Legal Due Diligence – The Vital First Step in Mergers and Acquisitions

What happens when you do not perform proper due diligence during Mergers and Acquisitions (M&A)?

• HP lost $US 5 billion in 2012 when they did not perform adequate financial due diligence before acquiring Autonomy!
• Quaker lost $US 1.4 billion in 1994 when they did not conduct proper intellectual property due diligence before acquiring Snapple!
• BMW lost GBP 790 million in 1994 when they did not perform adequate financial due diligence before acquiring Rover!
• AOL lost $US 99 million USD in 2004 due to their hurried legal due diligence while acquiring TimeWarner!

Introduction

The cases above are a small selection of losses suffered by very large companies due to the sole reason of not doing proper due diligence before the merger or acquisition of the target company. Several other small and medium companies continue to suffer losses every day just because they didn't make the effort to do proper due diligence on the company they acquired.

As legal consultants, our focus has always been to properly guide our clients through the merger and acquisition process. For this, the first step we take is to do proper due diligence on the target company. Many times, after doing preliminary due diligence on the target company, we have been able to advise the client not to proceed with the merger or acquisition for the sole reason that the company they wish to acquire is a sham or shell company.

On another occasion, we went through the entire due diligence process of the target company and informed the client that the IP of the company is owned by the founders in their personal capacity and not by the company. So, acquiring the target company would not give the client any advantage of having the goodwill of the target company. Again, the client decided to cancel the transaction and not proceed with it.

There are several other instances where proper due diligence has saved the client from huge probable losses. In other cases, we could flag and list all the issues existing in the target company and ask the target company to first resolve the existing issues before proceeding with the transaction.

Types of due diligence

There are several types of due diligence, which include:

1. Legal Due Diligence
2. Financial Due Diligence
3. Tax Due Diligence
4. Operational Due Diligence
5. Intellectual Property Due Diligence
6. Commercial Due Diligence
7. Information Technology Due Diligence
8. HR due diligence
9. Regulatory Due Diligence
10. Environmental Due Diligence
11. Confirmatory Due Diligence
12. Specialised Due Diligence

The role of legal due diligence in M&A transactions

Legal due diligence usually includes anything that is more or less legal, including understanding the Corporate Structure, analysing Regulatory compliance, reviewing contracts, ownership of IPs, Litigation or legal claims, if any.

Key elements of legal due diligence

1. Corporate Structure, Secretarial Compliance, and Governance

An essential part of due diligence is evaluating the target company's organisational setup, ownership, and governance. This includes a comprehensive review of the company's charter documents (such as the Memorandum and Articles of Association) and those of its subsidiaries. Additionally, it involves examining the current list of officers and directors, shareholders' agreements, board and shareholder meeting minutes, and filings with the Registrar of Companies.

2. Regulatory Compliance

Ensuring adherence to relevant laws and regulations is critical, especially in strict regulatory environments like the UAE, where non-compliance can lead to severe penalties. Due diligence involves reviewing licenses, permits, registrations, and regulatory filings to identify any compliance gaps or potential liabilities, particularly those vital to business operations. This is especially important for foreign direct investment scenarios, as non-compliance could result in fines, legal issues, or reputational damage, potentially impeding deal closures or restricting business operations.

3. Contractual Analysis

A thorough examination of the target company's contracts and agreements is essential. This includes analysing agreements with suppliers, customers, employees, leases, licenses, shareholder agreements, partnership agreements, and other governance documents. Understanding the terms and obligations of these contracts helps avoid unexpected issues after acquisition. Legal due diligence aims to uncover any unfavorable terms, termination clauses, change-of-control provisions, or other contingencies that could impact the company's value.

4. Intellectual Property Rights

Intellectual Property (IP) assets such as patents, trademarks, copyrights, and trade secrets are crucial to a company's value. Legal due diligence is necessary to verify the ownership, validity, and enforceability of these IP assets. It also involves assessing potential infringement risks, reviewing licensing and confidentiality agreements, and identifying any ongoing legal disputes related to IP.

5. Employment and Labour

Compliance with employment and UAE labour laws is crucial for effective business operations. Legal due diligence helps identify any compliance issues that, if ignored, could lead to significant civil or criminal consequences.

6. Litigation and Legal Claims

Reviewing existing legal disputes, past conflicts, and potential legal challenges is vital for assessing risks and liabilities. This includes examining court documents, settlement agreements, and any ongoing or anticipated legal proceedings. Understanding the nature and potential impact of these disputes is essential for making informed decisions and implementing appropriate risk mitigation strategies.

Phases Involved in Legal Due Diligence

1. Industry Research: Gather data on the target company's industry, considering its specific regulations, licenses, and approvals.
2. Questionnaire and Document Requests: Develop a questionnaire or checklist outlining the necessary documents and information for due diligence. Present these to the target company's representatives and review the materials in the data room, including legal documents, contracts, corporate records, and regulatory filings, to identify potential issues and understand the company's operations.
3. Information Analysis: Once the documents and information are collected, the due diligence team reviews and organises the details into separate annexures, which are then included in the main Due Diligence Report.
4. Management Meetings: Meet with key personnel from the target company to clarify legal questions, obtain additional information, request more documents, and uncover any hidden issues.
5. Due Diligence Report Preparation: After a thorough analysis, compile a comprehensive report that categorises issues and risks and provides recommendations for addressing and mitigating these risks.

Conclusion

Legal due diligence is essential for navigating M&A transactions. Its careful analysis, detailed assessment, and strategic recommendations are vital for making informed decisions, protecting investments, and ensuring a smooth transaction process.