By Milind Kumar Charu Mathur, Advocates
Due Diligence can be widely defined as a broad spectrum of investigative procedures in relation to an acquisition of a company's shares or of assets in a commercial context, a joint venture project, a financing transaction, the issue of securities and other general pre-contractual inquiries.
What do we mean by Due Diligence?
Due Diligence has become a sophisticated and intricate process requiring very special skills on which the most delicate business decisions are founded. As defined above due diligence require a whole lot of investigation into affairs and health of a company. In India there is as such no law or case law on due diligence. Jurisprudence of Due Diligence is closely associated with concept of Notice. A notice can be actual, constructive or imputed.
Section 3 of the Transfer of Property Act1 provides that "a person is said to have notice" of a fact when they actually know that fact, or when, but for willful abstention from an inquiry or search they ought to have made, or gross negligence, they would have known it.
Thus the statute casts a duty to find whether the fact presented is true or not and it presumes that every prudent man before making investment in any form of property will find whether a clear title to such property exists, or whether any debt or litigation is attached to it or whether it is in any form going to prove not to be a wise decision.
Now in case of big companies and multinational corporations when one company buys or sell any company or its assets the whole canvass is very big; lot of people, lot of documents, lot of money is involved and it is here that need for due diligence arises.
Due Diligence is now finding deserved place in Indian Statues. Mandatory provisions have been introduced for the conduct of due diligence under the Securities and Exchange Board of India (Mutual Funds) Regulations 1996 and offshore offerings of securities by Indian companies through American or global depository receipts (ADRs/GDRs).
Due Diligence is duty to take care. Many Indian statutes dealing with economic matters like S. 24 SCRA, 1956, s.53 MRTP, 1969, S.27 SEBI 1992, S.278B IT Act, 1961 contain a standard section on offenses committed by companies.
These section has the following proviso:
"Provided that nothing contained in this sub-section shall render any such person liable to punishment if he proves that the contravention took place without his knowledge or that he exercised all due diligence to prevent such contravention."
Due diligence implies a particular standard of care. In the Indian context, ordinarily there is neither a positive statutory duty on the part of the buyer to exercise due diligence nor a criminal liability for a failure to exercise due diligence.
Significance of due diligence
Due diligence is the process of obtaining sufficient reliable information about the business entity to help to uncover any fact, circumstances or set of conditions that would have a reasonable likelihood of influencing a business decision or the valuable making of an offer, of a consideration and of a price to complete the transaction.
To exemplify how due diligence saved the world from big frauds and stripping share-holders of their moneys, companies from their assets was evidenced in 1997 in Indonesia. This was the biggest fraud in the history of mining. A small Canadian exploration firm, Bre-X Minerals Ltd., announced that it had made one of the world's largest gold discoveries in a remote part of Indonesia2.
In August 1993 Bre-X began to explore in Kalimantan (Borneo), and it soon reported significant drilling results at Busang. Assays of the drill samples indicated consistent gold mineralization, extending from the surface to a depth of hundreds of metres, and estimates of the size of the resource steadily grew. By early 1997 it appeared that the deposit could contain some 3-4% of the world's reserves.
By then the value of Bre-X shares had soared from a few cents to give the company a market capitalization higher than that of several major mining companies. Its apparent success contributed to a boom in exploration worldwide, and Indonesia witnessed a gold rush of unprecedented proportions.
Eventually, Bre-X formed a partnership with Freeport-McMoRan, a U.S. company and operator in the Indonesian province of Irian Jaya of the world's largest copper-gold mine.
Before making a firm commitment, Freeport insisted on carrying out due diligence and sank some exploratory drill holes to obtain independent data. The results shook the mining industry; Busang contained no significant gold.
Overnight the Can$6 billion Bre-X stock was rendered worthless.
A preliminary report, commissioned by Bre-Xby Forensic Investigative Associates Inc., concluded that chief geologist de Guzman and a small group of mainly fellow Filipino geologists had salted the drill samples in the field prior to their delivery to the assay laboratories. They substituted mainly gold of alluvial origin purchased from a local gold panner. The salting began in December 1993, after the first two drill holes had revealed no gold and at a time when the company had contemplated ending exploration.
After the scam was uncovered, the Bre-X share price crashed, and disgruntled shareholders (who lost about $3 billion) began taking legal action against the company.
This whole affair was unearthed because Freeport-McMoRan insisted on carrying out due diligence before forming alliance with Bre-X.
This reflects importance of carrying out due diligence before investing in any form in any company anywhere. Carrying out Due diligence has become more significant in Indian context where everyday one or other Scam crops up.
In Today's fiercely competitive economy Mergers and Acquisitions, disinvestments, financing are order of the day. Even now good old principle of "caveat emptor"3 continues to hold paramount significance. This makes it incumbent on any party to exercise suitable precautions before undertaking any venture. Investigations holds paramount in such ventures investigating financial health of a company, its obligations, disclosures and non-disclosed facts and thus trying to minimizing its exposure to many problems and pitfalls that can arise during and after the acquisition.
Due Diligence influence decisions such as whether to make an investment, whether to choose one joint venture partner or another, what disclosure should be included in an offer document for issue of securities whether listed on a stock exchange or otherwise, whether to lend finance to a borrower for a project, whether a party to an agreement is capable of performing its contractual obligations.
In big World of Money where ironically "Knowledge is Power" due diligence ensures that there is no knowledge imbalance. It also ascertains information superiority, the risks in any transaction. One can negotiate those that are open to bargain and to apportion those, which are not, and avoid the disappointment, displeasure and immense loss and abortive cost on the sudden "discovery" of undisclosed risks.
Tools of due diligence
Understanding importance of Due Diligence, the next question comes is how to go about it and what are the tools for performing due diligence. Due the very complex nature of commercial transactions both local and international no single analytical method can be prescribed as such.
One way of going about it is put a questionnaire to target company so as to check about its general and financial health, risks involved in the business of company.
Another way is the representations and warranties that the seller can be asked to make in the commercial contract.
The third method is to review, in an integrated manner, the financial analysis of the seller's business with the analysis of the legal risks that are associated with the transaction.
Procedures regarding due diligence:
There are two ways of conducting due diligence
- Presentation of predetermined data by the seller/target company in a ‘data room’;
- Data provided in response to the acquirer’s questionnaire.
In Data Room method large amount of data is presented to interested parties to study and value it and get due diligence conducted. Here mammoth data is provided. Data room method has been successfully used for disinvestments by the tender route. By this process, the seller is able to maintain ensure that all the bidders are treated fairly and that they are given access uniformly to the same data or information. Hence, uniformly of the information and documents supplied to all bidders is maintained.
Any discrimination in the supply of information or documents could vitiate the bidding process. This applies more to disinvestments by the central or state government or government companies, which can be subjected to judicial review under the provisions of the Constitution of India.
In other method a questionnaire is put to target company and on that basis further one- to-one negotiations are done.
Thereafter a Due diligence report is prepared by lawyers which can be effectively used to negotiate the vexed question of the representations and warranties to be included in the sale and purchase or financing agreement, the disclosures that inevitably qualify (some if not many of them) and the amount, if any, to be set aside in escrow and on what conditions.
Managing the due diligence process
How do we actually go about due diligence? What kinds of people are involved in this procedure what are the parameters? Let us examine each in some detail
- Initial parameters – Management requires a preliminary evaluation of the areas of key importance for the success of the transaction. This can be continuity of the targets, key personnel, suppliers and customers after the acquisition.
- Selecting due diligence teams – The core team for the conduct of the due diligence should consist of:
- management representatives of the acquirer;
- legal counsel;
- valuation adviser;
- chartered accountants (CPA)/merchant bankers;
- technical consultants.
This stage will also involve the coordination plan among the team members, and allocating responsibilities and functions. Usually, all external counsels are required to execute confidentiality agreements before commencement of the assignment.
3. Preparing and executive preliminary investigation - The objective of the preliminary survey is to identify deal-breaking issues upfront before money and other valuable resources are committed to a detailed investigations. Some of the critical issues that may emerge during this exercise are:
- concealment of facts and figures;
- insufficient internal controls;
- non-compliance of or adventurous interpretations of contracts, legal provisions, accounting principles, policies or standards;
- employee retention and core management succession;
- contingent liabilities;
- statutory non-compliance;
- industrial sickness (erosion of net worth); and
- legal proceedings.
4. Detailed due diligence – The success of the investigation to make a well-informed decision would lie in a well-planned, integrated and coordinated detailed enquiry procedures.
5.Certification of completeness of disclosures – The due diligence team should obtain a declaration or certificate from the target company confirming the completeness of the disclosed information and documents, and that no material data has been withheld by the target.
Contents of the due diligence report
The due diligence report ordinarily contains information pertaining to:
- company information;
- corporate capacity;
- directors, their interests and conflicts, if any;
- statutory compliance with the applicable regulations;
- compliance with the Industrial Disputes Act 1947, the Payment of Bonus Act 1965, the Payment of Wages Act 1936, the Payment of Gratuity Act 1972, the Employees Provident Funds and Miscellaneous Provisions Act 1952, the Employees State Insurance Act 1948, and the Local Shops and Establishments Act; as well as with any industrial settlement, award, judgment or order in any labour dispute or litigation; recognized trade unions; retrenchments, lay-off and voluntary retirement schemes; and share options, share incentive, profit sharing or other incentive schemes for employees; pension, retirement, provident fund, superannuation and gratuity schemes;
- share capital;
- licenses, permits, approvals and specific statutory compliance;
- intellectual property rights – identifications of all patents, trade marks, copyrights, industrial designs, all other forms of registered and unregistered intellectual proprietary rights or other form of monopoly or property rights used or owned by the target company and rights granted to third parties;
- industrial property – know-how, trade secrets;
- infringement of third-party rights;
- assets – immovable and movable property;
- exports and imports, compliance with laws;
- litigation – judicial, quasi-judicial, arbitral and other administrative proceedings;
- taxation issues – income tax, customs, excise and sales tax;
- insurance – quality of insurance cover;
- contractual liabilities and commitments; and
- Environment-related issues – compliance with law, social issues, and the rehabilitation of people likely to be ousted by large natural resources projects, e.g. a reservoir for a hydroelectric project.
Thus a due diligence report is a detailed one, elaborating on various aspects of company right from its corporation to its labour problem, its history at share markets, to environmental issues to taxation. It is indeed a grilling task for any lawyer of any stature.
Challenges in conducting due diligence
Like elsewhere due diligence does have hurdles, some of them are:
- insufficiency of basic data; this makes going tough
- road-blocks to obtaining or sharing proprietary information; and
- confidentiality/secrecy covenants may prevent disclosure of material documents.
Some of the minor issues include language barriers, traveling to remote locations, or people who are not enthusiastic about or are unaware of the proposed transactions.
Professional project management of the due diligence process can however overcome these problems.
Benefits of professional due diligence
The benefits of a professional due diligence exercise include:
- accuracy of warranties and representations;
- a ‘big picture’ of the vision of the target company and its future earnings;
- Complete analysis of the target company;
- identification of deal-breaking issues and formulating business solutions to resolve them; and
- smooth transition of the merger.
How to get best result from due diligence exercise
There are certain steps that should be taken to ensure best results:
- clearly define the objective
- make firm and clear strategies;
- form groups of personnel for project management, data management, core due diligence team and support team;
- lay down the terms of reference for each group and formulate procedures for a clear allocation of responsibilities;
- observe an integrated approach for the due diligence process and rely on technical consultants’ expertise wherever necessary;
- use appropriate technology for the collection, analysis, indexing and retrieval of data;
- store the data in electronic form which makes it portable, capable of being transferred to and accessed from remote locations, and providing a single point access to the entire transaction team;
- never hesitate to ask questions or seek clarifications;
- always insist on plant visits – the on-site conditions contain a wealth of information which would be never be available on paper;
- due diligence should be continued until after the transaction is completed; and
- take media reports in stride, do not value them too much nor ignore them.
Due Diligence is order of the day and ensures free play. It helps avoid any pit falls, roadblocks, displeasure in clenching deal successful and nasty surprises later on.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.