THE IMPORTANCE OF  LEGAL DUE  

DILIGENCE IN M&A  TRANSACTIONS 

We pay great attention while carrying out the Merger and  Acquisition process and conducting its legal due diligence report  due to its importance and for its great effect on the business. 

 What are Mergers and Acquisitions? “Legal due  diligence is the  process of  

collecting,  understanding and  assessing all the  legal risks  associated during  a M&A process.  During due  diligence, the  acquirer reviews  all the documents  pertaining to a  target company  and interviews  people associated  with it. The idea  behind this  investigation is to  understand if there  will be any future  legal problems due  to this acquisition  or not.”

What are Mergers and Acquisitions? 

Mergers and Acquisitions (M&A) refer to the process of consolidating companies  or their assets. The terms merger and acquisition are often used interchangeably, but  have different meanings. 

A merger occurs when two companies agree to consolidate into a new entity. For  instance, Company A and Company B agree to come together to create a new entity,  Company C. 

An acquisition is a process whereby an existing company purchases and assumes  ownership over another firm or asset. For instance, Company A acquires Company  B and the two companies continue to operate as an existing entity, Company A. 

Why is the due diligence to be conducted? 

When purchasing pre existing assets, it’s the seller who holds much of the  information. Without a thorough information-seeking process, the acquirer could get  caught up in obligations it’s not yet ready to assume, such as litigation issues and  complicated tax matters… 

Before the acquirer enters into a contractual commitment to buy any assets and/or  shares of a target company, the acquirer needs to have an insight into what it is  planning to buy and what actual, potential and contingent liabilities it is assuming.  Reasonable verifications and precautions should be taken to identify target 

company’s legal, commercial and financial status, the target company’s obligations,  the effect of a change in ownership of the company on its substantial contracts,  litigations, potential risks, assets and intellectual property issues, relations with  customers and stakeholders. The process by which detailed information about the  target is obtained and assessed is called due diligence. 

Due diligence is an essential activity in mergers and acquisitions transactions and it  is mainly of three types; legal, financial and commercial. Therefore, the investigation  of the target may be conducted by different professional advisers, including business  advisers, accountants and lawyers. 

Financial due diligence is the process of determining whether the transaction creates  financial value for the acquirer, whereas, the commercial due diligence determines  the target’s current and projected performance and whether the business plan stands  up to the realities and competitiveness of the market.

The importance of legal due diligence 

Legal due diligence is the process of collecting, understanding and assessing all the  legal risks associated during a M&A process. During due diligence, the acquirer  reviews all the documents pertaining to a target company and interviews people  associated with it. The idea behind this investigation is to understand if there will be  any future legal problems due to this acquisition or not. 

We pay great attention while carrying out the Merger and Acquisition process and  conducting its legal due diligence report due to its importance and for its great effect  on the business; as, 

Firstly, it gives the acquirer a better opportunity to understand the target company  and its operations before purchase. Moreover, it acts as an icebreaker between the  legal counsel of both organizations so that they can work together to push the deal  through. 

Secondly, the buyer can use the information obtained through legal due diligence to  determine the right amount to pay for the transaction. It also gives a chance for the  buyer to closely analyze the financial, structural and operational aspects of the  business so that subtle things such as lawsuits against the company, employee and  labor arrangements, indemnification processes and intellectual property details can  be ascertained. 

Thirdly, the information obtained during the legal due diligence process can help  both the buyer and the target company to draft appropriate merger and acquisition  documents and other ancillary documents as may be needed. It also plays a role in  negotiating the right value for both parties, based on the legal obligations of the target  company; 

Lastly, the legal due diligence process will help to identify the possible problems  that can act as impediments to closing the deal. When both parties know the possible  impediments, they can take steps to address the same to ensure the smooth  completion of the agreement.

Conducting legal due diligence 

This article will shed light on the legal due diligence, its objectives and a sample  checklist. 

Legal due diligence is the process of collecting, understanding and assessing all the  legal risks associated during a M&A process. During due diligence, the acquirer  reviews all the documents pertaining to a target company and interviews people  associated with it. The idea behind this investigation is to understand if there will be  any future legal problems due to this acquisition or not. 

Legal due diligence is intended to be carried out to evaluate any legal issues that may  affect the value of the target company. Such an exercise is also required to identify  any prerequisites and conditions that must be fulfilled to achieve successful  completion of the transaction, or consents and approvals that may be required to duly  transfer ownership of the shares or assets of the target business. It is also vital for the  determination of the method of payment, negotiating the needed securities and  highlighting the main areas of risk and how such risks may be mitigated by agreeing  on proper risk allocation mechanisms including adequate representations, warranties  and indemnities. 

The legal due diligence process starts with the acquirer’s due diligence checklist and  request for the disclosure documents of the seller subject to confidentiality  restrictions. The scope of the investigation varies according to the type of the  proposed acquisition as it will usually be more extensive on the acquisition of the  entire share capital of a company than on an asset acquisition. 

Depending on the type of the proposed acquisition, a legal due diligence generally  covers an investigation of the following areas: 

Constitutive records 

First of all, the acquirer should know the incorporation framework of the target  company. Therefore, the acquirer’s lawyers should study among other things the  articles and memorandum of association of the target company, all general assembly 

Conducting legal due diligence 

and board of directors’ meetings, names of authority signatories and the authority  and capacity of each, shareholders register and list of all current shareholders  showing amounts of shares by percentage owned by each, all shareholders’  agreements, voting trusts, proxies and registration rights agreements. 

Management and Employment 

The acquirer’s lawyers will need to obtain full details of the target’s workforce, and  in particular the contractual terms that apply to its management team. The terms of  employment should be checked in addition to all severance agreements, pension and  profit sharing plans in which employees participate, including any such plans which  have been previously terminated but the assets of which have not been completely  distributed to plan participants, all incentive and non-incentive stock option plans  adopted for the benefit of employees, all welfare benefits plans (e.g., medical, dental,  life insurance, accidental death and dismemberment) which were adopted for the  benefit of employees, all governmental filings relating to the documents described  above including related to employees’ handbook or bylaws. 

Litigation 

Copies of all lawyers’ audit responses and summaries of all presently pending or  threatened claims, actions, suits, injunctions, legal proceedings, arbitrations,  amicable settlements, or any other legal or administrative proceedings by or against  the target company, including, without limitation, employment or labour claims (e.g.,  grievances, administrative charges, wage and hour claims, workplace safety matters,  civil litigation, unfair dismissal, unfair competition and workers’ compensation)  should be carefully examined. 

Tangible and Intangible Asset 

A target company should provide the acquirer a list of all tangible assets which are  owned by the seller; such as real properties also rented or leased properties including  all the relevant information and contracts regarding the assets, all the documentation  regarding intangible assets; for instance, patents, trademarks, copyrights, trade  names, franchises, licenses, and other intangibles.

Conducting legal due diligence 

The acquirer needs to ensure that the assets of the target company have the value as  stated, no restrictions are being imposed on the rights of the target company on these  assets and there are no risks that may depreciate the value of the assets. 

For instance, on an asset acquisition, the acquirer needs to verify whether the consent  of the landlord will be required for the assignment of any leasehold premises included  in the sale. 

Licenses and Permits 

It is important to check on all licenses, permits or certificates issued to the target  company by governmental authorities, which a particular target business should  have. These will need to be checked to make sure that they are still valid and they  cover all the operations of the business and whether the change of control in case of  a share acquisition shall not affect the validity thereof. 

Key contracts 

The significant contracts into which the target has entered should be examined in  order to (i) verify the obligations and the rights of the target company that will flow  down to the acquirer and that there are no non-arm’s length trading relationships; (ii)  investigate the chances to renew the contracts that are due to expire; (iii) figure out  the effect of change of control on such contracts and the requirements that need to be  satisfied to avoid any potential termination; and (v) investigate the assignment or  novation of contracts on an asset acquisition. 

Loans 

On an asset acquisition, the acquirer will need to enquire whether any of the assets  which are being transferred are the subject of a charge to decide whether any such  charge will have to be removed on completion, or the consent of the charge needs to  be obtained for the asset to be transferred. 

On a share acquisition, the acquirer should request copies of all loan or lien  documents, including notes, trust deeds and mortgages, security and finance 

Conducting legal due diligence 

agreements and financing statements in order to discern the nature and extent of the  target’s borrowing commitments and obligations.