Due Diligence in Corporate Reconstruction — Detailed Explanation with Legal Backing

1. Concept and Purpose

Due diligence in corporate reconstruction refers to the systematic investigation and assessment of all material aspects of a company undergoing restructuring. It involves reviewing the company’s business, assets, liabilities, contracts, finances, operations, legal compliance, and litigation exposure.

The purpose is to ensure that any proposed reconstruction scheme—such as a compromise, arrangement, merger, amalgamation, or corporate revival—is viable, fair, compliant with law, and free from undisclosed risks. It also protects stakeholders from hidden liabilities and prevents future disputes or regulatory action.

2. Types of Due Diligence

a. Legal Due Diligence

Covers corporate records, constitutional documents, board minutes, contracts, licences, litigation, statutory filings, regulatory compliance, environmental obligations, labour compliance, and intellectual property.

b. Financial Due Diligence

Reviews financial statements, auditor qualifications, cash flows, tax filings, debt structure, borrowings, contingent liabilities, and valuation inputs.

c. Tax Due Diligence

Examines direct and indirect tax exposure, pending tax claims, litigations, assessments, and compliance status.

d. Operational Due Diligence

Assesses business processes, supply chain, human resources, internal controls, management systems, and operational efficiency.

e. Valuation Due Diligence

Supports share-exchange ratios, restructuring outcomes, and fairness of financial terms in mergers and reconstruction schemes.

f. Regulatory Due Diligence

Ensures compliance with sector-specific laws, licensing requirements, environmental and safety standards, and other regulatory frameworks.

3. Why Due Diligence Is Critical in Reconstruction

• Reconstruction usually occurs in distressed circumstances; financial and operational information may be unreliable or incomplete.
• Schemes proposed before the Tribunal must disclose all material facts, making thorough due diligence essential.
• Hidden liabilities, fraudulent transactions, or regulatory non-compliance can cause the Tribunal to reject a scheme or expose parties to penalties later.
• In insolvency-driven reconstructions, creditors depend on due diligence to evaluate resolution plans and ensure the feasibility of revival.

4. Legal Framework Governing Corporate Reconstruction in India

A. Companies Act, 2013

i. Section 230 – Compromises and Arrangements

This provision empowers a company, its creditors or members, or a liquidator to propose a scheme of compromise or arrangement. When approaching the Tribunal, the applicant must disclose:

• the latest financial position of the company,
• auditor’s reports,
• details of investigations, prosecution, or regulatory actions,
• material facts relating to assets, liabilities, and ongoing litigations.

This is the statutory basis for full disclosure and, by implication, thorough due diligence.

ii. Section 231 – Tribunal’s Powers

The Tribunal may enforce the scheme, supervise its implementation, or modify its terms. Proper due diligence ensures that the scheme is realistic, implementable, and stands up to judicial scrutiny.

iii. Section 232 – Mergers and Amalgamations

In cases of merger-based reconstruction, the scheme must include:

• terms of transfer of assets and liabilities,
• accounting treatment,
• share-exchange ratios,
• valuation reports, and
• expert opinions.

NCLT approval depends heavily on the adequacy and accuracy of information provided—making due diligence indispensable.

iv. Section 233 – Fast-Track Mergers

Applicable to certain classes of companies, this procedure relies on simplified documentation. However, disclosures regarding financials, creditors, assets, and liabilities remain mandatory, necessitating proper due diligence.

v. Section 240 – Liability of Officers

Even after reconstruction, officers of the company remain liable for offences committed before the scheme.
Due diligence helps identify historical irregularities so that they can be properly addressed or disclosed before restructuring.

vi. Companies (Compromises, Arrangements and Amalgamations) Rules, 2016

The Rules require:

• notices to creditors and members,
• explanatory statements,
• valuation reports,
• latest financial statements,
• disclosure of the effect of the scheme on key stakeholders.

These obligations directly rely on due diligence findings.

B. Insolvency and Bankruptcy Code (IBC), 2016

Due diligence is fundamental when reconstruction occurs through the corporate insolvency resolution process.

• Resolution applicants must submit detailed plans backed by investigation of the debtor’s affairs.
• The resolution professional depends on information from management and creditors, making due diligence challenging yet essential.
• In liquidation, a revival scheme may sometimes be proposed under Section 230 of the Companies Act, and must be supported by thorough disclosures.

Courts have clarified that persons ineligible under the IBC cannot bypass the Code by seeking to regain control of a company through Section 230 schemes, reinforcing the need for transparent and compliant due diligence.

5. The Tribunal’s Role (NCLT)

The National Company Law Tribunal ensures that:

• the scheme is fair and reasonable,
• creditors and members have been properly informed,
• disclosures are complete,
• objections are considered, and
• implementation is monitored if required.

Due diligence reports and disclosures heavily influence the Tribunal’s decision to sanction or reject a scheme.

6. Risks Addressed by Due Diligence

a. Regulatory risk

Ensures compliance with corporate law, taxation, employment law, environmental obligations, and sectoral regulations.

b. Litigation and claims

Identifies pending suits, arbitration, fraud allegations, and contingent liabilities.

c. Valuation discrepancies

Validates accuracy of financial data used in valuation and share-exchange ratios.

d. Fraud and mismanagement

Detects irregular transactions, related-party dealings, siphoning of funds, and other governance failures.

e. Financial deterioration

Reveals solvency issues, eroding asset value, or misstatements in financial records.

f. Stakeholder objections

Minimizes grounds for objections from creditors, regulators, or minority shareholders.

7. Practical Steps in a Due Diligence Exercise

Step 1 – Scoping

Define the scope of review: corporate, legal, operational, financial, tax, regulatory.

Step 2 – Information Gathering

Collect data such as corporate records, contracts, licences, financial statements, auditor reports, property documents, litigation files, tax assessments, and HR records.

Step 3 – Verification

Cross-check information, conduct management interviews, validate financials, and engage technical experts where required.

Step 4 – Analysis

Identify red flags and assess risks in legal compliance, financial accuracy, operational resilience, and contractual obligations.

Step 5 – Reporting

Prepare a detailed due diligence report categorizing risks and highlighting critical findings.

Step 6 – Structuring the Scheme

Use due diligence output to:

• design payment terms for creditors,
• determine share-swap ratios,
• carve out risky assets or liabilities,
• negotiate with stakeholders,
• draft a fair and legally compliant scheme.

Step 7 – Tribunal Process

File the scheme with the Tribunal, present valuation and due diligence findings, address objections, and implement post-sanction compliance requirements.

8. Conclusion

Due diligence is an indispensable component of corporate reconstruction.
It ensures:

• legal compliance,
• transparency,
• fairness to stakeholders,
• financial and operational viability, and
• protection from hidden liabilities and future disputes.

The Companies Act, the IBC, and the Tribunal’s supervisory role collectively create a legal environment in which thorough due diligence is not just advisable but effectively mandatory for any scheme of compromise, arrangement, amalgamation, or revival.

Annexure – 1

Below is a professional, comprehensive Due Diligence Checklist specifically designed for Corporate Reconstruction (mergers, arrangements, compromises, amalgamations, revival plans, or schemes under Section 230/232 or under IBC contexts).
 

DUE DILIGENCE CHECKLIST FOR CORPORATE RECONSTRUCTION

This checklist is structured so it can be used directly by lawyers, RPs, valuers, financial advisors, or corporate management teams.

1. Corporate & Statutory Records

A. General Corporate Documents

• Certificate of incorporation and all certificates of name change.
• Memorandum & Articles of Association, including amendments.
• Details of the company’s registered office, branches, and subsidiaries.
• Board of Directors list (current and historical), including DIN, resignations, and appointments.
• Shareholder register, including beneficial ownership disclosures.
• Share certificates, transfer forms, and share allotment records.
• Minutes books of Board meetings, Committee meetings, and General Meetings.

B. Statutory Filings & Registers

• Annual returns and financial statements filed with ROC for past 5–7 years.
• Registers of members, directors, loans, charges, contracts, deposits, and investments.
• Copies of charge registration documents and satisfaction of charges.
• Copies of secretarial audit reports.

2. Financial Information & Accounting

A. Financial Statements

• Audited financial statements for past 3–5 years.
• Auditor’s qualifications, notes, and emphasis-of-matter points.
• Internal audit reports.
• Management representation letters.

B. Accounting and Internal Controls

• Accounting policies and changes over time.
• Fixed asset registers.
• Inventory reports and valuation methods.
• Cash flow statements, bank reconciliations, and cash management systems.

C. Liabilities & Contingent Exposures

• Detailed debt schedule (secured, unsecured, inter-corporate loans).
• Bank loans, overdrafts, and credit facilities with terms and covenants.
• Guarantees (corporate, personal, counter-guarantees).
• Contingent liabilities and off-balance sheet items.
• Related-party transactions and outstanding dues.

3. Taxation

A. Direct Tax

• Income tax returns for 5–7 years.
• Assessment orders, pending assessments, and appellate matters.
• TDS compliance records and reconciliations.
• Tax demand notices, refunds pending, and disputes.

B. Indirect Tax

• GST registrations, returns, compliance history.
• Excise, VAT, Service Tax legacy records (if applicable).
• Pending show-cause notices or audits.

C. Other Tax Matters

• Transfer pricing documentation (if applicable).
• Tax holiday/benefit certificates.

4. Assets & Property

A. Immovable Property

• Title deeds, lease deeds, and property tax receipts.
• Encumbrance certificates and land-use clearances.
• Valuation reports, approved plans, and licenses for building structures.

B. Movable Assets

• Machinery lists, acquisition invoices, warranties.
• Hypothecation or pledge documents.
• Vehicle registrations.

C. Intellectual Property

• Patents, trademarks, copyrights, designs—applications and registrations.
• IP assignments, licensing agreements, royalty arrangements.
• Pending IP disputes or oppositions.

5. Contracts & Commercial Arrangements

A. Material Contracts

• Supply and distribution agreements.
• Customer contracts and major revenue-generating relationships.
• Agency, dealership, franchise, and commission arrangements.
• Technology licensing, outsourcing, and service agreements.

B. Financial & Corporate Contracts

• Loan agreements, debenture trust deeds, credit facility agreements.
• Shareholder agreements, JV agreements, investment contracts.

C. Construction, Vendor, and Operational Contracts

• AMC contracts, service provider agreements, purchase orders.
• Contracts with EPC contractors (for infra-based companies).

D. Termination and Risk Clauses

• Contracts with change-of-control clauses.
• Contracts triggered by merger/reconstruction.
• Defaults, notices, and breaches.

6. Litigation & Disputes

A. Court & Tribunal Proceedings

• Civil, criminal, commercial court cases.
• NCLT/NCLAT cases.
• Arbitration matters.

B. Regulatory Proceedings

• SEBI, RBI, Competition Commission, environmental authorities.
• Labour commission, PF/ESI disputes.

C. Status Review

• Notices received, responses filed, orders passed.
• Legal opinions on contingent risks or financial exposure.
• Matters affecting assets or continuity of business.

7. Human Resources & Employment

A. Employment Contracts

• Employment agreements, appointment letters, offer letters.
• Non-compete, non-solicit, confidentiality agreements.
• Bonus, incentives, stock-options (ESOP), and pension schemes.

B. Statutory Compliance

• PF, ESI, Gratuity, Bonus, Maternity, and other labour law compliance.
• Registers and returns under labour legislation.
• Factory Act and Shops & Establishments Act compliance.

C. HR Policies

• Code of conduct, disciplinary policies, employee manuals.
• PoSH (sexual harassment) committee records.

8. Regulatory & Environmental Compliance

A. Licenses & Registrations

• Business licenses, trade licenses, factory licenses.
• Environmental clearances, pollution control consents.
• Industry-specific registrations (FSSAI, Drug License, DGCA, IRDAI, etc.).

B. Compliance Status

• Renewal history, non-compliance notices, corrective actions.
• Penalties or sanctions imposed by regulators.

9. Operational Due Diligence

A. Business Model Review

• Revenue streams, cost structure, and profitability of units.
• Market risks, competition, supplier dependence.

B. Technology & Systems

• IT infrastructure, ERP systems, cybersecurity frameworks.
• Data protection practices and policies.

C. Operational Efficiency

• Production metrics, plant capacity utilization.
• Supply chain stability and vendor performance.

10. Reconstruction-Specific Requirements

A. Information Needed for Scheme of Arrangement / Reconstruction

• Statement of affairs (updated and accurate).
• List of creditors and members with claims and voting rights.
• Valuation report from registered valuer.
• Auditor’s certificate on accounting treatment.
• Effect of scheme on stakeholders (creditors, employees, shareholders).
• Explanation of how the scheme improves viability or reduces financial stress.

B. For Mergers or Amalgamations

• Share-exchange ratio details.
• Details of transfer of assets and liabilities.
• Appointed date and effective date.
• Treatment of reserves, losses, and paid-up capital.

C. For Distressed Companies / IBC Context

• Information memorandum issued by the resolution professional.
• Evaluation matrix for resolution applicants.
• Section 29A eligibility checks.
• Details of avoidable transactions (preferential, fraudulent, undervalued).
• Liquidation value vs reconstruction value assessments.

11. Risk Identification & Red Flags

Common red flags in reconstruction include:

• Inconsistent financial records or auditor qualifications.
• Significant undisclosed liabilities.
• Pending regulatory or environmental violations.
• Related-party transactions that lack transparency.
• Litigation with high financial exposure.
• Overvaluation or undervaluation of assets.
• Change-of-control clauses that get triggered by restructuring.
• Non-compliance with statutory filings or outdated records.

12. Final Deliverables

The due diligence exercise should culminate in:

• A Due Diligence Report summarizing findings.
• A Risk Matrix categorizing issues as critical / major / moderate / minor.
• Suggested mitigation strategies for each risk.
• Inputs for drafting the final Scheme of Reconstruction, including:
  • reorganization of capital,
  • treatment of creditors,
  • asset transfers,
  • valuation basis,
  • implementation timelines.

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