Introduction to legal due diligence in group reorganisation and corporate simplification projects

This article provides an introduction to why legal due diligence is important in group reorganization and corporate simplification projects, and how to structure the legal due diligence process.

Main objectives

The main purpose of legal due diligence investigations in group reorganisation and corporate simplification projects is to:

• Preserve assets;
• Avoid triggering liabilities; and
• Ensure that the proposed corporate actions are implemented validly.

A typical example of preserving assets would be identifying unregistered land or other hidden assets held by a particular group company, and making sure that the assets are transferred elsewhere in the group before the relevant company is removed.

A typical example of liabilities would be a pension debt of the group which may be triggered if a group company participates in a defined benefits pensions scheme and is removed or transfers material assets.

Managing liability issues for directors

A clear due diligence process is important not just for the commercial reasons set out above. It is also important in order to manage personal liability issues for the directors who will be asked to approve the actions required to remove the relevant companies.

By adopting and following a standard approach for due diligence, directors are put in the best position to show that they have taken appropriate steps to satisfy their legal obligations. Ultimately, this is about the directors demonstrating that they have ensured that all reasonable steps have been taken to identify material assets and material liabilities. This is particularly important if, for example, directors are required to give statements of solvency as part of legal processes such as liquidations or reductions of capital.

The ‘corporate memory’ issue

It is often difficult to obtain definitive information about any given legal entity within a group. This especially a problem for companies which have existed for a number of years, or which have been used for different purposes over time. The relevant people in the group who knew about the history may have moved on, and there may be no clear records.

This issue can act as a block for undertaking corporate simplification projects or other reorganisations. However, the problem does not get easier over time. The best way to deal with the issue is to set a clear materiality threshold and adopt a consistent due diligence methodology – see further below.

Hidden assets and hidden liabilities

One of the challenges of legal due diligence is that some assets and liabilities may not appear on any given company's balance sheet, and may also not appear on any public register. Such assets may include:

• Assets held on trust or as nominee (for example, shares held in other group companies)
• Contractual rights
• Unregistered land
• Unregistered intellectual property
• The benefit of restrictive covenants

Similarly, hidden liabilities may include:

• Contractual obligations
• Contingent liabilities such as guarantees
• The burden of restrictive covenants
• Environmental liabilities relating to historic assets or activities

Where there is considered to be material risk that hidden assets or liabilities may be present, then additional investigations should be considered as part of the detailed due diligence process – see further below.

How to structure the legal due diligence process

Clearly, legal due diligence will form part of the wider investigations which are carried out to decide whether to go ahead with a particular set of steps, and to identify what actions are needed to implement them.

The approach taken will need to be appropriate in the context of the project and the group concerned. Typically it may involve:

• Setting a materiality threshold for due diligence issues
• Preliminary ‘desktop’ research on the companies involved
• Detailed due diligence, including issuing due diligence questionnaires

These are considered in turn below.

Materiality threshold

In many cases, this will be implicit rather than explicit. However, for larger projects, it can be very useful to make sure that the team has a clear understanding of what amounts are likely to be regarded as material.

It is impossible to ‘prove a negative’, and significant amounts of time and cost can be wasted in attempting to chase down every possible issues. Being clear about what is material in the context of the project is one way to make sure that investigations remain focused and productive.

Desktop research

In a larger project, this research may be organised by the core project team in order to categorise the relevant companies and plan more detailed work.

The desktop research may include information sources such as:

• Companies House or the relevant company registers
• Internal company secretarial records
• Annual accounts
• Internal accounting records
• Internal treasury records (such as whether the relevant companies have bank accounts)
• Register of Data Controllers
• Land Registries
• Trademark Register, Patent Registers and so on
• Registers of domain names
• Regulators (such as the UK Financial Conduct Authority)

When searches of public registers are carried out, it can be useful also to search using former company names, rather than merely the current name.

Consideration may also be given to possible typographical errors which may have occurred at the time of the original registration, and carrying out searches using those variants of the name involved. This may be particularly relevant if the company name includes digits which may have been transposed on the original registration.

Detailed legal due diligence

This often involves creating a legal due diligence questionnaire and issuing it to the relevant respondents. Clearly, this will need to be adapted to suit the particular circumstances of the group or companies involved.

For example, it will need to be adapted to take into account:

• The functions within the relevant organisation
• The group's processes for corporate approvals
• The business units involved
• Typical assets and liabilities
• The geographical scope of operations, and requirements of local law
• Third parties, such as external advisers or agents, who should be consulted as part of the process.

Depending on the circumstances, additional due diligence measures may be justified. These may include:

• Reviewing historic financial records for e.g. rents received and paid
• Reviewing historic corporate approval documents
• Reviewing internal announcements
• Reviewing registers of sealings (if applicable)
• Reviewing deeds packets