Jayant Mudgal, Student of Law, Amity Law School – I
Ever since the Indian Economy opened itself to the foreign market after the economic liberalization reforms of 1991, Mergers and Acquisitions have become a common phenomenon throughout India. In a highly competitive global environment, mergers and acquisitions have turned out to be one of the fastest strategic options for companies to gain competitive advantage. While a merger is a combination of two companies, with one company merging itself into the other and losing its identity, while the other prominent company gains more importance and either absorbs the other company or consolidates itself with the other company, an acquisition is the action whereby the acquiring company purchases the interests of the acquired company’s shareholders and ceases to have any interest or right after the acquisition.
Merger is an arrangement that assimilates the assets of two or more companies and vests their control under one company. Acquisition simply means buying the ownership in a tangible or intangible asset such as purchase by one company of controlling interest in the share capital of another company or in the voting rights of an existing company. In the merger context, both companies pool their interests, which mean that the shareholders of both companies still hold on to their portfolio interests from their company and also gets interests in the other enterprise.
The term ‘amalgamation’ is used synonymously with the term merger and both these terms are used interchangeably but both these terms are not precisely defined in The Companies Act, 1956. Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations, mergers and the procedure to be followed for getting the arrangement, compromise or the scheme of amalgamation approved in India but the term merger or acquisition is not defined within the Act ((News Legal , ‘Role of Due Diligence in Mergers and Acquisition’ [July 18, 2013] 3(2) Legal Articles
available at http://www.legalindia.com/role-of-due-diligence-in-mergers-and-acquisition, last accessed on 2nd april,2016)).
However, the Income Tax Act, 1961 defines the term ‘amalgamation’ under section 2(1B) of the Act as the merger of one or more companies to form one company in such a manner that all the properties and liabilities of the amalgamating company(s) become the properties and liabilities of the amalgamated company, and not less than three-fourth shareholders of the amalgamating company become the shareholders of the amalgamated company.
Under Section 5 of the Competition Act, 2002, “combinations” are defined with reference to assets and turnover of merging companies located exclusively in India or located in India and outside India. Section 6 of the Competition Act, 2002 states that, no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void. All types of intra-group combinations, mergers, demergers, reorganizations and other similar transactions are thus within the purview of the Competition Act, 2002 unless specifically exempted.
Further, mergers and acquisitions are also governed by the SEBI Takeover Code, 1994 and requires mandatory permission from High Courts of the respective jurisdiction of such companies to enable any scheme of amalgamation or merger or arrangement to come through.
Now, even though Mergers and Acquisitions have several advantages, but the risks involved are equivalent too. The real motive behind mergers or acquisitions should be on the table for all the parties concerned to ensure real success of such merger or acquisition. The post implementation phase is a very critical part where several mergers or acquisitions fail and before onset of any deal, most companies should conduct due diligence to ascertain the real risks and profitability of such deals. Due Diligence in Mergers and Acquisitions is the process of evaluating and investigating a prospective business decision by getting information about the financial, legal, intellectual and other material information from the other party ((http://www.divest.nic.in/Due_Diligence Last accessed on 3rd April 2016)).
The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business transaction under consideration. By performing due diligence, a perfect strategy can be evolved to carry out the merger or acquisition. Failure to exercise due diligence prior to entering into a transaction of enormous proportions such as a merger or acquisition may lead to a precarious situation where the asset acquired, may be marred by encumbrances, charges and other liabilities which get automatically transferred to the acquirer as a result of such acquisition. While the cost involved in performing a due diligence is on the higher side, as it usually involves the services of a CA and an attorney, the importance of conducting a thorough due diligence before undertaking a transaction cannot be undermined under any circumstances. To any company involved in merger or acquisition, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target company/unit/business.
The purpose of due diligence is to confirm that the business actually is what it appears to be. While gaining information about the business, the company conducting the due diligence can definitely identify deal killers and eradicate them. Further, information for valuing assets, defining representations and warranties, and/or negotiating price concessions can also be obtained vide due diligence. The information learned while conducting due diligence will further help in drafting and negotiating the transaction agreement and related ancillary agreements.
This information will also be helpful in allocating risks in regards to representations and warranties, pre-closing assurances and post-closing indemnification rights of the acquirer, organizational documents to determine the stockholder and other approvals required to complete the transaction, contracts, including assignment clauses, and permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required, regulatory requirements, to determine if any governmental approvals are required, and debt instruments and capital infusions, to determine repayment requirements. Why Due Diligence? Mergers and Acquisitions revolve around certain specific steps and due diligence is the first step to make the end business successful.
Mergers and Acquisitions
Mergers and Acquisitions is an important way for companies to grow and become stronger and better organizations. The main reasons underlying such operations are:
- Enhanced reputation in marketplace or with stakeholders
- Reduction of operating expenses or costs
- Access to management or technical talent
- Access to new product lines
- Growth in market share (complement/extend current business)
- Quick access to new markets or entry into new industry (diversification)
- Reduction in number of competitors
- Access to new technology, manufacturing capacity or suppliers
Now, even though Mergers and Acquisitions have several advantages, but the risks involved are equivalent too ((JohnH Sykes , ‘Abstract:’ [ July 17, 2013] 10(1) Role of Due Diligence in Mergers and Acquisition available on http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2294836 Last accessed on 2ndApril 2016)). The real motive behind mergers or acquisitions should be on the table for all the parties concerned to ensure real success of such merger or acquisition. The post implementation phase is a very critical part where several mergers or acquisitions fail and before onset of any deal, most companies should conduct due diligence to ascertain the real risks and profitability of such deals.
Due Diligence in Mergers and Acquisitions is the process of evaluating and investigating a prospective business decision by getting information about the financial, legal, intellectual and other material information from the other party.
The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business transaction under consideration. By performing due diligence, a perfect strategy can be evolved to carry out the merger or acquisition. Failure to exercise due diligence prior to entering into a transaction of enormous proportions such as a merger or acquisition may lead to a precarious situation where the asset acquired, may be marred by encumbrances, charges and other liabilities which get automatically transferred to the acquirer as a result of such acquisition. While the cost involved in performing a due diligence is on the higher side, as it usually involves the services of a CA and an Attorney, the importance of conducting a thorough due diligence before undertaking a transaction cannot be undermined under any circumstances.
To any company involved in merger or acquisition, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target company/unit/business. The purpose of due diligence is to confirm that the business actually is what it appears to be. While gaining information about the business, the company conducting the due diligence can definitely identify deal killers and eradicate them. Further, information for valuing assets, defining representations and warranties, and/or negotiating price concessions can also be obtained vide due diligence. The information learned while conducting due diligence will further help in drafting and negotiating the transaction agreement and related ancillary agreements ((Available at mergers-acquisitions/what-is-merger-and-acquisition-due-diligence available at http://www.cio.com/article/2931585/ Last accessed on 3rd April 2016)).
This information will also be helpful in allocating risks in regards to representations and warranties, pre-closing assurances and post-closing indemnification rights of the acquirer, organizational documents to determine the stockholder and other approvals required to complete the transaction, contracts, including assignment clauses, and permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required, regulatory requirements, to determine if any governmental approvals are required, and debt instruments and capital infusions, to determine repayment requirements ((Matt Matt h evans, ‘Course 7: Mergers & Acquisitions (Part 1)’ [March 2000] 16(3) Excellence in Financial Management 16-24 available at http://www.exinfm.com/training/pdfiles/course07-1Last accessed on 3rdApril 2016)).
THE PURPOSES OF A DUE DILIGENCE INVESTIGATION
When a company is considering the acquisition of a target, the purposes of a due diligence investigation include:
- To ascertain the appropriate purchase price to be paid by the buyer, and the method of payment, including earn outs;
- To determine details that may be relevant to the drafting of the acquisition agreement, including the substance, extent, and limitations of representations and warranties and any relevant escrow or hold-back agreement for a breach of the same;
- To evaluate the legal and financial risks of the transaction;
- To evaluate the condition of the physical plant and equipment; as well as other tangible and intangible property to be included in the transaction;
- To analyze any potential antitrust issues that may prohibit the proposed merger or acquisition;
- To determine compliance with relevant laws and disclose any regulatory restrictions on the proposed transaction; and
- To discover liabilities or risks that may be deal-breakers.
The evolution of due diligence
After passing the Securities Act, the meaning of the term “due diligence” has become associated with the orderly investigation of a variety of matters pertaining to business and has been adapted for use in many situations. Regardless of how it is used, “due diligence” implies that the person conducting the investigation has made a “diligent” effort to obtain all of the relevant and meaningful information pertaining to the matter under investigation and has disclosed all of that information in a dutiful and forthcoming manner. In other words, thorough, conscientious due diligence continues to provide a defense to those who find themselves tasked with the investigation of an important business matter ((Wendy BE Davis, ‘The Importance of Due Diligence Investigations: Failed Mergers and Acquisitions of the United States’ Companies’  5(3) The evloution of Due Diligence available at http://www.ankarabarosu.org.tr/siteler/AnkaraBarReview/tekmakale/2009-1/1.pdf Last accessed on 3rd April 2016.)).
Making Due Diligence
Work Since due diligence is a very difficult undertaking; you will need to enlist your best people, including outside experts, such as investment bankers, auditors, valuation specialist, etc. Goals and objectives should be established, making sure everyone understands what must be done. Everyone should have clearly defined roles since there is a tight time frame for completing due diligence. Communication channels should be updated continuously so that people can update their work as new information becomes available; i.e. due diligence must be an iterative process.
Throughout due diligence, it will be necessary to provide summary reports to senior level management. Due diligence must be aggressive, collecting as much information as possible about the target company. This may even require some undercover work, such as sending out people with false identities to confirm critical issues. A lot of information must be collected in order for due diligence to work. This information includes ((Frederick r.medero, ‘Understanding Mergers & Acquisitions: Due Diligence through a Different Prism’  2(3) Financial Services & E-Commerce News letter available at http://www.fed-soc.org/publications/detail/understanding-mergers-acquisitions-due-diligence-through-a-different-prism Last accessed on 3rd April 2016.)):
- Corporate Records: Articles of incorporation, by laws, minutes of meetings, shareholder list, etc.
- Financial Records: Financial statements for at least the past 5 years, legal council letters, budgets, asset schedules, etc.
- Tax Records: Federal, state, and local tax returns for at least the past 5 years, working papers, schedules, correspondence, etc.
- Regulatory Records: Filings with the SEC, reports filed with various governmental agencies, licenses, permits, decrees, etc.
- Debt Records: Loan agreements, mortgages, lease contracts, etc.
- Employment Records: Labor contracts, employee listing with salaries, pension records, bonus plans, personnel policies, etc.
- Property Records: Title insurance policies, legal descriptions, site evaluations, appraisals, trademarks, etc.
- Miscellaneous Agreements: Joint venture agreements, marketing contracts, purchase contracts, agreements with Directors, agreements with consultants, contract forms, etc. Good due diligence is well structured and very pro-active; trying to anticipate how customers, employees, suppliers, owners, and others will react once the merger is announced. When 17 one analyst was asked about the three most important things in due diligence, his response was “detail, detail, and detail.” Due diligence must very in-depth if you expect to uncover the various issues that must be addressed for making the merger work.
What Can Go Wrong
Failure to perform due diligence can be disastrous. The reputation of the acquiring company can be severely damaged if an announced merger is called-off. For example, the merger between Rite Aid and Revco failed to anticipate anti-trust actions that required selling off retail stores. As a result, expected synergies could not be realized. When asked about the merger, Frank Bergonzi, Chief Financial Officer for Rite Aid remarked: “You spend a lot of money with no results.” A classic case of what can wrong is the merger between HFS Inc and CUC International. Four months after the merger was announced, it was disclosed that there were significant accounting irregularities.
Upon the news, the newly formed company, Cendant, lost $ 14 billion in market value. By late 1998, Cendant’s Chairman had resigned, investors had filed over 50 lawsuits, and nine of fourteen Directors for CUC had resigned. And in the year 2000, Ernst & Young was forced to settle with shareholders for $ 335 million. Consequently, due diligence is absolutely essential for uncovering potential problem areas, exposing risk and liabilities, and helping to ensure that there are no surprises after the merger is announced. Unfortunately, in today’s fast-paced environment, some companies decide to by pass due diligence and make an offer based on competitive intelligence and public information. This can be very risky ((Bill snow, ‘Mergers and Acquisitions For Dummies’  2(1) The M&A Due Diligence Process available at
http://www.dummies.com/how-to/content/the-ma-due-diligence-process.html Last accessed on 3rd April 2016.)).
Due Diligence in India
The practice of undertaking a formal due diligence investigation is of comparatively recent origin in India and was mainly imported as a process by foreign investors/their legal and financial advisors after the economic liberalization reforms of 1991.
No statute defines the term ‘due diligence’. However, the SEBI mandates certain parties to undertake a due diligence, in the context of issuance of securities by a company. For instance:
Regulation 64 of Chapter VI of the ICDR Regulations, requires the BRLMs to exercise due diligence and satisfy themselves about all the aspects of the issue. The BRLM is also required to call upon the issuer, its promoters or in case of an offer for sale, the selling shareholders, to fulfill their obligations as disclosed by them in the offer document.
Regulation 65 requires the BRLM to submit post-issue reports to the SEBI. The BRLM is also required to submit a due diligence certificate as per the format specified in Form G of Schedule VI, along with the final post-issue report. (Regulation 65 (3))
Under Regulation 83, a qualified institutions placement shall be managed by BRLM(s) registered with the SEBI who shall exercise due diligence. The BRLM, while seeking inprinciple approval for listing of the eligible securities issued under the qualified institutions placement, is required to furnish to each stock exchange on which the same class of equity shares of the issuer are listed, a due diligence certificate stating that the eligible securities are being issued under qualified issuers placement.
Before the opening of the issue, the BRLM is required to submit a Due diligence certificate along with the draft offer document to the SEBI.
Under Regulation 8(2)(b), the lead banker is required to submit, after the issuance of observations by the SEBI or after the expiry of the stipulated period, if the SEBI has not issued observations, a due diligence certificate at the time of registering the prospectus with the Registrar of Companies ((Available at http://almtlegal.com/practice/mergers-acquisitions.htm Last accessed on 3rdAapril, 2016)).
Under Regulation 10(3)(a), the BRLM is required to submit to the SEBI, along with the offer document, a due diligence certificate including additional confirmations.
Diligence in Listed and Unlisted Companies in India
Listed companies entail more extensive review of compliances, as well as a greater degree of caution with respect to the sharing of information and structuring of a transaction, as compared to unlisted companies.
In case of a listed company, the provisions of the SEBI (Prohibition of Insider Trading) Regulations, 1992, as amended are applicable. The due diligence should not include review of unpublished price sensitive information except in certain special circumstances. However, publicly available information under the listing agreement signed by the listed companies with the stock exchanges may not be adequate to base an investment decision. Therefore, in case of a listed company, care must be taken to ensure (in consultation with the legal advisors and relevant members of the transaction team) that the insider trading regulations are not violated in the due diligence process. This matter has to be dealt with on a case-by-case basis.
For listed companies, analysis of potential triggers of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, as amended, in the case of a proposed acquisition or transfer will need to be made.
Reverse mergers are a very popular way for small start-up companies to “go public” without all the trouble and expense of an Initial Public Offering (IPO). Reverse mergers, as the name implies, work in reverse whereby a small private company acquires a publicly listed company (commonly called the Shell) in order to quickly gain access to equity markets for raising capital. This approach to capitalization (reverse merger) is common practice with internet companies like stamps.com, photoloft.com, etc.
For example, ichargeit, an e-commerce company did a reverse merger with Para-Link, a publicly listed distributor of diet products. According to Jesse Cohen, CEO of ichargeit, an IPO would have cost us $ 3 – 5 million and taken over one year. Instead, we acquired a public company for $ 300,000 and issued stock to raise capital. The problem with reverse mergers is that the Shell Company sells at a serious discount for a reason; it is riddled with liabilities, lawsuits, and other problems. Consequently, very intense due diligence is required to “clean the shell” before the reverse merger can take place. This may take six months. Another problem with the Shell Company is ownership. Cheap penny stocks are sometimes pushed by promoters who hold the stock in “street name” which mask’s the true identity of owners. Once the reverse merger takes place, the promoters dump the stock sending the price into a nose-dive. Therefore, it is absolutely critical to confirm the true owners (shareholders) of shell companies involved in reverse mergers ((Ptlb, ‘Online Petition And Survey By CCICI Regarding Cyber Law Due Diligence In India’ [ February 25, 2014] 5(3) Techno Legal Telecom Regulatory Compliances And Mergers And Acquisitions Legal And Consultancy Services In India available at http://perry4law.co.in/blog/?p=42 Last accessed on 3rd April 2016)).
Due diligence is an integral aspect of a merger and acquisition transaction. Integrating principles and techniques used in the management of risk can significantly enhance the effectiveness of due diligence by changing the focus from merely verifying facts to understanding the risk profile of the constituent institutions and the issues that can arise from efforts to integrate their businesses. A deeper understanding of those issues and the means for their resolution can lead to better and more efficient planning and execution of the integration process.
Once the Memorandum of Understanding and merger proposal has been approved by both the companies, each company should make an application under the Companies Act, 1956 to the High Court of the State where its registered office is situated so that it can convene the meetings of share holders and creditors for passing the merger proposal. Thereafter notices must be dispatched to the shareholders and creditors of the company to convene a meeting and such meeting must be subsequently held where at least 75% of shareholders of the company who vote either in person or by proxy must approve the scheme of merge.
Once the scheme of merger has been approved by the creditors and shareholders, another petition to High Court to confirm the scheme of merger must be presented and notices regarding the same published in two newspapers. After the High Court passes an order approving the scheme or merger or amalgamation, the certified true copies of the orders must be sent to the registrar of the companies and assets and liabilities of the companies stands transferred to the amalgamated company. It has been reported that mergers and acquisitions take about a three to four months for completion although the SEBI Takeover Regulations require the acquirer to complete all procedures relating to the public offer including payment of consideration to the shareholders who have accepted the offer, within 90 days from the date of public announcement ((Wendy b e davis, ‘ Mergers and Acquisitions of the United States’ Companies’  4(2) The Importance of Due Diligence Investigations available at http://www.ankarabarosu.org.tr/siteler/AnkaraBarReview/tekmakale/2009-1/1.pdf Last accessed on 3rd April 2016)).
However, ultimately, whatever the time limit might be, mergers and acquisitions definitely help the companies to strengthen and expand their business operations to increase profitability and consolidate the business structure. With strict due diligence in place, companies can definitely hope to tackle the risks involved and make the end result successful for effective mergers and acquisitions. Today, India presents the right opportunities for companies to engage in cross-cultural transactions and amalgamations and Indian markets are registering massive growth in mergers and acquisitions with consolidation of international businesses in India and fierce competition amongst business houses who are seeking to expand their market.