Understanding legal due diligence – Investors, Promoters, VC’s, Corporates – Know this before investing

With the growing liberalization of the Indian economy, a legal due diligence exercise has become a common feature of any investment activity. A legal due diligence process has become necessary for protection of economic interests of the investor and it affords an opportunity for the Indian promoters to be transparent in sharing information, so as to be able to compete with their competitors globally. The Indian promoters have also realized that their effective co-operation in the legal due diligence process is absolutely necessary for the growth of their business.

Globally, the necessity of a legal due diligence springs out of lack of an independent, reliable and exhaustive information resource on the basis of which an investor can make an informed investment decision. Hence the need to be dependent on promoters for information. In India, though independent searches at some of the government offices (like Registrar of Companies, Registrar of Assurances etc) will help in accumulation of some basic information, it is not possible to base an investment decision on the limited information available at such offices. Resultantly, the ability of the investor to conduct a thorough due diligence and make an informed decision on investment depends on the extent of co-operation given by the promoters.

A legal due diligence is a precursor to any private equity investment, merger, acquisition, initial public offering or any lending activity in India. The process involving a battery of lawyers, accountants and in some cases tax experts has become so important that in many cases the result of the exercise, will dictate the success of an investment.

So, what does a legal due diligence process involve? Broadly, it involves the following;

INFORMATION GATHERING : The exercise is a source of information on important matters, which will have a bearing on structuring a transaction. An investor will look to extract information about various matters including ownership of the company, background of the promoters, details of projects being undertaken, the company’s existing commitment to the lenders, rights available to other investors in the company, company’s adherence to corporate governance practices, disputes facing the company and the promoters, company’s strategy to deal with its competitors, permissions required for consummation of the investment etc

IDENTIFICATION OF RISK Knowledge of existing regulatory regime will help a lawyer in identifying the areas of legal non-compliance. Depending on the seriousness of a non-compliance and its consequence, an investor will look to the advise of a lawyer on whether the non-compliance needs to be cured before the investment.

MITIGATION OF RISK This is the key element of a legal due diligence processIn the process, the advisor would recommend ways to mitigate the risks identified, so that the company does not face the prospect of being penalized or prosecuted for being on the wrong side of the law. Typically, an investor’s preference would be to engage in a discussion with the legal advisor, understand the consequences of non-compliance and ensure that all non-compliances are cured before the investment proceeds are remitted to the company’s bank account. In respect of non-compliances, which do not have a significant effect on the business, it is also common to find that the investor may prefer such non-compliances to be cured within a specified period after the investment.

BASIS FOR NEGOTIATION The issues, which are incapable of cure/ remedy, would form a basis of negotiation, where the parties would need to decide on who is to bear the risks arising in future. In this process of risk allocation, a party may either agree to bear the risk completely or only up to a particular extent. In a private equity investment, these issues are addressed in the representation and warranty (as also indemnity) section of the investment agreement.

An agreement is invariably a result of lengthy negotiation between the investor and the promoters on a whole lot of issues ranging from lock-in on transfer of promoters shares, investors ability to veto certain decisions, promoters ability to start a competing business, special rights available to an investor to exit from the investment, investor participation in formulation of a business plan etc. An effective and a thorough legal due diligence will ensure that the investor has adequate information to be able to make informed decisions.

In a nutshell, investor’s understanding of the way in which the business is being run and the promoter’s understanding of the expectations of the investor is the beginning of a successful Venture.

Author :  Vasudev S, Corporate Advocate. The views expressed are personal.

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