DUE DILIGENCE: DO’S and DON'TS
05.11.2022
Due diligence is a comprehensive independent assessment of a company initiated by an investor who wants to finance it, or by a business owner who wants to conduct an expert assessment of the company's state of affairs.

The term “due diligence” first appeared in the US Securities Act of 1933, under which dealers and brokers became responsible for full disclosure of material information about the financial instruments they were selling.
Modern standards were developed in Switzerland in 1977 by banks, which signed an agreement on a uniform approach to gathering information about their clients. Later on, consulting businesses started applying the principles outlined in "The Swiss Banks Due Diligence Agreement" to comprehensively analyze a company's operations.

There are different types of due diligence, such as financial, market, and tax. For our purposes, we will be looking at legal due diligence, which involves analyzing the legal aspects of the company and identifying legal risks.
A company or project can be audited in several cases:
■ Company acquisition;
■ M&A transaction;
■ Investment in a company;
■ Acquisition or sale of company assets;
■ Change in the management structure of a company.

The main purpose of due diligence is to identify the legal risks of a company/project based on the information provided by the business. Simply put, the result should be a clear understanding of potential problems and the probability of them arising.

As a rule of thumb, the legal analysis of a project is limited only to documents submitted by the company. On this basis, the so-called "unknown unknowns" principle is at play in legal due diligence. If there is no information about a particular fact existing, assumptions about whether that information exists or not cannot be made. At the same time, expert due diligence can help identify contradictions and gaps in the provided data.

Given that documents are the main source of information, the first and most important step is to form a request for them. The request needs to be built in such a way as to collect the maximum number of documents that will help you draw the necessary conclusions.

It is worth remembering that the initial request may be supplemented after document analysis and most likely will not be final.
A properly conducted legal audit is a convenient, structured source of information about the company. It does the following:
  • Assesses the risks of investing in the company;
  • Considers the adjustment of company value (taking into account other methods);
  • Detects violations of the law in the company's activities;
  • Develops measures to prevent legal breaches.

Stages of due diligence include:
  • Preparation, during which lawyers request all the necessary information and documents for analysis from the company/project, ask questions and evaluate the depth and volume of expertise. In order for the experts to conduct due diligence, company representatives should carefully prepare for the audit, most importantly by creating a data-room (online storage space) , where documents should be divided into subject categories (constituent documents, transactions, employment, accounting statements, etc.).
  • Conducting a legal audit. This phase incorporates an analysis of all current legal relations, assets, documentation for compliance with current legislation and law enforcement practice, analysis and identification of deficiencies and missing documents, and development of recommendations for their remedy, if possible.
  • Drawing up a legal opinion. The legal opinion based on the results of due diligence contains information about the legal problems of the company/project, significant risks for long-term investment, recommendations for their remedy, and proposals for developing necessary missing documentation.
Due diligence, including legal due diligence, its scope, and depth depend on the target goals and the lifetime of the audited company.

What information is verified when investing in a business?
  • Information on the legal entity or group of entities that are investment targets
  • Legitimacy of the company's activities (legal mechanism of the project)
  • Management structure
  • Legitimacy of share ownership in the company
  • Analysis of transactions significant for the company
  • Labor relations
  • Taxes

Assurances and warranties in due diligence
In the US, assurances and warranties (representations) are common for an investment or M&A transaction. These two institutions are not mutually exclusive. Often, before the start of due diligence in the term sheet or after the due diligence, if the conclusion describes possible risks, investors require additional representations and warranties from the project. The main purpose of representations and warranties is to ensure that the contract can be easily repudiated, and that penalties or losses can be recovered in case of actual risks.
Moreover, in the US, insurance is actively used for protection against losses arising from a party's breach of its representations and warranties under the contract. Thus an investor may choose not to conduct due diligence and significantly reduce costs by taking advantage of the fully functional institution of representations and warranties, and, if desired, insure the representations and warranties provided by the project.

Due diligence results
The result of a legal due diligence is a legal opinion (report) containing an analysis of the business, the risks identified, and recommendations for their mitigation.
Due diligence conclusions include expert findings based on an analysis of audit sources. The report is a document that manages the client's expectations concerning the subject of the transaction and informs the decision on its settlement.

What risks can be identified during legal due diligence?
  • Significant risks include issues related to rights to non-tangible assets, the contractual model, and the correlation of rights to shares.
  • Most of the risks in legal entity operations can be eliminated.
  • Another important subset of risks are those related to claims from counterparties, tax, and other government agencies. While legal due diligence is an integral part of venture capital transactions, it is often neglected in transactions between individuals or non-specialized companies. The reason may be either a reluctance to incur costs or assurances from the seller of the company that there are no risks and that the audit is an unnecessary waste of money and time.

In this case, do not be surprised if, after the purchase of the company, you discover that:
  • The company is in arrears in taxes or with its contractors.
  • The shares acquisition may be held invalid (e.g., because the previous owner did not pay for acquired shareholding).
  • Assets (including intellectual property) may not be owned by the company or be the subject of claims by third parties. Of course, even with the most elaborate due diligence, unforeseen situations or undetected risks may arise in the future. It may be due to the dishonest behavior of the audited party (non-disclosure of information).

Appendix: "List of documents for due diligence"
Corporate matters
1. Certificate of State Registration of a Legal Entity and certificate of tax registration.
2. Charter (all editions and amendments) with a stamp of the Federal Tax Service.
3. Incorporation resolution.
4. Resolutions of the Company's founders and management bodies approving its constituent documents (all editions and amendments of the Charter).
5. Resolution of the Company's management body on the election/appointment of the incumbent CEO.
6. Order on taking office of the CEO.
7. Order on the appointment of the Chief Accountant (if applicable).
8. Letter of Absence of Chief Accountant and Acting Chief Accountant by the CEO.
9. Documents confirming payment of charter capital, including in case of its increase:
  • If the charter capital was paid in cash: payment orders, warrants, bank statements, etc.;
  • If the charter capital was paid in non-monetary funds: acts of acceptance and transfer of property; reports of an independent appraiser on the valuation of the contribution to the share capital.
10. A description of all changes in the structure of the Company's charter capital since its incorporation (increases and/or decreases in the volume of the Company's charter capital), with the relevant resolutions of the Company's management bodies attached.
11. Resolutions/memoranda of the Company's management body on the election of the Board of Directors (if applicable).
Resolutions/memoranda of the Company's management body on the approval of major transactions and/or interested-party transactions.
13. Resolutions/memoranda on annual general meetings of the Company's members/shareholders on the approval of the Company's annual performance results.
14. List of members on the current date.
15. List of the Company's affiliates.
16. Description of all changes in membership of the Company's shareholders with supporting documents (contracts of sale and purchase of shares, payment orders confirming the payment under the contracts, documents confirming the respect for the pre-emptive rights of members, members' applications for withdrawal from the companies).
17. Information on the Company's participation in other organizations with documents attached, specifying the shares of this participation and the start date of this participation.
18. The resolution of the Company's management body on profit distribution.
19. Information on opened branches, representative offices, separate subdivisions, resolutions/memoranda of their opening, documents confirming their registration in accordance with the procedure established by law, the order on appointing the manager of a branch or representative office, regulations on the branch/representative office/separate subdivision.
20. Regulations on the branch (representative office) of the Company (if any).
21. Option agreements (if any).
22. Corporate agreement (if any).
23. Documents confirming the Company's share pledge (if any).
24. Loan or credit agreements or other debt commitments (if any).
25. Suretyship or pledge contracts (if any).
26. Documents confirming earlier investment in the Company (if any):
  • A contract of sale and purchase of a share in the charter capital of the Company;
  • Company’s general meeting minutes/resolution of the sole member to increase charter capital;
  • Loan agreements;
  • Convertible loan agreement.

Labor Relations
27. The employment agreement with the CEO of the Company.
28. The Company's staff schedule approved by the CEO (as amended).
29. Employment agreements and/or civil law contracts with employees.
30. Local regulations of the Company.

Intellectual Property

31. Documents confirming rights to intellectual property items (trademark, patents, know-how, inventions, utility models, design solution, etc.).
32. Regulations on work for hire, labor contracts with employees, creating intellectual property (including work tasks, and confirmation of payment for alienation of exclusive rights).
33. Contracts with authors (contractors) who are not employees (including all appendices, certificates, confirmation of payment under such contracts).
34. License agreements (if applicable).
35. Regulations on the commercial secret (with the list of information constituting the Company's trade secret).
36. Order of the Company's CEO on the Company's trade secret mode.
37. Register of employees who have access to the Company's trade secrets.
38. Non-disclosure agreements with the Company's employees/officials who have access to information that constitutes a trade secret of the Company.
39.Company’s regulations on processing and storage of personal data. Contractual relations
40. Contracts with all of the Company's clients/customers, including its key clients/customers.
Proceedings and disputes
41. Claims, suits against the Company for the last three years (if any).
Other
42. All licenses (permits) for certain types of activities issued to the Company (if any).
43. All quarterly, semi-annual and annual balance sheets and tax returns of the Company for three years.
44. Results of government audits (such as the Federal Tax Service, ).
45. Documents confirming favorable tax status.
46. Documents confirming the Company's receipt of grants.


Based on materials by https://zarlaw.ru