Moshe Kahn*
The words "due diligence" are sometimes mentioned by the managers of companies in a context that arouses anxiety about what is to come.
As we know, due diligence is usually performed by entities outside the company, such as those considering investing in it, purchasing holdings in it or granting it credit, as well as underwriters before the process of raising money from the public.
As part of the due diligence, all aspects of the company's operations are examined and inspected. A significant part of the due diligence process focuses on the company's legal status and its fulfillment of the various laws pertaining to it, in accordance with its field of business and the nature of its operations.
It is not at all rare, in the due diligence framework, to discover defects in the company's operation. However, the discovery of such defects at an advanced stage of negotiations for investing in the company or on the eve of raising capital may sometimes be of critical significance if, as a result of the discovery, the entity with which the company was in contact decides that it is no longer interesting in that company.
In fact, there is almost no company in which a meticulous due diligence examination does not uncover some defects in its operations. However, the management perceptions or business outlook of the potential investor or party to the contract regarding the gravity of the defects, as well as the legal opinion of its attorneys, will generally be the deciding factor, and not the gravity with which the company or its managers views those same defects.
For certain investors who take a strict view, it is actually a defect that is considered minor by the company management, which indicates a defective management culture and management's contempt for the law. From there it is but a short step to losing the faith in the company as an entity worthy of investment, one to which credit should be granted or engaged with contractually.
Since it is impossible to know which defects will cause a deal to stand or fall, it is best to prepare in advance and take precautionary measures.
The goal of this list is to review several issues of which the company management should be cognizant and conduct its own due diligence examination from time to time, to ensure positive results in the future, when due diligence is performed by an outside entity.
1. Registries and reports pursuant to the Israeli Companies Law and the Securities Law
According to the Companies Law, all companies are required to keep and update a register of shareholders
(a public company must also keep a register of the major shareholders), and a register of the minutes of the board of directors and shareholders meetings, as well as a register of the company's directors.
Every company must submit annual and current reports to the Registrar of Companies, including when transferring or allocating stock, when there are changes in the capital stock, in the board of directors, or in the articles and one and implementing encumbrances and changes of address.
It is important to ascertain the existence of all the above registries and continuously update them with the appropriate forms, and submit the current reports to the Registrar in a timely fashion. Reports that are not implemented on time should be submitted as soon as possible with an attached letter of explanation to the Registrar of Companies.
A public company is obligated to submit periodic and intermediate reports at times specified in the regulations.
The complete correlation between the data appearing in the computerized statement from the Registrar of Companies and the data appearing in the company's books and registries should be verified on an ongoing basis, and the existence of copies of all the documents should be verified, including internal documents such as stock transfer deeds and notification of resignations from the board of directors, since the company may be required to present these documents in the course of due diligence.
2. Capital stock and holdings
The company's Cap Table must be up to date at all times, and it must contain separately all the possible alternatives regarding dilution of the shareholders' holdings. A copy must be kept of every document that may result in the company being required to issue securities (including agreements with promoters and brokers) and it must reflect their impact in the table.
3. Agreements between shareholders
The company management must try to obtain copies of agreements made between shareholders, including as connected with voting at the general meeting, the right of refusal and preemptive rights in stock transfers, etc. Frequently, the existence of such agreements is extremely significant to an investor.
4. Loan agreements, guarantees, and encumbrances
From time to time, the loan agreements to which the company is a party should be examined in order to ascertain that the company is not in breach of contract. Many loan agreements contain provisions regarding the need to obtain approval for any in the shareholders' holdings, changes in the nature of its operations, etc. The company should consider whether it is necessary to negotiate with the lender in order to obtain its prior or retroactive approval for changes in the holdings.
Copies of all the guarantees given by the company or guarantees that were given to the company should be compiled and examined for necessity from time to time. Every guarantee should be released, insofar as possible, whether it was given in favor of the company or was given by the company, in accordance with the conditions of the transaction and the guarantee.
A common event that reoccurs in many companies is that of loans that have long since been repaid while the encumbrance remains in place in the records of the Registrar of Companies. The record should be deleted for every encumbrance that is discharged.
5. material agreements
Is best to compile and manage a condensed record of all the company's major agreements and to re-examine their conditions from time to time.
The company should strive to formalize, in written agreements, business ties with entities that are important to the company. Potential investors are aware of the fact that changes in the company's controlling shareholders or management may affect the willingness of business entities to maintain their ties with the company. Additionally, agreements with such parties that are left at the level of oral understanding might trouble the investors who may fear that their entrance into the company is liable to cause changes in the relationship with that external entity as long as the details of the relationship are not clear to all and are not formalized in
a written contract.
Additionally, the company should beware of entering into exclusivity contracts with suppliers or customers, which are tantamount to restrictive agreements as defined in the Antitrust Law.
6. Employees
It is recommended that the company management keep an up-to-date list, at all times, containing the names of the company's employees, the date of commencement of their employment, a brief description of their employment conditions, and the period of advance notice required to dismiss them.
The employment contracts should be kept together and the employees should be notified of their employment conditions as required by law and the forms on the regulations.
If the company is subject to any collective agreement, the company must ensure that it fulfills all the provisions of the agreement.
It is mandatory at all times to update the allocations for the employees' provident fund, severance pay fund, managers' insurance, and pension insurance.
All provisions of the law pertaining to employer-employee relations, including the prevention of Sexual Harassment Law, must be upheld. In a company that employs 25 or more employees, the articles must be published as required by the above Law.
It is also necessary to meticulously uphold the laws and procedures governing safety in the workplace, which are relevant to the company's field of operations, and to establish an efficient mechanism for assimilating the safety procedures among the employees and implementing them as required under the relevant laws.
7. Proprietary rights
Real estate -The registration status of the rights to the assets should be examined from time to time. Here too, if a loan has been paid off, or a cautionary note in the Land Registry Office can be deleted, it is best to do so immediately. With regard to rental agreements, it is recommended to ascertain that there are no provisions restricting changes in the shareholders' holdings.
Intellectual property -An up-to-date letter should be obtained from time to time from the attorney or the patent attorney regarding the company's status vis-?-vis patents and trademarks that were submitted for registration in Israel and abroad, with regard to other intellectual property rights, and with regard to fees and other payments.
An examination should be conducted from time to time to ascertain that no entity is infringing the company's intellectual property rights.
Other assets
With regard to other assets, such as vehicles and so forth, the registration should be compared with the books that are kept pursuant to law and the company's books. The removal of encumbrances on any equipment purchased with financing or under lease agreements that have terminated should be verified.
8. Insurance
It is advisable that an orderly opinion be obtained from an insurance consultant regarding the insurance coverage required for the company, its property, and its operations, including product liability insurance, professional liability insurance, directors insurance, etc. Afterward, a kind of tender can be implemented to obtain the best offer for the company, for the price, and, primarily, for the coverage conditions.
9. Benefits from government entities
If the company is entitled to benefits from government entities such as the Israel Investment Center, the Chief Scientist, or any other government entity, it is important to verify that the company is fulfilling the conditions of the approvals and that reports have been submitted as required.
10. Banks
From time to time, and as far as possible, the company should try to conduct negotiations on reducing the security. If possible, it is preferable to ascribe security primarily to assets or specific receipts and to avoid giving a floating lien or a negative pledge.
11. Lawsuits
Close to the time of preparing the financial statements, the attorneys representing the company in its lawsuits usually provide it with a detailed report on the state of each action to which the company is a party and the company's chances of prevailing in the action. The company should ascertain that, at all times, it has up-to-date and detailed reports on the above.
12. Licenses, permits, and fulfilling specific provisions of the law
Almost every company encounters the need to obtain licenses for its operations. The most common is
a business license, granted by the local authority. Obtaining this sometimes entails obtaining approval from other authorities. Additionally, companies that operate in certain fields, such as building contractors, transportation, insurance, etc., require specific licenses according to the nature of the activity. It is very important that these licenses be valid at all times.
From time to time, every company should check the applicability of specific provisions of the law to its field of operations. For example, a company with a database should check whether its must register as required under the Privacy Protection Law.
This article has reviewed only a shortlist of issues requiring periodic examination. Obviously, a specific list must be drawn up for each company, which is adapted to the nature of its operations. A periodic check of the company's procedures according to a list made specifically for it will, without doubt, make it easier for the company to successfully undergo the due diligence process when the time comes, and will improve the chances of success for the business process in which the due diligence is conducted.
Published in Status, the magazine for managerial thinking -October 2002.
* Moshe Kahn is an Israeli lawyer specializing in Business Law. He is licensed to practice law both in Israel and in the U.S. and serves as the vice-chairman of the High-Tech Committee and as a member of the Corporations and Capital Market Committee of the Israel Bar Association.
www.kahn.co.il
