Due diligence is a comprehensive audit of an asset in order to identify and assess existing and possible future risks that may arise from transactions / operations with this asset.
Such audit is usually carried out by independent consultants:
What is the scope of legal due diligence?
Depending on the subject matter of the transaction and the objectives of the legal due diligence initiator, the scope and methods thereof may vary.
For example, in the case a credit is granted or funds are borrowed, the initiator of due diligence is most often a bank or other lender, in order to make sure of the proper status and stable financial position of the borrower. The scope of the audit, as a rule, is limited to such issues as the proper establishment and payment of the authorized capital of the borrower, the existence of risks of compulsory liquidation (as a result of material violations of the law) and challenging the transaction by third parties, net assets, the need for approval of the transaction by the management bodies of the borrower and / or by third parties (often referred to as "corporate matters" for convenience).
In the event of a sale of a business, the seller – its management and / or owner (s) of shares in the company may initiate due diligence for the purpose of justifying the assessment of the value of business and determining what terms of the transaction, i.e. price, the procedure for its payment and liability are fair and is any leverage to negotiate them with the buyer. The seller can also use the results of due diligence to improve the condition of the assets and minimize / eliminate risks, which ultimately leads to an increase in the value of the asset and improves the bargaining position in relationships with other potential buyers.
In M&A transactions, due diligence is usually initiated by an investor - buyer.
The scope of legal due diligence in transactions for the sale and purchase of a business as a going concern where 100% (or a controlling stake) of shares / interests in the target company is purchased, covers a wider range of issues.
In addition to the corporate matters, the following are analyzed:
Based on the risks identified in the course of legal due diligence and the recommendations of external consultants to eliminate / minimize the consequences of such risks, the buyer gets broader negotiating opportunities:
How does the due diligence initiator obtain information and documents?
When due diligence is conducted by the buyer, the information and documents are provided directly to the buyer's team which conducts the due diligence - as a rule, to external consultants, based on the checklist they prepare which is handed in to the seller and the target company.
Documents and information are most often provided electronically in a virtual information room; or, in the case of exclusive confidentiality, by granting to the due diligence team access to originals or copies of such documents, without the right or with the right of limited copying.
The due diligence team also receives information about the target company and the seller from publicly available sources, including open registers: the Unified State Register of Legal Entities, the Unified State Register of Real Estate, the Unified Federal Register of Bankruptcy Information, Open Registers of Rospatent, etc.
Due diligence, as a rule, is limited by strict time frames - from several working days to several weeks, depending on the scope of the audit.
If the verification team is not provided with any of the requested documents and information due to their absence, this may, to one degree or another, influence the conclusions and recommendations regarding the identified risks.
How are the results of due diligence presented?
Based on the results of legal due diligence, a report is prepared, which usually includes the following sections:
1) Introduction, which describes: the transaction planned to be concluded; target company and areas of its economic activity; scope of due diligence and sources of information; limitations on the liability of external consultant that conducted due diligence; the right of the recipient of the report to disclose it to third parties (or prohibition to carry out such disclosure), the main contact persons of the external consultant if questions arise in connection with the content of the report; the date on which the due diligence report is issued, as well as the applicable assumptions (that all information provided as part of due diligence contains correct data, that the submitted copies of documents correspond to the originals, signatures and seals on documents are genuine, etc.).
2) Brief conclusions on the results of due diligence (executive summary): this section contains a description of the most significant risks identified during due diligence, taking into account the provisions of applicable legislation and law enforcement practice, the estimated level of such risks (low - medium - significant) and recommendations for their elimination / minimization of consequences. For example, a due diligence may reveal several violations by the target company of industry legislation with an unexpired statute of limitations for prosecution, each of which may involve a significant administrative fine or suspension of activities; in this case, the report indicates the maximum amount of administrative fines and other penalties that may be incurred by the target company.
3) The main part of the report, the structure of which is based on the due diligence scope, i.e. corporate matters, litigation, material contracts of the target company, containing a more detailed description of the identified risks, especially when it comes to the history of the acquisition by seller of its shares, history of acquiring rights to immovable and material movable property by the target company, terms and conditions of material agreements and labor contracts with top management, etc.
4) Schedules to the report include:
Author: Yana Dianova, Counsel
GRATA International Russia