Due Diligence
Ukrainian business has for a long time adhered to the practice of applying to law firms to have due diligence carried out when concluding merger and acquisition deals. It has become especially popular after the arrival in Ukraine of large European companies, for which carrying out due diligence before concluding a deal is not only a usual practice, but an obligatory requirement failing which any negotiations are simply impossible.
What is “due diligence”? The definition of due diligence is that it is a comprehensive examination of a company’s activity, its financial state and position on the market. It has been part of world practice for a long time. First of all, due diligence is aimed at comprehensive examination of the lawfulness and commercial attractiveness of the proposed deal or the investment project, thereby enabling investors or business partners to assess all the advantages and disadvantages of cooperation more profoundly.
It is important to realize that in its initial meaning due diligence is a complex study aimed at analyzing all aspects of company activity, and providing recommendations as to the attractiveness of the deal and possible risks. Depending on the goals of the study we can single out several principal kinds of due diligence, namely financial, legal, marketing, etc.
Initially each kind was an integral part of due diligence and dealt with its own matters. Thus, financial due diligence determined the correctness of keeping accounting records, reliability of accounting and other documents, and their compliance with normative acts. It also assessed the tax burden and the possibility of optimizing taxation. Legal due diligence is aimed at examining a company’s activity according to legislative regulation, particularly in the field of civil law, labor law, environmental law and corporate law. Marketing due diligence analyzed the position in the market, namely the possibilities of developing production and technologies, and drew comparisons with data about market needs, assessed the activity of the company in the market, competitive advantages, etc.
As a result, each of the above types of due diligence became a part of a single report providing the investor or potential purchaser with any and all information about the company he was interested in.
However, due to the complexity and length, the wish to reduce expenses for carrying out the procedure, each of the stages has become an independent kind of due diligence. Undoubtedly, such an approach partially misrepresents the essence of due diligence as a full and comprehensive examination. Yet, it should be understood that such a situation has developed not only due to the unwillingness of law firms to carry out the relevant study or engage outside advisors, but due to the lack of demand for such comprehensive services.
Today, Ukrainian practice understands due diligence just as legal due diligence, since it is the optimal ratio between the value and completeness of analysis. The assignments given by the client to legal advisors, aspects of the activity to be analyzed, and conclusions at the end of due diligence are corresponding. Financial due diligence is carried out additionally only by some major legal and audit firms at the separate request of clients, and marketing due diligence is carried out in very rare cases.
The latest trends in this field prove the difference between the classical meaning of the term “due diligence” and modern procedure for carrying it out in Ukraine. The desire of companies to, on the one hand, to minimize expenses for legal services and, on the other, the wish of law firms to attract more clients using a “modern”, term results in the appearance of such phenomena as “land due diligence”, “tax due diligence”, etc. In fact, comprehensive examination comes down to analysis of separate aspects of the company’s activity, and due diligence as a single, complete and comprehensive document boils down to a usual legal opinion prepared at the request of the client.
What is the structure of modern due diligence and what must it contain?
Each law firm has its own approach to drafting due diligence, but we can note the basic elements. Conditionally each due diligence is divided into three basic parts: introduction, analysis, conclusions.
The introduction contains descriptive information, list of documents analyzed and information, sources of their origin, scope of the study, warnings, etc. The conclusions specify the basic facts established during the examination (for instance, the lawfulness of property possession, existence of certain obligations, etc.) and risks. The analysis provides comprehensive assessment of risks and conclusions by means of a detailed description of the study carried out, with reference to normative acts and court practice.
Depending on the approach of the law firm to the due diligence structure, it is possible to either combine the analysis and conclusions into separate sections, and then to structure them into sub-sections according to the thematic blocks being analyzed, or contrariwise: singling out thematic blocks into sections, each containing the analysis and conclusions. It is difficult to say which approach is more expedient and convenient to use as this depends mainly on the client’s preferences, so each approach has the right to exist. The issue of singling out thematic blocks which directly influence the amount of the information described and, consequently the depth of the analysis, is more important.
Today seven basic thematic blocks which must be contained in every due diligence are formed in practice: corporate history, financial information, property of the company, obligations of the company, state regulation of the company’s activity, litigation and pre-trial disputes of the company, labor relations. Nevertheless, depending on the specific nature of the activity and existence of special property, additional thematic blocks may be singled out, namely: intellectual property, land relations, ecology relations, etc.
Let’s consider each of these thematic blocks and the information to be contained therein.
The corporate block analyses constituent documents and amendments thereto, transactions for acquisition and alienation of corporate rights, minutes of the general meeting of the company. The purpose of this block is to analyze the company’s corporate history, compliance with the law when concluding deals with securities (stakes, shares), the circumstances that may influence the lawfulness of holding securities (stakes, shares), the possibility to impose recovery thereon, etc.
The purpose of the financial block is to analyze the company’s current assets and correctness of payment of taxes and duties by the company from the standpoint of tax law, etc.
The block related to a company’s property analyzes the lawfulness of the company’s ownership of fixed assets, such as land plots, real estate, vehicles, production lines, corporate and other proprietary rights, intellectual property, etc. For this section it is advisable to set a so-called “cut-off price”, i.e. the minimum value of the property which may be analyzed.
The section related to obligations analyses contracts with contractors. As a rule, the analysis covers current contracts and contracts concluded no later than three years until the day of the analysis in order to establish the presence of all essential conditions in contracts, risks of invalidation thereof, risks of imposition of sanctions on the company for breach of conditions of the contracts, etc. It is also advisable to set a “cut-off price” for this block, but it is important to realize that there are a number of contracts which in any case must be analyzed irrespective of their price due to essential legal consequences of such contracts. These are agency contracts, commission contracts, etc.
The analysis of state regulation of the company’s activity is mainly aimed at checking compliance with licensing law, currency and customs law, and to determine the availability and validity of licenses and special permits, risks of revocation thereof, etc.
The content of the block related to litigation and pre-trial disputes is rather obvious. The purpose of the analysis is to identify the company’s risks connected with claims raised and the claims of third persons, as well as the prospects of court consideration of disputes initiated by the company.
The section on labor relations analyses labor disputes at the company, compliance with the procedure for hiring and firing employees, labor protection matters, conformity of internal documents (the collective agreement, by-laws, etc.) with legislative provisions.
Thus, legal due diligence covers all the principal matters of a company’s activity and describes the current state of affairs rather accurately. That is why legal due diligence has become so widespread. In fact, it is an optimal ratio between, on the one hand, time spent and the value of the procedure and, on the other, comprehensive interpretation of possible risks and problems.
At the same time, it should be clearly understood that the main advantage and essence of legal due diligence is complex and comprehensive analysis. That is why deliberate narrowing of the range of matters to be analyzed not only preserves certain risks for the client, but considerably neutralizes the value of carrying out the procedure on the whole.