With the growing liberalization of the Indian economy, a legal due diligence exercise has become a common feature of any investment activity. A legal due diligence process has become necessary for protection of economic interests of the investor and it affords an opportunity for the Indian promoters to be transparent in sharing information, so as to be able to compete with their competitors globally. The Indian promoters have also realized that their effective co-operation in the legal due diligence process is absolutely necessary for the growth of their business.
Legal due diligence is a crucial aspect of any business transaction, yet it is often misunderstood or overlooked. In simple terms, legal due diligence is the process of investigating a company or asset to determine its legal status and identify any legal risks or issues. This is done before a transaction takes place, such as a merger or acquisition, in order to assess the potential legal liabilities and risks involved. In this blog post, we will explore the key aspects of legal due diligence and why it is essential for businesses.
The legal due diligence process involves reviewing various legal documents and records to ensure that a company or asset is legally sound. This typically includes reviewing contracts, permits, licenses, and other legal documents to verify their validity and compliance with relevant laws and regulations. Legal due diligence may also include reviewing litigation records, intellectual property rights, employment agreements, and environmental compliance records, among other things.
The purpose of legal due diligence is to identify any potential legal risks or liabilities that may impact the transaction or the value of the company or asset. By conducting a thorough review, the parties involved in the transaction can better assess the potential risks and take appropriate steps to mitigate them. This can include negotiating contractual provisions to protect against potential risks, seeking legal advice or counsel, or even canceling the transaction altogether.
There are several key reasons why legal due diligence is important for businesses. Firstly, it can help to identify any legal risks that may impact the success of the transaction. By addressing these risks early on, the parties involved can take steps to mitigate them and avoid potential legal disputes down the line.
Secondly, legal due diligence can help to protect the parties involved from potential legal liabilities. By identifying any potential liabilities or legal issues, the parties can take steps to address them and minimize their exposure to legal risk.
Finally, legal due diligence can help to ensure compliance with applicable laws and regulations. By verifying the legal status of a company or asset, the parties can ensure that they are in compliance with relevant laws and regulations and avoid potential legal penalties or fines.
Globally, the necessity of a legal due diligence springs out of lack of an independent, reliable and exhaustive information resource on the basis of which an investor can make an informed investment decision. Hence the need to be dependent on promoters for information. In India, though independent searches at some of the government offices (like Registrar of Companies, Registrar of Assurances etc) will help in accumulation of some basic information, it is not possible to base an investment decision on the limited information available at such offices. Resultantly, the ability of the investor to conduct a thorough due diligence and make an informed decision on investment depends on the extent of co-operation given by the promoters.
A legal due diligence is a precursor to any private equity investment, merger, acquisition, initial public offering or any lending activity in India. The process involving a battery of lawyers, accountants and in some cases tax experts has become so important that in many cases the result of the exercise, will dictate the success of an investment.
So, what does a legal due diligence process involve? Broadly, it involves the following;
INFORMATION GATHERING: The exercise is a source of information on important matters, which will have a bearing on structuring a transaction. An investor will look to extract information about various matters including ownership of the company, background of the promoters, details of projects being undertaken, the company’s existing commitment to the lenders, rights available to other investors in the company, company’s adherence to corporate governance practices, disputes facing the company and the promoters, company’s strategy to deal with its competitors, permissions required for consummation of the investment etc
IDENTIFICATION OF RISK: Knowledge of existing regulatory regime will help a lawyer in identifying the areas of legal non-compliance. Depending on the seriousness of a non-compliance and its consequence, an investor will look to the advise of a lawyer on whether the non-compliance needs to be cured before the investment.
MITIGATION OF RISK: This is the key element of a legal due diligence process. In the process, the advisor would recommend ways to mitigate the risks identified, so that the company does not face the prospect of being penalized or prosecuted for being on the wrong side of the law. Typically, an investor’s preference would be to engage in a discussion with the legal advisor, understand the consequences of non-compliance and ensure that all non-compliances are cured before the investment proceeds are remitted to the company’s bank account. In respect of non-compliances, which do not have a significant effect on the business, it is also common to find that the investor may prefer such non-compliances to be cured within a specified period after the investment.
BASIS FOR NEGOTIATION: The issues, which are incapable of cure/ remedy, would form a basis of negotiation, where the parties would need to decide on who is to bear the risks arising in future. In this process of risk allocation, a party may either agree to bear the risk completely or only up to a particular extent. In a private equity investment, these issues are addressed in the representation and warranty (as also indemnity) section of the investment agreement.
An agreement is invariably a result of lengthy negotiation between the investor and the promoters on a whole lot of issues ranging from lock-in on transfer of promoters shares, investors ability to veto certain decisions, promoters ability to start a competing business, special rights available to an investor to exit from the investment, investor participation in formulation of a business plan etc. An effective and a thorough legal due diligence will ensure that the investor has adequate information to be able to make informed decisions.
In a nutshell, investor’s understanding of the way in which the business is being run and the promoter’s understanding of the expectations of the investor is the beginning of a successful Venture.
In conclusion, legal due diligence is an essential aspect of any business transaction. By conducting a thorough review of legal documents and records, the parties involved can identify any legal risks or issues and take appropriate steps to mitigate them. This can help to protect against potential legal liabilities and ensure compliance with relevant laws and regulations. If you are involved in a business transaction, it is important to engage legal counsel to conduct legal due diligence to protect your interests and ensure a successful outcome.
