Safeguarding Your Deal: The Critical Role of Legal Diligence in Mergers and Acquisitions

By Mohd. Sahil Khan 14 Minutes Read

Introduction

Mergers and Acquisitions are commonly construed as the same; however, they are distinct concepts. A merger is a fusion of two companies, leading to the creation of a single entity; it essentially is a merger of two companies to promote their interests by working in unison. On the other hand, the acquisition is a transaction resulting in the purchase of the dominant interests of a company, such that the company acquired becomes a daughter company of the company acquiring it.

A merger is an intricate process as it leads to significant changes in the financial structure and management of the company. M&A is a thorough and detailed process during which both companies must overcome various obstacles, the cultural differences being the biggest of them all. Each company has its own work culture and environment, which might not be beneficial to the other company; therefore, cultural differences become a significant obstruction in the M&A process.

Everyone can’t be on the same page, therefore; the company keeps an exit mechanism in place, so that top executives of the company could leave the company if they cannot integrate to the cultural shift. Much work must be done in the legal, financial, and consultancy domain to ensure a smooth M&A. Since the process is highly complex, significant legal assistance is required. The article discusses the necessary work in M&A and the legal implications ensuing it.

Types of Mergers and Acquisitions

1. Mergers

A merger combines two companies of comparable size into a single new entity. Both companies’ boards of directors must approve the merger, and shareholder approval is also required. For instance, in 1998, Digital Equipment Corporation merged with Compaq, forming a larger company under the Compaq name. Subsequently, in 2002, Compaq merged with Hewlett-Packard. The combined company adopted the ticker symbol HPQ, a combination of Compaq’s previous symbol (CPQ) and Hewlett-Packard’s (HWP).

2. Acquisitions

An acquisition occurs when a larger company purchases a substantial portion of a smaller company’s shares. Unlike a merger, where two companies combine to form a new entity, an acquisition maintains the original structure of the acquired company.

This means that there is typically no need for significant organizational changes or alterations to the company’s identity. As a result, challenges related to merging different corporate cultures are generally less pronounced in acquisitions compared to mergers.

3. Consolidations

Consolidation involves the creation of a new company by combining the core operations of two existing companies while eliminating redundant corporate structures. This process requires the approval of both companies’ shareholders. Subsequently, common equity shares are distributed within the newly formed company.

4. Tender Offers

A tender offer involves a company purchasing outstanding shares of another company at a predetermined price, rather than the prevailing market rate. Unlike traditional acquisitions where negotiations occur between companies, tender offers are directed directly at the target company’s shareholders.

This bypasses the company’s management and board of directors. For example, Johnson & Johnson acquired Omrix Biopharmaceuticals in 2008 through a tender offer.

5. Management Acquisitions

Management Buyouts (MBOs) occur when a company’s management team acquires the business they manage from the owners. This involves purchasing the company’s assets and operations. Management teams often partner with financial institutions to secure the necessary funds for the transaction. MBOs typically result in the company becoming privately owned.

6. Acquisition of Assets 

An asset purchase occurs when one company directly acquires the assets of another. This often happens during bankruptcy proceedings, where multiple companies may compete to purchase the bankrupt company’s assets. Once the sale is complete, the acquired assets become part of the purchasing company.

Issues associated with M&A

Transaction issues represent a significant challenge in the M&A landscape. These complexities often surface at the early stages, such as the letter of intent phase, and require careful resolution. Contrary to popular belief, M&A transactions are highly intricate processes demanding rigorous due diligence from the acquiring company.

Deal Structuring

Structuring a deal in mergers and acquisitions involves several critical considerations. Key options include merging two companies, acquiring a smaller company’s assets, or purchasing its shares to become a shareholder. The divergent legal interests of involved parties often prolong negotiation processes.

1. Transfer of Liability: Unless explicitly stated, liabilities typically transfer to the purchaser. In mergers, the surviving entity assumes the liabilities of the dissolved company. Asset transactions limit liability transfer to assumed liabilities, with non-delegated liabilities remaining with the target company.
2. Stockholder Approval: While the board can authorize asset sales on behalf of shareholders in corporate mergers, stock sales necessitate individual shareholder approval. To streamline this process, companies often establish mutually agreed-upon stockholder approval thresholds.
3. Third-Party Contractual Requirements: The target company must be free from exclusive agreements hindering its business or assignments. Pre-closing authorization might be required if such restrictions exist.
4. Tax Implications: The tax consequences of M&A transactions vary based on structure. Asset sales and stock purchases generally incur immediate taxes, while certain mergers and reorganizations offer tax deferral opportunities.
5. Regulatory Landscape: Antitrust regulations often dictate permissible deal structures. For example, the merger of two dominant players in a particular market might face scrutiny from competition authorities.

The Dilemma Between Cash and Equity Distribution

M&A transactions can be executed using two primary payment methods: cash or equity. The target company typically favors cash transactions due to their low risk and high liquidity, providing a clear valuation of the firm. Conversely, the acquiring company often prefers equity, as it preserves cash reserves, potentially improves debt ratings, and offers flexibility in capital structure.

However, equity transactions involve complexities such as brokerage and registration fees and may face shareholder opposition. The optimal payment method depends on various factors, including the relative valuation of the companies involved.

Requirement of Working Capital

Working capital adjustments are commonly incorporated into M&A deal prices. Buyers aim to ensure the target company possesses sufficient funds to meet post-sale obligations to customers and creditors. Sellers seek compensation for the asset base that enabled the company’s profitability.

Standard working capital adjustments involve comparing current assets (cash, inventory, receivables, prepaid expenses) to current liabilities (accounts payable, accrued expenses). A benchmark working capital level is established based on historical data and included in the definitive agreement. The calculation may also consider unusual or non-recurring items. Post-closing adjustments are often made within a few months, with dispute resolution procedures outlined in the agreement.

Warranties Associated with a Transaction

An M&A transaction involves extensive negotiations regarding representations and warranties. While the target company strives for maximum representation, the acquirer aims to minimize its liability. Buyers seek to expand their representation to exert greater control over the acquiring company. Conversely, the target company focuses on securing guarantees for specific issues, while the acquirer seeks broader coverage due to its influential position and potential future challenges.

Specific Legal Challenges: Intellectual property rights, environmental liabilities, and product liability claims are common areas of concern. For example, a pharmaceutical company acquiring another might inherit undisclosed product liability lawsuits.

Even when a mistake aligns with the criteria outlined in Section 18 to establish misrepresentation or a patent breach of promise, the consequences under Section 19 of the Indian Contract Act may not necessarily follow. To address this, contracts often include detailed provisions for indemnities, liquidated damages, and termination options.

The strength of each party’s negotiating position significantly influences these terms. For instance, in telecom transactions, warranty breaches related to operating licenses can result in substantial liquidated damages, as these warranties are crucial to the acquisition. However, less critical issues like stamp duty non-payment or lease expirations might not warrant specific remedies.

Indemnification

Corporate structures heavily rely on profit and loss projections, leading to intense discussions about indemnification. A critical aspect is determining the cap for the escrow account. This neutral third party holds assets and funds before transferring them to the other party. Claims are limited by the escrow amount and distributed based on liability. However, cases involving fraud, misrepresentation, or intellectual property breaches often exceed the escrow cap, with damages capped at the total purchase price.

To prevent excessive claims impacting business operations, many acquiring companies establish minimum claim thresholds below which indemnification is not provided.

Liabilities

The concept of joint and several liabilities is closely linked to indemnification. In transactions involving multiple target stockholders, a crucial consideration is the responsibility of each stockholder for post-transaction indemnification obligations. Joint and several liability holds each stockholder fully accountable, while shared liability limits responsibility to a proportionate share. Acquirers generally prefer joint and several liability to protect their interests, while target stockholders, especially controlling shareholders and financial investors, often resist this. A manufacturing company acquiring another might inherit undisclosed environmental contamination issues, leading to significant cleanup costs.

Closing Conditions

A definitive agreement for a merger or acquisition must outline specific conditions that must be fulfilled before the deal can be finalized. These conditions are typically subject to extensive negotiation prior to the final agreement.

Examples of such conditions include obtaining necessary board approval, ensuring no significant adverse changes in the target company’s business or financial standing, the absence of ongoing litigation, securing a legal opinion from the target’s counsel, and securing the required stockholder approval.

One of the more complex closing conditions involves stockholder voting requirements. While a company’s operating agreements and state laws might stipulate a lower approval threshold, acquiring companies often seek a higher one to mitigate the risk of minority shareholders exercising appraisal rights. Target companies should carefully assess their shareholder structure before agreeing to overly stringent requirements, although higher approval rates generally strengthen the deal.

Conclusion

The rise of capitalism has spurred significant growth in mergers and acquisitions globally. India has experienced a surge in M&A activity since economic liberalization in 1991. Government agencies and prominent financial institutions have actively participated in these deals, revitalizing the Indian commercial landscape.

Intensifying global competition has compelled Indian companies to adopt M&A as a strategic tool for growth and survival. The regulatory framework governing M&A in India has evolved over time, and the impact of these transactions on the financial system has varied across sectors. While international ventures were once limited for Indian companies, the M&A landscape has transformed, facilitating cross-border collaborations.

Successful M&A outcomes depend on various factors including strategic planning, regulatory flexibility, and aligned interests of involved parties. However, thorough due diligence is imperative to mitigate legal risks and ensure the long-term success of these complex transactions. Ultimately, mergers and acquisitions can be powerful tools for expanding market reach and driving economic growth when executed effectively.

Mohd. Sahil Khan