Due Diligence Process in Mergers and Acquisitions
The words “due diligence” are surely familiar to anyone who may be keen to undertake a sale or purchase of a company. The process of due diligence is an extensive investigation process that provides a purchaser or investor with an opportunity to obtain as much information as possible about the business of a company he wishes to acquire. By undertaking due diligence, the purchaser or investor will be made aware of potential risks that he can take measures to mitigate. These measures may include a reduction of price or the incorporation of contractual provisions to account for the risks.
There are three different kinds of due diligence, namely: legal, business and financial. The focus of this article will be on legal. Legal due diligence checks and analyses the company’s legal compliance with statutes and regulations, as well as the effect of provisions of material contracts on the proposed transaction. It is important to consider that legal due diligence does not stand alone – it is complementary to business and financial due diligence.
It is also important to note that slightly different processes may be used for due diligence in relation to a “private treaty” between buyer and seller where the seller has an agreement with only one potential buyer as compared to an “auction process” where there are multiple potential buyers. The difference is also related to the size of the transaction, with larger acquisitions usually requiring more extensive checks or processes. These processes are largely similar to those for a merger as well.
Stage 1: Acquisition of data/Managing a data room
The process of acquiring data is usually the first step in any due diligence process. Typically, the lawyer working with the buyer will come up with a questionnaire or checklist. Every document that needs to be looked at will be listed in this due diligence checklist, and irrelevant documents like small contracts that do not have any bearing on the transaction price or risks will be excluded. A proper due diligence checklist will also set out the areas of investigation and a list of questions and enquiries to be put to the seller. The criteria by which a contract is considered material will also be indicated.
Setting up a data room
In response to such a checklist, the relevant documents and information will be provided for inspection. For smaller transactions, this is typically done by way of the legal advisors or lawyers from the buyer’s side visiting the seller’s premises to undertake a manual inspection of the documents. If the sale or purchase involves a larger sum or an auction process, a data room is usually set up. Such a room would usually be a private repository of documents and information which might be of interest to potential buyers. This room would be set up and maintained by the seller. The seller’s or issuer’s advisors or counsel will typically be requested to help establish the data room and provide guidance on the relevant information to be included and rules governing its access. The data should also be well-indexed.
Handling information in the data room
The information that will be included in a data room must be relevant to the specific merger or acquisition being undertaken. Each item of data should be approved for release by seller’s counsel/in-house manager or in the case of an IPO, by an appropriate officer, in-house counsel or issuer’s counsel. Such caution is usually taken to ensure that information provided does not allow competitors to “fish” for information and compromise the interests of the company. Crucially, parties to an anticipated merger should exercise caution when exchanging commercially sensitive information. The exchange of such information, if done wrongly, may infringe Section 34 of the Competition Act (against anti-competitive agreements) where it has the object or effect of restricting competition within Singapore.
Given the advent of technology, the data room can also be constructed virtually. A virtual data room can limit access to only certain parties. It also allows for quick and efficient access and retrieval from anywhere and negates the need for physical supervision.
Stage 2: Preparation of due diligence report
There are primarily two types of due diligence reports, a long-form report or an exceptions-only report. The current trend is towards an exceptions-only report, as it takes lesser time and costs. A long-form report describes the business in detail and summarises each and every document reviewed while an exceptions-only report is increasingly common in Singapore and covers only material issues.
What should a due diligence report contain?
A due diligence report should cover particular concerns raised by either seller or buyer. In addition, typical areas of risk and liability in the relevant industry should be highlighted. The budget and role of other non-legal advisors should also be elaborated upon if relevant.
General issues that can be raised in a due diligence include employment, shareholders’ and joint venture agreements, litigation, licenses and permits, land and buildings, finance issues, corporate secretarial matters and the impact of material contracts like leases and supply agreements.
Employment can relate to matters such as employment retention, benefits, restrictive covenants and compliance with the Employment Act.
2. Shareholders’ and joint venture agreements
Shareholders’ and joint venture agreements will also be looked into, with board representation, share structure and ownership, restrictions on share transfers and financing obligations of particular relevance.
Litigation relates to any claims pending or in progress and whether they are covered by insurance. Even threats of future litigation will be considered.
4. Licenses and Permits
Licenses and permits will be checked for their compliance with business operations, asset compliance, environmental issues and health safety issues.
5. Land and Buildings
With regard to land and buildings, there is a need to check title, planning, contractual relationships and contingent liabilities. It is also crucial for the lawyer acting for the buyer to conduct legal requisitions
Finance relates to any repayment provisions and outstanding indemnities.
7. Corporate Secretarial Matters
As for corporate secretarial documents to review, they include constitutional documents, minutes of meetings and registers. A review of these documents should look into matters like encumbrances over shares and minority shareholder protections.
8. Impact of Material Contracts
Finally, with regard to material contracts, the matters to be checked include onerous and unusual terms, warranties, indemnities and guarantees and the requisite term and termination for these contracts.
The list above is not comprehensive and there may be other issues that may arise in a due diligence. It is always preferable to obtain legal advice throughout this complicated process.
For an IPO sale or purchase, an additional disclosure letter needs to be issued by the counsel for the person issuing shares. This letter should state that disclosure requirements under the Securities and Futures Act and subsidiary legislation have been met.
Post due diligence actions
If the report reflects negative findings, the parties can take necessary measures to account for these findings. For instance, the price may be adjusted or concessions are made in specific areas to account for certain risks. In extreme cases, the entire merger or acquisition may even be cancelled.