Mergers and acquisitions (M&A) transactions have become in recent years a central tool for business growth, expansion of operations, and the achievement of a competitive advantage. Alongside the business opportunities inherent in such transactions, however, they also involve significant legal, financial, and regulatory risks. One of the principal tools for reducing these risks is the due diligence process, which is intended to provide the acquiring party with as comprehensive a picture as possible of the target company’s condition prior to completion of the transaction.
Due diligence is, in practice, a central stage in the decision-making process in corporate transactions. As part of this process, various legal, financial, regulatory, and business aspects of the company’s operations are examined in order to identify risks, existing or potential liabilities, and issues that may affect the value or structure of the transaction.
Among other things, due diligence includes the examination of the company’s material agreements, financial obligations, pending legal proceedings, regulatory exposure, intellectual property rights, labor relations framework, tax liabilities, and obligations toward suppliers and creditors. The findings of the review enable the parties not only to assess the viability of the transaction, but also to tailor its terms, for example through price adjustments, indemnification mechanisms, or representations and warranties in the transaction agreement.
The Importance of Due Diligence in Merger Transactions
The importance of due diligence exists in every acquisition transaction, but in merger transactions it assumes particular significance.
Under the provisions of the Israeli Companies Law, a merger is a process whereby all of the assets and liabilities of one company are transferred to another company, while the merging company ceases to exist and the surviving company continues its operations. The legal significance of this structure is that the surviving company steps into the shoes of the merged company and assumes not only its assets, but also all of its liabilities.
This consequence underscores the importance of conducting a thorough due diligence review prior to completion of the merger. Liabilities not identified during the review, such as debts, contractual obligations, regulatory exposure, or potential claims, effectively become liabilities of the surviving company itself once the merger is completed. Hence the critical importance of taking such exposures into account during the negotiations and structuring of the transaction.
For comparison purposes, in a share purchase transaction the acquired company continues to exist as a separate legal entity. Accordingly, even after the change of ownership, the legal obligations remain those of the company itself. Although, from an economic perspective, the purchaser is affected by the company’s liabilities, from a legal perspective those liabilities are not transferred directly to the purchaser.
It is this structural distinction between the two types of transactions that magnifies the importance of due diligence in merger transactions.
Judicial Aspects and Protection of Third Parties
Israeli case law has also emphasized over the years the importance of conducting an early and thorough examination of the condition of the companies involved in corporate transactions, particularly transactions with broad implications for creditors and other stakeholders.
For example, in Civil Appeal 9555/02, Zidane v. Brith Pikuh for the Agricultural Cooperative Society Ltd., the Israeli Supreme Court emphasized the need to carefully examine the status of creditors in corporate proceedings and the potential impact of corporate actions on their rights. This approach reflects the view that structural corporate actions, including mergers, may affect numerous parties beyond the shareholders themselves.
In this context, it is evident that the Israeli legislature has also incorporated into the Companies Law mechanisms intended to protect the creditors of the merging company within merger proceedings. Among other things, the board of directors is required to examine whether there is a reasonable concern that, following the merger, the company will be unable to meet its obligations, and the law further grants creditors the right to oppose the merger before the court.
These mechanisms highlight the need for an early and comprehensive examination of the company’s condition, an examination which in practice is carried out through the due diligence process. It should be emphasized that this concerns the creditors of both companies, namely the creditors of the surviving company as well as those of the target company, since the merger transaction effectively changes both the nature of their claims and the identity of the corporate entity liable to them.
Due Diligence as a Risk Management Tool in the Transaction
Beyond its role in identifying risks, due diligence also serves as a central tool for managing risk within the transaction itself.
For example, the findings of the due diligence review may affect the determination of the company’s valuation in the transaction, the structure of the transaction, whether as a merger or an acquisition, the drafting of representations and warranties in the agreement, the determination of indemnification mechanisms between the parties, the structure and scope of security arrangements associated with the transaction, and the inclusion of conditions precedent to completion of the transaction.
In certain cases, the findings of the review may even lead to the decision not to proceed with the transaction at all, where significant risks are discovered that cannot be adequately mitigated through contractual mechanisms.
Conclusion
Due diligence constitutes a central tool in the management of the risks inherent in corporate transactions. Its importance is particularly pronounced in merger transactions, in which the surviving company may directly inherit all of the rights and liabilities of the merged company.
Accordingly, conducting a thorough and comprehensive due diligence review prior to completion of a merger transaction is not merely a technical stage in the business process, but rather an essential component of informed decision-making and of ensuring the stability of the surviving company following completion of the transaction.
For further information, please contact:
Adv. Hanan Efraim – Tel: +972-3-691-6600 | Email: hanan@ekw.co.il
Adv. Amit Kubos – Tel: +972-3-691-6600 | Email: amit@ekw.co.il