Hilary Muza 
IN business and in life every transaction is characterised by risk. For instance, when you buy food, there is the risk that it may be bad. When you buy a gadget, it might not work as advertised.
This is the reason why in every transaction, the buyer must exercise a great amount of discretion, and in doing so must engage in a due diligence process to ascertain if the asset is truly worth the trouble of purchasing.
In this week’s article we discuss the importance of due diligence in mergers and acquisitions. I will specifically look at the importance of litigation due diligence and debunk the myth that litigation and dispute resolution practitioners’ contribution to major transactions is cosmetic. I will argue instead that though it is often overlooked, litigation due diligence has a huge impact on major business transactions, as we have come to learn in recent days.
What is a legal due diligence?
Due diligence refers to the process of investigation or audit of a deal or investment opportunity to give a buyer confidence in what he is purchasing. It basically means that every corporate organisation must conduct adequate research prior to entering into a legal contract or business deal. The term “due diligence” refers to an in-depth review of all important business factors. Due diligence must be performed on every part of the business, including the financial, operational, corporate structure, supply chains, tax, commercial tax, IT, integrity, social, environmental, health and safety, licences, dispute resolution, regulations and so on. Essentially, a due diligence must cover the entire anatomy of a business to ascertain what risks lie in purchasing it.
When is legal due diligence necessary?
Legal due diligence is most common in two situations:
– Sale of the proprietary rights to goods or services (this mainly has to do with intangible assets like intellectual property), and
– Sale or purchase of a business in a merger, acquisition, or partnership
The sale of proprietary rights to goods has become more common in the digital age. With the sale of intangible goods and trademarked intellectual property, an investigation into right to use and ownership is very important. Legal due diligence investigations are much more comprehensive for a merger or acquisition. There’s simply more information to sift through and investigate. Mergers often include intellectual property and digital information now as well.
Why is it necessary?
Legal due diligence helps identify existing problems that can prevent the deal from going through. When all the parties are aware of these problems, they can discuss solutions that will ensure a smooth transaction. This brings me to another myth associated with legal due diligence exercises. They are often thought only to be means of exposing problems.
That is only one part of a larger matrix. Due diligence exercises are in fact a tool to both discover problems (if any) and to facilitate finding solutions to them. For example, where a target business is lacking in certain key regulatory and compliance areas, it is easy to throw in the towel and declare the business not worthy of being purchased. However, a holistic due diligence report will advise the purchaser of what needs to be done to rectify the issue, how long it will take and what potential costs are involved.
This way, the advisor acts not only as a legal sounding board for the business, but as a trusted navigator of issues who is dedicated to finding a way for the transaction to go through. Remember, by the time a due diligence exercise is conducted, the purchaser has already made the decision to make the purchase. It is the job of a legal advisor to ensure that the deal is not only done within the ambit of the law, but also remains profitable for the client. That’s should be a lawyer’s first ambition in my view: finding a way to make the client’s decision to purchase work. Naturally, where such a decision ultimately reveals itself to be contrary to the client’s business interests, it is also the duty of the legal advisor to say so, give compelling reasons why and leave it to the client to decide.
Who should conduct a due diligence exercise?
Purchasers often hold more leverage in mergers and acquisitions because of their financial power. However, this does not mean that they should be the only ones to do a due diligence on the target business. The target business can also conduct a duel diligence on the prospective purchaser. In doing so, the target business confirms the authority of purchasing company representatives to agree to deals and sign contracts, ascertain the purchaser’s true intention behind a purchase and so on. There are many reasons a target might want to do a due diligence on a purchaser, some of which I will not get into in this article. Suffice it to say, however, that due diligence must not only go one way.
Litigation due diligence
Oftentimes in due diligence exercises, attention is paid to issues more pertinent to the day to day activities of a business such as tax, regulatory and compliance and real estate. However, litigation poses a significant unseen threat to a purchaser if attention is not paid to its consequences. When it comes to a business, anything on its asset portfolio can be the subject of litigation. If a litigation report does not show what assets are subject to court proceedings, this may create a distorted view of the target company’s true balance sheet and ultimately, its overall value. I will give an example, a purchaser might value a target company at $100 million. The crown jewel in the asset register of the target company might be worth $60 million. Unbeknownst to the purchaser, that crown jewel is the subject of a court order stating that it now belongs to a third party. This means that the value of the target company cannot be $100 million as long as that court order stands. This has the potential of ruining the transaction and it would ordinarily be the best thing to advise the purchaser to hold the transaction.
Court processes capable of bankrupting a purchaser are not limited to cases surrounding assets. There might also be several large claims that, if looked at cumulatively, can wipe out the target company’s bank account. If purchasers do not have a clear picture of what is going on with court cases involving the target company, they will inherit these problems, leading to a nosedive in financial performance.
For the above reasons, due diligence is an exercise that must be taken seriously and executed thoroughly to protect the client’s business interests. I will talk more on how aspects that are normally overlooked like labour law elements of transactions have a significant bearing on their success.
Muza is a duly admitted lawyer with expertise in business advisory, labour law and commercial litigation. He writes in his personal capacity. For feedback, email him at hilarykmuza@gmail.com or call on +263719042628.
