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Article by Tejas Sateesha Hinder and Vibhu Pahuja
(Students from National Law Institute University, Bhopal)
Due Diligence: What and why?
An initial comprehensive risk assessment in cases of mergers and acquisitions is imperative for identification of areas of risk and associated issues of corruption, which majorly involves gaining sound knowledge of the activities, transactions and nature of the target business.[1] In addition to this, assessment of this nature after a merger or acquisition is quintessential for improving compliance.
The need
Before the initiation of a merger or an acquisition, due diligence should be utilized as a tool to ascertain the feasibility of revenues, costs and margins arising out of such transactions, which should stand in addition to assessment of the target company’s potential performance (on the basis of progress in the past and the possible shape of market in the future).[2] Further, on closure of such transaction, due diligence should be utilized to put forward obligations on the target company, so as to ensure minimized or nil possibility of corrupt practices. The same can be done through proactive measures, which would help identify the risks in compliance, and mitigate the same through supporting policies such as workforce training, reporting of misconducts, etc.[3] In addition to this, an acquiring company may choose to legitimately appoint or come in terms with a third party, such as business partners, in order to keep a check on the target company, so as to be better prepared for future risks.
Having addressed how due diligence ought to be utilized as a tool before the initiation of a merger or acquisition and after its conclusion, it becomes imperative to understand how due diligence ought to be exercised in the course of concluding the transaction. In cases of cross border mergers or acquisitions, parties, owing to differences in taxation and accounting/currencies, should attempt to come to a consensus on such liquidation metrics, which would determine the friendly progress of the transaction.[4] Due diligence becomes essential here for both the acquiring and the target companies for the purposes of agreeing to a common currency and tax system for transaction, so as to assure minimized loss in the process owing to differences in currency values in their respective countries.
The next point for employment of due diligence in this process would be in ascertaining the law governing the merger or acquisition contract and understanding the foreign regulations as well as possible developments in the same in the near future, so as to ensure that the possible risks assessed and ascertained prior to the transaction are in a position to be redressed in case any of them is encountered as well as effectively make use of tactics such as employing a third party for keeping a check on the target company, without any legal hassles. The aforementioned legal considerations mentioned should necessarily include, but not be limited to, the foreign investment laws, control over exchange, the prevailing antitrust laws and procedures involved in the completion of requisite documentation, such as the mandatory filings to be made.[5]
The Problems and the Road Ahead
Shifting away from the paradigm of antitrust, in the absence of a fixed guide that puts forward steps that put forward systematically, a pre-determined step to be taken in the before, during and after a merger or acquisition, it becomes imperative to understand the uncertainties that due diligence as a concept involves, and how can the same be mitigated to the best possible extent.
Firstly, a company’s liability and/ or disadvantage that may possibly accrue cannot be mitigated in the after the transaction due to the changing legal position and legislative frameworks. This may involve changing restrictions on the upper limit imposed on the amount that can be charged for a particular exchange or transaction in the course of dealings, during or after the transaction, or change in filing requirements to prevent rampant cross-border takeovers, such as the changes brought out by enactment of Foreign Investment Risk Review Modernization Act by the United States of America. Changes like these may seem unexpected and rampant while assessing the legal position and the possible changes to the same in the course towards completing the transaction. The solution to this issue could be determining the extent to which such laws could possibly come into place owing to political situations, for example the Foreign Investment Risk Review Modernization Act was enacted to prevent hostile takeovers by Chinese Companies,[6] and assess the extent to which such legal changes can possibly impact the acquiring company and its shareholding (in case of a merger), and plan an exit strategy if such a situation arises, as the moving ahead in furtherance of an adverse impact due to the change in laws can result in marginal monetary losses to the company.
The next point of concern is in the evaluation of effectiveness of the target company as a business entity while exercising due diligence as a tool, prior to the initiation of a transaction. This paves way for a differential understanding of how the nature of business of the target company may prove effective in the long run in future, which largely creates a gap in terms of determining recourse in cases of sudden shift in market structure, which may be caused due to various reasons ranging from changes in demand structure owing to changes in environmental and social patterns to sudden outbreaks of pandemics. This problem can again not be countered through pre-emptive strategies using the current trends of due diligence. The way out here is once again planning, considering this as a worst case scenario, and being prepared to shift from one line of business to another, give up on a certain amount of existing shares to make the aforementioned shift or propel the business with modifications or plan out a potential exit strategy in such cases.
The contract for the purposes of transaction should contain a clause either allowing for withdrawal from the transaction in such instances, or allowing for a change in the currency being used for purposes of transaction (in cases where widely accepted currencies like the US Dollars or the Great Britain Pounds are not the means for currency exchange), in order to combat the impact of sudden fluctuation of currency rates, sue to reasons such as economic slumps or recessions in the countries in which one of the parties is registered and functioning.
[1] Francis Cherunilam, International Economics, Fifth Edition, McGraw Hill Education, 5th ed. (2008) [2] Bacon, Charles F., (2006, 2008, 2010), Next Generation Due Diligence, MONDAQ, Europe. [3]SladjanaSavovic, DraganaPokrajcic, Due Diligence as a Key Success Factor of Mergers and Acquisitions, Actual Problems of Economics, (Jan., 2013). [4] Anna Olsson Fladby, Andrea Urban, The Rationale Behind Cross-border Mergers & Acquisitions, Bachelor thesis, International Business, University of Gothenburg (2014) [5] Taxation of cross-border mergers and acquisitions, KPMG International, available at: https://assets.kpmg/content/dam/kpmg/xx/pdf/2018/04/taxation-of-cross-border-m-and-a.pdf (2018) [6] Farhad Jalinous, National security reviews 2018: A global perspective, White and Case, p.5 available at: https://www.whitecase.com/sites/whitecase/files/national-security-reviews-2018-v16.pdf
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