Introduction
Due diligence is a review or assessment performed to confirm the presence or absence of certain factual issues under investigation. Put differently it looks at risks and opportunities in a business that is targeted for a merger or acquisition. Common in mergers and acquisitions are financial and legal due diligence exercises. In this article I look at legal due diligence.
Financial versus legal due diligence
Finance due diligence involves an exercise to establish the true financial situation of target company i.e. presence or absence of certain financial situations. Financial due diligence is wide in scope. It can cover reviewing a company’s financial records to establish factual positions such as the financial position of a target company, profitability, cashflows and so on. On the financial position a due diligence looks at the completeness of creditors (existing or contingent), existence and valuation of assets such as property, plant and equipment, intangible assets, debtors, etc. In fact, a financial due diligence may be carried out as a business due diligence where non-financial issues such as industry issues, company specific issues may be looked at. It is common for the business opportunities and risks to be reviewed, market tends and share, future outlook and so on to be assessed.
Legal due diligence looks at the legal affairs particularly risks of the target company. A financial due diligence may be extended to cover legal due diligence by way of the financial advisors engaging the company’s legal practitioners for a legal position or opinion on specific issues such as recent material litigation, pending litigation or disputes. Alternatively, an investor may ask a law firm to carry out a legal due diligence separate from the one done by business or financial advisors.
Legal due diligence
This normally covers the areas explained below.
Litigation
A review of recent, current or pending litigation. This may give indications of claims or legal risks against the business.
Review of major contracts
The review may cover contracts currently in existence or key business situations not covered by contracts. The latter might include situations where entities have some understanding but not contractual relationships. This may be a big risk for a group company that is being disposed of where business is based on a group set up instead of signed commercial contracts. A review of major contracts may deal with the following:
- Major contracts with customers or clients and the likely continuation or termination of such contracts.
- Major contracts with key suppliers as such contracts usually provide for products to be supplied, tenure, renewal, pricing, termination, etc. Some supply contracts are so key to a business such that without them there is no business to talk about.
- Lease agreements. Many businesses operate from leased premises. It is important to ensure continuity of leases at affordable rentals.
- Human resources contracts. Employment contracts especially for senior executives ought to be reviewed for continuity or the terms and conditions for their termination. Some key employees may want to leave after a merger or acquisition while those not wanted may want to stay.
- IT systems for companies that rely heavily on such systems.
Compliance due diligence
As part of legal due diligence, it is important to review regulatory and other compliance requirements. For instance, where a target company requires certain licences, it is important to ensure that such licences do exist and are up to date.
New laws
Legal due diligence should also cover new laws or likely changes in existing laws that may affect the target business. Key laws may include currency laws, exchange control, investment laws, mining, taxation, environmental laws, labour laws and many other laws.
Taxation due diligence
This can easily fall under financial or legal due diligence. It is advisable to assess the target company’s tax affairs to avoid surprise future tax liabilities. Where a company is purchased as a going concern it is possible for tax obligations from past transactions to arise after a merger or acquisition.
Conclusion
In mergers and acquisitions both financial and legal due diligence exercises are important to cover both opportunities and risks in the target company.
Disclaimer
This simplified article is for general information purposes only and does not constitute the writer’s professional advice.
Godknows (GK) Hofisi, LLB(UNISA), B.Acc(UZ), Hons B.Compt (UNISA), CA(Z), MBA (EBS, Heriot- Watt, UK) is the Managing Partner of Hofisi & Partners Commercial Attorneys, chartered accountant, insolvency practitioner, registered tax accountant and advises on deal and transactions. He has extensive experience from industry and commerce and is a former World Bank staffer in the Resource Management Unit. He writes in his personal capacity. He can be contacted on +263 772 246 900 or ghofisi@hofisilaw.com or gohofisi@gmail.com
