[Expert Corner Series] Origin of Due Diligence and What precedes due diligence by Bodhisattwa Majumder- PART-VI | Corp Comm Legal on Corporate Law

History and Background of Due Diligence

The essence of due diligence has been present since ages for transactions between two or more parties for ensuring transparency and legitimacy. The Roman Law prescribed the concept of diligentia, with two subheads.[1] Firstly, ‘diligentia quam suis rebus’ or care which should be taken by a person for managing is own affairs and Secondly, ‘diligentia exactissima’ or ‘diligentia boni patrisfamilia’ the care which should be taken by the head of a family.
The legal maxims of Caveat Emptor and Caveat emptor, which are also known to be originated under the Roman Empire, connoted the identical principle of imposing a burden on the buyer/seller to know about the information related to the transaction.[2]
The English Law distinguished diligence into three degrees in the Seventeenth Century namely, Common or ordinary, High or Great, Low or Slight.[3] These were varying degrees of care a person can be imputed upon regarding the management of their affairs taking consideration of their prudence. Although the term “due diligence” has originated from the common law system in medieval England after the Norman Conquest,[4] however, its codification had taken place only under legislative enactments by the United States, namely the United States Securities Act, 1933 (which mentioned a process of ‘reasonable investigation’).

A.      Due diligence in American jurisprudence

The American laws on securities used to impose huge liabilities on the dealers who used to sell securities or properties to the public and the required Standard of Care was known as ‘due diligence’. The US Securities Act[5], in a provision which deals with the civil liabilities on account of false statements and providing inadequate information to investors, connotes that the statement should be made after a “reasonable investigation”.[6]
This phrase of a ‘reasonable investigation’ shares the essence of due diligence, and it provides a defence to any person who deals with properties or securities and has taken every possible step to ensure that adequate information is provided to the investor in the prospectus.[7]

B.      The Indian scenario

Indian jurisprudence has also accommodated due diligence in its legislator framework, which makes it mandatory for the decisions related to business to undergo a process of investigation, research and other precautionary steps. However, there is no law or case law on Due diligence.
In the Indian scenario, the most proximate concept associated with due diligence can be of ‘Notice’, actual, constructive or imputed.[8] Various Indian statutes adopt the essence of due diligence. Transfer of Property Act[9] was probably the first legislation to do so when it provided for imputation of notice from actual knowledge or wilful abstention from an enquiry or search, they ought to have made.
This imputation cast a duty on the person involved to enquire about the property before making a sale, much like the U.S. legal framework in cases of securities. In this case, the person buying a property is expected to act as a reasonable man who conducts sufficient research and investigation to find out about the title or ownership of the property.
Due diligence has been adopted in many Indian legislations, whenever it involves a commercial transaction involved. It is made mandatory in cases where the transaction involves a lot of people, documentation, capital and property.
Mandatory due diligence has been introduced under the SEBI Regulations[10] and offshore offerings of security from American or other Global depositories. Furthermore, many legislations such as Securities Contracts (Regulation) Act, 1956[11], Monopolies and Restrictive Trade Practices Act (MRTP), 1969[12], SEBI Act[13] and IT Act[14], have placed obligations to take care in case of economic matters.
However, the Indian framework only places a standard of care rather than placing statutory duty or consequential criminal liability for failure to exercise due diligence.

What precedes Due Diligence

In every M&A transaction, the due diligence forms an integral part of the transaction as it helps the parties to make an informed decision after weighing the potential liabilities and discrepancies.[15] It ensures that the transfer of assets won’t bring unnecessary risks to the shareholders. The purpose of due diligence is to measure the benefits and liabilities of the transaction by enquiring all relevant information of past, present or futures and assessing the prospects. This is usually done in three phases starting with an examination of financial statements, assessing management and operations and lastly, reviewing legal liability.[16]

        i.            Self due diligence

The first step in any due diligence exercise lies with the acquiring party where it is required to introspect and determine the outcomes, it seeks from the due diligence exercise. Peter Howson[17] enlists the following questions which any acquirer should ask himself before any due diligence exercise:
·       What is the business strategy?
·       How do acquisitions fit into the business strategy?
·       How does the target fit the strategy?
·       Have we carried out sufficient pre-acquisition planning?
·       Are we sufficiently prepared for the due diligence exercise?
·       Which areas are we going to investigate? Why?
·       Do we know what we really need to know in each area of investigation?
·       Do we have enough time to complete the process? If not, what are we going to do about it?
·       Do we know where the synergies are going to come from? Have we tried to quantify them in detail? What further information is needed?
·       Have we worked out an adequate implementation plan?
·       Have we explored all the consequences of the deal, for example the effects on current operations, existing personnel, the industry and competitors?
·       Have we set material limits for the due diligence investigation?
·       Have we explained the process to the seller?
·       Have we agreed access to people and documents with the seller?

      ii.            Environmental factors for a due diligence process.

The factors affecting the smooth execution of a due diligence process are mainly threefold:
(i)                 the external factors which affect the work;
(ii)              the internal restraints for the acquirer during the review process; and
(iii)            the nature of the entity being acquired.
Before initiation of any due diligence process, these criteria need to be taken into consideration and acted upon the acquirer in order to have a swift and efficient review.
External Impediments: The ideal pre-condition for a due diligence process includes having sufficient time for review, sufficient resources and unhindered access to the company being acquired. If provided with these factors along with a pre-emptive bid, the acquirers may participate in the process directly without intermediaries in the process which is spread over an expanded time period and the target company allows the disruptions due to the detailed review. [18]
However, the ground reality is quite different. The acquirers get a limited time for a review, in a very competitive environment where the target company aims to work for its own benefit by the acquisition.[19] Also, the target company employs various advisors who advice financially and legally to extract a beneficial deal out of the acquisition. Various constraints are put to give limited access to the information and avoid sensitive, proprietary information. Further, the company management is mostly kept distant from the review process.[20]

Limitations of the acquirer – The acquisition does not take place in isolation. The target company might have ongoing processes such as restructuring, alliances, internal procedures, divestitures or other acquisitions. The simultaneous processes also require similar access to to the management and information, which causes delay and hindrances.[21]

Nature of the target company – The nature of the company has numerous impacts on the due diligence process of the company. For example, a company at an early stage would have limited resources and experience of the processes when compared to a large and mature company, which is well versed and acquainted with the process.[22] The latter would require less stimulation from the acquirer as they would have established mechanism for execution of a due diligence process.[23]

    iii.            Preliminary agreements for due diligence.

Before initiating a due diligence process, the acquirer is made to execute documents which include an agreement of confidentiality and also a letter of engagement towards the consultant.[24] Apart from these, there are several agreements necessary for a due diligence process.

C.      Confidentiality Agreements

It is essential to any M&A transaction that the information obtained during the due diligence process remains confidential and not misused. It is also essential that the information obtained during the process of due diligence is used only to the extent of the due diligence process.[25] A formal Confidentiality Agreement serves the purpose as it ensures clarity on the information which cannot be shared and also acts as a deterrent for disclosing it to a third party.[26]

D.    Break Fees

Break fees include failure cost agreements, termination fees et al., which imputes the cost of failure of the consummation of the agreement for certain specific reasons listed in the broken agreement. It places an obligation to the target company to bear at least its own costs and contribute to the due diligence costs.[27]

E.      Exclusivity Agreement

Due diligence is a lengthy process which requires the involvement of a huge amount of capital, human resource and time of the involved parties.[28] For this reason, it is essential to ensure that the target company is serious about the deal and is not negotiating with other prospective acquirers.[29] An exclusivity agreement serves this purpose and is quite common in the process of acquisitions. FICCI, in its knowledge paper,[30] had listed the following general terms:
i.          The duration of the exclusivity period, A reasonable period should be fixed and maybe anything from a few weeks to a few months, depending on the particular transaction.
ii.        An obligation on the seller to immediately cease any ongoing discussions with a third party regarding a possible transaction during the exclusivity period.
iii.      An obligation on the seller not to solicit, initiate or enter into any new discussions with third parties in connection with a possible transaction. In this case, the definition “transaction” should include a full range of possible transactions and not just the specific transaction that the buyer has in contemplation.
iv.      An obligation to not provide any confidential information about the business/company to any other prospective buyer

    iv.            Creation of a due diligence team.

To perform due diligence, the acquirer usually seeks retained consultants and advisors who have in-house sources of expertise. The team includes people having expertise in accounting and legal, for the financial review and liability exposure. However, the team is not limited to that and also includes management consultants, financial experts, environmental advisors, or any other person having expertise.[31] The Acquirer needs to ensure that the whole process is free from every conflict of interest and the party directing the review should not have any connections with the transaction.[32] The conflict of interests include prior engagement with the company being acquired, be in terms of auditing, consulting, bookkeeping, design, actuarial services, brokerage services, legal services, or any other outsourcing services.[33]Larger companies usually choose to prefer a core team specialised on M&A and Finance professionals supported by experts in specific areas such as financial modelling and strategic planning. Whereas smaller organisations would prefer a business manager and finance expert assigned as team leaders for guiding a team assembled by a company consisting of both internal and external professionals.[34]

       v.            Structure of the team

The due diligence teams are usually divided based on the area of work and their specific expertise. Each team would generally have a team leader who is responsible for leading the team in the required direction and coordinate among the team and also the other teams. There would be multiple levels of reviewers to avoid any possible infirmity or anomaly.[35]
·         Finance/Accounting – Usually, the financial due diligence requires the maximum amount of human resources due to the huge volume of data which need to be reviewed. This number will be directly proportional to the size and complexity of the company. This part of the team consisted of financial professionals, tax experts, accounting and acquisition specialists.[36] Often, independent accountants are also hired to increase manpower and have a second opinion of a third party who has not been a part of the process.[37]
·         Business Development – The composition of this team will also be proportional to the size and complexity of the enterprise. In those instances where the function exists, the acquisition process in general, and the due diligence review in particular, will significantly benefit from the participation of business development staff seasoned in the organization’s strategic planning process and acquisition justification efforts and experienced in managing due diligence reviews.[38]
·         Legal – The legal team would be employed right from the commencement of the process, from the drafting of contracts regarding confidentiality, non-disclosure and exclusivity agreements. This team needs to be involved in the whole process, assisting with the legal issues at every stage. They will provide the necessary expertise to review legal documents and assess legal issues of all sorts during due diligence.[39] Besides, because they will also be intimately involved in negotiating and drafting the purchase agreement, their participation will provide the knowledge base to effectively address legal aspects of business issues that typically emerge during final negotiations.[40]
·         Human Resources – The human resources team deal with the issues related to staff management, compensation plans, change of control issues, and benefits management, and treatment of staff. In, addition they strive to improve cultural integration and diversity in the workplace during an acquisition.[41]
·         Information technology – the IT experts provide guidance in terms of the operations of the due diligence which will take place with the help of technology. It includes product support technology (particularly in technology-intensive businesses such as software development, communications, financial services, and entertainment) and its compatibility with that of the acquiring company.[42] This would require substantial resources in terms of software, hardware and personnel.
·         Sales and Marketing – This team would comprise of sales experts who would assess the marketability of the business of the target company, its products and services, and customer perceptions/relationships.[43] The Sales team comprises of expert market reviewers with the expertise of predicting the growth of the product, revenue strategies among other things.

    vi.            Initial Preparation

According to Paul Hilger[44], In order to prepare for the due diligence process, the teams should be provided with the following documents necessarily:
·         _The plan to create value or the organization’s functional equivalent that outlines the assumptions about the transaction’s ability to enhance the enterprise’s value
·          The approval document presented to corporate management to justify the transaction and the accompanying valuation model, including detail of projected growth, profitability, and synergies
·          Information, such as the offering document or other preliminary data, that may have been provided by the seller or its representative
·          Company and product information, such as promotional materials, that may be available
·          A copy of the Information Request presented to the seller
·         The acquirer’s standardized pre-acquisition checklist
In the wake of being given the above records, the groups ought to be made mindful of the procedure by the group heads and furthermore advised about the data found in the above archives. The groups ought to be completely mindful of dangers and openings related to the procedure, the goals of the procedure and the normal result of the procedure. There ought to be agreeability and a benevolent domain all together for the redistributed individuals with less experience. In conclusion, the secrecy of the entire procedure must be focused on with each part to maintain a strategic avoidance from any accidental disclosure.[45]
Prior to starting the process, the due diligence agenda must be settled. The people with essential duty regarding each team to be investigated ought to present their final version of their part of the program to the people driving the team of the due diligence survey. Group heads ought to assess its substance and give contribution varying.[46] They ought to guarantee that the targets set up for the individual teams will challenge presumptions made in the arrangement to make esteem and instigate the team reviewing to give noteworthy discoveries that can be used in the post due diligence period of the acquisition.

The author of the post, Bodhisattwa Majumder is a law student at Maharastra National Law University and currently intern at Corp Comm Legal under Mr. Bhumesh Verma.




[1] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Edition; Tata McGraw Hill), 2010. 23-24
[2] “Some thoughts on Due Diligence”, International Business and Commercial Laws: Berg and Duffy, (1995). Available at http://www.bergduffy.com/Personnel/Articles/95ddartl.htm, Accessed on 26th March, 2020.
[3] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Edition; Tata McGraw Hill), 2010. 22-23
[4] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Edition; Tata McGraw Hill), 2010. 22-23
[5] Securities Act of 1933, Amended Through P.L. 115–174, Enacted May 24, 2018.
[6] Section 11 (b) (3), of the US Securities Act of 1933.
[7] S. Spedding, Linda. Due Diligence Handbook: Corporate Governance, Risk Management and Business Planning, Burlington: CIMA Publishing, 2009, 9-10.
[8] Charu Kumar, M, “Legal due diligence”, Mondaq, Available in https://www.mondaq.com/india/Strategy/17241/Legal-Due-Diligence, Accessed on 8th April, 2020.
[9] Section 3 of Transfer of Property Act, 1882.
[10] Securities and Exchange Board of India (Mutual Funds) Regulations 1996
[11] Section 24 of Securities Contracts (Regulation) Act, 1956.
[12] Section 53 of Monopolies and Restrictive Trade Practices Act (MRTP), 1969
[13] Section 27 of Securities and Exchange Board of India Act, 1992.
[14] S.278 B Information Technology Act, 1961
[15] Chapter 6: Why Due Diligence, “Mergers and Acquisitions: The evolving Indian Scenario”, PWC, Available at https://www.pwc.in/assets/pdfs/trs/mergers-and-acquisitions-tax/mergers-and-acquisitions-the-evolving-indian-landscape.pdf, Accessed on 27th March, 2020, 22-23.
[16] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Editiob; Tata McGraw Hill), 2010. 6-7
[17] Howson, Peter, “Commercial Due Diligence: The Key to understanding value in an Acquisition”, 2006. 38-39
[18]Due Diligence: Investigation or audit of a potential deal or investment opportunity”, Corporate Finance Institute, Available at https://corporatefinanceinstitute.com/resources/knowledge/deals/due-diligence-overview/, Accessed on 29th March, 2020.
[19] Loev, JD, David M. and CPA “Due Diligence Activities in Merger and Acquisition Transactions”, American Academy of Attorney – CPAs, Available at https://www.attorney-cpa.com/articles/due-diligence-activities-in-merger-and-acquisition-transactions/, Accessed on 30th March, 2020.
[20] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 113-115.
[21] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 115-117
[22] Putz, Adam, “M&A 101: The role of due diligence in mergers and acquisitions”, Pitchbook, Available at https://pitchbook.com/news/articles/ma-101-the-role-of-due-diligence-in-mergers-and-acquisitions, Accessed on 26th March, 2020.
[23] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 115-117
[24] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Editiob; Tata McGraw Hill), 2010. 18-19.
[25] Mengus, Dogan Baran. "Due Diligence Process in Mergers & Acquisitions and Integration Problems.”, Available at https://pdfs.semanticscholar.org/3268/ae5d0f1248afeb70d5ac0113f403cb1fc713.pdf,
[26] Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI in collaboration with J Sagar Associates. Available at http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on 3rd April, 2020. 51.
[27] Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI in collaboration with J Sagar Associates. Available at http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on 3rd April, 2020. 51.
[28] Harper, Pam. "Merging cultures." Executive excellence 19, no. 11 (2002): 7-7.
[29] Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI in collaboration with J Sagar Associates. Available at http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on 3rd April, 2020. 51-53
[30] Id.
[31]The Panel on Audit Effectiveness: Report and Recommendations” (the “O’Malley Panel Report”), Dated. 31, 2000. ¶5.6
[32] Reed- Lajoux, Alexandra and Elston, Charles. “Art of M& A Due diligence”, (2nd Editiob; Tata McGraw Hill), 2010. 21-22.
[33] Categories of Non-audit services, Sarbanes – Oxley Act, 2002; available at http://www.sec.gov/rules/final/33-8183.htm.Accessed on 26th March, 2020.
[34] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 117-118.
[35] Iacono, Mario Pezzillo. "Cultural due diligence as a proactive strategy of organisational change: An empirical analysis." Social Science Research Network (SSRN).
[36] Müller-Stewens, G. "Wettbewerbsvorteil Corporate M&A." M&A-Review 2 (2003): 2003.
[37] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 96-97.
[38] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 97.
[39] Broker, Brandons, “Due Diligence in Mergers and Acquisitions”, Business Benefits Group, Available at https://www.bbgbroker.com/due-diligence-in-mergers-and-acquisitions/
[40] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 96.
[41] Lucks, Kai. "Die Organisation von M&A in internationalen Konzernen." Die Unternehmung (2002): 197-211.
[42] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 96, ¶2.
[43] Klingler, Urs. "Performance Management." In Moderne Personalentwicklung, pp. 103-120. Gabler, 2008.
[44] J. Gole. William And Hilger, Paul. “Due Diligence: An M&A value creation approach”, Wiley Publishers. 112 at ¶1.
[45] Müller-Stewens, G. "Wettbewerbsvorteil Corporate M&A." M&A-Review 2 (2003): 2003.
[46] Knowledge Paper on “Evolving Dynamics in India’s M&A Landscape”, FICCI in collaboration with J Sagar Associates. Available at http://ficci.in/events/21076/ISP/Knowledge-paper-M&A-FINAL.pdf, Accessed on 3rd April, 2020. 51-53

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