Due Diligence of Corporate Debtor
The Insolvency and Bankruptcy Code
The IBC was established as an extensive code to consolidate laws dealing in reorganization and insolvency resolutions of corporates, partnerships as well as individuals. The entire process starting from the institution of proceedings until approval of a resolution plan or liquidation is expected to be time bound.
The IBBI (i.e. Insolvency and Bankruptcy Board) has also framed the Insolvency Resolution Process for Corporate Persons Regulations, 2016 (“CIRP Regulations”) in order to focus on several aspects pertaining to the insolvency resolution process of a corporate debtor.
What are the various types of Due Diligence?
Due Diligence is one of the most valuable, substantial as well as lengthy procedures in an M&A deal. The procedure of due diligence is something that the buyer conducts to validate the certainty of the seller’s claims. A probable M&A deal includes various types of due diligence.
Types of Due Diligence
DD (i.e. Due Diligence) is a lengthy procedure undertaken by an acquiring enterprise in order to comprehensively and completely evaluate the target organization’s business, capabilities, assets as well as financial performance. There may be about twenty or more angles of due diligence analysis.
The fundamental types of due diligence inquiry are as follows:
1. Administrative Due Diligence
Administrative Due Diligence is the phase of due diligence that comprises of authenticating admin-related items such as facilities, occupancy rate, number of workstations etc. The motive behind going for due diligence is to authenticate the varied facilities possessed or engaged by the seller and decide if all operational costs are rounded up in the financials or not. Administrative Due Diligence also provides a better picture of the kind of expenditure that the buyer is expected to bring upon itself in case they plan to opt for the extension of the target organization.
2. Financial Due Diligence
One of the most critical and crucial types of due diligence is the financial due diligence as it investigates and checks if the financials demonstrated in the CIM (i.e. Confidentiality Information Memorandum) are authentic or not. Financial Due Diligence intents to provide complete understanding of all the company’s financials, including, but not limited to, audited financial statements for the past three consecutive years, latest unaudited financial statements with comparable statements of the previous year, the organisation’s predictions and basis of such predictions, schedule of inventory, capital expenditure plan, debtors and creditors etc.
3. Asset Due Diligence
Another type of due diligence conducted is asset Due Diligence. These reports basically involve a specific itinerary of fixed assets as well as their locations (if in case possible, physical authentication should also be done), all lease agreements for equipment, a schedule of sales along with purchases of major capital equipment during the last three to five financial years, mortgages, real estate deeds, title policies, and use permits.
4. Human Resources Due Diligence
Human resources due diligence is comprehensive. It includes all of the following:
- Analysis of the total number of employees, inclusive of vacancies, current positions, due for retirement, and also those serving their notice period
- Analysis of current remuneration, bonuses paid during the last three financial years, and the total number of years of service
- All employment contracts with non-solicitation, non-disclosure, and non-competition agreements between the organization and its members. In case there are a few violations concerning the general contracts, all questions or issues need to be sorted.
5. Taxes Due Diligence
Due diligence in the aspect of tax liability involves an analysis of all taxes that the organization is needed to pay and assuring their proper calculation with no motive of under-reporting of taxes. Furthermore, validate the status of any tax-related case pending with the tax authorities.
The report of a tax agreement and potential issues specifically involves authentication and analysis of the following:
- Transcripts of all tax returns – including sales tax, withholding, and income tax– for the last three to five financial years
- Knowledge about any past or pending tax audits of the organization
- Transcripts linked to Net Operating Loss (i.e. NOL) or any unused credit carryforwards of deductions or tax credits
- Any substantial, out-of-the-ordinary correspondence with tax agencies
6. Intellectual Property Due Diligence
Almost every organization has intellectual property assets that they can use to monetize their business. These intangible assets are things that separate their product as well as service from their opponents, and may often consist of a few of the organization’s most valuable assets. Some of the items that need to be considered in due diligence review are as follows:
- Schedule of patents along with patent applications
- Schedule of trademarks, copyrights as well as brand names
- Pending patents authorization form
- Any pending claims case by or against the company in regard to contravention of intellectual property
7. Legal Due Diligence
Legal due diligence is, of course, extremely crucial and it typically consists of examination as well as a review of the following elements:
- Memorandum and Articles of Association copy
- Minutes of the meeting for Board Meetings held in the last three financial years
- Minutes of all meetings as well as actions of shareholders for the last three financial years
- Transcript of share certificates circulated to Key Management Personnel
- Transcript of all guarantees to which the company is a party
- All material contracts, including any limited liability company or operating agreements; joint venture or partnership agreements
- Licensing as well as franchise agreements
- Transcripts of all bank financing agreements, loan agreements and lines of credit to which company is a party
- Does the target have important products, technology or market access that the acquirer requires and has need of or can make adequate use of?
- Does the target have key staff members that symbolize a substantial gain in human resources?
- Evaluate both operational as well as financial synergies gains that can be anticipated from the target’s integration with the acquirer
- If in case, the target company is to be consolidated or incorporated with the acquirer or another firm that the acquirer already owns, evaluate the plan for merging the project and have knowledge how long the merger process will take. One also needs to measure the cost of implementing the actual process of merging the two firms
- Decide the best personnel from both the acquirer as well as the target for managing the merger process
Other areas of due diligence research include issues of stocks and/or bonds, IT networks, research and development (R&D), and sales and marketing. Administering thorough due diligence is important to any successful acquisition. Without thorough and intimate knowledge about the target company, it is not possible to make the best-informed decisions on mergers and acquisitions.
In the situation of a proposed merger or a situation where shares of stock in the acquiring company compromises of a considerable part of the purchase transaction, the target company might well look to execute its own due diligence on the acquirer.
Initiation of a Corporate Insolvency Resolution Process
Once a corporate debtor defaults for an amount of Rs. one lac, an operational creditor, a financial creditor or the corporate debtor itself may commence with the CIRP (i.e. corporate insolvency resolution process) for such corporate debtor by filing an application before the NCLT. The corporate insolvency resolution process begins from the date such application is accepted by NCLT.
The Insolvency and Bankruptcy Code orders that the entire corporate insolvency resolution process should be completed within 180 days from the date of admission. This time period can be drawn-out only once by NCLT for up to an additional 90 days.
Thus, the entire process has to be winded up within 270 days. NCLT can permit withdrawal of an application admitted for initiation of CIRP, on an application filed by the applicant with the approval of 90% voting share of the COC. The process in which withdrawal shall be permitted by NCLT is to be recommended.
What happens after admission?
Moratorium
Once an application for commencing CIRP against a corporate debtor is accepted, a moratorium order is adopted inhibiting the institution of suits or continuation of pending suits or proceedings against the corporate debtor or any action to expropriate, recover or enforce any security interest developed by the corporate debtor in respect of its property. Passing on possession of assets by the corporate debtor is also forbidden.
This order of moratorium is effective till the finalization of the CIRP or earlier only if NCLT authorizes a resolution plan or else passes an order for the liquidation of the corporate debtor. A moratorium, however, will not affect any suit or case pending before the Supreme Court under Article 32 of the Constitution of India or where an order is authorized under Article 136 of the Constitution of India.
A moratorium will also not influence the power of the High Court under Article 226 of Constitution of India. However, a money suit or a suit for recovery, against the corporate debtor, registered before any High Court under original jurisdiction, cannot progress after official proclamation of the moratorium. The impact of moratorium on actions by governmental authorities has cropped up in multiple cases before the NCLT.
Appointment of Resolution Professional
An interim resolution professional (“IRP”) is appointed by the NCLT whose term continues till the date of appointment of the resolution professional (“RP”). The committee of creditors (discussed below) once formed, either appoint the IRP as the RP or replaces the IRP by another resolution professional, by a majority vote of not less than 66% of the voting share of the financial creditors, at its first meeting.
Management of the Corporate Debtor
From the date of appointment of the interim resolution professional, the administration of the proceeding of the corporate debtor vests in the IRP. The powers of the Board of Directors stand suspended & are exercised by the IRP. The officers and managers of the corporate debtor are required to report to the IRP.
If any personnel of the corporate debtor, its promoter or any other person required to assist or cooperate with the IRP does not assist or cooperate, then the IRP can make an application to NCLT for necessary directions.
This right has already been exercised in various ongoing insolvency resolution processes, and NCLT has given directions to the personnel of corporate debtors to extend all co-operation. The IRP/RP has to make every endeavor to protect and preserve the value of the property of the corporate debtor and manage the operations of the corporate debtor as a going concern. Further, the IRP/RP is responsible for complying with the requirements under any law for the time being in force, on behalf of the corporate debtor.
The IRP and thereafter the RP, therefore, plays a central role in the entire insolvency resolution process as, unlike a debtor-in-possession bankruptcy regime in many other countries, the IBC provides for the suspension of the Board of Directors and vesting of the management in the IRP/RP.
Due diligence becomes a critical exercise in the entire process because unlike in a normal M&A transaction, a Resolution Applicant will not have the benefit of representations and warranties from the promoters. Often the Resolution Applicant is required to submit a bid on an as is where is basis, and to that extent the risks are passed on to the Resolution Applicant with very little fall-back option. A Resolution Applicant may work under various constraints while undertaking a due-diligence of a corporate debtor. A potential constraint in conducting a due diligence is the quality of information provided. The Resolution Applicant is dependent on the RP to provide all relevant information who in turn may have to depend on the existing management to a large extent for providing relevant information. As the CIRP is a time bound process, a Resolution Applicant has a limited time frame to complete the due-diligence process, which may further impact an effective due-diligence.
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