Legal Due Diligence – Meaning, Scope & Advantages

Legal Due Diligence Meaning

During a merger or an acquisition, the buyer conducts legal due diligence on the target company as a part of the due diligence process. It involves analyzing and understanding the legal risk associated with the target company before a merger or an acquisition transaction.

The buyer reviews all the documents and interviews of related personnel of the target company. Thereafter, it tries to identify whether there will be any legal problems in the future.

Legal due diligence generally covers the investigation of the following areas –

Scope of Legal Due Diligence

Corporate and Legal Structure

It is important for the acquirer to understand the structure of the target company. This information is available in the company’s Memorandum of Association, Articles of Association and by-laws. Understanding the target’s corporate and legal structure helps the acquirer understand the company in a more organized manner, thereby strengthening the base for future investigations.

Commercial Contracts

The legal due diligence involves analyzing commercial contracts of the target company. These include vendor contracts, contracts with the seller, service contracts, rental agreements, etc. When studying these contracts important information can come to light. For example, terms regarding credit period of each contract, legal liabilities such as trade secrets, or usage of trademark or patent, etc. help the buyer understand the nitty-gritty of the company contracts. This, in turn, helps in identifying legal risks involved in these contracts.

Intellectual Property

As mentioned above intellectual property includes patent, trademark, copyright and trade secrets. Contracts, licenses and pending litigations related to all the intellectual property of the target company are thoroughly analyzed during legal due diligence.

Employee Contracts

Employee contracts include – salary and wages, terms of employment, obligation towards employees, duration of employment, confidentiality agreements, pension plans, tax liabilities, etc. The acquirer investigates major subgroups of employee contracts during legal due diligence. This analysis helps understand the target company’s risks and future liabilities towards the employees.

Legal Due Diligence

Regulatory Compliance

Regulatory compliance is an organizations adherence to the laws, regulations, policies, and standards under which it operates. The acquirer must make sure that the target company is on the right side of the law and doing everything to adhere to regulatory compliance. This is where legal due diligence comes into the picture and it is the only part of the due diligence process where the acquirer gets to analyze the target company’s guidelines and its adherence to regulatory compliance.

Tax Aspects

While analyzing the tax aspects during legal due diligence, the acquirer tries to find the red flags. These include any kind of deferred tax liabilities and pending government litigations. If the target company is liable under any of these, then it will create huge future liabilities for an acquirer in terms of both losing money and reputation.

Litigations

Like tax aspects, litigation related to anything can cause a company the loss of its money as well as reputation. The acquirer must look in all the directions for a current, pending and even expected future litigations. Litigations can come from customers, vendors, employees, and government.

Health and Safety

Workplace health and safety has become significantly important in recent years. It is the company’s responsibility that the employees get a healthy and secure work environment. Under legal due diligence, acquirer tries to understand the target company’s compliance with standards of health and safety. These standards may include anything from the availability of safety gear in factories to healthy ventilated offices.

Furthermore, the acquirer must also look into pending litigations related to health and safety which may be risky in the future. For example – sexual harassment litigation on the target company must be eliminated before the M&A transaction.

Environment Laws

Compliance to environment laws has become a very serious issue lately. Especially if the target company is manufacturing unit, it is necessary for the acquirer to understand factors such as – Is the company well within their range of carbon footprint limit? Does the company have a wastewater management plant in place? What process is used to dispose of solid waste? etc. Even if the target is not a manufacturing company, it may still fall under certain environmental standards which it must conform to. Moreover, one must also check if the target has any pending litigation under non-adherence to the environment law.

The overall goal of the legal due diligence to understand all the current and future legal risks and liabilities before the merger or acquisition, and try to eliminate as many as possible.

Advantages of Legal Due Diligence

There are four main advantages of legal due diligence as follows –

Opportunity to Understand Target Company

When the question is to conduct legal due diligence of the target company, all the legal documents are considered. Documents such as the Memorandum of Association, Articles of Association, bylaws, minutes of past meetings, non-disclosure, and other legal agreements, etc. are analyzed in detail. This helps the acquirer understand the target company and its operations before purchase.

Aids Determination of Fair Price

The second important advantage of this due diligence is that through legal due diligence the buyer can obtain information that can help determine the fair price of the target company. When we analyze the financial, structural and operational aspects of the target company, it so happens that the finer factors such as lawsuits against the company, employee and labor agreements, details about intellectual property, etc. come to the light. This gives the buyer and the target company a good base to start a negotiation. Furthermore, this process will make sure that both the parties deal at a fair price for the M&A transaction.

Aids in Preparation of a Strong M&A Contract

An advantage of the legal due diligence is that it helps identify the problems that may act as a hindrance in closing the deal. When both parties know possible problem points, they can discuss and eliminate them during the process of negotiation. Thereby, they make sure that the transaction occurs smoothly and without any hurdles.

Identifies Future Legal Risks

Other than the risks that may cause trouble in closing the deals, there may be risks that are embedded within the target company that may become problems post-merger. Such risk may include pending litigations, approval on pending intellectual property such as patent, trademark, etc., tax and other government liabilities, etc. These risks can cause major problems in the future, and lead to negative value after the M&A deal. Legal due diligence helps identify these future risks today. These risks can be eliminated or at least taken into consideration during the transaction.1,2

1.
Legal due diligence best practice. Dentons. September 2019. [Source]
2.
M&A Directions: Getting the most out of your M&A Legal Due Diligence. Ashurst. September 2019. [Source]
Last updated on : September 3rd, 2019
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