Legal due diligence is an indispensable link for enterprises in the implementation of mergers and acquisitions (M&A). An effective due diligence report should make conclusive opinions based on a full investigation of the facts to help the acquirer understand the real state of the target company and the legal risks. To this end, lawyers are required to be diligent and conscientious in the process of due diligence and perform the duty of prudent verification.
Although law firms and lawyers have mostly summed up methods and procedures in practice, the lack of clear rules and guidelines for legal due diligence in the field of M&A has led to unclear due diligence boundaries in some cases.
At this point, how should lawyers conduct due diligence and where is the boundary? We may refer to specific rules for lawyers’ due diligence in the more rigorous field of securities legal services. This article will explore the boundary of due diligence under the premise of “diligence, conscientiousness, and prudent verification”.
“Diligence” is the requirement for the scope of due diligence, which means that lawyers should collect materials personally, conduct inspection in person, and carry out investigation at a reasonable and necessary level. In accordance with relevant provisions provided in the Practicing Rules of Legal Firms for Securities Legal Services (trial) and the Administrative Measures for Law Firms Engaged in Securities Legal Service:
- When conducting due diligence, lawyers should prepare an inspection plan and then assess and summarize the implementation of the plan after inspection;
- For qualifications, deposits, real estate, and intellectual property rights, which can be examined through written vouchers, originals of such vouchers should be verified or in the absence of originals, they should be confirmed by way of inquiry and re-examination;
- The inspection of such rights as the occupational history of a natural person, or whether a guarantee or other encumbrance has been set up on the property or in the instance of a production equipment inspection, bulk products and significant raw materials should be conducted through field investigation and interviews;
- If the evidentiary materials obtained from different sources or through different means of inspection are inconsistent in terms of the conclusions made with respect to the same matter, necessary procedures must be supplemented for further verification.
“Conscientiousness” is the self-protection of lawyers, which means that a lawyer who performs due diligence should fulfil his/her duty of inspection as a reasonable legal person, and the evidence that a lawyer has fulfilled this obligation is the working papers of due diligence. The practicing rules require law firms to keep the work records produced in the process of issuing legal opinions, including the relevant records of the review of the legal opinions, as well as all the documents and materials obtained in the work, and sort the abovementioned documents into working papers in a timely manner. The sorted working papers must be true, complete and clear, and should be marked with an index and page numbers, signed by the assigned lawyers and stamped with the official seal of the law firm. Working papers are the important basis to judge whether a lawyer is diligent and conscientious, and thus should be collected and sorted in the process of due diligence.
“Prudent verification” is a requirement for the depth of due diligence, which means that lawyers should make necessary examination, analysis and judgment against the authenticity, accuracy, completeness and validity of the relevant evidentiary materials by reasonable means when obtaining relevant evidentiary materials.
The administrative measures require lawyers to perform a special duty of care of legal professions in law-related matters, and to perform general duty of care of ordinaries for other business matters. If a lawyer discovers that the materials provided by the client are a false record, misleading statement or major omission, or that the client committed a major violation of law, the lawyer should require the client to correct and supplement the material in a timely manner. It should be noted that for the non-legal documents obtained by professional intermediaries such as accounting firms, asset evaluation agencies and credit rating agencies, the law firm should still perform a general duty of care and should not quote such documents directly. In the Written Decision of Administrative Punishments, the China Securities Regulatory Commission (CSRC) determined that if a law firm directly quotes in its working papers the reports and materials of other intermediaries and if there is no obvious flaw in such quotations, the firm will be deemed as having not fulfilled a general duty of care.
According to the abovementioned rules and opinions of the CSRC, when performing legal due diligence, lawyers should, on the one hand, carry out reasonable and necessary verification procedures, fulfill the appropriate duty of care, collect and sort materials that ought to be collected and verified in M&A, and obtain sufficient evidence to support the opinions to be released.
On the other hand, lawyers should sort the materials and work records obtained in the process of inspection and verification into complete, authentic and clear working papers, supporting the evidence that proves that the lawyers have fulfilled the duty of diligence and conscientiousness. Therefore, in the event that an investigation boundary cannot be determined in the process of due diligence for the M&A of an enterprise, the lawyer is able to use the “evidentiary materials obtained [that] are sufficient to support the opinions to be released” as the boundary and the “diligence, conscientiousness, and prudent verification” as the standard to measure whether the investigation is effectively conducted or not.
Zhao Renying is a partner and Zhang Xiaoyang is an associate at East & Concord Partners in Shenzhen