Due Diligence Issues in M&A

By Sonakshi Das, School of Law- KIIT University

Editor’s Note: This paper discusses the need for a due diligence in M&A. In today’s business world, the concepts of due diligence and corporate governance are of increasing importance. Due Diligence is not mandatory, however SEBI mandates certain parties to undertake a due diligence, in the context of issuance of securities by a company. The author argues that due diligence is a very essential procedure for a corporation and when suitably conducted, it attaches a high degree of fairness to the whole transaction and this also leads to a significant reduction in the risks associated with a cross-border acquisition of a foreign companyThis paper further goes on to elaborate on the issues that are generally faced during Mergers and Acquisitions.


To make most of the literal deliverance of the term, due diligence is an on-going, proactive and reactive process through which companies can ensure that they respect human rights and do not contribute to conflict[1]. Or so as to say, it is a process of thorough and objective examination that is undertaken before corporate entities enter into major transactions such as mergers and acquisitions, issuing new stock or other securities, project finance, securitization, etc[2]. One of the key objectives of due diligence is to minimize, to the maximum extent practicable, the possibility of there being unknown liabilities or risks. The exercise is multi-dimensional and involves investigation into the business, tax, financial, accounting and legal aspects of an issuer.

No statute defines the term ‘due diligence’. However, the SEBI[3] mandates certain parties to undertake a due diligence, in the context of issuance of securities by a company. Of the number of mandates that SEBI has regularized, one of them speaks of the BRLMs to exercise due diligence and satisfy themselves about all the aspects of the issue[4]. The BRLM is also required to call upon the issuer, its promoters or in case of an offer for sale, the selling shareholders, to fulfil their obligations as disclosed by them in the offer document[5].

The BRLM is required to submit post-issue reports to the SEBI[6], along with a due diligence certificate as per the format specified in Form G of Schedule VI, along with the final post-issue report.

In today’s business world, the concepts of due diligence and corporate governance are of increasing importance. Both concepts have broadened as regards their scope and meaning. Indeed their application has also come to overlap as a result of the regulatory and voluntary frameworks that are emerging globally. From purely economic roots, they have come to encompass many aspects of corporate behaviour. Moreover, in view of the corporate scandals that continue to attract media headlines and demonstrate the need for improved due diligence and corporate governance, all organisations – regardless of their size or location – should regard these issues as paramount.

An understanding and respect for due diligence and corporate governance make absolute business sense. Moreover, it is very important that any definition of due diligence is clear. Charles Francis Bacon, Founder of the Association of Due Diligence Professionals (ADDP), has referred to this in important ways that are quoted below. It is essential to set some parameters around the terms that we want to review and analyse since for due diligence, there is an endless variety of related words in the dictionary that we can apply[7]. For the present purpose, it is not very useful to set out all of the available definitions, nor to suggest all the legal terms that appertain to due diligence. It is more helpful to propose a few meanings that support the premise and the background to the initiative to create a fully professional approach to those who undertake due diligence.

The importance, ergo, of such a process can be categorically coined as “mainly a legal and financial course of action, first designed to avoid litigation and risk, second to determine the value, price and risk of a transaction and third to confirm various facts, data and representations”[8]


Whereas financial and legal due diligence ascertain the potential value of a deal and concern buying the company “at the right price,” Strategic Due Diligence explores whether that potential is realistic (however luring). It tests the strategic rationale behind a proposed transaction with two broad questions. Is the deal commercially attractive? And are we capable of realizing the targeted value? The first question requires external inquiry; the second demands an internal focus. Each question partially informs the other, reinforcing an inquiry that thoroughly plumbs the wisdom of the deal.

Looking at all, strategic due diligence ensures that no two transactions are treated in the same way; each deal has its own value drivers, and thus the composition of each due diligence team must change[9]. Executives should determine which areas of the organization will produce value in the merger, and draw members of the due diligence team from those areas accordingly. Strategic due diligence counterbalances the danger of institutionalizing and replicating a diligence capability ill-fitted for the task at hand. Companies must tailor their process to the issues and potential integration challenges of each specific deal.

When analyzing a business be it for investment, acquisition, merger, or as part of an existing group or holding looking at historic and current trading performance is relatively easy. But what about looking further into the future, what are the strategic issues ahead. What are the risks of significant demand or supply changes what is the chance of new technological or regulatory change, or the deployment of new business models and market propositions which could have a major impact on the business in question?

Strategic due diligence, thus, adds an important deal-screening filter. After all, executives must be convinced not only that the potential deal value justifies the significant investment being made, but also that the business is truly capable of realizing this value[10]. Indeed, a sober strategic due diligence evaluation should help set the purchase price. The buyer should demand a price that is consistent with the level of integration risk uncovered and be willing to walk away if that price isn’t met.


To begin with, each company has its own set of culture, derived from several components: corporate policies, rules, compensation plans, leadership styles, internal communication, physical work environment, and the like. Cultural due diligence attempts to answer the question as to what is the extent two companies change and adapt to the differences between the two corporate structures. The wider the cultural gap, the more difficult it will be to integrate the two companies[11]. Consequently, cultural due diligence identifies issues that are critical to integration and helps management plan necessary actions for resolving these differences before the merger is announced.

Workforce assessment

The fundamental drive of total business operating cost and work efficiency is headcount and determining how the labour is organized into jobs. The prime objective should be to determine whether the headcount allocations for each job category are structure efficient or otherwise. If relevant workforce has been on the pedestal, then one should enquire of the skills inventory. An instance on this mode, if it is a trades or technical organization, the factors to be taken into account should be the formal education qualifications of the staff members, the customer service unit and the formal training given to the customer service representatives, and the like.


One of the most critical areas is remuneration since issues flatten out to take longer duration to be resolved. If the staffs are underpaid, it costs a lot for business organizations to bring them to the market rate and most business employees cannot afford a hundred percent wages increase at a go. If the staffs are over-paid, then in a low inflation environment and a tight labour market, it would seem like a walking on egg shells exercise to realign the pay system. Ergo, it becomes essential to obtain staff remuneration data and underpaid labour market position prior to the pending merger[12].

Employment agreements and legal compliance

It becomes essential to check the redundancy liabilities including staff transfer obligations, leave obligations, employment agreement entitlements, trade union arrangements, health & safety, contractual commitments with HR-related suppliers and the target’s history on legal action, eg, a history of difficulty with personal grievances or OSH infringements maybe a symptom of sub-standard people management and a demotivated workforce[13].

Cultural and talent indicators

Because culture is the aggregation of individual behaviour, individuals having knowledge of key company personnel need to be questioned on the staff behaviours experienced at their behest. Interviewing key senior managers and collecting information on skills of staffs in specific areas shall be a determinant in analyzing core directional methodologies for the company.


A director is duty-bound to fulfil his fiduciary obligations towards the company and always act in the best interests of the company. The standard of care and skill required from a director was enunciated in City Equitable Fire Insurance Co., Ltd., In re, whereby it laid down a very mild duty of care and skill on the directors of the company and operated on the presumption that the directors, in making a business decision, acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company, unless the contrary was proved. However, the principle endorsed in the aforementioned judgment is redundant in the present day.

The position of the directorship comes with a very exorbitant standard of care and diligence and the business judgment rule has witnessed a high degree of modification. A landmark case law which merits a mention is that of Smith v. Van Gorkom, which was the harbinger of the principles of informed decision-making and process due care. In the aforesaid case law, the Court reasoned that in addition to the director’s fiduciary duty of informing himself in preparation for a decision, there is an affirmative duty on the director to protect the interests of the company, which is to be realised in a critical manner after assessing all the material information available under the prevailing circumstances.

Further the Court, as regards the business judgment rule is concerned, opined that the directors will enjoy no protection in cases where they have failed to act in a presumably reasonable manner. The focal point of the Court’s derivation was the process by which the Board made its decision, exhaustively specifying its many purported process failures, and thus establishing the requirement of a procedural, or process due care as a prerequisite for invoking the business judgment rule. The Court also went on to lay down an ideal procedure for the directors to follow in arriving at a business decision. The Court’s opinion categorically accentuates the necessity of undertaking careful planning and structuring of Board participation when initiating a major corporate transaction such as the sale of the company.


There are four distinct levels of a due diligence which a company looks into before it goes in for a merger or an acquisition. This move acts as a safeguard for the acquirer company in its future prospects.

Investigation of the industry is the first level of due diligence. It applies not only to the business but also to the technical and human resource analysis and is the investigation done by the acquirer company of the industry to which the target company belongs. For example, if the acquisition is of an airline corporation, the acquirer should first study the aviation industry as to whether it is subject to government regulations, who are the potential investors in the industry, scope of FDI and if any restrictions on the same, financial results for comparable companies, IPR issues, etc. This analysis would have a greater impact on vertical and conglomerate mergers since the acquirer would be entering a new industry that he is not very familiar with.

Investigation around the target is the second level of due diligence which deals directly with the net worth of the target company in the industry. The directors in this stage are duty-bound either by themselves or by specialised agencies to assess the company’s market position, reputation, potential for growth and other allied factors. For instance, when Proctor & Gamble acquired Gillette, it is not sufficient just to investigate on Gillette, but also require P&G to do a thorough analysis of the target by going through their business, management evaluation, financial condition, customer opinions, etc. Thus this stage is even more important for vertical and conglomerate mergers.

Investigation of the documents is the third level of due diligence and also the most critical stage of the due diligence process. In this level, the acquirer has a direct communication of information and documents with the target company. The acquirer first expresses his intention to go ahead for the acquisition and thereafter solicits the required documents from the target company. The acquirer’s due diligence check-list for these required documents is given as an annexure for examination which requires all documents connected to the corporate records and licensing regulations of the company, regulatory filings, financial and other business related information, investments, litigation, taxation issues among others. There may be cases where the target company may not disclose the complete information, for instance, in matters related to pending litigation. Thus a stringent verification of the documents and the information procured is very important to overcome such problems.

Investigation for public records is the fourth level of investigation which requires the acquirer company’s examination of the public documents which mainly consists of a review of the incorporation documents, outstanding debts, pending litigation, HR issues, retirement plans among others.

Thus, these four levels constitute the due diligence procedure which is undertaken by corporations before entering into an acquisition. In order to ensure that this procedure is undertaken successfully, corporations engage experts from outside the organisation as well, for example, tax consultants for taxation issues, lawyers for pending litigation and other legal issues and HR management agencies for labour and HR related matters.

With globalisation increasing, the number of corporations growing inorganically in the form of mergers and acquisitions is also increasing thereby consolidating the market with fewer and larger entities[14]. Therefore, success of M&A is important and strategies that increase such chances for success need to be mastered. India, which has seen many major M&A activity within the country, is slowly spreading its wings across the border. There have been significant acquisitions overseas by Indian companies in Europe, US and Asia Pacific regions recently. While international banks are flushed with liquidity, financial markets on the other hand, are flooded with products like credit-linked notes that help banks to ease off their risk. The risk appetite of private equity players and investment banks has now increased and they are willing to fund companies growing either organically or inorganically. Many firms like GE, Nokia, Infosys and Google are focusing on delivering higher organic growth from internally created innovations within their core businesses.

Thus in our opinion, due diligence is a very essential procedure for a corporation and when suitably conducted, attaches a high degree of fairness to the whole transaction and also leads to a significant reduction in the risks associated with a cross-border acquisition of a foreign company[15]. A future generation due diligence system and strategy will lead to a significant improvement in financial performance, strengthen competitive positions, expand organisations more effectively, preserve human performance and develop internal know-how. With the application of these improvements companies will be better equipped to expand and develop through mergers and acquisitions, spin-offs and alliances. It pumps in fresh blood into the economy as well as advances its abilities and success rate when acquiring or merging.

Edited by Hariharan Kumar

[1] OECD (2011), OECD Guidelines for Multinational Enterprises, OECD, Paris; OECD (2006), OECD Risk Awareness Tool for Multinational Enterprises in Weak Governance Zones, OECD, Paris; and, Guiding Principles on Business and Human Rights: Implementing the United Nations “Protect, Respect and Remedy” Framework (Report of the Special Representative of the Secretary-General on the Issue of Human Rights and Transnational Corporations and other Business Enterprises, John Ruggie, A/HRC/17/31, 21 March 2011).

[2]Steps involved in due diligence process’ <accessed at: http://www.divest.nic.in/due_diligence_process.pdf>

[3] The Securities and Exchange Board of India <accessed at: www.sebi.gov.in>

[4] Regulation 64 of Chapter VI of the ICDR Regulations

[5] Ibid.

[6] Regulation 65 of ICDR Regulations

[7] Supra note 2.

[8] As defined by Charles Bacon, ‘A Traditional understanding of Due Diligence’.

[9] Report on Corporate Law – Dealings and having dealt, M.S.Rao Committee.

[10] Ibid.

[11] T.M. Rasheed, ‘Professional program on Due Diligence and Corporate Compliance Management – An Overview’, The Hindu, 12/06/2013, last seen on 10/08/2013.

[12] Ibid.

[13] Francis Cherunilam (5th edition). International Economics. p. 456.

[14] Executive Committee Conclusion No. 102 (LVI) – 2005, Report of the 56th Session, UN doc. A/AC.96/1021, 7 Oct. 2005, para. 20 (f).

[15] ‘A Global Humanitarian Organization of Business Standards’, by William Davis.

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