Due Diligence in Securities Issues, Mergers and Banking Transactions
Part B of Paper 3 moves from statutory audit into due diligence — the structured investigation a party undertakes before a securities issue, an acquisition, or a lending decision, to understand exactly what it is buying into, investing in, or lending against.
Due diligence is fundamentally a risk-identification exercise, and this chapter's core discipline is knowing which category of due diligence surfaces which category of risk, since a due-diligence team scoped only for legal issues will systematically miss financial ones, and vice versa.
1. Legal due diligence — the checklist
Legal due diligence tests the structural and compliance integrity of the target, and its checklist spans several distinct areas. It reviews the corporate structure and ownership (shareholding pattern, cap table, any encumbrances on shares), the entity's statutory and regulatory compliance history (filings, licences, past violations), and material contracts (their key terms, change-of-control clauses, termination rights).
It also covers pending or threatened litigation and disputes, the entity's intellectual property portfolio (ownership, registration status, any infringement exposure), employment and labour compliance, required licences and permits, encumbrances on assets (charges, mortgages, liens), related-party transactions, and environmental compliance.
2. Financial due diligence — a different lens on the same target
Financial due diligence, by contrast, tests the target's economic and financial health and the reliability of its reported numbers, examining revenue and profitability trends, the working-capital position, debt structure and any restrictive covenants attached to it, the quality of earnings (whether reported profit reflects genuine, sustainable operating performance rather than one-off or aggressively recognised items), tax exposures, and the reliability of internal financial controls.
The core distinction worth stating precisely: legal due diligence tests structural and compliance integrity and legal risk, while financial due diligence tests economic and financial health and reporting reliability — the two are complementary, not substitutes for each other, and a transaction of any real size runs both in parallel, typically supplemented by a separate tax due-diligence workstream and, increasingly, an ESG/BRSR-linked due-diligence review as sustainability reporting obligations widen.
3. Due diligence in a securities issue
In a public issue, merchant bankers carry a specific statutory due-diligence obligation under SEBI's ICDR Regulations, verifying the accuracy and completeness of the disclosures in the offer document before it is filed — this is not a discretionary best-practice step but a defined regulatory responsibility attaching to the merchant banker's own role in the issue, since the merchant banker effectively vouches for the offer document's integrity to the investing public.
4. Due diligence in M&A and banking transactions
In an M&A transaction, due diligence directly shapes both the deal price (through valuation adjustments for identified risks) and the transaction documents themselves — specific representations, warranties and indemnities are drafted to allocate the risk of issues the due-diligence process uncovers, so a well-run due diligence process feeds directly into the legal drafting that follows it, rather than existing as a separate, disconnected exercise.
In a banking/lending transaction, due diligence (often framed as credit due diligence) focuses on the borrower's repayment capacity, the quality and enforceability of proposed security, and covenant compliance capacity — a lender's due diligence emphasis differs meaningfully from an equity investor's, since a lender's primary concern is downside protection and repayment certainty rather than upside growth potential.
5. Red flags common across all three contexts
Certain red flags recur across securities issues, M&A and banking due diligence alike, and a well-trained due-diligence professional treats them as universal warning signs regardless of the specific transaction type: undisclosed or inadequately disclosed litigation, gaps in required licensing or permits, a declining revenue trend inconsistently explained by management, unusually high leverage relative to the sector, a persistent working-capital gap, irregularities or inconsistencies in financial reporting, and related-party transactions that are not conducted on arm's-length terms.
Worked Examples
Example 1. A due-diligence team reviewing a target company discovers that a material supply contract contains a change-of-control clause allowing the counterparty to terminate the contract if the target is acquired. Which category of due diligence would typically surface this finding, and why?
Legal due diligence — reviewing material contracts, including their change-of-control and termination provisions, is a core part of the legal due-diligence checklist, and this specific risk (the deal itself potentially triggering contract termination) is exactly the kind of structural/legal risk that workstream is designed to catch.
Example 2. A due-diligence team finds that a target's reported profit for the past two years included a large, one-off gain from selling an unrelated asset, without which the company's actual operating profit would be substantially lower. Which category of due diligence would typically surface this, and what specific concept does it illustrate?
Financial due diligence — this illustrates a quality-of-earnings concern, since the reported profit does not reflect genuine, sustainable operating performance, and a financial due-diligence review is specifically designed to distinguish sustainable earnings from one-off or aggressively recognised items.
Example 3. A merchant banker managing a public issue signs off on an offer document without independently verifying several of the company's key financial disclosures. Is this consistent with the merchant banker's due-diligence role under SEBI's ICDR Regulations?
No — the merchant banker carries a specific statutory due-diligence obligation to verify the accuracy and completeness of the offer document's disclosures before filing; signing off without this verification is inconsistent with that defined regulatory responsibility, not merely a best-practice lapse.
Example 4. A lender is evaluating a loan application and is primarily concerned with whether the borrower can reliably repay the loan and whether the proposed security is enforceable, rather than the borrower's long-term growth prospects. How does this due-diligence emphasis differ from that of an equity investor evaluating the same company?
The lender's credit due diligence emphasises repayment capacity, security quality/enforceability and covenant compliance capacity — a downside-protection focus — whereas an equity investor's due diligence would place more emphasis on growth potential and upside, reflecting the fundamentally different risk-and-return position of a lender versus an equity holder in the same company.
Example 5. A due-diligence review uncovers that several transactions between the target and an entity controlled by the target's promoter were not conducted on arm's-length terms. Is this a red flag common across securities-issue, M&A and banking due diligence, or specific to only one context?
It is a red flag common across all three contexts — non-arm's-length related-party transactions are treated as a universal warning sign, since they raise concerns about value being diverted away from the company (relevant to an equity investor, an acquirer and a lender alike), not a risk specific to only one type of transaction.
Example 6. In an M&A transaction, due diligence uncovers a specific, quantifiable environmental compliance gap at the target's manufacturing facility. Explain two distinct ways this finding could affect the transaction, beyond simply being noted in a report.
It could affect the deal price, through a valuation adjustment reflecting the cost of remediation or the ongoing compliance risk, and it could be addressed through specific representations, warranties and indemnities in the transaction documents, allocating the risk of this specific environmental issue (and its potential cost) contractually between the buyer and seller.
Example 7. Explain why a due-diligence exercise scoped only to cover legal matters, with no financial due-diligence component, would be an incomplete risk assessment for a significant acquisition.
Legal due diligence tests structural and compliance integrity — contracts, litigation, licences, IP, employment compliance — but does not, by itself, test the target's economic and financial health or the reliability of its reported numbers.
A target could be entirely compliant from a legal standpoint while still carrying serious financial risk (declining margins, poor earnings quality, unsustainable debt), which only financial due diligence is designed to surface — so relying on legal due diligence alone would leave a significant, distinct category of transaction risk entirely unassessed.
Summary
Legal due diligence (corporate structure, compliance history, contracts, litigation, IP, employment, licences, encumbrances, related-party transactions, environmental compliance) and financial due diligence (revenue/profitability trends, working capital, debt structure, quality of earnings, tax exposure, internal controls) are complementary workstreams testing different categories of risk, typically run in parallel and supplemented by tax and, increasingly, ESG-linked due diligence.
Merchant bankers carry a specific statutory due-diligence obligation under SEBI's ICDR Regulations in a securities issue; M&A due diligence directly shapes deal pricing and the representations/warranties/indemnities in transaction documents; and banking/credit due diligence emphasises repayment capacity, security quality and covenant compliance, reflecting a lender's distinct downside-protection focus relative to an equity investor.
A common set of red flags — undisclosed litigation, licensing gaps, declining revenue trends, high leverage, working-capital gaps, reporting irregularities, and non-arm's-length related-party transactions — recur as universal warning signs across securities issues, M&A and banking due diligence alike.
