounts of the company;
• Compliance with the applicable company laws and regulations;
• Appointment and functioning of the personnel of the company;
• Compliance with applicable labour laws such as the Payment of Wages Act, 1936, the Industrial Disputes Act 1940, the Payment of Gratuity Act 1972, the Payment of Bonus Act 1965, the Employees State Insurance Act 1948, the Employees Provident Funds and Miscellaneous Provisions Act of 1952, Shops and Establishments Act along with any judgement, industrial settlement in a labour dispute or litigation; retrenchments, recognised trade unions, lay-offs and VRS, share options, incentives, profit sharing and incentive schemes for employees, retirement, pension, superannuation, provident fund and gratuity schemes;
• Share capital of the company;
• Shareholders of the company;
• Permits, licenses and regulatory approvals from specific authorities with the company;
• Right over Intellectual property held by the company including the patents, copyrights, trademarks, industrial designs and all the other forms of registered and unregistered intellectual property rights owned by the target company and also the rights that have either been licensed, sold or bought by the company;
• Both the movable and immovable property owned by the company;
• Imports and exports made by the company along with its relevant documentation;
• Taxation issues that the company is embroiled in;
• Litigation including all the judicial, quasi-judicial, arbitral and administrative proceedings that the target is involved in;
• Insurance coverage of the company;
• Environmental issues such as compliance with the local laws, social issues etc.; and
• Contractual liabilities and commitments.

This list provides a number of factors that lawyers, undertaking a legal due diligence exercise, need to take into account right from the incorporation of the target company to its labour issues, from its ownership structure to environmental and taxation issues.

Checklist for Legal Due Diligence  

1. Contracts

The legal due diligence report should be made on the basis of service contracts, vendor contracts, customer contracts and associated obligations, purchase contracts, operating contracts, employee contracts and termination letters, contracts that are terminable upon change of control or other corporate events, JV/partnership/franchise agreements and other contracts that form part of the ordinary course of business.

2. Intellectual Property

This section is one of the most crucial sections of legal due diligence and the lawyers go through all the IPs, such as trademarks, patents, copyrights, service marks etc., that are held or applied by the target company, employees, shareholders, directors or any other affiliate of the target company. A list of the creators for each of these IPs is prepared and a summary of the material trade secrets held by the company. 

3. HR Operations

In the HR operations, copies of the current employment applications, hiring procedures, history of cases of sexual harassment in the company, POSH compliances, a summary of disciplinary and termination proceedings and involuntary terminations in the past 5 years. History of all the labour-related disputes, grievance proceedings, arbitrations, the payroll structure of the company, and compliance with the applicable labour laws is taken into consideration.

4. Pending litigation

Generally, a summary is prepared of the pending, closed and current litigations the company has been involved in for the past 5 years. Similarly, a summary of the arbitral proceedings, current and closed administrative proceedings where the target company, its directors and executives have been involved from the past 5 years. A record has to be prepared of the audit inquiries faced by the company. Finally, a list of all the statutory orders, rulings and decrees, to which the target company is subject to, have to be analysed as well. 

5. Ownership structure

Thelawyers take into account the current shareholders and the number of shares held by them, the record of stock transfers, a list of the stock broker contracts and agreements made with them, bottlenecks in transferring of equity and the evidence of the outstanding stock paid in full.

6. Product/Services

The details of the products and services owned and offered by the target company. Whether approvals from the respective regulatory bodies have been obtained or not. Additionally, a summary of all product warranty claims, product recalls and liabilities associated with products or services.

7. Permits and licenses:

The report should also provide an account of all the applicable permits and licenses and other authorisations. This includes a summary of all the licenses, sublicenses, franchise and royalty agreements, permit renewals and copies of auto registrations. 

Benefits of Legal Due Diligence

Having clarity with respect to the legal protection and pitfalls regarding a target company certainly puts the buyer/investor in a better position at the time of negotiating and making a deal with the target company. Some of the benefits accrued to the buyer by undertaking Legal Due Diligence are as follows:

• Preparing better M&A contracts

Legal due diligence provides the buyer with a better understanding of the target company and its legal affairs. Accordingly, the buyer is in a position to decide the fair market value and prepare a strong M&A contract with the target company.

• Make informed decisions about finalising the contract

A lot depends on the legal due diligence report of the target company because it apprises the buyer about the legal issues the company is embroiled in and whether the commercial benefits are sufficient to offset the legal risks involved in the acquisition of the company.

There is a misconception that legal due diligence is carried out from the buyer’s end only which is not true. Quite often, it is the seller company that also wants to get legal due diligence performed on its company before the investor initiates the same process from its own end. Following are the benefits for the sellers in undertaking legal due diligence:

• Gives the target company a chance to identify and rectify the deficiencies

The exercise of legal due diligence discloses the true picture of the seller company from the legal perspective. Data reveals that nearly half of the M&A deals do not go through after the due diligence process. If the seller is aware of the legal risks its company is exposed to, then it can very well fill the gaps before the buyer company initiates the legal due diligence exercise.

• Higher value deal

Legal due diligence streamlines the due diligence process and makes it less frustrating for the buyer to go through with the deal. This often, results in securing a high-value deal from the buyer.