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Significance of legal due diligence in M&A


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Significance of legal due diligence in M&A

The spectre of a dead deal loomed when it emerged that an employee of BOC Kenya Plc, an industrial and medical gas manufacturing company, which is currently involved in an acquisition process by Carbacid Investments Ltd and Aksaya Investments LLP, filed a labour dispute in court against the company for a claim of Sh15 million. The employee made an application to the Nairobi’s Industrial Court seeking to halt the acquisition until his claim is heard and determined.

The court’s riposte to that petition was to provisionally restrict BOC from pursuing its buyout deal; with Justice Mbaru Monica ordering it to temporarily hold off any merger, transfer or reorganisation of its business and/or disposal of assets until the said labour dispute was resolved. The court’s decision thwarted the progress of the buyout resulting in a substantial delay of the publication of key transaction documentation.

Consequent to the court’s order, the Capital Markets Authority (CMA) advised both parties to the transaction to hold off the process until the dispute is determined.

The propensity of an ongoing labour dispute to stall a buyout process should come as no surprise to those adept to the specialised nook of mergers and acquisitions. The case of BOC, however, provides an opportunity to accentuate the importance of legal due diligence in assessing investment opportunities as it is through it that such potential liabilities become unearthed. Although due diligence is time-consuming and resource-intensive, it ultimately determines whether a deal worth huge sums will fall into a morass hence its often cited significance. Even Achilles was only as strong as his heel.

Once a potential investor sources for an attractive investment opportunity, they normally undertake to ascertain the viability of the investment by conducting an audit of all material facets of the target to understand its underlying strengths and weaknesses. The areas commonly covered by due diligence include commercial, human resources, legal and financial.

An investor’s decision whether to go ahead with the deal or not and what areas would require negotiations rests with the results of due diligence. Legal due diligence is characteristically carried out by law firms which are engaged by deal teams and involves a thorough review of a target company’s material and non-material documentation. Materiality is determined by the parties to a transaction on a case-by-case basis. Such documentation include corporate records, licences, property documentation, employee related records, intellectual property information, and material agreements. An assessment of threatened/pending litigation, Environmental, Social and Governance (ESG) concerns and any other potential liabilities buttressed in contractual associations is also done as part of the legal due diligence.

This assessment is done in various stages after the deal team presents a checklist to the target company detailing the documents it considers relevant for review. The process begins through preliminary due diligence where a confidentiality agreement is signed to ensure data security by limiting the buyer’s ability to reveal information about the target to industry players. The deal team is then presented by the target with an overview of the target’s business and the investment opportunity. The team is further given an opportunity to understand the target’s operations and business developments.

Formal due diligence is conducted thereafter and involves a thorough appraisal of both confidential information provided by the target and publicly available information. Granular details of the target company are probed and any grey areas are addressed. A legal due diligence report is issued by the buyer’s lawyers and the buyer determines whether to go ahead with the deal based on the findings set out in the report. If the buyer considers the deal viable, a bid for the target is formalised and the parties move to preparation of transaction documentation. The main goal of due diligence in general is to identify potential risks which ultimately impact the purchase price, which is usually a result of valuation of the target company. The risks identified in the legal due diligence report also assist the parties to determine which issues can be resolved prior to closing the transaction and those that can only be dealt with post-closing.

While most deal teams tend to focus their legal due diligence probe on areas such as general corporate matters, contractual agreements, pending regulatory issues, tax matters, anti-trust compliance and property issues, potential liability in terms of pending, threatened, potential or settled litigation matters is sometimes not deeply probed in comparison to the other parameters. This could perhaps be imputed to litigation lawyers not being involved in commercial deals by virtue of their job description which entails cut-throat competition; thus the misleading reputation that they are not cut out for such transactions which require a negotiation mindset coupled with business acumen.

Nonetheless, lawyers should be judicious in the entire process and search tenaciously for any red flags, a task that can be well achieved by the inclusion of litigation lawyers who are fairly risk averse albeit not to the extent of insurance underwriters. Considering what is at stake in multi-million deals, approximation and superficiality cannot not be accepted.

An assessment of litigation issues concerning the target company would include a review of: filed and settled cases, threatened cases, court orders against the target, correspondence with auditors, and matters determined or pending in arbitration or mediation avenues.

The rationale for assessment of these parameters is to determine the impact of potential liabilities arising out the cases such as judgment debts and legal fees. Such payments might have a significant impact on the cash flow of the target company, thus affecting the valuation negatively. This ultimately determines whether a deal is attractive enough for a buyer. The reputation of a target is also likely to be impacted by litigation liabilities which also affect the transaction purchase price, its valuation and profitability.

A common risk to look out for in legal due diligence is potential shareholder litigation. In the US for example, lawsuits on behalf of or by shareholders challenging M&A deals have been on the rise.

Deal teams in multiple jurisdictions are often put through the wringer by shareholders for failing in their fiduciary duty to maximise shareholder value in such deals. One common ground of such opposition is a target company undervaluing itself.

This situation presented itself in the BOC buyout where a minority shareholder who owns 7.6 per cent of the target filed a petition at the Capital Markets Authority’s tribunal objecting the deal on the ground that the target was undervalued.

The minority shareholder relied on the valuation of a local Investment Bank, Dyer and Blair, which put the target at Sh1.7 billion contrary to the bid’s valuation of Sh1.2 billion.

Whilst shareholder litigation is typically characterised by claims against a target’s board of directors for violation of fiduciary duties, the BOC case is unique on account of the board of directors approbating the minority shareholder’s claim of undervaluation.

Whereas the board and the minority shareholder are essentially on the same team, the majority shareholder, BOC Holdings, remains steadfast in selling its 63.5 per cent stake for the alleged undervalue of Sh1.2 billion.

A notable effect of shareholder litigation as shown by studies is that the expected acquisition premia rises as a result of buyers seeking to appease the shareholders of undervalued target companies.

Litigated offers have a higher percentage of price revision compared to non-litigated offers. However, litigated offers expose M&A deals to failed bids.

Owing to the complexity of M&A deals, legal due diligence is often not smooth sailing. The common mistakes that occur include the deal team making assumptions that the seller has disclosed all relevant issues and that documentation from the seller is error-free.

Such mistakes end up being costly and as such the value of proper due diligence cannot be gainsaid. The result of legal due diligence has a consequential effect on the terms and conditions related to the assumption of risk and exposure when drafting the sale and purchase agreement in a buyout.

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