Even though Ray Limited has agreed in principle to acquire 30% shares in Whirl Limited and has signed a memorandum of understanding to this effect; it does not have enough information about that company. For instance, it does not know whether and to extent the company is in debt, how its business is doing, and who its main customers are. Obviously, just as you will not buy a car or a home theatre without a thorough investigation of its benefits, Ray Limited will never purchase shares in Whirl Limited without having complete knowledge about that company. Ray Limited will only invest in Whirl Limited once it carries out a thorough investigation of Whirl Limited. Such an investigation, called a ‘due diligence’ process, helps an investor carry out a cost-benefit analysis of whether the investment is beneficial. During this process, an investor investigates the financial, commercial, and litigation-related details and contractual and other information about the target company.
Such investigations can be of different types. They include:
– Commercial due diligence: This consists of a review of the industry, market, and business model of the target company;
– Reputational due diligence: This includes a review of the credit worthiness and reputation of the target company;
Financial due diligence: This includes a review of the tax, financial position, policies, and internal controls of a target company; and
Legal due diligence: This is usually very broad in nature, and consists of a review of all relevant documentation and material contracts. This due diligence process, which is the focus of this post, aims to understand the business and identify potential legal issues that can impede the transaction or affect the transaction value.
As a lawyer carrying out a legal due diligence, the first step is to send to the target company, a questionnaire or list of the documents you require. This list is typically called a requisition list or a due diligence checklist. It helps the other side of the transaction organise documents in the manner you want and ensure that all the documents you require are provided to you. In the absence of such a list, confusion is likely to arise about the nature of documentation required.
This information is provided by the target company in a data room, set up for the purpose of the diligence. Such a data room is either a physical data room or an online data room, which is becoming more prevalent these days. Depending upon the nature of the deal and the extent of confidentiality required for the documents, the target company can grant limited access to the advisors of the acquirers or permit them to examine the records, contracts, and information about the company in person (in a physical data room) or download or edit them (in an online data room).
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You will always have to comply with the directions of the target company in relation to handling sensitive information. For instance, you may be asked to not make copies of any documents. You will have to strictly comply with that direction.
While carrying out this investigation, bear in the mind the following:
1. Remember, what you are doing can make or break a deal.
You are the one who has access to all the company’s records and therefore, you have a responsibility to provide a complete and true picture of the company you are investigating. Your client will depend on your report to make a final decision. Never cut corners while investigating. Ensure that all the information is made available to you. If you face a problem accessing any information about the target company (which you feel is vital), let your client know that your investigation will be incomplete unless the information is provided to you.
2. Never assume any fact.
Always ask for documents or written evidence to confirm any statement made by the company. For instance, if a company says it has paid off a loan of Rupees 10 crore in the last two months, ask for written evidence (such as a letter or undertaking from the bank) stating that the loan has in fact ben repaid. If you don’t get what you have asked for in the beginning – ask again.
3. Never forget the nature of the transaction.
The type of documents you will ask for depends on the type of transaction. For instance, if you are only going to buy a specific part of the business, ask only for the documents relevant to that part. If you are acquiring the whole company – you need documents pertaining to the whole company.
4. Always be polite and courteous to those who are providing you the documents.
Remember, the documents will often be provided to you by employees or company secretaries who have little or no background to the deal and may not know the reason why the document may be important to your investigation. Patience is key to a successful due diligence investigation.
5. Where you can, make copies of documents.
Always keep copies of all documents you have looked at (if you are permitted to photocopy documents). If not, make detailed notes of every document. This will be helpful while preparing the report as you can look at your notes to refresh your memory. Remember, once the target company has provided some information, it is unlikely to provide it again. So, your notes will form the basis of the report and your conclusions regarding the deal.
6. Be efficient.
Almost all due diligence investigations are carried out within a limited time period. Parties are eager to close the deal and there is immense pressure on lawyers to carry out a diligence efficiently and effectively. While actions such as sending a requisition list will help save time, never hurry up the investigation and ignore documents just to complete the process on time. If necessary, ask your client for more time after providing a detailed explanation about why you need more time.
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After this process is complete, as a lawyer you will be asked to prepare a due diligence report setting out details about the investigation and your conclusion about the legal issues in the deal. I will discuss the important points to keep in mind while drafting the due diligence report in my next blog.
(Deepa Mookerjee is part of the faculty on myLaw.net.)