Role of Due Diligence in Mergers and Acquisition
Introduction
Ever since the Indian Economy opened itself to the foreign market after the economic liberalization reforms of 1991, Mergers and Acquisitions have become a common phenomenon throughout India. In a highly competitive global environment, mergers and acquisitions have turned out to be one of the fastest strategic options for companies to gain competitive advantage. While a merger is a combination of two companies, with one company merging itself into the other and losing its identity, while the other prominent company gains more importance and either absorbs the other company or consolidates itself with the other company, an acquisition is the action whereby the acquiring company purchases the interests of the acquired company’s shareholders and ceases to have any interest or right after the acquisition.
Merger is an arrangement that assimilates the assets of two or more companies and vests their control under one company. Acquisition simply means buying the ownership in a tangible or intangible asset such as purchase by one company of controlling interest in the share capital of another company or in the voting rights of an existing company. In the merger context, both companies pool their interests, which mean that the shareholders of both companies still hold on to their portfolio interests from their company and also gets interests in the other enterprise.
The term ‘amalgamation’ is used synonymously with the term merger and both these terms are used interchangeably but both these terms are not precisely defined in The Companies Act, 1956. Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations, mergers and the procedure to be followed for getting the arrangement, compromise or the scheme of amalgamation approved in India but the term merger or acquisition is not defined within the Act. However, the Income Tax Act, 1961 defines the term ‘amalgamation’ under section 2(1B) of the Act as the merger of one or more companies to form one company in such a manner that all the properties and liabilities of the amalgamating company(s) become the properties and liabilities of the amalgamated company, and not less than three-fourth shareholders of the amalgamating company become the shareholders of the amalgamated company.
Under Section 5 of the Competition Act, 2002, “combinations” are defined with reference to assets and turnover of merging companies located exclusively in India or located in India and outside India. Section 6 of the Competition Act, 2002 states that, no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void. All types of intra-group combinations, mergers, demergers, reorganizations and other similar transactions are thus within the purview of the Competition Act, 2002 unless specifically exempted.
Further, mergers and acquisitions are also governed by the SEBI Take Over Code, 1994 and requires mandatory permission from High Courts of the respective jurisdiction of such companies to enable any scheme of amalgamation or merger or arrangement to come through.
Why Mergers and Acquisitions?
Mergers and Acquisitions is an important way for companies to grow and become stronger and better organizations. The main reasons underlying such operations are:
– Enhanced reputation in marketplace or with stakeholders
– Reduction of operating expenses or costs
– Access to management or technical talent
– Access to new product lines
– Growth in market share (complement/extend current business)
– Quick access to new markets or entry into new industry (diversification)
– Reduction in number of competitors
– Access to new technology, manufacturing capacity or suppliers
Now, even though Mergers and Acquisitions have several advantages, but the risks involved are equivalent too. The real motive behind mergers or acquisitions should be on the table for all the parties concerned to ensure real success of such merger or acquisition. The post implementation phase is a very critical part where several mergers or acquisitions fail and before onset of any deal, most companies should conduct due diligence to ascertain the real risks and profitability of such deals. Due Diligence Due Diligence in Mergers and Acquisitions is the process of evaluating and investigating a prospective business decision by getting information about the financial, legal, intellectual and other material information from the other party.
The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business transaction under consideration. By performing due diligence, a perfect strategy can be evolved to carry out the merger or acquisition. Failure to exercise due diligence prior to entering into a transaction of enormous proportions such as a merger or acquisition may lead to a precarious situation where the asset acquired, may be marred by encumbrances, charges and other liabilities which get automatically transferred to the acquirer as a result of such acquisition. While the cost involved in performing a due diligence is on the higher side, as it usually involves the services of a CA and an attorney, the importance of conducting a thorough due diligence before undertaking a transaction cannot be undermined under any circumstances. To any company involved in merger or acquisition, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target company/unit/business.
The purpose of due diligence is to confirm that the business actually is what it appears to be. While gaining information about the business, the company conducting the due diligence can definitely identify deal killers and eradicate them. Further, information for valuing assets, defining representations and warranties, and/or negotiating price concessions can also be obtained vide due diligence. The information learned while conducting due diligence will further help in drafting and negotiating the transaction agreement and related ancillary agreements.
This information will also be helpful in allocating risks in regards to representations and warranties, pre-closing assurances and post-closing indemnification rights of the acquirer, organizational documents to determine the stockholder and other approvals required to complete the transaction, contracts, including assignment clauses, and permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required, regulatory requirements, to determine if any governmental approvals are required, and debt instruments and capital infusions, to determine repayment requirements. Why Due Diligence? Mergers and Acquisitions revolve around certain specific steps and due diligence is the first step to make the end business successful. Due diligence helps in understanding the following about the company:
Capital structure including shareholding pattern.
Composition of board of directors.
Shareholders’ agreement or restrictions on the shares, for example, on voting rights or the right to transfer the shares.
Level of indebtedness.
Whether any of its assets have been offered as security for raising any debt.
Any significant contracts executed by it.
The status of any statutory approvals, consents or filings with statutory authorities.
Employee details.
Significant litigation, show cause notices and so on relating to the target and/or its areas of business.
Intellectual Property of the Company
Any other liability, existing or potential.
Conducting Due Diligence: By conducting due diligence before finalizing any merger or acquisition helps in evaluating and structuring the transaction and identify legal or contractual impediments that might impact the end result. It also helps to validate the business plan and mitigate any risks that seem imminent and formulate solutions to deal with various issues. The first step in conducting due diligence is to plan the due diligence so that the business transaction can undergo smoothly. Liaisons with Regional Legal Advisor/General Counsel, Contracting Officer/OAA, Program Office, or other office to plan an efficient approach toward conducting the due diligence should be conducted to determine and plan the due diligence memo. Secondly, information should be gathered about the company from public domains such as news articles, company reports and subscription-only resources, such as Dun & Bradstreet, Lexus-Nexus, Factiva, etc. Constitutional documents of the Company, annual reports and annual returns filed with statutory authorities, giving information on shareholdings, directors should also be analyzed including quarterly and half-yearly reports, in the case of listed companies (in accordance with the standard listing agreement prescribed by the SEBI). Government resources should be checked to see if there are particular issues concerning the business, relationship with a particular country, government, or client, or other policy concern.
The top managers or board members of the company can also be scrutinized by conducting a search involving sensitive information to determine if the company individual is eligible for a visa to the US, which is one way to identify risks to the agency. By conducting web searches about the company untapped information about the company may also become evident which would be helpful in furthering the business transaction. Local searches should also be conducted to gather information about the company’s current customers, suppliers, and/or private sector or government partners, relevant local associations and to assess the overall reputation of the company. Thirdly, after all the information about the company has been obtained, the same must be analyzed to understand the business operation and the key strengths and weakness of entering into any scheme of merger or acquisition with such company.
Fourthly, the stock exchanges where merging and merged companies are listed should be informed about the merger proposal. From time to time, copies of all notices, resolutions, and orders should be mailed to the concerned stock exchanges. Fifthly, the due diligence memo must be prepared and discussions held with the company to bring out the true nature of the transaction process and finalize the transaction. The Memorandum of Understanding (MOU) must be drafted thereafter and reviewed by the Agency deciding official well before serious alliance discussions begin with the potential partner. The Board of Directors of each company must approve the draft merger proposal and pass a resolution authorizing its directors/executives to pursue the matter further.
Although it might seem that due diligence has come to an end after the draft merger proposal has been approved by both the companies, however, due diligence is an ongoing process and may continue right throughout the existence of the amalgamated or merged company to evaluate any risk that may crop up at any point of time during the alliance. Conclusion Once the Memorandum of Understanding and merger proposal has been approved by both the companies, each company should make an application under the Companies Act, 1956 to the High Court of the State where its registered office is situated so that it can convene the meetings of share holders and creditors for passing the merger proposal.
Thereafter notices must be dispatched to the shareholders and creditors of the company to convene a meeting and such meeting must be subsequently held where at least 75% of shareholders of the company who vote either in person or by proxy must approve the scheme of merge. Once the scheme of merger has been approved by the creditors and shareholders, another petition to High Court to confirm the scheme of merger must be presented and notices regarding the same published in two newspapers. After the High Court passes an order approving the scheme or merger or amalgamation, the certified true copies of the orders must be sent to the registrar of the companies and assets and liabilities of the companies stands transferred to the amalgamated company. It has been reported that mergers and acquisitions take about a three to four months for completion
although the SEBI Takeover Regulations require the acquirer to complete all procedures relating to the public offer including payment of consideration to the shareholders who have accepted the offer, within 90 days from the date of public announcement. However, ultimately, whatever the time limit might be, mergers and acquisitions definitely help the companies to strengthen and expand their business operations to increase profitability and consolidate the business structure. With strict due diligence in place, companies can definitely hope to tackle the risks involved and make the end result successful for effective mergers and acquisitions. Today, India presents the right opportunities for companies to engage in cross-cultural transactions and amalgamations and Indian markets are registering massive growth in mergers and acquisitions with consolidation of international businesses in India and fierce competition amongst business houses who are seeking to expand their market.