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Top 5 Common Issues in Legal Due Diligence

1. Governing Documents

A review of the Target’s governing/constitutional documents (e.g. Articles/Memorandum of Association, Charter, Shareholders' Agreement, etc.) should be conducted as part of the legal due diligence process. Such a review should result in assurance being gained over the fact that there are no “surprise” entities within the Target’s group or in the way in which the Target may be run post-transaction (for instance, how shares may be allotted or how contracts may be assigned).

The Articles set out the duties, rights and responsibilities of the shareholders of the Target and create a relationship between the Target and each shareholder. They also detail the powers and duties of the Board of Directors, how they may be appointed and usually, by whom. It is notable that a company can, to an extent, choose the content of its Articles and constitutional documents, however, it will be subject to the relevant companies act (which typically, will overrule the Articles).

2.Contracts

Due diligence should cover a review of customer and supplier contracts, operating contracts and licenses. Issues to consider as part of this review process include:

(i) identifying whom the relevant parties of the contracts are,
(ii) whether there is a change of control provision included within any contracts (which might be triggered by a transaction) and
(iii) whether contracts are assignable and/or if consent is required. Additionally, consideration should be given as to whether change of control (brought about via a transaction) constitutes assignment of any contracts.

Other key considerations include:

  • Is there an automatic renewal provision to any contracts?
  • Can either party to the contract terminate without consent?
  • How is pricing determined?
  • What does the Target own being under contract?
  • Is anything triggered in the Target’s existing contracts by the proposed transaction?
  • Are there any verbal agreements with key customers or suppliers, which are not subject to contract but should be?

3. Liabilities

As with financial due diligence, legal due diligence should involve a detailed review of the Target’s liabilities (both known and unknown). Key areas to be addressed include:

  • Is the Target compliant with all laws and regulations it is subject to?  
  • Is the Target exposed to any contingent liabilities (a potential liability that may occur, depending on the outcome of an uncertain future event) or incorrectly recorded/disclosed liabilities?; 
  • Will any liabilities crystallize as a result of the transaction? For instance, could a change in the legal owner of the Target result in liabilities being triggered – for instance, are there contractual arrangements that would result in liabilities arising from an acquisition (such as employment agreements, severance agreements, leases, contract exit clauses. etc.)?
  • Does the Target settle its debts on time or do outstanding liabilities exist?
  • Has the Target been party to any legal proceedings or litigious activities?
  • Is the Target subject to any specific risks or liabilities, which the acquirer may not be not exposed to (due to operating in a different industry) for instance, product liabilities/warranties, seasonality, or geographic risks?

4. Ownership of Title

Prior to making an acquisition (whether shares or assets) the acquirer should be certain of what they are actually purchasing (what the Target owns [assets] and what it owes [liabilities]). The assets of the Target may include plant and machinery, real estate, inventory, cash and cash equivalents (securities), intellectual property (covering areas such as trademarks, patents, copyrights, designs and domains) and accounts receivable, amongst others. The liabilities of the Target may include but or not limited to trade payables, various accruals, bank debts (term loans, overdrafts, interest payable, etc.), outstanding employee benefits (holiday and redundancy pay and shares due to employees under an options scheme), tax liabilities (including corporation, payroll and social) lease payments (including termination payments) and product warranties.

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5. Insurance

Gaining an understanding of a Target’s insurance cover is imperative in order to assess the risks associated with making an acquisition (and whether additional insurance coverage will be necessary post-transaction, at extra cost to the acquirer). If the level of coverage, terms, and types of insurance are inadequate for the risks the Target is subject to, this could expose the acquirer to significant costs should anything go wrong. 

As part of due diligence on the insurance of the Target the following considerations should be made:

  • Detailed understanding of the Target’s business operations and the key risks faced;
  • Review of the Target’s business profile (for instance, the financial statements, annual reports, laws, market reports, minutes of board meetings, etc.) to identify additional key risks;
  • Obtain copies of all relevant insurance policies (for instance, covering general liability, property, directors & officers/key man, professional liability and environmental, etc.);
  • Review the current insurance coverage of the Target against the coverage considered standard for the industry in which the Target operates;
  • Review details of any insurance claims and obtain an understanding of the nature and quantum of any such claims;
  • Review the terms and conditions of any policies, including limits of liability, policy excess, renewal details, policy period, names of those insured, and any exclusions;
  • Identification of potential issues/shortcomings in coverage and establish the cost of obtaining sufficient cover.

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