Due Diligence, in its simplest form, can be defined as a study of the target company in terms of many areas such as legal, tax, financial, environmental, human resources in the process of mergers & acquisitions and corporate finance transactions, conducted to clearly reveal its true condition.
As a result of Due Diligence, the Purchaser or Investor aims to reveal the true state of these areas, as well as determine the risk factors and make accurate decisions for going through with the planned transaction or its terms and conditions. This legal study is one of the most critical stages of the due diligence process.
Although there is no specific regulation in the Turkish legislation on legal due diligence review and its legal consequences, it is unlikely that a corporate finance transaction, regardless of its size will take place in Turkey or the world today without a legal due diligence process.
This Due Diligence process is mostly carried out by the Purchaser or Investor’s consultants subsequent to the signing of a letter of intent or term sheet between the parties and before the commencement of drafting of the final contract regulating the details of the transaction. At this stage, the parties have not yet signed a binding Agreement on the details of the transaction and the possibility of a definite transaction will be clearer following the due diligence.
This study has been prepared to briefly explain the legal due diligence process that has become a part of the agenda in the above-mentioned transactions.
Prior to certain merger & acquisition and corporate finance transactions, it is common for companies preparing for such a transaction to apply to an independent law firm and determine their own current legal status (vendor due diligence). In this way, companies considering to receive third party investment can objectively see their current legal situation before the legal due diligence of the investor party and make the necessary corrections.
Scope of Legal Due Diligence and Its Execution:
During a legal due diligence, the Purchaser or Investor usually reviews the Investee’s commercial books and records, operational information, financial documents (general loan agreements, etc.), contracts, movable and immovable property records, intellectual property documentation (license agreements, trademark, patent registrations etc.,) governmental permits and approvals, human resources documents and application, legal disputes proceedings such as lawsuits and enforcement procedures and environmental issues concerning the target company.
Legal due diligence investigations usually start with document request lists and legal question lists submitted to the target company by the Purchaser or Investor. The collected documentation, information and records are either physically reviewed by the Purchaser’s or Investor’s legal consultants at the premises of the target company and/or electronically through virtual data rooms designated for the due diligence. The latter practise is the most commonly seen example these days, with only highly sensitive or confidential information being subjected to a physical review at the target company’s premises.
Different Legal Due Diligence Expectations from Seller and Purchaser and Their Effect on the Transaction:
Parties in a merger & acquisition or corporate finance transaction usually have different expectations with respect to the outcome of the due diligence process.
Based on the outcome of a legal due diligence investigation, Purchaser or Investor side often determines:
i) whether the target company is incorporated and operating in compliance with the applicable laws,
ii) whether the target company carries out all of its activities in line with the applicable legislation
iii) whether the target company is under any close and probable risks such as administrative fines, tax penalties, termination of its contracts, liability lawsuits and so forth,
iv) the risks of the target company caused by legal disputes such as current and possible administrative and legal investigations, lawsuits and enforcement proceedings,
v) whether there is any risk of having the company’s operations shut down or suspended due to breach of legal requirements,
vi) the extent to which important commercial contracts of the target company, such as the supply chain and sales channel contracts may be affected by this transaction and other legal risks etc.
Information obtained as a result of the legal due diligence, together with other due diligence results, guide the buyer or investor in deciding whether to continue the transaction, and if continued, what risks they should take into account. In addition to risk assessment and valuation, due diligence process also helps with the company valuation determination of the investment amount as well as the list of representations & warranties to be requested from the target company in the final contract to be signed for the transaction.
As for the Seller or the Investee, the principal expectation from the legal Due Diligence process would be to limit its own future liability arising from the transaction. The best tool for realising this expectation would be to include exception provisions in the final transaction agreement , stating that “matters revealed by the target company in the course of its due diligence process or the documents delivered to the Purchaser/Investor or its professional advisors” would be considered “disclosed”.
In this frame, the Seller under Turkish law may attempt to claim that they are not liable for the defects already known or that should be known to the Purchaser, as these defects would no longer qualify as “hidden defects”. For this purpose, the Seller usually provides a Disclosure Letter to the Purchase, listing the exceptions of the representations and warranties.
Representations and warranties that are typically requested by the Purchaser/investor from a target company or is shareholders after a due diligence process generally include:
- The shareholders of the target company being the full legal and beneficial owner of the target company’s shares, free from any and all encumbrance,
- Compliance with applicable Law, Permits; Governmental Consents,
- Good and valid title or a valid and binding right to Company assets or property, these assets and business being in god condition,
- The target company’s or its shareholders’ authority to enter into the planned transaction,
- Tax records, company books and financial records being true and in compliance with applicable rules,
- Arm’s length Business Relationships with the Related Parties and Affiliates,
- Legal Proceedings, investigations and legal disputes,
- Intellectual Property,
- Issues regarding Information Technologies,
- Compliance with all contractually and statutory based oblations towards Employees and Human Resources,
- Environmental matters,
- Legal, valid, binding and enforceable Agreements, including agreements with suppliers, representatives and customers,
- No state of insolvency or bankruptcy.
For example, if it is determined during the legal Due Diligence that the target company lacks certain environmental permits, however, the Purchaser or Investor still wishes to go ahead with the transaction; the representations & warranties section of the main transaction agreement may include a warranty clause stating that the target company has all the licenses and permits necessary for the operation of its business other than those determined/disclosed during the Due Diligence study, or that the target company warrants that the missing licences and permits can be obtained within a specific time-frame.
Additionally, in accordance with the findings of the Due Diligence process, the Purchaser often deems it necessary to re-negotiate the purchase price or investment amount, and/or collateral requirements from the other party. In some cases, the Due Diligence results may even result in both sides re-considering their decision to go through with the planned transaction.
Due to this reason, it would be beneficial for companies and shareholders who consider becoming a party to a merger& acquisition or corporate finance transaction to make their plans and preparations with taking into consideration the above explained issues.
Avukat İrem Alevok
