Due Diligence - Challenges & Way Ahead
Updated: May 31, 2020
Payal Parikh, Managing Partner, ANB Legal, Mumbai
Introduction & Background
“To require the steps taken by the company to prevent these occurrences under any circumstances whatsoever absolutely would go beyond due diligence, and would make the company a virtual insurer against any error. I do not think that was the intention of the legislation; the words all due diligence import an area of precaution sufficient to prevent the foreseeable, but not the unforeseen, the unexpected, the unknown, or the unintended.” - R. V. Steinberg
The term ‘Due diligence’ can be defined as the reasonable verifications and precautions taken to identify or prevent foreseeable risks, in layman terms. Thus, due diligence can be defined as,
“a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent person under the particular circumstances; not measured by any absolute standard but depends on the relative facts of the special case” (Black’s Law Dictionary).
The importance of a due diligence process can never be undermined. In the context of COVID-19 pandemic, the aspect of due diligence has gained a lot more importance. Assessing the impact on a target company due to the COVID-19 pandemic has become a critical focus area of the due diligence process. However, the current pandemic poses significant challenges to the due diligence process and thus would undergo significant changes to adapt to the current situation.
The present article analyses the impact of COVID-19 pandemic on the process of due diligence and discusses the challenges posed in the current times. The first section analyses the impact and challenges posed by COVID-19 on the due diligence process. The second section deals with the possible way ahead in the current time with a view to ensure effective due diligence process.
A. Section I: Due Diligence During Covid-19: Impact & Challenges
On the backdrop of the COVID-19 pandemic, the due diligence process has attained a key position in all the transactions. Even in the case of on-going transactions, the companies are re-assessing the impacted areas of the target company, such as the supply chain, contractual obligations and liquidity. Conducting a due-diligence is extremely important for the acquirer entity. It will assist the acquirer is in the process of familiarising with the target company, identify its weaknesses, consider the probable impact of any unforeseen or unprecedented event.
The due diligence process would undergo changes such as physical meeting; site visits would be replaced via a virtual data room. There will be a significant reduction in communication and accessibility. The companies will have to focus on the financial health of the targets and its consequences if a failure occurs while performing its obligation under the agreement Clauses such as force majeure and termination rights would need to be drafted in a watertight manner after considering the all the relevant factors and conditions. Factors such as the liquidity and insolvency risk, liabilities towards medical and health care of employees, compliance with government directives related to the pandemic. Need to be considered. In order to conduct a smooth due-diligence process, the companies would need to overcome several hurdles.
With the significant travel restrictions in place, there are challenges transactional lawyers & financial consultants face for conducting due diligence. Even though there was a considerable shift to virtual data rooms in the recent past, there were certain aspects/ documents that demanded in-person/ physical meetings. The companies would face challenges with regard to trust, credibility and ability to verify the information due to the shift to a virtual environment.
The following are the significant challenges encountered while conducting due-diligence amidst the current COVID-19 pandemic:
1. In-person meetings
A researcher of body language Albert Mehrabian has stated that the impact of a message relayed during communication passed on to the receiver is 7% verbal (words only), 38% vocal (tone, inflexion and other sounds) and 55 % non-verbal. A firm handshake, a slight nod or movement of eyes can clearly portray a wide range of emotion without the utterance of a single word. Well, a handshake is definitely the manner of the past, but since non-verbal communication is so essential, the professionals have shifted to platforms to engage in virtual conversations and audio-visual means to study the body language virtually.
2. On-site visits
With borders closed, it is next to impossible for the professionals to conduct an on-site visit. The on-site visits were imperative in industries that were evaluating the working conditions was the key. For example, Verification of the on-field implementation of labour laws could also be ascertained only upon an on-site visit.
3. Verifying original documents
With the lockdown in place, not only that the professionals would be able to verify the originals, but even the companies would not have access to the same at the moment. The investors would have to take a call based on the copies made available. Situations wherein there is no scanned copies available pose a significant hurdle while conducting the due-diligence process.
4. Abuse of the situation
There is also a possibility that some companies/ management claim that they do not have access to the required corporate documents signed contracts to avoid the diligence process altogether. This could possibly be done in furtherance of a scheme not to disclose any misconduct or illegal activities by the company.
Of course, not taking away the genuine cases, where there would be companies which do not have all the information and documents such as statutory registers and other bulky files available on cloud thereby making it difficult to bridge the gaps during the diligence process.
5. Importance of IT Infrastructure
With the new normal being – ‘being virtual’, the IT & IT solutions are an integral part of each and every business. Thus, the diligence of IT infrastructure shall have to be extensively carried out, keeping in mind the data privacy laws & cybersecurity laws. The company’s cybersecurity practices and preparedness to deal with any breach needs to be critically evaluated. The company’s IT infrastructural ability to ensure stability and deal with disruptions should be evaluated.
6. Modifying the checklist
The DD checklist of the lawyers and the financial consultants may also have to be modified to include one or more of the below question:
a) What is/ was the impact of COVID-19 on your present & future operations?
b) How was the liquidity position in the company affected due to COVID-19?
c) What are the changes that you have adopted in your overall business strategy as a result of COVID-19?
d) Are there any material impairments or restructuring exercise expected as a result of COVID-19?
e) Are there any expected impacts on your ability to service your existing debt obligations?
f) Does your material contracts cover ‘Force Majeure’ clause and if so, what the implication is thereof?
g) Would there be any material contract that you or the counterparty may not be able to perform/ suspend/ terminate due to COVID-19?
h) Do you have a robust business continuity plan in place? If yes, what are the challenges faced for the implementation thereof?
i) Do you have a friendly ‘Work from Home’ policy in place for your employees? If yes, what measures are taken for the security of data and maintaining confidentiality?
j) Whether the company has plans to change its supply chains in response to the outbreak?
k) Does the company have existing insurance coverage and whether any business interruption insurance in place provides sufficient cover for the particular risks which could impact the company due to COVID-19?
Thus, in order to conduct proper due diligence, one must take into consideration the employees, financing, contingency plans, insurance coverage, governance, remote work capabilities, operational considerations, data privacy, mitigation plans, and tax considerations.
B. Section II: The Way Ahead
As stated above, the due diligence process will undergo a change to adapt to the current situation. The pandemic is surely to cause a delay to due diligence activities owing to the impossibility to conduct on-site audits and inspection, and exercising the relevant access rights. The buyer, as well as the target company, should be well-prepared for a broad and extensive due diligence. Thus, it is likely that the completion timeline of the same will increase.
The following are the few of the changes and precautions which can be taken to deal with the effects (during and post) of the COVID-19 pandemic:
· There needs to be watertight drafting of clauses such as material adverse effects, termination, representations and warranties in order to safeguard against any future adverse implications.
· The discussion regarding purchase price might be re-opened and deliberated as per the change in the valuation of the target.
· The due-diligence needs to consider and review all the insurance policies, key suppliers, key contracts.
· The virtual data room should be considered by the companies as it will provide access to multiple documents. This will be a considerable aid to the due diligence process since it will help in assessing the possible impact of the outbreak on the operations, financial stability, and will also include relevant and appropriate mitigation and contingency plans.
Further, some of the implications of COVID-19 for a company and its business may not be apparent such as the issues that may impact the target’s customers or suppliers rather than the target itself. The COVID-19 has led to the issuance of numerous laws, orders, and guidelines, the exact scope and applicability of which are still being determined and interpreted. Further, many COVID-19-related laws, orders, and guidelines are likely to be enacted and issued as the pandemic, and the response thereto evolves. The companies should understand the laws and regulations applicable to a target and the target’s compliance therewith.
There are significant challenges posed while conducting due diligence in the COVID-19 pandemic. However, companies need to comply with legal obligations. The companies would need to make effective use of the technology and the local personnel to undertake the due diligence process. The companies need to keep a close track of any regulatory update which would be of aid. In order to conduct proper due diligence, one must take into consideration the employees, financing, contingency plans, insurance coverage, governance, remote work capabilities, operational considerations, data privacy, mitigation plans, and tax considerations. However, the present procedural and technical hurdles need to be dealt with in an efficient and effective manner. Thus, the due diligence process needs to be tailored in a manner so as to consider the consequences of COVID-19 pandemic and its potential impact on the company’s business operations and stability.