Legal audit (due diligence) of a company

A legal audit is a necessary step when buying or selling shares in a company. This process will examine in detail the legal status and documentation of the target company, from verification of the ownership of the assets and the setup of contractual relations to compliance with legislation and existing legal risks. The aim is to get an accurate picture of the company’s legal position and identify potential issues that could affect the value of the transaction or the future operation of the company. If you are planning to sell or buy a company, a legal audit is a tool that will give you confidence in your decision-making.

What is a legal audit?

A legal audit, due diligence or legal due diligence, refers to a comprehensive review and analysis of a company’s legal status in order to identify the company’s legal risks. The purpose of a legal due diligence is to protect the interests of the company or the buyer or investor of the company by familiarising itself with the legal status of the company, checking compliance with the law and also compliance with contractual obligations and commitments before taking any further steps.

The primary role of a legal audit is to identify legal issues that may have an adverse impact on a company’s business, such as the invalidity of key contracts that a company has entered into, the existence of excessive contractual penalties that may be liquidating in nature, or the absence of permits that a company needs to conduct business, among many others. For this reason, it is essential that the legal audit is carried out by a professional team of legal advisors who will ensure the staffing and organisation of the entire process, expertly assess the findings and their degree of seriousness and demand answers to them. The result is a summary of the findings, called a report, which outlines the various risks identified and the proposed course of action to resolve or compensate for them.

Types of legal audits

Depending on the specific industry in which a company operates, approaches to conducting a legal audit vary. These differences lie in the areas to focus on, the scope of documents required and the degree of scrutiny of individual information.

• For example, for a company focused on waste treatment, permits for these activities, compliance with regulatory measures that carry heavy fines, as well as environmental impacts, will be essential.
• Conversely, for a company that operates a shopping mall, the lease agreements entered into with tenants of the premises who generate profit for the landlord, their duration, methods of unilateral termination, competing clauses and the like will be crucial.

A suitably selected legal advisor will identify specific key areas in the initial stages, depending on the type of company, and tailor the relevant data collection requirements accordingly.

For each company, the legal audit is unique and tailored to the specifics of the company and the client’s interests. The final report includes basic general findings and deficiencies that have occurred or potentially may occur if not corrected. However, the report also contains analysis, summaries or summary information critical to the client. Any customization and level of specification can be tailored to specific needs.

Key areas of legal audit

A standard legal audit focuses on the individual areas of the company being analysed, for which the party providing the information submits the relevant information. Such an organised disclosure process will ensure clarity of the data disclosed and a more efficient organisation of the process:

Corporate information

This area contains basic information about the company and its bodies, examines the compliance of the decisions taken by the company with the law, compliance with the form of the decisions and their compliance with the entries in the public registers. A significant group is information on the company’s shareholders and their relationship to the company, identifying contracts, silent partnerships or other arrangements that would affect the voting rights or the distribution of profits to shareholders or competitive activity against the company. For the company’s organs, the statutory body of the company, the contracts concluded between the company and its directors, as well as the contracts concluded by directors in a smaller company and their validity, if any, and the approval of the general meeting, play an essential role.

In terms of contractual relationships, the key corporate information relates to the review of intercompany agreements with related parties, lease agreements, hire purchase agreements, the definition of the company’s liabilities and the assessment of the company’s solvency. The impact on the company’s business or even reputational risk shall be examined by reviewing lawsuits and foreclosures both in favour of and against the company.

Professional permits

If the legal audit is carried out in a company that operates in a selected sector, the activity of which requires the fulfilment of legal prerequisites or the issuance of a certain permit, the subject of the legal audit is the examination of licenses, permits, verification of their validity, compliance with the conditions of issuance, possible examination of violations that would result in their withdrawal or the imposition of penalties for non-compliance. Anything that could jeopardize the company’s business and could lead to negative impacts on the company’s activities must be assessed by legal counsel and the degree of such severity evaluated.

Employee and labour relations

This area of legal audit is particularly important in terms of the intensity of the inspections carried out by the Labour Inspectorate on compliance with the provisions of the Labour Code and the health and safety of workers in the workplace. The legal audit consists of a comprehensive check of employment contracts and working conditions, internal directives and instructions of the employer, examining the relations between employees and so-called contractors, whose performance of activities and provision of services may be considered as an employment relationship, and the issue of the shvarc system. From the buyer’s point of view, in the case of a company acquisition, the retention of top key employees in the company is important, therefore it is necessary to examine the agreements with these employees, their benefits system or their remuneration set-up.

Contractual relations

In the course of its business activities, the Company enters into a number of transactions on an almost daily basis that need to be selected for their significance or materiality in a legal audit. It is neither objectively possible nor practical to examine every single contract entered into by the company; it is the task of the legal adviser to define the subject matter of the examination and to determine the criterion for examining the most relevant contracts for the company. For a company’s intellectual property, similarities on trademarks are examined, patents, proprietary copyrights owned or exercised by the company. Equally important are complaints or objections alleging infringements of the intellectual property rights of third parties.

Real Estate

Real estate is a relatively large area to explore, with the degree of exploration depending on the company’s business activities. In real estate transactions, real estate is the main topic, in which case the subject of the legal audit is all data from the permitting processes of zoning, construction and building permits through the examination of the legal titles of ownership of real estate by the company, the rights to land under buildings, the existence of third party rights to real estate or other encumbrances that would affect the value or exercise of the property right to real estate are examined. Clients are most often interested in specific and non-standard contractual obligations in lease agreements that may jeopardize the economic benefit of the company.

When is a legal audit necessary?

In any standard purchase, the buyer usually inspects the subject of the purchase, assesses its condition, considers the offer and decides whether to proceed with the transaction. If defects are found, he or she may negotiate a price reduction. In a business acquisition, however, the situation is much more complex, as the subject of the transaction is not just one object but a whole set of interrelated assets, liabilities and information. For a successful acquisition, it is therefore crucial to engage expert advisors who can accurately define the level of detail needed to assess the risks in the early stages and identify the areas that require special attention.

If the buyer or its team does not have the necessary expertise or capacity to analyse the disclosed information in detail, a dedicated team of experts can coordinate the entire due diligence process and prepare a summary of key findings. This allows the buyer to focus fully on the commercial and strategic aspects of the transaction, leaving the difficult and time-consuming due diligence to the experts. Involving specialists early in the process is optimal to identify and address potential issues early on, while ensuring that the buyer’s decision-making is based on detailed and verified information.

How a legal audit works in a company

The process of legal audit is divided into different phases, in which the buyer’s or seller’s activity alternates. During the initial negotiations of both the buyer and the seller, it is advisable to reach out to an advisor for information on the process, estimation of the duration of the individual steps with respect to the size of the transaction and the company, we can provide these services during the initial consultation.

After confirmation of the buyer’s interest and, as a standard, confirmation of interest in the form or terms of the transaction (term sheet) or confirmation letter, letter of intent, the phase of collecting data and documents about the target company by the seller begins. The seller makes information about the target company or group of companies available to the buyer and its team of advisors through a dedicated platform called a data room.

This is followed by a phase of active work on the part of the buyer or its advisors, who, within a limited time, have access to the target company’s information and documents, identify and evaluate the risks arising from them. The result of this process is a summary of the legal findings or even a legal due diligence report, which they present to the buyer.

In the legal audit process, the buyer is basically only informed of the results of the findings, which are supplemented by an assessment of the level of risk to the buyer and a recommendation to the buyer on how to minimize the risk or otherwise ensure the protection of the buyer.

What to prepare for a legal audit of the company?

A legal audit may cover all key areas of the target company or it may be conducted on a limited basis, focusing on specific information about the company. In any case, it is the role of the advisors to provide a list of required data (request list), which the seller will complete and make available through the data room. Submitting a request letter can significantly save the seller’s time in selecting and prioritizing the data to be presented to the buyer. It is then the role of the buyer’s advisors to verify that all relevant information and data has been supplied and, where appropriate, to solicit answers to related questions.

Selection of professionals to carry out the audit

Choosing the right advisor is almost as crucial as choosing a business partner. When executing a transaction, the client is in daily contact with the advisor, relying on his or her judgment and expertise, and entrusting the advisor with the confidence to represent his or her interests. When selecting advisors, we recommend an initial consultation to review the advisor’s experience with respect to the transaction. It is important that the advisor be able to meet expectations and tailor the work to the client’s specific needs. Similarly, for more complex transactions, approach an adviser who has the staff capacity to be able to complete all steps in the shortest possible time.

Legal audit increases the value of the company

The purpose of a legal audit is not only to necessarily point out deficiencies and risks, but mainly to ensure their effective remediation and thus minimize future breaches or damage to the company or its shareholders. When due diligence deficiencies are properly captured and effectively corrected, the company will achieve its healthy functioning and ultimately increase its value, which is not contaminated by potential claims arising from breaches.

If you are interested in this topic, please do not hesitate to contact us:

• Tomas Demo, e-mail: tomas.demo@highgate.sk

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