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Published by Enhelion, 2019-11-21 22:55:28





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Whenever a decision is taken, it takes into account prudent man under the particular
various factors such as consequences, risks involved circumstances; not measured by any absolute
and its overall impact. In large business transactions, standard, but depending on the relative facts of
such as mergers and acquisitions, huge sums of the special case.”
money and resources are involved. Their
consequences also tend to be enormous, at times To understand it further, we may refer to the
affecting the overall operations of the business. definition given in William Crilly’s handbook on due
Therefore, it is important to check every aspect diligence which describes it as a process undertaken
before committing to the deal. This ensures that by an individual or organisation to gather enough
there are no uncertainties with regard to the information about a business entity in order to make
transaction, its risks and results. This is done by an informed decision as to its value for a specific
conducting a thorough due diligence to elicit all the purpose.i
relevant information about the transaction.
Due diligence therefore is an exercise wherein a
1.1 WHAT IS DUE DILIGENCE? company thoroughly examines the financial and legal
state of another company with which it is entering
Basically due diligence means appropriate into a business relation. The corporate structure of
carefulness. It is the reasonable care that a company the company as well as its compliance record with
should exercise before making a transaction. A more general and sector-specific laws and regulations are
sophisticated legal definition is that given in Black’s thoroughly scrutinized. This helps to uncover any fact
Law Dictionary: or circumstance that will reasonably influence a
business decision or any aspect of the transaction. It
“Such a measure of prudence, activity, or ensures that the company is commercially sound and
assiduity, as is properly to be expected from, the transaction will not have an adverse effect on the
and ordinarily exercised by, a reasonable and company that is making a deal with it.

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The concept of due diligence as a standard of conduct expenses, assumptions in the management’s
can be traced to Roman law. Under Roman law, a projections and accounting information systems.iii
person was liable if he caused accidental harm to
others if the harm so caused resulted from the Legal due diligence: Its purpose is to ascertain if the
person’s failure to meet the standard of conduct company is complying with all the applicable laws and
expected of a diligence paterfamilias- roughly regulations and whether there is any litigation
meaning a sensible head of a household.ii This was an against the company. The broad areas covered here
objective standard that was specific to the facts of the under include corporate structure, contracts,
case and examined a person’s conduct against an litigation, property- real and intellectual, licenses,
external standard rather than his own motives and employment and insurance.
intentions. It led to the development of the tort of
negligence and became a relevant standard of Commercial due diligence examines the company’s
conduct. This became the ‘reasonable man’ test in market position and its prospects. It focuses more on
English law. Thus, due diligence and negligence are the future performance of the company in the
somewhat related concepts. markets specific to it.

Due diligence involves examination of a humongous Other areas of due diligence include, inter-alia,
amount of data related to a company. Over a period human resource (to inquire about the organisational
of time, it has become an integral part of almost every culture, terms of employment), environmental
commercial transaction. There are dedicated teams (whether sites of the company comply with
in law firms that carry out due diligence and prepare environmental norms and if any liability may arise
a report with their findings. thereof), intellectual property rights (to examine the
validity, duration and protection of intellectual
The major areas of due diligence cover three aspects- property), property (to check land records, lease
financial, legal and commercial. agreements, validity of title) and antitrust (to check if
any of the company’s activities violate the provisions
Financial due diligence: It examines the financial of competition law).
performance of the company in the past and present
and whether it will be profitable in future. It studies While there is no specific law mandating due
the company’s economic earnings, operating diligence, there is a fiduciary duty of care of the
directors of a company. Before taking any decision,

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the directors have to exercise their duty of care and Before committing to the deal, Freeport began its due
carry out due diligence to ascertain any risk diligence into Bre-X. It sank some exploratory drills to
associated with the transaction. This duty to take obtain independent data. It was revealed that the
care has been indicated in statutes relating to core samples found by Freeport during its due
different areas of law. These have been discussed in diligence showed “insignificant amounts of gold.”iv
the next section. This sent the share price of Bre-X nose-diving. It
demanded further investigation. An independent
1.2 IMPORTANCE OF DUE DILIGENCE company, which analysed the samples, concluded
that the ore samples had been salted with gold dust.
The importance of due diligence in a commercial A group of geologists working for Bre-X salted the
transaction can be exemplified by the Bre-X case. drill samples with gold before sending them to
This was a case of one of the largest frauds in the laboratories for examination. This started when their
mining industry. initial samples did not indicate any gold at the site.

Bre-X Minerals Limited, a Canadian gold exploration The scandal sent the shares of Bre-X crashing and
company was set up in 1988 by David Walsh. In 1992, shareholders initiated legal action against the
it commenced gold exploration near Busang River in company. The scam came to light only due to due
Indonesia. It announced that the site was estimated diligence carried out by Freeport before signing the
to fetch a significant quantity of gold. Samples sent deal.
for examination showed considerable gold
mineralization. The estimates increased over a period As can be inferred from the above example, it is vital
of time, as did the stock price of Bre-X. The to conduct due diligence before investing or
Indonesian government got involved and it suggested partnering with any company. It helps in identifying
that Bre-X should share the site with another large the correct value of a business transaction. It brings
company since the former was a small company and to the fore the risks involved with the company and
could not carry out the operations by itself. After a has the potential to influence significant business
deal was negotiated, it was agreed that Freeport- decisions. An important aspect of duel diligence is to
McMoRan Copper and Gold, an Arizona-based ensure that there is no knowledge imbalance. A
company would run the mine while Bre-X will have company discloses all the information to a
land rights for thirty years.

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prospective partner company so that there is no loss known but for a “willful abstention from an inquiry or
due to undisclosed risks.v To sum up, the principal search” which he should have made. This indicates a
objective of conducting a due diligence is to confirm duty that a person has to verify the facts before
facts and representations involved in a commercial making any investment in a property. One should
transaction so as to confirm the value and risk of such make sure that the property has a clear title and is
transactions, including the risk of future without any encumbrances.

1.3 DUE DILIGENCE IN VARIOUS FIELDS Mergers and Acquisitions: Before finalizing a deal,

This section discusses the application of due diligence the acquirer carries out intensive due diligence of the
in various fields of law.
target company. This gives the acquirer sufficient
Capital Markets: Since this market deals with
issuance of securities, a thorough due diligence is information about the target and its business such as
carried out of the issuer to ensure that it complies
with all the applicable regulatory norms and has the legal ownership of assets, statutory or regulatory
capacity to issue the securities. This ensures that
there is no misrepresentation to potential buyers of compliance and breaches and pending and
securities. The Securities and Exchange Board of
India (SEBI) has, in SEBI (Issue Of Capital And prospective litigation. During a
Disclosure Requirements) Regulations, 2018
mandates due diligence for various intermediaries merger/amalgamation process, the manager of the
involved in issuance of securities. Section 24 of the
Securities Contracts (Regulation) Act, 1956, absolves open offer has to submit a due diligence certificate to
a person responsible for the business of a company
from any liability if he exercises all due diligence to SEBI in compliance with the Substantial Acquisition
prevent the commission of an offense.
of Shares and Takeovers Regulations, 2011.
Property law: Section 3 of the Transfer of Property
Act, 1882 states that a person is said to have notice of Competition law: In competition law, due diligence
a fact when he actually knows it or should have is conducted to check if the company’s practices are
in compliance with the law and to identify activities
that could potentially expose the company to anti-
competitive behavioral risks. The effect of due
diligence may alter the value of the deal or put in
place an effective mechanism to ensure fairness and
adherence to competition law principles.

Environmental law: Before entering into any
business relationship with a company, it is necessary

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to conduct an environmental due diligence of International Law: Due diligence in International
environmental factors. It includes evaluation of Law is a standard of conduct prescribed for a state to
emission of hazardous substances and its mitigation, define its responsibility with respect to third
regulatory compliances and cost of any non- parties.vii It is the duty of a state to use due diligence
compliance, the reaction of society to the activity of to prevent criminal acts in its territory against
the company and its effect on environment, another nation or its citizens.viii As long as it exercises
examination of environmental impact assessment due diligence to prevent the occurrence of such acts,
report. it cannot be held liable for the acts of private
individuals within its territory.ix Thus, due diligence
defines the extent of state’s responsibility under
particular circumstances.

i William M Crilly, Due Diligence Handbook (American srv/inatl/longterm/canada/stories/brex051897.htm?nored

Management Association, 1998). irect=on>
vCharu Mathur, ‘India: Legal Due Diligence’ Mondaq.
ii Jonathan Bonnitcha and Robert McCorquodale ‘The
Concept of ‘Due Diligence’ in the UN Guiding Principles Available at
on Business and Human Rights’ [2017] 28(3) European
Journal of International Law, 899. <

viMartin Ortega, ‘Human Rights Due Diligence for

iii ‘Understanding the differences between an audit and Corporations: From Voluntary Standards to Hard Law at
financial due diligence’ Maxwell, Locke and Ritter (31 last?’ [2013] 31 Netherlands Quarterly of Human Rights,

October, 2017), available at 44.
viiHessbruegge, ‘The Historical Development of the

< Doctrines of Attribution and Due Diligence in International
Law’, [2004] 36 International Law and Politics, 265.

diligence/> viiiCase of the S.S. Lotus (France v Turkey) 1927 PCIJ

iv Howard Schneider, ‘A Lode of Lies: How Bre-X Fooled Series A, No. 10.

Everyone’ Washington Post Foreign Service (18 May, ixWipperman Case (United States of America v

1997). Available at Venezuela) (1887), reprinted in J Bassett MooreP,aHgeis|to4ry

< and Digest of the International Arbitrations to Which the
United States Has Been a Party (Vol 3, 1898–1906).

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