Legal Due Diligence in Mergers and Acquisitions

AN OVERVIEW OF LEGAL DUE DILIGENCE IN MERGERS AND ACQUSITIONS TRANSACTIONS

Kenya has experienced a substantial increase in Mergers and Acquisitions (“M&A”) activity in recent years. The Deal Drivers Africa Report, published by Merger market, ranks Kenya among Africa’s most sought-after country for M&A transactions.

The most notable M&A activity in Kenya in recent years has been in the banking, financial services and petroleum sectors. As Kenya remains a hub for technological innovation, with pioneering mobile money platforms and high mobile-phone penetration, increased activity in the telecoms and Fintech space is expected. Similarly, the pre-pandemic demand for petroleum products globally coupled with the relatively low prices at the time facilitated perhaps the biggest M&A transaction that’s taken place in the country in recent years.

Rubis Energie SAS’s (Rubis) acquisition of KenolKobil (now Rubis Energy Kenya PLC) was a major shift in the M&A landscape in the country. Rubis Energie SAS is a subsidiary of Rubis SCA, a French international firm that deals in the storage, distribution and sale of petroleum, liquefied petroleum gas, food, and chemical products. The transaction was a public take-over and resulted in Rubis taking 100% control of KenolKobil. The deal value was approximately USD350-million. The deal was a vote of confidence in the Kenyan economy, which is a gateway into the East and Central Africa region.

Similarly, the merger of two of Kenya’s largest banks: NIC Group PLC (NIC) and Commercial Bank of Africa Limited (CBA) was a monumental moment in the M&A landscape as the acquisition led to the formation of one of the biggest banks in Africa in terms of asset base: NCBA Bank Kenya PLC. The Central Bank of Kenya stated the merged entity will have a combined market share of 9.9% and a customer base of over 40-million people in East Africa.

This interest in the Kenyan M&A space coupled with the growth of Kenyan economy means that similar M&A deals will become more and more commonplace in the future.

This begs the question: What is an M&A transaction and what are the steps involved in such transactions? For purposes of this Article, we shall focus on Due Diligence in M&A transactions and explain the key role that Due Diligence plays in their success.

INTRODUCTION

A merger is a voluntary amalgamation of two companies and/or firms on roughly equal terms into one new legal entity. The decision is usually mutual between the merging companies.[1] Mergers are geared towards enjoying greater economies of scale and increasing a company’s competitiveness in the market.

Takeovers/Acquisitions on the other hand, are a general offer to acquire all voting shares in the offeree company and includes a takeover scheme. Takeovers can be classified into:

1. Hostile Takeovers: These involve the acquisition of all or a majority of the company’s shares therefore giving the acquiring company control or ownership of the target company without consent of the board of directors or shareholders.

2. Friendly Takeovers/Acquisitions: These usually occur with the knowledge and consent of the board of the target company. In some cases it can be negotiated through a consensual process.

Mergers and Acquisition are a common feature in the current corporate environment with many companies desirous of increasing their competitiveness in the market thus gaining an edge over their competitors.

LEGAL FRAMEWORK FOR MERGERS & ACQUISITIONS

1. Competition Act, No. 12 of 2010

The key statute regulating mergers in Kenya is the Competition Act, No. 12 of 2010. It has a mandate to promote and safeguard competition in the national economy. Section 42(2) of the Act requires that emerging entities should seek the approval of the Authority prior to implementing a merger. Section 42(1) of the Act also authorizes the Authority to exclude any proposed merger from the requirement of approval.

2. Companies Act No.17 2015

The Companies Act regulates the formation, conduct and winding up of companies registered in Kenya. The Companies Act does not regulate mergers directly but impacts the shares in a company as it prohibits a company from giving financial assistance to any person to acquire its shares.

3. The Capital Markets Act, CAP 485 A

The Act provides for approval and licensing of players in the security industry. These includes advisors and investors. Any person who takes part in structuring of a merger and acquisition must hold a license and be approved as per the Act. Section 12(1) the Cabinet Secretary is empowered to formulae rules and regulations to govern aspects in the security market.

STEPS IN A TYPICAL M&A TRANSACTION

A M&A transaction is unlike most other commercial transactions due to the numerous steps and procedures that must be followed and executed precisely. Each step in an M&A transaction is connected and the progression and success of such transactions depends on the success of the preceding step. The steps in a typical M&A transaction are as outlined in the below diagram:

https://www.ashitivaadvocates.com/wp-content/uploads/2022/10/STEPS-IN-A-TYPICAL-M-A-TRANSACTIONS.pdf

Perhaps the most important step in an M&A transaction is the Due Diligence (DD) stage of the transaction. The success of a typical M&A transaction is usually anchored on the information obtained during the DD stage of the transaction. A successful DD process can either make or break an M&A transaction.

This therefore begs the question: What is Due Diligence in M&A transactions and why is it so important to the success or failure of these type of transactions?

DUE DILIGENCE IN M&A TRANSACTIONS

Due diligence is a process of verification, investigation, or audit of a potential investment to confirm all relevant information, facts and financial information and to verify anything brought up during the preliminary transaction negotiations.

A typical Due Diligence process covers all aspects of the target company’s operations. The Due Diligence process shall cover the following areas of the target company’s operations:

1. Corporate Records and Related Matters of the target company;

2. Material Contracts that the target company is party to;

3. Financing of the target company;

4. Intellectual Property and Assets of the target company;

5. Real Property owned by the target company;

6. Employment Contracts of employees of the target company;

7. Litigation and other Disputes that the target company is currently engaged in; and

8. Licenses and Consents that the target company is required to obtain.

The above listed areas of due diligence shall proceed to inform the types of due diligence that the acquiring company shall undertake.

TYPES OF DUE DILIGENCE

Once the acquiring company has identified the areas that it intends to conduct its due diligence on, it shall proceed to conduct any number of the following types of due diligence investigations:

1. Financial Due Diligence: a detailed investigation into the target company’s financial records including balance sheets, financial reports, and audit reports.

2. Legal Due Diligence: The acquiring company will be able to find out whether the target Company has pending legal proceedings and if so the nature of the legal proceedings. Legal Due Diligence also seeks to find out the nature of contracts which the target company is party to; legal encumbrances, intellectual property and target markets of the Target company.

3. Commercial Due Diligence: The acquiring company reviews the organizational documents, products and services offered to target markets.

4. Environmental Due Diligence: The acquiring company evaluates the environmental conditions and risks of acquiring the target company and forms a detailed cost-benefit analysis of the proposed acquisition.

5. Operational Due Diligence: The acquiring company conducts a detailed investigation into the operational aspects of the target company including an analysis of the business model, supply chain and organizational structure of the target company.

6. Human Resource Due Diligence: The acquiring company investigates the employee base of the target company, the human resource policies and other staff related policies.

7. Tax Due Diligence: The acquiring company shall also investigate the tax aspects of the target company by examining whether the target company is and has been tax compliant as well as the tax liabilities that the target company currently holds.

LEVELS OF DUE DILIGENCE

Due diligence is divided into various levels which include:

1. RED FLAG DUE DILIGENCE

A Red flag in the Due Diligence process is anything that raises concern about the legitimacy of the entity with which you are considering engaging. The red flags raised during the DD process shall be outlined in the DD report and shall mainly focus on the material risk and their effect on the transaction.

2. DETAILED DUE DILIGENCE

This type of due diligence provides the client with a greater level of insight on the target entity. Usually required for customers who are regarded as high risk or where the acquirer is obtaining a significant stake in the target entity.

DUE DILIGENCE PROCESS

A typical Due Diligence process generally follows the below flow chart:

https://www.ashitivaadvocates.com/wp-content/uploads/2022/10/DUE-DILIGENCE-PROCESS.pdf

Points to Note:

1.The DD Questionnaire is a list of Frequently Asked Questions (FAQs) required by the merging companies to effectively undertake the merging process and minimize risk. The questionnaire doesn’t eliminate all work and investigation, but it does identify early risks and red flags that need to be raised either in the DD Report or before preparation of the report.

2.The information collected during the DD Process is often bulky and requires proper storage and maintenance of all the information collected. The information collected is usually stored in Data Rooms. A data room is a physical or digital storage medium in which all data, records and information collected during the DD process can be securely stored. As the DD Process proceeds, new information collected will be added to the Data Room and later used in the preparation of the DD Report. Most organizations and firms prefer use of Digital Data rooms which the employees will have access to thus speeding up the process.

3.The DD Report is a summary of all the information collected and the analysis of said information. The Report shall outline the severity of the risk associated with the proposed acquisition.

21^STCENTURY TRENDS IN DUE DILIGENCE

1. ENVIRONMENT SOCIAL AND GOVERNANCE (ESG) POLICIES, DIVERSITY AND SUSTAINABILITY

Many investors believe ESG is key in due diligence process. This has led to the increase of the due diligence. Some of the important things to put into consideration include:

– Whether the target entity have dedicated ESG investment teams?

-Whether the target entity has ESG corporate statements and investing principles?

-Whether the strategy objectives have been clearly articulated?

-Whether the oversight of the initiates of ESG are becoming a norm?

2. INCREASED USE OF TECHNOLOGY

Many investors believe due diligence is an activity that takes the greatest amount of time in a transaction. Digital solutions that transform operation, by speeding up the due diligence Process will be highly prized.

Law firms will look for digital services that use advanced technologies like a natural language, Artificial Intelligence, and machine learning to accelerate and streamline the manual due diligence process.

3. DOCUMENT AUTOMATION

Drafting documents is in all in a day’s work but it isn’t the most thrilling part. Legal technology trends involve some forward thinking. Law firms that are now gaining a competitive edge by using automated software to draft documents. Something that would usually take days to be manually crafted by a mere mortal can now be generated in a matter of minutes.

IMPORTANCE OF DUE DILIGENCE

Due diligence helps the acquiring Company to make an informed decision this increases the chances of success. It also helps to confirm information brought up in the during the making of the deal. One is able to identify potential defects and therefore the buyer will be able to know the kind of risks involved before acquiring the target company.

CONCLUSION

Mergers and Acquisition is a burgeoning area of law that will continue to experience significant growth as many companies and industries are experiencing significant growth and reforms. The legal framework and regulatory framework governing Mergers and Acquisition will influence this growth.

For more information on this subject, please do not hesitate to contact the lawyers whose details are set out below: