Due diligence is a common and important step in most share acquisitions and corporate transactions, regardless of whether an acquirer seeks to obtain a controlling or minority interest in the target company. The common legal maxim "caveat emptor", which means "let the buyer beware", is the rationale and justification for due diligence. The burden is on the buyer to satisfy himself or herself as to the value or quality of the goods, or shares, that he or she is purchasing. This maxim essentially means that a person who purchases something must take responsibility for the quality of goods that he or she is purchasing. It is imperative for buyers to conduct due diligence to ensure that the shares or assets intended to be acquired do not cause unforeseen harm to them.
The term 'due diligence' is commonly defined as an investigation, exercise and/or research conducted on a business, company or individual before entering into an agreement with another party. There is no legal definition for the term 'due diligence'. However, under the Securities Commission Guidelines, 'due diligence' simply refers to the process in which a person must conduct enquiries and investigation, consider risk tolerance for potential investment and is carried out for the purpose of timely, sufficient and accurate disclosure of all material statements, information and/or documents.1
The Malaysian regulatory framework for public listed companies demands high standards of disclosure and due diligence on the part of all persons involved in the preparation and submission of a corporate proposal and/or in the preparation of warranties for an acquisition of shares. For transactions that fall within the Capital Markets and Services Act 2007, the onus of assessing the merits of primary offerings of securities is placed on the investors, while applicants (ie. the target company) themselves are required to adopt high standards of disclosure in their interactions with the market.2 For the purpose of this Article, reference shall be made to the legal due diligence process only and specifically in merger and acquisition transactions in Malaysia.
Mergers & Acquisitions Transactions
For due diligence in a company share acquisition transaction, the seller is not legally obliged to inform the buyer of any defects or liabilities of the target company unless the buyer requests for such disclosure.3 Therefore, buyers must conduct a detailed inquiry into the affairs of the target company. This process is crucial for the buyer to develop an understanding of the target company they intend to acquire an effective risk management strategy. However, due diligence is not a one size fits all exercise, as different investors have different risk tolerance levels and investment goals.4 For instance, due diligence for the financial and/or health sector may prove to be more regulatory and voluminous as compared to a smaller target company in the media and communications industry.
Corporate due diligence in Malaysia is subdivided into 3 separate categories, i.e. (i) financial/tax, (ii) commercial/technical/operational and (iii) legal due diligence.
Conducting effective financial and tax due diligence assists prospective buyerrs in structuring transactions, avoiding losses and calculating working capital and/or projected accounts. It can also help sellers better understand the strengths and weaknesses of their positions pursuant to a deal. The requirements for financial and tax due diligence may vary considerably depending on the size and complexity of the target company, the knowledge of the target company's seller and size of the transaction in terms of value. It is pertinent to note that financial and tax due diligence do not constitute an audit and the extent of verification of information will depend on the requirements of the client and the scope of engagement.5 Financial and tax due diligence are commonly undertaken by accountants, tax advisors and/or auditors that are typically appointed by the potential buyer in an M&A transaction.
Depending on the industry sector, operational, technical and/or commercial due diligence is undertaken by third party professionals in the industry to ascertain whether the target company meets all requirements in its industry sector. For example, if the target company is in the business of property development, a technical/operational due diligence may consist of an analysis of the development project, a report by engineers on the structure of the building and place emphasis on the potential problems that may occur post-acquisition. With commercial due diligence, the prospective buyer will obtain an in-depth knowledge of the target company including its weaknesses and any potential risks in the business.6 The process is comprised of the following stages:
- A corporation or private equity firm will liaise with a third party to conduct the report on their behalf.
- The third-party then prepares a commercial due diligence report, outlining the information required for a potential acquisition.
- This report is then reviewed by the prospective buyer, in conjunction with other reports, before a final decision is made.
Legal Due Diligence
Legal due diligence is usually conducted in a structured and coordinated manner. The scope of legal due diligence revolves around several factors such as the size and complexity of the transaction, the confidentiality of the deal, the industry in which the business is in and the friendliness of the parties. In Malaysia, lawyers are typically appointed to conduct the legal due diligence process on behalf of their clients (potential buyers). In addition, the lawyers will also prepare the necessary documents such as transaction documents, the scope of the terms and conditions, representations, warranties and disclaimers. For most M&A transactions in Malaysia, the lawyers will prepare the planning memorandum, agenda, materiality guidelines, scope of work and the due diligence working group report.7 In a legal due diligence exercise, lawyers will draw up and submit a list of preliminary inquiries tailored for each transaction. This comprehensive list will provide a guide to other professionals involved in providing information or documents to be reviewed and reduces the possibility of oversight in the due diligence process. In an acquisition transaction, the key areas in a legal due diligence include corporate information, business activities, material contracts, litigation, personnel, real property, intellectual property and compliance with laws and regulations.
It is pertinent for all legal due diligence, as a first step, to review all corporate information as this provides a guideline as to the basic corporate structure of the target company and any possible associated companies such as subsidiaries or other interests held by the target company or its directors. Lawyers will have to review not only corporate documents such as the memorandum and articles of association (also known as the constitution) of the target company but also minutes of shareholders and directors meetings. No doubt, potential buyers will have a rough idea of the business of the target company they intend to acquire. However, due diligence is necessary to further uncover aspects of the business activities which may not have been disclosed by the seller. For instance, an analysis of some contracts may uncover triggering termination clauses and/or breach clauses which are pertinent for the buyer to be aware of. This process will go beyond surface-level information and may involve a review of the written terms and conditions of the target companies' contracts.8 Sometimes, existing contracts are valuable to a prospective buyer and the due diligence process is conducted to ensure the validity and continuity of these contracts even after acquisition. The objective here is to determine whether a change of ownership in the company would nullify the contract. Agreements with government bodies must be checked carefully as they may not carry over and continue to be valid after a change in company ownership. It is important for buyers to be aware that they should prevent the purchase of a company that binds them to perform services to a third party on commercially unfavourable terms. As such, every contract that affects the target company's performance or profit estimated must be reviewed extensively.
Legal due diligence will also encompass the potential discovery of any existing litigation action the target company is subjected to. Undisclosed litigation could in turn affect the pricing of the deal, resulting in an indemnity being given by the seller for potential costs. Other aspects of legal due diligence include the review of all employment contracts wherein a buyer must be informed about employment terms of key personnel especially matters relating to remuneration, length of employment and termination provisions. Personal arrangements such as policies in relation to benefits, retirement plans, bonuses, insurance, severance packages as well as trade unions and work councils should be fully disclosed before any acquisition.
Depending on the nature of business and industry sector of the target company, the buyer must be confident that the target company is licensed for them to conduct their intended business and they are to be informed if there is anything done by the target company which may lead to revocation of any essential licenses.9 Lawyers are typically tasked with reviewing the validity of all relevant licences and approvals required, i.e. compliance with guidelines issued by regulatory bodies. A basic review on intellectual property matters is also another aspect, if required, depending on the nature of the business. Documentation such as evidencing trademarks, trade names, copyright or patents that have been registered, rejected or are pending should be reviewed. Further, arrangements with third parties is required to ensure that any intellectual property is protected by confidentiality or non-disclosure agreements.
In a nutshell, there are many other areas that can be investigated as part of a corporate due diligence in Malaysia. It is important to note that although due diligence may appear to be very basic, shoddy due diligence work may lead to problems and difficulties in not only the acquisition process but can surmount the buyer with costly litigation. The underlying principle is always to conduct a review of the target company that is sufficiently inquisitive to uncover any skeletons in the closet. A prospective buyer should only proceed with the transaction with utmost confidence after being advised about the risks and disclosure of the target company as stipulated in the legal, financial and commercial due diligence reports.
1 Securities Commission, 'Guidelines on due diligence conduct and for corporate proposal', 2008, p.5 https://www.sc.com.my/regulation/guidelines/due-diligence
2 Securities Commission, 'Guidelines on due diligence conduct and for corporate proposal', 2008, p.6 https://www.sc.com.my/regulation/guidelines/due-diligence
3 Lee Kin Hing & Ng Bee Tung, 'The Extent and Scope of Due Diligence Over a Listed Target Company in Malaysia', para 3, https://www.hg.org/legal-articles/the-extent-and-scope-of-due-diligence-over-a-listed-target-company-in-malaysia-48930
4 Ryan Barnes, 'Due Diligence in 10 Easy Steps', https://www.investopedia.com/terms/d/duediligence.asp
5 Financial Due Diligence Services in Malaysia, https://www.3ecpa.com.my/services/business-advisory/financial-due-diligence/
6 Commercial due diligence, https://www.duedil.com/blog/a-guide-to-commercial-due-diligence
7 'Counsel: An overview of legal due diligence, https://www.theedgemarkets.com/article/counsel-overview-legal-due-diligence
8 Ryan Barnes, 'Due Diligence in 10 Easy Steps', https://www.investopedia.com/terms/d/duediligence.asp
9 'Counsel: An overview of legal due diligence, para 6 https://www.theedgemarkets.com/article/counsel-overview-legal-due-diligence
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