Importance of due diligence in corporate transactions

Before the 1930s, due diligence was not practiced frequently. But when the securities dealers and brokers started hiding material information about the instruments they were selling, in turn causing huge losses to the buyers and investors, then the United States of America issued the Securities Act 1933 that stated that if the dealers and brokers did not disclose all the material information about the instrument they were selling, they would be liable for a criminal prosecution, here is when due diligence became a common part of a transaction. Consequently, due diligence as a practice was used to attain full information about the instrument the potential buyer was buying and a way of safeguarding the dealers and brokers from false claims of the buyer as they could show a due diligence investigation report in their defense.

Due diligence can be understood as a detailed investigation or audit with respect to an investment in practice. A prospective buyer usually performs due diligence in order to confirm the accuracy of information provided by a seller before concluding the transaction. In the English language, the term due diligence refers to the exercise of care and caution by a prudent individual under given circumstances.

 

Broadly, there are three types of due diligence.

1. Financial due diligence – Financial due diligence is the most important and critical form of due diligence. In a financial audit, the accuracy of the financial records in the Confidentiality Information Memorandum (CIM) are investigated at length. The investigations are done to understand overall financial performance and stability and realize if there are any other issues. Items audited may include financial statements, private equity investments, the company’s forecasts and projections, inventory schedules, purchase of a business in the UAE or overseas, and project financing or pre-lending reviews.
2. Business due diligence – This kind of due diligence refers to companies and firms practicing prudence by carefully assessing associated costs and risks prior to completing transactions. These audits can also surface potential issues. Due diligence helps predict the impact and the risks associated with the transaction when acquiring the firm’s current customers. Companies and firms exercise due diligence by researching customer reviews and the seller’s reputation, evaluating price compared to competitors, considering the environmental impact of the transaction, and supplementing purchases with insurances or warranties.
3. Legal, due diligence – Legal, due diligence helps a potential investor understand whether the company in question is legally subservient or embroiled in issues. During the due diligence, all the contracts, corporate documents, board meeting minutes, and compliance doctrine are assessed in detail.

Even though the above mentioned are types of due diligence, the process by which it is carried out cannot be generalized. In short, there is no “one fits all” approach when it comes to carrying out due diligence. The process is customized keeping in mind the facts, circumstances, and the nature of the transaction, details required, and the risks involved.

 

Usually, the due diligence report mentions the company and its shareholders and directors, any litigation the company is involved in, the company’s intellectual property rights, company’s insurance cover, real estate owned or leased by the company, company’s licenses, any contracts the company has gotten into, etc.

As a normal practice, the due diligence clause is mentioned in the Letter of Intent, i.e., a preliminary document that commits that one party is interested in doing business with the other party and where the skeleton terms of a prospective deal are mentioned along with the non-disclosure clause. In the clause mentioned above, the parties generally note down the deadline by which the due diligence has to be performed and what are the actions that are to be taken if the results of the investigation report are not in favor of the seller party.

Due diligence is a very imperative and challenging undertaking. It is an essential step towards a successful business transaction as it helps the purchaser to assess the value of the business and verify various facts about the transaction. Due diligence helps identify critical and possible risks, it can save a business from incurring losses because of a bad decision. Usually, a company or investors considering a merger and acquisition finds it necessary to go through due diligence in order to establish the authenticity and transparency of the merger.

Financial due diligence has become a necessity while carrying out a transaction. It enables the owners or potential investors to make such investments with confidence and causes them less risk and stress.

The United Arab Emirates (UAE) is slowly opening itself to allowing the practice of due diligence as with changing times, globalization, and in-flow of foreign capital; it has become the need of the hour. There is no explicit law that prohibits anyone from conducting due diligence investigations in the UAE. Interestingly, it is actually allowed in UAE, but due diligence in UAE is a time-consuming and tedious affair because of the lack of knowledge available to the public. For example, the register which contains all the ownership details and is maintained by the Dubai Land Department is private. 

Companies can perform background checks, executive screening into either individuals or companies or firms as long as they don’t commit any breach of UAE’s federal law and policy made by the local governing authorities. While performing due diligence, companies or individuals have to keep in mind the privacy laws imposed by UAE to conduct a lawful due diligence procedure. 

The easy way to perform due diligence and acquire accurate and reliable information in UAE is through a local investigator as he can cross the language and cultural barriers without any hassle and procure information from various government agencies smoothly. However, it is pertinent to remember that there can be serious consequences to those who don’t comply with the local laws of UAE; non-compliance can often lead to prosecution. But nowadays, since the number of complex and high-value deals is increasing, the demand for due diligence is also increasing as every purchaser wants to be sure and confident before entering into a deal or closing a transaction. The investors register more and more requests of due diligence, and sellers are being asked to facilitate the process. It is becoming reasonably common for inquiries before contract to be raised and copies of any site investigation studies (for example, environmental surveys, etc., to be requested) and site inspections undertaken. The investors often ask their lawyers to conduct due diligence, and purchasers request a due diligence report from their lawyers and obtain professional valuation surveys of the property.

Hence, it can be stated that the process of due diligence holds immense importance as it provides the buyers or investors with peace of mind that they’re making the right deal and acquiring all the data they require to make a good purchasing decision. At the same time, it helps the seller uncover the company’s fair market value or asset.