Due Deligence
This query is : Resolved
26 April 2008
focus on the issues connected with or part of the practical process that is undertaken or appropriate in the course of consideration by the banks and financial institutions of a proposal for borrow-ing of funds/monies in the Indian context is due diligence.
Some of these steps will no doubt be familiar to parties doing businesselsewhere.The three basic elements of a due diligence pertaining to lending are:· business data base research;· public records search; and· direct contact with existing lenders and confidential sources.An optional fourth element, a detailed written disclosure and background questionnaire, can also provide criticalinformation. Voluntary questionnaire responses often provide valuable, cost-effective leads, as well as benchmarks thatcan be used in assessing the credibility of the subject.
Due diligence, pre-dominantly, is carried out by the lenders under three different heads and stages.
The three different heads and stages of thedue diligence are as follows:· Due diligence in respect of the borrower itself: Stage I· Due diligence in respect of the borrower’s Project: Stage II· Due diligence in respect of the securities: Stage IIIDue diligence in respect of the borrower itself: Stage IOnce the borrower submits its proposal and applies to the lenders for finance, the mechanism and clock of due dili-gence is put into operation. Immediately, on receipt of the application and proposal for borrowing, the lender startsexamining the credibility of the applicant borrower and that of its promoters. Basically, there are two documents whichare examined by the lenders to ascertain the integrity and credibility of the borrower, these are, first, the introductorybrochure or the background note or the profile of the borrower and secondly, the last few years’ audited annual reports/balance sheets of the borrower. If need be, the lenders seek additional documentary material from the borrower or itsauditors. The annual reports as tendered by the borrower are examined by the in-house accountants and financepeople. In the event that the details contained in the documents are found to be satisfactory, Stage I due diligencestands concluded in favour of the borrower. Depending on case to case, the lenders may engage lawyers to carry out ageneral search in the local courts of law so as to find out pendency of any legal proceedings against the borrowerincluding that of winding up etc..The important aspect here, which also needs a certain amount of deliberation, is as to whether the lenders can seekdocumented information from the existing lenders of the borrower in light of the provisions pertaining to secrecy andconfidentiality. This will be dealt with separately in the succeeding paragraphs.
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Page 2
Due diligence in respect of the borrower’s project: Stage IIOn conclusion of Stage I, the lenders proceed to examine the viability of the project in respect of which financing isbeing sought. The applicant borrower submits a detailed project report highlighting the details and projections of theproposed turnover, profit etc. for the next ten years. The in-house project experts of the lenders also examine the saidproject report in detail. Once the prima facie feasibility of the project is found demonstrable on the face of the projectedreport, the due diligence of Stage II stands concluded in favour of the borrower. It should also be noted that the projectso contemplated has to fall within the parameters and guidelines for financing framed and stipulated by the lenders.Due diligence in respect of the securities: Stage IIIThis is the most important stage of due diligence. On having decided in principle to sanction credit in whatever form tothe applicant borrower, the lender stipulates the type and nature of securities required from the borrower so as to securethe credit. The lenders ordinarily seek securities of the following kind:1. mortgage of the immovable property in favour of the lender;2. hypothecation of project-related movables in favour of the lender;3. pledge of shares, bonds and other securities.Apart from the above, certain other documentation is also obtained by the lender from the borrower such as personalguarantees, corporate guarantees, post dated cheques, promissory notes, indemnity bond, undertakings etc.In respect of the above, a major due diligence exercise is carried out by the lender by appointing a lawyer specialisingin due diligence and title verification. First, the lender seeks from the borrower details of the immovable property soughtto be mortgaged including photocopies of its title documents. These details are then passed on to the concerned lawyerwith instructions to verify the correctness of the title. The verification of the title by the lawyer is carried out in thefollowing manner:Verification of the title documents in the office of the Registrar of PropertiesThe history of the immovable property sought to be mortgaged is available in the office of the Registrar of Propertieswho is also known as the Registrar of Assurances. It can be gathered from the records available with the Registrar as towho is the current owner of the property and from whom it has assumed the property. It can be gathered from the chainof transactions preceding the existing ownership of the property whether the property title is clear or not.Verification whether the property sought to be mortgaged is free from all chargesand encumbrancesThe lenders through its lawyer carry out a search in the office of the concerned Registrar of Companies (ROC) (whereinthe borrower is a company) to ascertain whether the property is free from all encumbrances, lien and other charges.This can be ascertained from the office of ROC because under the Indian Companies Act 1956 any charge over theproperty of a company is required to be registered with the ROC concerned, failing which the said charge is not to beheld good, in the eventuality of liquidation, against the official liquidator. Hence, it can be found out whether the bor-rower has already got the said property charged with some other creditor(s) or not.Search in the winding-up court and civil courtsA search is also carried out in the companies court within whose jurisdiction the Registered Office of the borrowercompany is situated to ascertain if any liquidation proceedings are pending against the borrower company. Likewise, athorough search is also carried out in the civil courts within whose territorial jurisdiction the office of the borrower islocated, again to ascertain if any recovery proceedings are pending against borrower.After carrying out the aforementioned exercise of due diligence, the lawyer of the lender prepares a title verificationreport categorically outlining the clarity or the defect viz. the title of the property sought to be mortgaged.The same principle applies also in the case of other securities. However, in case of post dated cheques, the borroweris directed to furnish a certificate of signature of indication from its banker.Finally, before making disbursements of the loan, the lenders also insist upon the borrower obtaining a ‘no objection’certificate under the relevant provision of the Income Tax Act from the relevant Income Tax Officer (ITO) who has donethe assessment of the borrower. By way of the said certificate, the ITO gives his ‘no objection’ regarding the creation ofsecurity over the assets of the borrower/assessee thereby certifying that no tax dues are pending against the borrower(in the absence of such certificate, the security so created remains void against income tax).
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Page 3
Co-sharing credit information: secrecy/confidentiality angleThe duty of the banker or a public financial institution is to treat the customer’s affairs as strictly confidential unlesscompelled by law to do otherwise in the same manner as it is the duty of the agent to keep the affairs of the principal asconfidential. The duties relating to maintenance of secrecy is a legal duty as it gives rise to legal consequences in caseit is not honoured.For instance, disclosure of information is specifically barred by the provisions of section 3 of the Public FinancialInstitutions (Obligations As to Fidelity and Secrecy) Act 1983 as applicable in India. As a matter of courtesy to theinternational business or its advisor, the provisions of section 3 are reproduced below:‘Section 3 Obligation as to fidelity and secrecy: - 1. A public financial institution shall not, except as otherwiseprovided in sub-section (2) or in any other law for the time being in force, divulge any information relating to, orto the affairs of, its constituents except in circumstances in which it is, in accordance with the law or practiceand usage, customary among bankers, necessary or appropriate for the public financial institution to divulgesuch information.(2) A public financial may, for the purpose of efficient discharge of its functions, collect from, or furnish to, -(a) the Central Government; or(b) the State Bank of India constituted under section 3 of the State Bank of India Act 1955 (23 of 1955), anysubsidiary bank within the meaning of the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959),any corresponding new bank constituted under section 3 of the Banking Companies (Acquisition andTransfer of Undertakings) Act, 1970 (5 of 1970) or under section 3 of the Banking Companies (Acquisitionand Transfer of Undertakings) Act 1980 (40 of 1980), any other scheduled bank within the meaning of theReserve Bank of India Act 1934 (2 of 1934); or(c) any other public financial institution, such credit information or other information as it may consider usefulfor the purpose, in such manner and at such time as it may think fit.Explanation – For the purposes of this sub-section, the expression “credit information” shall have the samemeaning as in clause (c) of section 45A of the Reserve Bank of India Act 1934 (2 of 1934) subject to themodification that the banking company referred to therein shall mean a bank referred to in clause (b) of thissub-section or a public financial institution.’However, the Reserve Bank of India has by way of a circular advised the financial institutions to insert a new clause intheir future loan agreements and also amend the existing executed loan agreements by inserting a clause which wouldenable the institutions to publish and/or disclose to the Reserve Bank of India (RBI)/Government of India the names anddetails of the borrowers and its promoters/directors without any hindrance whatsoever.Section 45B of the Reserve Bank of India Act empowers RBI to collect any credit information from any bankingcompany. A banking company according to section 45A of the Act also includes a financial institution. Further, Section45L of the Act also empowers RBI to call for any statement, information and particulars from a financial institution.However, a financial institution is not obliged under law to furnish any particulars of the defaulters to the ReserveBank unless asked for under the provisions of the Reserve Bank India Act 1934.Recent innovation-permutationThe Indian Banks’ Association (IBA), backed by the Reserve Bank of India which is the central bank of the country, isformulating a set of guidelines on multiple banking. This is to prevent a defaulter borrower accessing other banks forfunds. This is to cap the rise in the number of those cases where a defaulter approaches another bank for funds withoutdisclosing the details.The evolution of concept is to verify whether a potential borrower is already a defaulter in any other bank. Thisconcept will help and come to the rescue of those banks which have inadequate or no information on the borrower andin the face of intense competition amongst rivals and competitors, provide loans to the these borrowers with little duediligence.A no objection certificate (NOC) will also have to be signed by the borrower which allows the lending bank to collectand share information with other banks that the borrower may have borrowed from. This process will bring various bankstogether to assess and share information in a formal or informal way. In fact, steps have been initiated to establish creditinformation bureaux (CIB) for creating a data base on borrowers. Credit Information Bureau India Ltd, a joint partnershipbetween State Bank of India and HDFC, is expected to be operational once the legislation procedures are in place.The Ministry of Finance is drafting umbrella legislation to facilitate the setting up of the Credit Information Bureau(CIB), an institutional arrangement for the sharing of credit-related information by lending institutions. The setting up ofthe bureau would also require simultaneous amendments to the relevant provisions in the other banking legislation asabove stated, which prohibit the sharing of details of borrowers’ accounts. Currently, sharing of information is allowedamong lending institutions for the suit-filed accounts and transactions for which the constituents have given consent tothe lender to disclose to another financial entity.
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Page 4
ConclusionAn effective due diligence programme can prevent, detect and deter violations of terms of lending. Compliance with thefinance terms and conditions is a continuing obligation and does not apply only when a new borrower-lender relationshipis commenced. Relationships acceptable at their inception may change materially. Furthermore, early detection of lackof credibility of the borrower or may be its integrity can also protect a lender from being cheated, defrauded and de-ceived.
SOURCE; SRI HEMANT BATRA-SECRETARY-GENERAL-SAARCLAW
www.womeninlaw.com/newsletter4/batra.pdf
DUE DILIGENCE IS CARRIED OUT NOT ONLY BY LENDERS BUT ALSO BY A PROSPECTIVE ACQUIRER OF A COMPANY/ENTITY ALSO TO KNOW IN DEPTH ABOUT THE ACQUIREE.
R.V.RAO
Some of these steps will no doubt be familiar to parties doing businesselsewhere.The three basic elements of a due diligence pertaining to lending are:· business data base research;· public records search; and· direct contact with existing lenders and confidential sources.An optional fourth element, a detailed written disclosure and background questionnaire, can also provide criticalinformation. Voluntary questionnaire responses often provide valuable, cost-effective leads, as well as benchmarks thatcan be used in assessing the credibility of the subject.
Due diligence, pre-dominantly, is carried out by the lenders under three different heads and stages.
The three different heads and stages of thedue diligence are as follows:· Due diligence in respect of the borrower itself: Stage I· Due diligence in respect of the borrower’s Project: Stage II· Due diligence in respect of the securities: Stage IIIDue diligence in respect of the borrower itself: Stage IOnce the borrower submits its proposal and applies to the lenders for finance, the mechanism and clock of due dili-gence is put into operation. Immediately, on receipt of the application and proposal for borrowing, the lender startsexamining the credibility of the applicant borrower and that of its promoters. Basically, there are two documents whichare examined by the lenders to ascertain the integrity and credibility of the borrower, these are, first, the introductorybrochure or the background note or the profile of the borrower and secondly, the last few years’ audited annual reports/balance sheets of the borrower. If need be, the lenders seek additional documentary material from the borrower or itsauditors. The annual reports as tendered by the borrower are examined by the in-house accountants and financepeople. In the event that the details contained in the documents are found to be satisfactory, Stage I due diligencestands concluded in favour of the borrower. Depending on case to case, the lenders may engage lawyers to carry out ageneral search in the local courts of law so as to find out pendency of any legal proceedings against the borrowerincluding that of winding up etc..The important aspect here, which also needs a certain amount of deliberation, is as to whether the lenders can seekdocumented information from the existing lenders of the borrower in light of the provisions pertaining to secrecy andconfidentiality. This will be dealt with separately in the succeeding paragraphs.
--------------------------------------------------------------------------------
Page 2
Due diligence in respect of the borrower’s project: Stage IIOn conclusion of Stage I, the lenders proceed to examine the viability of the project in respect of which financing isbeing sought. The applicant borrower submits a detailed project report highlighting the details and projections of theproposed turnover, profit etc. for the next ten years. The in-house project experts of the lenders also examine the saidproject report in detail. Once the prima facie feasibility of the project is found demonstrable on the face of the projectedreport, the due diligence of Stage II stands concluded in favour of the borrower. It should also be noted that the projectso contemplated has to fall within the parameters and guidelines for financing framed and stipulated by the lenders.Due diligence in respect of the securities: Stage IIIThis is the most important stage of due diligence. On having decided in principle to sanction credit in whatever form tothe applicant borrower, the lender stipulates the type and nature of securities required from the borrower so as to securethe credit. The lenders ordinarily seek securities of the following kind:1. mortgage of the immovable property in favour of the lender;2. hypothecation of project-related movables in favour of the lender;3. pledge of shares, bonds and other securities.Apart from the above, certain other documentation is also obtained by the lender from the borrower such as personalguarantees, corporate guarantees, post dated cheques, promissory notes, indemnity bond, undertakings etc.In respect of the above, a major due diligence exercise is carried out by the lender by appointing a lawyer specialisingin due diligence and title verification. First, the lender seeks from the borrower details of the immovable property soughtto be mortgaged including photocopies of its title documents. These details are then passed on to the concerned lawyerwith instructions to verify the correctness of the title. The verification of the title by the lawyer is carried out in thefollowing manner:Verification of the title documents in the office of the Registrar of PropertiesThe history of the immovable property sought to be mortgaged is available in the office of the Registrar of Propertieswho is also known as the Registrar of Assurances. It can be gathered from the records available with the Registrar as towho is the current owner of the property and from whom it has assumed the property. It can be gathered from the chainof transactions preceding the existing ownership of the property whether the property title is clear or not.Verification whether the property sought to be mortgaged is free from all chargesand encumbrancesThe lenders through its lawyer carry out a search in the office of the concerned Registrar of Companies (ROC) (whereinthe borrower is a company) to ascertain whether the property is free from all encumbrances, lien and other charges.This can be ascertained from the office of ROC because under the Indian Companies Act 1956 any charge over theproperty of a company is required to be registered with the ROC concerned, failing which the said charge is not to beheld good, in the eventuality of liquidation, against the official liquidator. Hence, it can be found out whether the bor-rower has already got the said property charged with some other creditor(s) or not.Search in the winding-up court and civil courtsA search is also carried out in the companies court within whose jurisdiction the Registered Office of the borrowercompany is situated to ascertain if any liquidation proceedings are pending against the borrower company. Likewise, athorough search is also carried out in the civil courts within whose territorial jurisdiction the office of the borrower islocated, again to ascertain if any recovery proceedings are pending against borrower.After carrying out the aforementioned exercise of due diligence, the lawyer of the lender prepares a title verificationreport categorically outlining the clarity or the defect viz. the title of the property sought to be mortgaged.The same principle applies also in the case of other securities. However, in case of post dated cheques, the borroweris directed to furnish a certificate of signature of indication from its banker.Finally, before making disbursements of the loan, the lenders also insist upon the borrower obtaining a ‘no objection’certificate under the relevant provision of the Income Tax Act from the relevant Income Tax Officer (ITO) who has donethe assessment of the borrower. By way of the said certificate, the ITO gives his ‘no objection’ regarding the creation ofsecurity over the assets of the borrower/assessee thereby certifying that no tax dues are pending against the borrower(in the absence of such certificate, the security so created remains void against income tax).
--------------------------------------------------------------------------------
Page 3
Co-sharing credit information: secrecy/confidentiality angleThe duty of the banker or a public financial institution is to treat the customer’s affairs as strictly confidential unlesscompelled by law to do otherwise in the same manner as it is the duty of the agent to keep the affairs of the principal asconfidential. The duties relating to maintenance of secrecy is a legal duty as it gives rise to legal consequences in caseit is not honoured.For instance, disclosure of information is specifically barred by the provisions of section 3 of the Public FinancialInstitutions (Obligations As to Fidelity and Secrecy) Act 1983 as applicable in India. As a matter of courtesy to theinternational business or its advisor, the provisions of section 3 are reproduced below:‘Section 3 Obligation as to fidelity and secrecy: - 1. A public financial institution shall not, except as otherwiseprovided in sub-section (2) or in any other law for the time being in force, divulge any information relating to, orto the affairs of, its constituents except in circumstances in which it is, in accordance with the law or practiceand usage, customary among bankers, necessary or appropriate for the public financial institution to divulgesuch information.(2) A public financial may, for the purpose of efficient discharge of its functions, collect from, or furnish to, -(a) the Central Government; or(b) the State Bank of India constituted under section 3 of the State Bank of India Act 1955 (23 of 1955), anysubsidiary bank within the meaning of the State Bank of India (Subsidiary Banks) Act, 1959 (38 of 1959),any corresponding new bank constituted under section 3 of the Banking Companies (Acquisition andTransfer of Undertakings) Act, 1970 (5 of 1970) or under section 3 of the Banking Companies (Acquisitionand Transfer of Undertakings) Act 1980 (40 of 1980), any other scheduled bank within the meaning of theReserve Bank of India Act 1934 (2 of 1934); or(c) any other public financial institution, such credit information or other information as it may consider usefulfor the purpose, in such manner and at such time as it may think fit.Explanation – For the purposes of this sub-section, the expression “credit information” shall have the samemeaning as in clause (c) of section 45A of the Reserve Bank of India Act 1934 (2 of 1934) subject to themodification that the banking company referred to therein shall mean a bank referred to in clause (b) of thissub-section or a public financial institution.’However, the Reserve Bank of India has by way of a circular advised the financial institutions to insert a new clause intheir future loan agreements and also amend the existing executed loan agreements by inserting a clause which wouldenable the institutions to publish and/or disclose to the Reserve Bank of India (RBI)/Government of India the names anddetails of the borrowers and its promoters/directors without any hindrance whatsoever.Section 45B of the Reserve Bank of India Act empowers RBI to collect any credit information from any bankingcompany. A banking company according to section 45A of the Act also includes a financial institution. Further, Section45L of the Act also empowers RBI to call for any statement, information and particulars from a financial institution.However, a financial institution is not obliged under law to furnish any particulars of the defaulters to the ReserveBank unless asked for under the provisions of the Reserve Bank India Act 1934.Recent innovation-permutationThe Indian Banks’ Association (IBA), backed by the Reserve Bank of India which is the central bank of the country, isformulating a set of guidelines on multiple banking. This is to prevent a defaulter borrower accessing other banks forfunds. This is to cap the rise in the number of those cases where a defaulter approaches another bank for funds withoutdisclosing the details.The evolution of concept is to verify whether a potential borrower is already a defaulter in any other bank. Thisconcept will help and come to the rescue of those banks which have inadequate or no information on the borrower andin the face of intense competition amongst rivals and competitors, provide loans to the these borrowers with little duediligence.A no objection certificate (NOC) will also have to be signed by the borrower which allows the lending bank to collectand share information with other banks that the borrower may have borrowed from. This process will bring various bankstogether to assess and share information in a formal or informal way. In fact, steps have been initiated to establish creditinformation bureaux (CIB) for creating a data base on borrowers. Credit Information Bureau India Ltd, a joint partnershipbetween State Bank of India and HDFC, is expected to be operational once the legislation procedures are in place.The Ministry of Finance is drafting umbrella legislation to facilitate the setting up of the Credit Information Bureau(CIB), an institutional arrangement for the sharing of credit-related information by lending institutions. The setting up ofthe bureau would also require simultaneous amendments to the relevant provisions in the other banking legislation asabove stated, which prohibit the sharing of details of borrowers’ accounts. Currently, sharing of information is allowedamong lending institutions for the suit-filed accounts and transactions for which the constituents have given consent tothe lender to disclose to another financial entity.
--------------------------------------------------------------------------------
Page 4
ConclusionAn effective due diligence programme can prevent, detect and deter violations of terms of lending. Compliance with thefinance terms and conditions is a continuing obligation and does not apply only when a new borrower-lender relationshipis commenced. Relationships acceptable at their inception may change materially. Furthermore, early detection of lackof credibility of the borrower or may be its integrity can also protect a lender from being cheated, defrauded and de-ceived.
SOURCE; SRI HEMANT BATRA-SECRETARY-GENERAL-SAARCLAW
www.womeninlaw.com/newsletter4/batra.pdf
DUE DILIGENCE IS CARRIED OUT NOT ONLY BY LENDERS BUT ALSO BY A PROSPECTIVE ACQUIRER OF A COMPANY/ENTITY ALSO TO KNOW IN DEPTH ABOUT THE ACQUIREE.
R.V.RAO
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