What flashes through your mind when you hear the phrase "due diligence"? And what does "due diligence" really mean in the context of a merger & acquisition ("M&A")?
In simple terms, due diligence is a thorough, systematic process of investigation or evaluation of facts and risks, that is done before an important or significant decision (to purchase) is made.
Reason behind Due Diligence – "Let the Buyer Beware"
Before delving into the intricacies of due diligence, an important concept to understand is the legal maxim "caveat emptor", which stands for "let the buyer beware". This simply means that a buyer is itself that is ultimately responsible for checking the quality and suitability of the things it intends to buy.
In an M&A transaction, where an acquirer intends to acquire typically the shares or assets of a target company, it is recommended for the acquirer to conduct appropriate due diligence on the target company at the outset. Legal due diligence is typically done at different stages of a deal: upon signing a non-disclosure agreement, upon signing a term-sheet even if just a non-legally binding one; OR shortly after signing a binding definitive agreement such as a sale and purchase agreement.
As there is no statutory obligation to compel the vendor to disclose information which may materially affect the acquirer's decision to proceed, a properly executed due diligence exercise allows the acquirer to identify and assess the underlying risks, liabilities and state of affairs of the target company, to decide whether or not to acquire the target to start with.
And, if the buyer does decide to proceed with the acquisition, the due diligence equips the buyer with vital information on what it should negotiate with the seller, to mitigate any foreseeable risks and losses occurring, or to re-allocate such risks and losses to the seller.
What are the different areas of legal due diligence in an M&A?
The scope of a M&A due diligence exercise differs from case to case, but would typically include legal, financial, commercial, tax and even environmental and other more specific due diligence on the target company.
Typical Scope Of Legal Due Diligence
Every legal due diligence exercise can and should be tailored to fit the acquirer's priorities and also be made relevant to the target company's business activities. However, a typical scope of legal due diligence would involve comprehensive reviews of:
- Contracts: Meticulous examination of various contracts significantly helps the acquiring company in understanding the obligations, rights, and potential liabilities that it will likely inherit after the M&A. Ongoing loan facility agreements, debt instruments and the existence of third party security documents can negatively impact the value and even impede the ability of a company to be sold. Besides, supplier contracts and key client contracts will also shine some light on the company's financial performance and even its future cash flows.
- Corporate Information: Scrutinizing the target company's corporate records, including its company constitution, minutes of board meetings, statutory forms and shareholder agreements allows the acquiring company to get a glimpse of the target company's corporate structure, governance, ultimate beneficial owners, and any restrictions on the transfer of shares.
- Litigation: Pending lawsuits or disputes can have a substantial impact on the transaction's risk and valuation. Especially in Malaysia, legal proceedings can be protracted across several years. This can result in the mandatory provisioning of potential liability in the company's financial statements impacting it negatively, not to mention the taking up valuable time and resources of management away from business to attend to such proceedings. In Malaysia, as there is currently no consolidated registry recording the existence of legal proceedings in the various courts or tribunals, it can be challenging and time consuming to find out the existence of ongoing litigation.
- Real Property: An acquiring company would generally be interested to know if the target company owns or leases real estate, partly because it could end up becoming either an asset or a liability (if it is still financed under loan). Reviews on the terms of leases and property titles, along with whether they are subject to financing or any third-party encumbrances, are therefore crucial to a buyer to assess the value of the target company, or to determine whether or not it should carve out the property from the acquisition deal.
- Intellectual Property: Intellectual property including patents, trademarks, copyrights, and trade secret would be significant intangible assets in certain types of businesses, especially technology companies, companies whose brands are established and well known in the market, or businesses that rely on licensing or franchise models. In a due diligence exercise, lawyers can help assess whether such intellectual property is properly protected and whether any renewal is due and necessary (e.g. for trademark and patents).
- Employees /Compliance withLabour Laws: This is especially important in a share acquisition, or a business transfer, where the buyer may inherit the target company's employees, along with their existing employment terms and years of seniority. It is therefore crucial for the acquirer to understand the organizational structure, terms of engagement of these personnel, whether benefits comply with minimum requirements, any inherent liabilities from unpaid statutory contributions, any existing or threatened litigation or ongoing industrial court disputes, validity of immigration and work permits, and employee mobility-related matters (ie secondments, overseas employment etc). Engaging a specialist that is familiar in this area of employment law is important, as the labour laws in Malaysia are generally considered rather pro-employee, hence any oversight by an acquirer in this aspect could prove very costly.
3 Reasons Why You Should Not Skip Legal Due Diligence
- Compliance with Laws and Regulations: In many cases, non-compliance with the law can attract a hefty fines and irreversible reputational damage. Hence, ensuring that the target company is in proper compliance with applicable laws and are operating with valid licenses is paramount. This includes matters such as operational licenses, work permits / visas, compliance with employment laws and adherence to industry-specific regulations. Particularly, some sectors in Malaysia (including oil & gas, transportation and private recruitment agencies) are still subject to licences which commonly contain equity restrictions on local and foreign ownership. A foreign buyer, in particular, should be mindful to check if its intended acquisition, even a partial one, of a local company could interfere with any of its critical operational licences and equity requirements.
- Risk Mitigation and Re-Allocation: Acquirers
need to make well informed-decisions and often times, material
adjustments in the negotiated terms, the deal structure and even
deal sequence become inevitable, after being aware of the risks
highlighted during a legal due diligence exercise. Sometimes, it
may also affect the acquiring company's decision to proceed
with the M&A. For actual or foreseeable risks discovered during
the legal due diligence process that are sufficiently material, an
acquirer can then consider negotiating:
– protective contractual terms (ie indemnities, conditions precedent and subsequent) to mitigate the risks materializing or to shift the burden of dealing with such risks to the sellers, or
– reducing the purchase price, or having claw back mechanisms to shift the economic / financial burden to the sellers. - Avoiding Buyer's Remorse: Ultimately, every acquirer wishes to obtain the best value it can for its purchase, and to be able to focus on post-acquisition integrations and value maximization of the target. Allocating time and money to conducting legal due diligence at the outset before purchasing an asset goes a long way in avoiding buyer's remorse, or worse, a protracted legal dispute in court, which can be even more costly and time consuming.
Key Takeaways
In summary, legal due diligence is an integral part of any M&A process typically carried out at the beginning stages of the deal. It is critical to help acquirers (i) uncover potential risks and liabilities, (ii) make sound business judgements, (iii) understand what to negotiate on, and (iv) to protect the acquirer's legal, commercial and financial interests post-acquisition.
How we can help both local and foreign acquirers:
- Conduct high level or red flag legal due diligence to render a legal opinion or executive report;
- Conduct detailed legal due diligence, preparing full due diligence reports;
- Conduct paid searches from reliable sources (intellectual property, winding-up, SSM, CTOS etc);
- Conduct manual searches in the Malaysian court systems and websites for ongoing litigation;
- Inspecting documents via a virtual data room or conducting due diligence on-site at various locations in Malaysia
This article was written by Tiffany Chin (Pupil in Chambers) edited by Shawn Ho (Partner).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
