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Introduction
Once the “Term Sheet” is executed, the incoming investor or acquirer will conduct due diligence on the Target Company which is the deciding factor of the success of any “Corporate Merger and Acquisition or Joint Venture transaction”. The process implies checking the health of the Company being acquired in “legal”, “financial” and other required areas by the acquirer while assessing the records. Due Diligence can be called as “a field of investigative procedures”[1] in context to shares or of assets in a commercial context, a joint venture project, a financing transaction, the issue of securities, and other general pre-contractual inquiries of a company being acquired. And IP Due Diligence an audit to assess the quantity and the quality of IP assets. The main purpose of conducting this research is to evaluate the advantages and detriments of the proposed Transaction.
Meaning of Due Diligence
“Due Diligence” has become a sophisticated and intricate process requiring very special skills on which the most delicate business decisions are based or founded. Due diligence requires a whole lot of investigation into affairs and health of a company checking records related to financial and legal positions of the “Target Company”.
Need of Due Diligence
Now in case of big companies and multinational corporations when one company buys or sell any company or its assets the whole canvass is very big; a lot of people, lot of documents, lot of money is involved and In any sale and purchase of goods, even though the seller is under a duty to sell the genuine goods, as per the specifications and of merchantable quality, the very principle of “Let the Buyer be Aware”, i.e. the buyer should be provided an opportunity to conduct its personal due diligence and inspection of the goods before buying the same and hence upon the basis of this concept the Due Diligence in M&A transactions, so it becomes very necessary to know the advantages and the detriments of the Targeted Company whom the acquirer wishes to collaborate in respect of Legal, Financial and Business point of view.
The Legality of Due Diligence in India
“In “India” there is as such no law or case law on due diligence. The Jurisprudence of Due Diligence is closely associated with the concept of Notice which can be actual, constructive, or imputed”.
Section 3 of Transfer of Property Act [2] provides that “a person is said to have the notice” of a fact when they know that fact, or when, but for wilful abstention from an inquiry or search they ought to have made, or gross negligence, they would have known it.
“Thus, the statute casts a duty to find
- “whether the fact presented by the seller is true or not”
- The pros and cons because Presumption is that every prudent man before investment in any form of a property will find whether a clear title to such property exists,
- Inquiry pertaining to any debt or litigation is attached to it
- A strong basis whether it is in any form going to prove not to be a wise decision”.
Indian Statues have introduced for the conduct of due diligence under the Securities and Exchange Board of India (Mutual Funds) Regulations 1996 and offshore offerings of securities by Indian companies through American or global depository receipts (ADRs/GDRs)[3].
Statutes which cover the economic matters like S. 24 SCRA[4], 1956, S.53 MRTP[5], 1969, S.27 SEBI[6], 1992, S.278B IT[7] Act, 1961 contain a standard section on offenses committed by companies and all the mentioned sections have the following proviso:
“Provided that nothing contained in this sub-section shall render any such person liable to punishment if he proves that the contravention took place without his knowledge or that he exercised all due diligence to prevent such contravention.”
Due diligence implies a particular standard of care and there is neither a positive statutory duty on the part of the buyer to exercise the said process of due diligence nor a criminal liability prevails for a failure to exercise due diligence in any transaction.
Significance of due diligence
Due diligence which is the process of obtaining sufficient reliable information about the Targeted Company- Which helps to find relevant fact and to uncovercircumstances or set of conditions which have a reasonable likelihood of influencing a business decision or the valuable making of an offer, of consideration and of a price to complete the business transaction especially in the cases of Mergers and Acquisitions
IP due diligence provides detailed information that may affect the key elements of a proposed transaction or the Price and can abort the further consideration of the proposed transaction if it conducted properly evaluating the risks and health of the company being acquired. Due Diligence valuation of IP is crucial to the transaction due to –
- The Disparity of information (about net assets value) between the seller and the buyer[8].
- It starts with a “Letter of Intent” or a “Memorandum of Understanding”, in which the parties agree to exchange requisite information, documents, business plans, stipulating the schedule, mode, and deadlines.
- Confidentiality Agreement may be contracted if the IP involves certain trade secrets, protecting Attorney-Client privileges[9].
Purpose of Due Diligence is to-
- Identify and locate IP assets,
- Assess the nature andscope of the IP to evaluate their benefits
- Allocate risksassociated with the ownership or use of the relevant IP assets; in particular, it seeks to determine whether the relevant IP is free of encumbrances for its intended business use(s).
- Identify problems in and barriers to the transfer, hypothecation, orsecuritization of the IP assets under consideration.
- Identify and apportion between the two parties the expenses incident to the transfer of IP assets under consideration.
Tools
The Corporate Transaction is not a fixated transaction it has a broad view and scope of coverage and due to this complexity in nature of commercial transactions, both local and international any single analytical method cannot be prescribed as such therefore there are various methods which are given below-
- Documentation and Questionnaire- Putting a questionnaire to target company pertaining to general and financial health, risks involved in the business of the company asking for the necessary documents to comply with the same stated facts. Because the documentation provided by the seller to the buyer in due diligence will add as much value as possible to the corporate transaction to make an uptight deal. Ideally, the seller should have maintained an up-to-date IP portfolio with all the necessary documentation.
- Another way is the representations and warranties that the seller can be asked to make in the commercial contract in order to protect the buyer the seller needs to ensure the responsibility of representations and warranties and must effectively transfer to the buyer in the assignment, so any claims pertaining to any asset cannot be made against them following the sale. In order to mitigate this risk, both parties seek a definitive agreement in order to protect themselves from the event of misrepresentations or claims.
- The third method is to review the financial analysis of the seller’s business with the analysis of the legal risks that are associated with the transaction by an integrated approach.
Procedures
There are two ways of conducting due diligence
- DATA ROOM-Presentation of predetermined data by the seller/target company in a ‘data room’
- Data provided in response to the acquirer’s questionnaire.
In the Data Room method, a huge amount of data is presented to interested parties to conduct study and analysis it and get the required due diligence conducted. Data room method is very successful because in, this process, the seller is able to maintain ensure that all the bidders are treated fairly and that they are given access uniformly to the same data or information. Hence, uniformly of the information and documents supplied to all bidders is maintained.
Any discrimination in the supply of information or documents could vitiate the bidding process. This applies more to disinvestments by the central or state government or government companies, which can be subjected to judicial review under the provisions of the Constitution of India.
Another method is a questionnaire method in which a questionnaire is put to the target company and on that basis further, one-to-one negotiations are done. Thereafter a Due diligence report is prepared by lawyers which can be effectively used to negotiate the vexed question of the representations and warranties to be included in the sale and purchase or financing agreement, the disclosures that inevitably qualify (some if not many of them) and the amount, if any, to be set aside in escrow and on what conditions.
Managing the due diligence process
- Analysing the Parameters–Evaluation areas pertaining to continuity of the targets, key personnel, suppliers, and customers after the acquisition.
- Formation of Due Diligence Team– The core team for the conduct of the due diligence should consist of the management representatives of the acquirer a legal counsel a valuation adviser, chartered accountants (CPA)/merchant bankers and, the technical consultants. Responsibilities and functions to initiate the process are distributed amongst this team and the normal practice is that all external counsels are required to execute confidentiality agreements before the commencement of the same
- Conducting preliminary investigation – The entire objective of the preliminary survey is to identify deal-breaking issues upfront before money and other valuable resources which are committed to a detailed investigation of such facts. “Some of the critical issues[10] which emerge are:
- misrepresentation or concealment of facts and figures
- insufficient internal controls
- non-compliance of or adventurous interpretations of contracts, legal provisions, accounting principles, policies, or standards
- employee retention and core management succession
- contingent liabilities
- statutory non-compliance
- industrial sickness (erosion of net worth); and
- legal proceedings”
- Detailed Report of due diligence– Comprehensive critically examined well-informed decision would lie in well-planned, integrated and, coordinated detailed enquiry procedures that determine the success of this investigative spectrum.
- Certification– A declaration in a form of Certificate must be obtained by the due diligence team from the target company confirming the complete disclosure authenticity of the disclosed information and documents, and that no material data has been withheld by them for any future fraud.
Challenges in conducting due diligence
- insufficiency of basic data; this makes going tough
- roadblocks to obtaining or sharing proprietary information; and
- confidentiality / secrecy covenants may prevent disclosure of material documents.
- Some of the minor issues include language barriers,
- traveling to remote locations, or
- people who are not enthusiastic about or are unaware of the proposed transactions.
Professional project management of the due diligence process can however overcome these problems.
Benefits of professional due diligence
The benefits of a professional due diligence exercise include the accuracy of warranties and representations which helps to mitigate the risks of future claims by third parties and then comes the ‘big picture’ of the vision of the target company clear indication of the direction where the Acquirers need to put their efforts upon and its future earnings by the assets, the goodwill, the market hold or other factors contributing to the same and overall financial analysis of the target company; one of the key advantages is the identification of deal-breaking issues and formulating business solutions to resolve them which can lead to a smooth transition of the merger.
Conclusion
The goal of due diligence is to assist the buyer in assessing the value of a prospective acquisition, to identify and mitigate potential risks. Through due diligence, the buyer is better able to assess the risk and to build an accurate picture of the assets and liabilities. But if acquirers ignore or undervalue the potential of IP, they can weaken negotiation strategies, reduce the chances of securing future licensing agreements, and damage their ability to obtain financing. The IP portfolio has to be understood critically and thus for the same acquirers must undertake due diligence.
Conversely, failing to undertake adequate due diligence can lead to an overvaluation of the target, expose the acquirer to unknown risks and liabilities, and create integration problems which could undermine synergies. These factors reflect the importance of carrying out due diligence before investing in any form in any company for expansion. Carrying out Due diligence has become more significant since the financial community is waking up to the benefits of generating additional funding on the back of patents, trademarks, and copyrights as a result of which Mergers and Acquisition is one such strategy which is becoming popular in Corporate World.
References:
[1] By Charu Mathur, India:Due Diligence(July 5th 2020) https://www.mondaq.com/india/operational-performance-management/17241/legal-due-diligence.
[2] Transfer of Property Act,1882,S.3
[3] Charu Mathur, India- Due Diligence(July 5th 2020) https://www.mondaq.com/india/operational-performance-management/17241/legal-due-diligence.
[4] Securities Contracts Regulation Act, 1956 S.24
[5] Monopolies and Restrictive Trade Policies ,1969 S.53
[6] Stock Exchange Board of India Act, 1992 S.27.
[7] Information Technology Act 1961, S.278B
[8] D. McGavock and M. Newell , Five Critical Questions Your CFO Should Be Asking About IP, 4
INTELLECTUAL ASSET MANAGEMENT 76, 80 (2007)
[9]GLENN A. GUNDERSON AND PAUL KAVANAUGH, INTELLECTUAL PROPERTY IN MERGERS & ACQUISITIONS, TRADEMARKS IN BUSINESS TRANSACTIONS FORUM 87 (International Trademark Association 1999)
[10] By Charu Mathur, India:Due Diligence(July 5th 2020) https://www.mondaq.com/india/operational-performance-management/17241/legal-due-diligence.
