Overwhelming deals, overdue diligence

23 May, 2016

The Arbitration order directing former Ranbaxy shareholders to pay Daiichi Sankyo compensatory damages with retrospective effect has once again highlighted an obvious fact: that the process of due diligence itself calls for serious due diligence particularly in connection with any M&A transaction.  No wonder it is reduced to a perfunctory exercise (merely a financial audit in most cases) more lured by the enormity of the deal than guided by the criticality of the diligence.

It appears that Daiichi Sankyo chose to downplay the glaring 2006 FDA observations on allegedly suspect Ranbaxy practices as a mere ‘risk call’. Quite obviously, the unflinching focus was on the 34.82% stake that was to make Daiichi Sankyo a Pharma heavyweight in India.  

In many such cases, on-site inspection of assets don’t fit into their scheme of things given the lop-sided attention to the ‘closure’ that leaves many gaps inviting legal mishmash at a later date. Worse, this spur-of-the-moment stance is often glorified as ‘thinking on one’s feet’ in the larger interest of the business. History has shown us how this larger interest makes way for larger issues.      

Due diligence often rests easy on standard corporate documentation and pure wishful thinking–that the target company is necessarily honest and transparent. To make matters worse, law firms often depute junior lawyers and trainees on due diligence assignments and leave limited or very selective monitoring to senior lawyer or partners, more so when demanded by clients. 

The process of due diligence hence needs a complete overhaul. Luckily much of the needful is no rocket science – it’s simply a better application of mind and method in: 

Holding comprehensive discussions with the members of the financial, legal and technical teams of the target company.

Ensuring that different teams seamlessly interact with each other and are on same page. (If they are not, probe deeper into the reasons.)

Clearly articulating objectives and deliverables of the due diligence exercise. 

Asking for documentation beyond the standard check list – like undocumented dealings with customers, vendors, key employees.

Stressing on relevant information, not available information. (Prefer smart executive summaries over raw, bulky records.)

Deliberating upon industry specific issues or special areas of concern at the very beginning of the exercise.

Monitoring progress at regular intervals, to retain focus and purpose end-to-end. 

What seems obvious is often overlooked. Only a thorough study into the internal fabric of the target company can make a due diligence exercise purposeful, a probe that should typically raise fundamental questions including:

How strong are the internal policies and procedures?

Is the company running any anti-fraud programmes?

How does the company deal with operational risks? Is there an internal team constituted for the purpose?

What is the quality of compliance monitoring? How does the company deal with deviations? 

Does the company have a documented vision statement, code of conduct, business ethics, operating principles? 

Is there a whistleblowing policy in place? (This is most important in today’s times of contentious happenings.)

Much of the problem lies in the convenient interpretation of the term ‘due diligence’. In scores of M&A cases, there are special teams assigned to do a cover-up job–of shielding facts and fabricating figures–which is decidedly more comprehensive than the surface-level technical audits conducted in the name of due diligence.  

But the roots of this thorny issue are even deeper. Today, the business landscape has undergone a sea change in terms of scope and size. Given the diversity of opportunities across a plethora of service sectors and verticals, innovation today is invariably disruptive in nature. It goes without saying that risks emanating from this dynamic environment can’t be studied under the old microscope of the manufacturing-centric regime or the routine approach adopted by consultants. 

They demand specialised skill sets and inter-disciplinary due diligence teams armed with a holistic approach. We also need a fool-proof legal environment capable of check-mating new frauds and inventive wrongdoings.  Unfortunately, the Indian legal system yet leaves a lot to be desired when it comes to arresting the suspect practices of a digital and distributed world. So where does that leave us? 

It’s most important to scan the character of the target company and its promoters (not just financial track records) before zeroing in on any investment decision. The onus is obviously on legal practitioners to be extra-vigilant in their roles as watchdogs. It’s their responsibility to ensure that diligence is not rendered ‘overdue’ simply because the deal is ‘overwhelming’.

Nitin Potdar is the M&A Partner at law firm J. Sagar Associates. Views are personal.

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Overwhelming deals, overdue diligence

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