Due diligence is a study and analytical procedure that is carried out before a merger and acquisition, an investment, a business partnership, or a bank loan to establish the worth of the topic of the due diligence, if there are any serious difficulties, and to ensure that the transaction is legal. There are majorly 3 types of due diligence, namely, business due diligence, legal due diligence, and financial due diligence.
Brief History of Due Diligence
Due diligence is a term that refers to the process of completing a transaction. It became popular after the passage of the United States Securities Act of 1933, specifically Section 11b3, which states that sellers of securities must provide sufficient information to allow investors to make an informed decision before purchasing. The phrase signified “necessary carefulness” or “due care” in this context. Since then only the expression has become common to other areas and has found its most common use in mergers and acquisitions.
Need for Due Diligence
A Company needs to initiate the process of due diligence because it performs various functions that benefit both buyers and sellers in a merger or acquisition. These benefits include the following:
- To confirm and verify the information that was brought up in a particular deal or investment
- To identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
- To obtain information that would be useful in the valuation of the concerning deal
- To ensure that deal or investment opportunity complies with the investment or deal criteria
Challenges to Due Diligence
Some of the challenges in undertaking the due diligence in distress M&A are given below:
- Lack of information: Due diligence on a corporate debtor is limited by a lack of shared information, since the reliance on information at several levels, beginning with the IRP, COC, and existing management for supplying important information, frequently leads to discrepancies that can lead to conflicts.
- Access to the information: Since the management of the affairs of the corporate debtor vest in the IRP; having access to the information itself is a challenge. This has to do with the IRP, who, in most cases does not possess knowledge of the industry and simply relies on the promoters and other officers of the corporate debtor for such information. The promoters, being already removed, are typically not very cooperative and leave a huge piece of anonymous information with the IRPs. Though, the IBC directs the promoter or the other person to co-operate with the IRP and provides IRP a right to approach NCLT with an application for necessary directions just in case of default.
- Time Factor: In a normal M&A situation, the stakeholders have time to negotiate with third parties to obtain consents or negotiate changes to allow the sale to proceed, but in an unsettled sale, there could be situations of interaction with third parties who have interests in the sale of assets and over whom the seller has no control. This can create significant delays in the wind-up of a transaction.
Due Diligence in Indian Law
In India, there are no particular regulations governing due diligence, but the Securities and Exchange Board of India (SEBI) and various clauses in the Companies Act, 2013 put a requirement on directors to act in the best interests of the firm. While doing so, he is required to exhibit proper caution and expertise. In Nirma Industries and Anr v. Securities Exchange Board of India, the Supreme Court held that under Regulation 27 (d) of the SEBI, 1997, an investor Company needs to ensure that appropriate due diligence is carried out with respect to the target company before investing.