Introduction
Due diligence refers to investigations and research conducted on a business or individual before entering into an agreement with another party. The Securities Commission Guidelines define due diligence as a process of conducting enquiries and investigations, assessing risk tolerance, and ensuring timely, sufficient, and accurate disclosure of material statements, information, and documents.
Conducting due diligence is an important step in corporate transactions be it mergers & acquisitions (M&A) or Initial Public Offerings (IPO). During an M&A, the legal principle of "caveat emptor", or "let the buyer beware", is the reason for due diligence. The burden is on the buyer to ensure that the goods or shares they are purchasing have the desired quality and value. Thus, due diligence is crucial for buyers to avoid unforeseen harm. Whereas, in an IPO exercise, due diligence is conducted to identify any potential legal issues that could affect the company's potential market value, ensure compliance with regulatory requirements, and provide transparency to investors
In Malaysia, the regulatory framework for public listed companies requires high standards of disclosure and due diligence in corporate proposals and share acquisitions. Investors have the responsibility to assess the merits of primary offerings of securities, while the target company must adopt high standards of disclosure.
Legal Due Diligence
Legal due diligence involves a review of key areas such as corporate information, business activities, material contracts, litigation, personnel, real property, intellectual property, and compliance with laws and regulations. The first step in legal due diligence is reviewing all corporate information, including the memorandum and articles of association of the target company/issuer, as well as minutes of shareholders and directors’ meetings. This will provide a guideline to the basic corporate structure of the target company/issuer and any associated companies or interests held by the target company/issuer or its directors
This exercise also involves an analysis of contracts to uncover triggering termination clauses and/or breach clauses that may be pertinent for the buyer/investors to be aware of. The objective is to determine whether a change of ownership in the company would nullify material contracts. Additionally, legal due diligence will encompass the potential discovery of any existing litigation action the target company/issuer is subjected to, as well as a review of all employment contracts, including remuneration, length of employment, and termination provisions.
Depending on the nature of the business and industry sector of the target company, legal due diligence will also involve a review of licenses and approvals required, as well as an assessment of intellectual property matters such as trademarks, trade names, copyrights, or patents that have been registered or pending. Arrangements with third parties are also reviewed to ensure that any intellectual property is protected by confidentiality or non-disclosure agreements.
For the purpose of this article, we will explore key approvals to be obtained and matters to look out for when reviewing contracts, during a corporate exercise such as an M&A.
Checklist of Approvals to be obtained
When commencing an M&A transaction, determining the necessary approvals and notifications for the deal can aid in organizing the workflow and establishing a timeline. These approvals and notifications mainly pertain to changes in control, shareholders, shareholding, or directors of the company being targeted.
Complying with regulatory requirements by obtaining approvals from relevant authorities. For example, acquiring shares in a company involved in banking or insurance necessitates prior written approval from the Central Bank of Malaysia if the acquisition surpasses the thresholds specified under the Financial Services Act 2013.
Securing approvals from directors and shareholders of both the selling and buying entities (if they are corporations) for the transaction. Shareholders' approval may not always be mandatory, as it depends on factors like the respective constitutions and shareholders' agreements (if any) of the involved parties. In cases of public companies listed on Bursa Malaysia, shareholders' approval is obligatory if the transaction exceeds the thresholds prescribed under the Listing Requirements.
Obtaining the target company's directors' approval for the transfer of shares from the seller to the buyer.
Seeking approval or waiver from shareholders who choose not to sell their shares in the target company. This is in accordance with the terms specified in the shareholders' agreement or constitution, if applicable.
Gaining approvals or notifying banks and other financiers about the changes in control, shareholders, shareholding, or directors of the target company, as stipulated in the financing documents.
Receiving approvals or notifying counterparties as outlined in the terms of agreements.
Obtaining approvals or notifying relevant authorities based on the conditions of licenses, permits, and approvals granted to the target company by these authorities
Other approvals may also pertain to the following:
Antitrust and Competition Clearances
Depending on the jurisdictions involved and the size of the transaction, antitrust or competition authorities may need to review and approve the merger or acquisition to ensure it doesn't create a monopoly or significantly reduce competition in the market;
Environmental and Regulatory Approvals
In cases where the target company operates in industries with significant environmental impact, there might be a need to obtain environmental and regulatory approvals;
Consent from Landlords or Real Estate Owners
If the target company leases its premises or operates on properties owned by third parties, obtaining their consent in certain cases for the transfer of the lease or change in ownership may be required.
What to look out for when reviewing Contracts
In our experience, most buyers prefer a condensed legal due diligence report known as a "red flag report" instead of a comprehensive one. The red flag report focuses solely on highlighting potential legal issues, particularly concerning contracts entered by the target companies.
This type of report covers the following contract-related aspects:
Identifying whether the contracts allow counterparties to unilaterally terminate them or terminate them based on specific events triggered by the M&A transactions, such as change of control or shareholding provisions.
Determining if the contracts grant the target companies or the counterparties the ability to terminate the agreements without any specific cause.
Investigating the presence of liquidated damages, penalties, uncapped liability or indemnity, or service level clauses that may lead to loss-making contracts.
Clarifying the ownership of intellectual property rights for deliverables (e.g., reports) provided by the target companies to their clients.
Analyzing whether the contracts include any covenants and exclusivity provisions that could restrict the target companies' business operations.
Checking for the presence of extension or renewal clauses within the contracts.
Examining whether counterparties have the right to assign the contracts to third parties without obtaining consent from the target companies.
Identifying any other burdensome provisions that could potentially impact the business or financial standing of the target companies.
Conclusion
Legal due diligence is a critical step in any corporate exercise, whether for M&A transactions or IPOs. It provides both buyers and investors with a detailed assessment of potential legal risks, allowing for informed decision-making. By ensuring regulatory compliance and uncovering any contractual or operational issues early on, companies can mitigate unforeseen complications, protect their interests, and enhance the success of their corporate ventures. Conducting thorough due diligence fosters transparency, reduces risks, and ultimately facilitates smoother, more secure transactions that benefit all parties involved.
The above content presented in this article is meant solely for offering general information and should not be considered as legal opinion or professional advice. Should you speak to any one of our lawyers to assist you on a potential transaction please feel free to contact us for a complementary consultation.
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