Legal Due Diligence Before a Transaction

What is legal due diligence?

There is no single statutory checklist that applies to every transaction. The scope of due diligence depends upon what is being acquired or transferred, who the parties are, the structure of the transaction, the industry involved and the legal risks particular to the subject matter.

A transaction involving the acquisition of shares in a company may require examination of the company’s incorporation and governance records, ownership and capital structure, material contracts, litigation, regulatory compliance, employment arrangements, intellectual property and indebtedness.

A transaction involving immovable property may require a different review, including the chain of title, registered documents, encumbrances, permissions, land-use restrictions, possession and pending disputes.

An acquisition of a business or undertaking may require both forms of examination, together with a review of the contracts, employees, licences, assets and liabilities that are intended to move with the business.

Begin with the transaction itself

Before reviewing documents, it is useful to understand precisely what the parties propose to do. The legal questions can differ considerably between different types of transactions.

The transaction structure determines what is actually changing hands and which liabilities remain with the existing owner. This distinction affects the scope of the review and the protections that may need to be built into the transaction documents.

A useful preliminary exercise is therefore to identify:

• What is being acquired or transferred?
• Who currently owns or controls it?
• What rights accompany it?
• What liabilities or obligations may remain attached to it?
• What approvals or consents are required?
• What could prevent the transaction from being completed or the intended rights from being enjoyed afterwards?

Corporate and ownership position

Where a company or other business entity is involved, the first questions concern its legal identity and the authority to undertake the transaction. The review may include:

• constitutional and incorporation documents;
• current ownership and shareholding;
• authorised and issued share capital;
• shareholder and partnership arrangements;
• board and shareholder resolutions;
• changes in ownership or control;
• statutory filings and corporate records;
• existing charges and security interests;
• related-party arrangements; and
• the authority of the relevant persons to enter into the proposed transaction.

The Companies Act, 2013 contains specific requirements regarding the registration of charges created by companies over their property or assets. Section 77 requires a company creating a charge to register prescribed particulars with the Registrar within the statutory framework. A registered charge can therefore be an important part of the legal review when assets or businesses are being acquired.

Assets, title and encumbrances

Where the transaction involves assets, ownership should be distinguished from possession or registration. This is particularly important for immovable property.

Indian property registration operates within a system in which registration of a document does not, by itself, amount to conclusive proof of title. The Supreme Court has recently reiterated that registration creates a public record with presumptive evidentiary value and that prospective purchasers therefore need to undertake title due diligence, including examination of the chain of ownership and encumbrances.

Depending on the transaction, an examination of property may include:

The same underlying principle applies to other assets: the question is not simply whether an asset appears on a balance sheet or is physically controlled by the seller, but what legal right exists in relation to it and whether that right can be transferred as contemplated.

Contracts and commercial relationships

A business may derive much of its value from contractual relationships rather than from physical assets. Material contracts should therefore be reviewed for provisions that could affect the transaction or the future operation of the business.

Depending on the circumstances, this may include:

• customer and supplier agreements;
• leases and licences;
• distribution and franchise arrangements;
• financing documents;
• guarantees and indemnities;
• joint venture or shareholder agreements;
• technology and service agreements;
• long-term supply or purchase commitments;
• confidentiality obligations;
• non-compete or non-solicitation provisions, where legally relevant;
• termination rights;
• change-of-control provisions;
• assignment restrictions; and
• dispute-resolution clauses.

A contract may contain a right to terminate, require consent, restrict assignment or become subject to particular consequences when ownership or control changes. These provisions can be easy to overlook if the review is limited to the principal transaction documents.

Litigation, disputes and legal claims

Pending litigation is an obvious area of review, but legal exposure is not necessarily limited to cases already filed in court. The review may need to consider:

• pending suits and appeals;
• arbitration proceedings;
• tribunal proceedings;
• regulatory proceedings;
• legal notices;
• threatened claims;
• settlements and undertakings;
• judgments and orders;
• execution or enforcement proceedings; and
• disputes involving material contracts or assets.

The purpose is to understand what each dispute concerns, what rights or liabilities may arise from it, and whether it affects the transaction or the value of what is being acquired.

Regulatory, compliance and other considerations

Regulatory diligence depends on the business involved. A company operating in a regulated sector may require licences, registrations, approvals or continuing compliance with sector-specific legislation. Even businesses that are not heavily regulated may have obligations under laws relating to employment, taxation, environment, consumer protection, competition, data, property, foreign investment or other areas.

Questions may include:

• What licences or registrations are required?
• Are they valid and current?
• Are they transferable?
• Have required filings been made?
• Are there outstanding notices or proceedings?
• Are there restrictions on the proposed transaction?
• Does a change in ownership or control trigger approval or notification?
• Are there material compliance failures that could result in penalties or loss of the relevant permission?

From findings to transaction decisions

Not every issue identified during a review has the same significance. A practical classification may be:

A practical due diligence checklist

Before completing a transaction, the following questions provide a useful starting point:

Due diligence is about knowing what you are agreeing to

Legal due diligence does not eliminate all risks. Its value lies in improving the information on which the transaction is considered. A considered due diligence process allows the parties to proceed with a clearer understanding of the legal position before the transaction becomes difficult to unwind.