What is a Legal Due Diligence?
A Legal Due Diligence is an exercise by virtue of which legal risks are evaluated during a merger or acquisition transaction. Typically said exercise is based on a review of documents belonging and related to an entity which is the Target of an acquisition.
Akin to, and often running in parallel with, a financial audit (the Financial Due Diligence), the legal due diligence is normally limited to a review of available documents. It is therefore commonly referred to as a “Documents Only” due diligence. It requires the legal professionals to gather, comprehend and gauge the legal hazards, if any, related to a prospective acquisition.
Who commissions a Legal Due Diligence?
The due diligence exercise is often commissioned by the prospective buyers with a view to ascertaining the viability of the proposed acquisition based on the risks outlined through the said exercise. This exercise is known as a Purchasers’ Due Diligence.
On occasion, particularly where the vendors are preparing a bidding process for the Target, the vendors will commission a due diligence process and an often detailed due diligence report, so as to facilitate prospective bidders’ consideration of the Target. This exercise also enables the vendors and the Target to get their house in order (document-wise) before engaging in detailed discussion with the preferred bidder which will nonetheless require to carry out its own due diligence process prior to or as a condition of the sale. When it is the vendors who request the examination of the documents pertinent to the asset they consider selling, the process is referred to as a Vendors’ Due Diligence.
Is a Legal Due Diligence required at law?
There is no legal requirement to carry out a due diligence exercise before buying or selling an asset or shares in a company. It is however advisable and common practice to do so particularly when the asset or shares are of considerable value.
This having been said, small and medium sized entities are also encouraged to carry out legal due diligence exercises before an acquisition (or sale) since the benefits of identifying the risks typically outweigh the costs incurred during the exercise. Potential purchasers of shares in a Maltese Company do not only expose themselves to the ownership, wholly or partially, of the profits or assets of the Target, but also to the broader responsibility for the existing and contingent liabilities of the company being acquired.
It is therefore recommendable for a thorough investigation to be carried out on the potential Target before any agreements are reached and any money is traded. The legal due diligence (together with the financial one) will enable the buyer to obtain better visibility on the viability of the acquisition being considered.
When would a Legal Due Diligence typically commence?
The legal due diligence should be initiated during the early stages of discussions related to a potential sale. Following the initial show of interest and possibly initial negotiations between the parties, and once a realistic possibility is established that, subject to the necessary verifications, the sale may go through, then the buyers should insist to kick off the due diligence process. It is not uncommon for a share purchase agreement to be signed before the due diligence process commences but the obligation to purchase will be subject to a satisfactory outcome (to the buyers) of the due diligence investigation. Buyers should engage legal and financial advisors to make the necessary requests to the sellers for documents to be provided in order for them to be able to carry out said examination. Typically, a time frame is set within which this process must be concluded, and the professionals, engaged to carry out this exercise, would need to abide by the said time limits.
Should any documents be signed before the commencement of a Legal Due Diligence?
Before the commencement of the due diligence exercise, parties will be strongly advised to execute a Non-Disclosure Agreement which would bind the buyers (and their advisors) to keep the documents and information disclosed during the negotiations and the due diligence exercise, as private and confidential between the parties. It is not uncommon for the non-disclosure/confidentiality agreement to include non-solicitation provisions barring the prospective buyer from soliciting employees or customers of the Target or the sellers in relation to whom the prospective buyer will be given important information.
What documents are reviewed during the exercise?
To start off with, the advisors would normally provide the Sellers/ Target with a Due Diligence Checklist setting out a list of documents and files which they would expect the Seller/ Target to provide for the purposes of the exercise. The assessment will be limited to the documents provided. It is therefore imperative for this initial collection of documents to be thorough for the advisors to be able to assess the entity on the basis of these documents.
The documents would typically be divided into a number of categories and would cover aspects such as: corporate, material commercial and financing agreements, property, employment, litigation, intellectual property, environmental, regulatory and other compliance and insurance. Tax and accounting matters are often left to the financial advisers to deal with, with input from the legal team only where required. Each section in the data room would include the documents pertinent to each category, as applicable.
In view of the fact that the representations and warranties given by a seller in relation to the Target in a purchase agreement will be limited to the extent that disclosure was made to the buyer prior to the sale, the seller has a material interest in ensuring that the documents made available to the Buyer in the Data Room are as comprehensive as they are accurate and that they give a true and fair view of the legal state of affairs of the Target.
Any documents omitted which may have a bearing on the sale and which are not produced during the exercise will not exclude the seller from liability in the event of a claim for breach of warranty.
What expertise is required for the carrying out of a Legal Due Diligence exercise?
In view of the variety of legal documents typically made available for review during a due diligence exercise, a number of lawyers specialising in the relevant sectors would need to be involved in the process. Upon being given access to the Data Room, the person heading the team would carry out an assessment of the types of documents available and would then determine which members of the team would be most suited to be involved.
It is for this reason that it is characteristically the larger firms which are entrusted with carrying out such legal due diligences, in view of the vaster array of expertise which such firms have by their very nature. The legal team would then be in a position to review the documents falling within their area of expertise and to highlight any concerns for the potential buyers (or the vendors as the case may be). These concerns will then either be remedied as a condition precedent to the acquisition or excluded from the representations or warranties included in the share purchase agreements. The price of the acquisition may also be affected as a result of findings in the due diligence exercise.
How are documents accessed?
Lawyers will be given access to the documents either physically, or else through online access. The former option would entail the physical presence of the lawyers at the offices of the Target or at a location specifically set up for the purpose and having the physical files made available to the professionals for review over a period of a week or two.
The more common approach, however, is to make use of the variety of available online services specifically catering for the setting up of virtual data rooms (VDRs). Documents are electronically uploaded on a designated online portal and the lawyers are given access to same for a period of time. The systems often allow for notifications to be received for every new document uploaded and allow the professionals to access the documents at their desk. These methods are generally preferred by lawyers and Clients alike, also because they are more cost efficient.
What independent searches are typically carried out in Malta?
Independent searches external to the data room or VDR are also typically carried out as part of the legal due diligence exercise depending on the nature of the Target . These searches may include:
- Searches on the online portal of the Malta Business Registry (the “MBR”);
- Obtaining Good Standing Certificates and Certificates of Incumbency from the MBR;
- Searches at the Public Registry for registered encumbrances over the Target generally or any immovable property it may own;
- Searches at the local authorities such as Malta Financial Services Authority or the MGA for any licences where the target is a regulated entity;
- Searches at the Registry of Courts in Malta with respect to any pending litigation;
- Searches at the Industrial Tribunal for litigation involving employees; and
- Intellectual Property searches for registered trademarks, patents or designs;
Other considerations to keep in mind during the process of an acquisition are potential competition law implications and foreign direct investment considerations. Both assessments are typically carried out once a more definitive decision has been taken to proceed with the transaction.
What is the result of a Legal Due Diligence exercise?
Following the assessment of all the documents provided and consideration of the independent searches carried out, a Legal Due Diligence Report is produced. Said Report may take various formats depending on the Client’s needs and budgets. Reports would typically include an executive summary which would set out the main findings for ease of reference.
The lengthier Reports would provide a description of all the documents reviewed. Some purchasers request that matters of note are indicated with a green, amber or red flag to distinguish between the importance of the findings with respect to the planned transaction. Other Reports only include matters which are to be considered as Red Flags and do away with any other description of the documents under review. Said Reports may also include further requests to be made to the sellers on the basis of the documents provided or omitted.
Typical red flags may include important commercial contracts which contain change of control limitations, significant potential or pending litigation, financial agreements indicating substantial loans or property leases with impending expiry dates. A well drafted Due Diligence Report should be able to distinguish the substantial risks from the more ordinary ones and will be an important tool in the effective structuring of the purchase agreement, confirming price considerations, and limiting or qualifying the representations and warranties given by the sellers.
A satisfactory due diligence exercise and DD Report will often be a condition to completion of a purchase transaction and, therefore, on successful completion of the exercise, and subject to the fulfilment of other conditions precedent, the parties will typically move on to complete the transaction.
©Fenech & Fenech Advocates 2021
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