In this post I will explain the goals of legal due diligence (“DD“) reports, information request lists (“IRL“) and the importance of legal DD in M&A transactions. Let’s start:

A – Goals of Legal DD

Almost every M&A transaction involves a DD process, regardless of the jurisdiction in which the transaction would take place. This process usually involves inputs from multiple teams, such as financial, tax, legal and technical DD teams.

The legal DD may be carried out by the vendor prior to negotiating with potential buyer(s). In that case the report prepared at the end of the exercise would be referred to as a “vendor’s DD report”. The DD may also be carried out by potential buyers following the execution of a non-disclosure agreement (NDA). In that case the end-product would be referred to as “buy-side DD report”.

The goals of legal DD reports – that are specific to vendor’s reports – can be summarized as follows:

1. Provide the vendor company with an opportunity to decide whether it would be financially and/or strategically worthwhile to make the transaction altogether;
2. Provide the vendor company with an opportunity to decide what percentage of the target company’s ownership that the vendor would be willing to divest;
3. Enable the vendor company to do proper “house-keeping” before the parties commence negotiating the transaction terms. This may include completing the missing permits or approvals, adopting the required board decisions or settlement of ongoing legal disputes;
4. Provide the vendor company with a realistic expectation as to the company’s financial valuation in the market;
5. For target companies that are a subsidiary of the vendor, how the business relationship between the vendor and the target company will be conducted beyond the date of closing.

On the other hand legal DD reports – that are specific to buy-side reports – can be summarized as follows:

1. Detect (or prove the absence thereof) any “deal-breaker” issues, which could be a ground for terminating the negotiations between the parties;
2. Find out information about the target company, which is not accessible from publicly available resources;
3. Provide grounds for the negotiation of representations and warranties (rep&war);
4. Provide concrete data for an accurate financial valuation of the company;
5. Provide a preliminary action-plan for the post-transaction integration and smooth transition of the target company.

B – Information Request Lists (IRL)

In order for the buy-side parties and their legal teams to conduct DD on target companies, they would need access to target companies’ information. These information are often listed under a document called an IRL. The list is usually sent to the vendor’s legal team.

Depending on the industry of the target company or the nature of the transaction, the content of the IRLs can vary. However most IRLs include the following sections:

• Corporate documents (AoA, minutes of GA, minutes of BoD meetings, and a list of authorized signatories);
• Material agreements (supply agreements, sales agreements, lease agreements);
• Financial agreements (loan agreements, financial leasing agreements);
• Property title records (deeds of the real estate properties, or vehicle registrations);
• Litigation records (documents as to court proceedings or arbitration awards);
• Regulatory documents (target company’s permits, licenses, concessions);
• Insurance policies (usually includes a list of assets that are covered by the insurance policy);
• Employment agreements (a template employment agreement).

Depending on the industry of the target company, the IRL can also include:

• Domain registrations (especially important for e-commerce companies);
• IP registrations (such as patents or trademarks) (especially important for technology and R&D companies);
• Correspondence with regulatory authorities (especially important for regulated industries such as banks and financial institutions).

C – Components of Legal DD Reports

As a response to the IRLs, the legal DD teams are provided with the required documents and a legal DD report is prepared at the end.

Whether it is a vendor’s report or a buy-side report, the reports usually have the following findings in it:

1. Good standing of the company and its ownership structure;
2. Corporate organs and their functions;
3. Issues related to material agreements (change of control clauses, termination rights or penalties);
4. Issues related to financial agreements (cross-default provisions);
5. Good title to properties (encumbrances on the properties);
6. Summary of the disputes (list of pending or potential lawsuits, their likely results and the potential liability amount tied to those disputes);
7. Regulatory compliance issues (absence of any licenses or permits, if any);
8. Insurance matters (pending insurance claims)
9. Competition compliance matters (ongoing competition investigations, or competition authority fines, if any);
10. Intellectual property matters (IP infringement cases, or pending IP right registrations);
11. Employment related matters (labor disputes, collective bargaining agreement negotiations);
12. Data protection matters (ongoing data protection measures, compliance programs, etc.).

D – Importance of Legal DD Reports

Conclusion of legal DD reports can be “make or break” moments for a transaction. In the case of vendor’s DD report, the vendor can actually abort the idea of selling the target company altogether. This can happen if the DD reports points out that there are too many “housekeeping items” that it is not feasible for the vendor company to complete them in the short-term; or the DD report can point out that the valuation of company should actually be much higher than the vendor’s expectation.

The legal DD report is equally – if not more – crucial for the buy-side. It is absolutely common for buy-side parties to walk away from a transaction because of the findings of a legal DD report. It is also very common for the parties to negotiate a completely different price tag for the target company due to such findings.

If the buy-side’s DD report fails to detect crucial issues pertaining to the target company, the buyer can face with a disastrous situation and never be able to financially recover from the investment in that particular target company.

E – Conclusion

To summarize the above, the goals of legal DD are various and essential to both buyers and sellers. IRL is the main document which lists the legal team’s document requests. The components of the report are aligned with the IRL. Lastly the legal DD reports are indispensable for deciding whether a particular transaction would be consummated or not.

Can Ergür