Introduction: What is Legal Due Diligence?
Due diligence is a comprehensive investigative process undertaken during asset and share transactions to assess potential risks and liabilities prior to entering into a contract or agreement. The purpose of due diligence is to ensure that all relevant legal, financial and operational information is considered and verified, thereby minimising risks and making informed decisions.
Key Areas Covered in Legal Due Diligence
Legal due diligence typically involves an in-depth review of various aspects of the target company or assets, including:
- Real Estate: Reviewing property titles, leases, zoning regulations, encumbrances and any potential disputes related to the real estate owned or leased by the company.
- IT/IP: Assessing intellectual property rights, including patents, trademarks, trade secrets / know how, copyrights, and software licenses, to ensure there are no infringement risks or unresolved disputes.
- HR: Evaluating employment contracts, employee benefits, compliance with labour laws, and potential liabilities arising from employee claims.
- Material Contracts: Analysing key contracts with customers, suppliers, and partners to ensure their terms are favourable and that there are no hidden obligations or risks.
- Financials: Reviewing financial statements, tax records, and other financial documents to assess the company’s financial health and identify any discrepancies or liabilities.
- Searches: Conducting various searches, such as company searches, litigation searches, creditor reports, and PPSR searches, to uncover any hidden legal issues.
Importance of Legal Due Diligence
For both Buyers and Sellers, legal due diligence plays a crucial role in the transaction process:
- Buyer’s Perspective: Due diligence allows the Buyer to identify assets, value and risks that may not be apparent on the surface. The process is designed to counteract the inherent dangers of caveat emptor. In transactions, caveat emptor is the principle that the Buyer makes the acquisition at their own risk in the absence of any express warranties by the Seller. Due diligence helps to mitigate this risk by ensuring the Buyer is aware of as much as possible about the entity they are seeking to purchase.
- Seller’s Perspective: Legal due diligence allows sellers to understand and rectify potential issues such as missing documents or lapsed registrations before going to market. This helps them anticipate potential due diligence enquiries from a Buyer which might otherwise delay or derail a transaction. Sellers can also identify restrictions on transfers and process requirements to ensure their assets or shares are presented in the best possible light, potentially leading to a smoother transaction process and a higher sale price.
Addressing Issues Identified During Due Diligence
When issues are discovered during due diligence, it is crucial to address them promptly to avoid potential complications. For example, potential litigation against the seller may be uncovered during due diligence. The parties can negotiate a deed of release to resolve the issue before proceeding with the transaction. Likewise, an unregistered lease may be identified and an application for registration of that lease may be required as part of the transaction process.
Exceptions-Only vs. Full-Scale Due Diligence Reports
There are two main types of due diligence reports:
- Exceptions-Only Reports: These reports focus on identifying and addressing significant issues (red flags) and ignore minor details that have no bearing on the transaction. This approach is typically used when time/financing is limited or when the transaction is relatively straightforward.
- Full-Scale Reports: In contrast, full-scale reports provide a comprehensive review of all aspects of the transaction, regardless of their significance. This approach is more thorough but can be more time-consuming and expensive.
The scope of due diligence should be proportionate to the size and complexity of the transaction and the parties involved.
Warranties and Indemnities Insurance: A Safety Net
Warranty and indemnity insurance is a type of insurance that protects the buyer or seller against breaches of warranties and indemnities in the sale agreement. This insurance is designed to cover financial losses arising from inaccuracies or breaches during the transaction process. Obtaining it is a time-consuming endeavour that must be built into the transaction timeline, but which can ultimately provide both parties with an added layer of security.
For more information on Buyer and Seller warranties, please see our previous article on this topic.
Consequences of Poor Due Diligence
Failing to conduct thorough due diligence or skipping the process altogether can have serious consequences. Buyers may end up acquiring assets or shares with hidden liabilities, leading to financial losses, legal disputes, and reputational damage. These consequences may not always be covered by an insurance policy. Sellers may also face challenges if they are not adequately prepared for the due diligence process, potentially leading to a failed transaction or a lower sale price.
Conclusion
Legal due diligence is a critical component of asset and share transactions, providing both buyers and sellers with the information they need to make informed decisions and mitigate risks. At M+E, our lawyers have experience in undertaking legal due diligence for transactions of all sizes. If you have any queries on how we can support you through an asset or share transaction, feel free to reach out to Lisa (lisa@moranenglish.com.au) and Ersel (ersel@moranenglish.com.au) from our Corporate + Commercial team today.
