Conducting a legal due diligence is usually the preliminary step taken by an investor intending to enter into an asset or share sale transaction. The purpose of a legal due diligence is to assess the potential risks of a transaction by investigating the obligations and liabilities of the target company. This provides objective and reliable information to a potential purchaser as to whether to proceed with the transaction or ring fence, exclude or limit the risks, and negotiate warranties or the purchase price.

The scope of the due diligence is usually determined by the type of business conducted by the target company and the size and the type of acquisition envisaged (such as whether it is a sale of shares or a sale of business). Depending on the requirements of the specific due diligence, the due diligence team could be multidisciplinary, including financial and technical experts (in addition to legal experts).

A purchaser should always ensure that there is a condition precedent in the sale agreement regarding the successful completion of a legal due diligence to the satisfaction of the purchaser. This will ensure that the purchaser has an exit opportunity from the sale agreement if the legal due diligence results are not satisfactory to the purchaser. A seller will usually expect a non-disclosure agreement to be signed by the potential purchaser prior to the legal due diligence being undertaken.

A legal due diligence generally covers an investigation of the following areas: corporate, commercial contracts, employment, intellectual property, information systems, environmental, health and safety, regulatory compliance, competition, litigation, property and tax. A due diligence should also provide a framework to enable understanding of the jurisdiction in which the target company is operating.

Whilst a full and detailed due diligence on the target company is always recommended, with limited exceptions only, a high-level due diligence will achieve similar results. In the latter case, red or yellow flags highlighting “deal-breaker” or “commercially negotiable” issues respectively will be indicated. Documents are usually provided by the seller in response to a specific due diligence questionnaire prepared by the purchaser’s lawyers. It is also useful to have face-to-face interviews with key management of the target company to obtain first-hand information or clarification in regard to specific issues.

A prudent purchaser should utilise the results of a due diligence investigation as a negotiation tool in the transaction. For instance, any potential liabilities discovered (such as tax liabilities, litigation, outstanding amounts due by debtors, fines/penalties imposed) can be used as a pricing chip to reduce the amount of the purchase price.

Where risks have been identified, the seller could provide warranties or indemnities to protect the purchaser from any future liabilities which may arise from these risks. Where consents and approvals are required, to assign contracts or licences or in relation to change of control provisions or pre-emptive rights, these can be incorporated as conditions precedent in the sale and purchase agreement. Furthermore, where specific issues require action by the seller prior to the implementation of the transaction, these may also be added as conditions precedent in the sale and purchase agreement.

The more thorough the due diligence is, the more specific the ensuing contractual protection can be. Although a due diligence may not uncover or quantify every risk in the transaction, it provides a comprehensive platform from which to negotiate the transaction, especially in instances where there is full disclosure by the seller. It gives the purchaser a bird’s eye view of the target company’s business in order to make an accurate assessment of the pertinent issues and limit any potential future exposures.