What Are The Legal and Commercial Implications of Lender’s Due Diligence for My Business
If you want to finance your business, any lender will use a set of financial criteria to assess the risk and determine the lending terms. This is known as due diligence.
It’s essential to understand how due diligence works to best position your business and secure the most favourable loan terms. However, borrowers must also be aware of the legal obligations that due diligence may give rise to and, if necessary, seek expert legal advice to support the process and before signing a loan agreement — see our Investment Disputes page for guidance.
As specialist litigation solicitors we act in transactions in the context where something has gone wrong. This leads to disputes, including disputes arising out of business transactions and failures in due diligence processes. We don’t get involved in non contentious transactions, unless something has gone wrong.
The Core Role of Due Diligence in Commercial Financing
Any lender must be able to determine whether your business can repay the loan as part of their lending decision, as well as what security is available to protect against payment defaults.
A lender will also want to know why you want the loan. They’ll conduct an inspection of your company’s accounts to assess its financial health.
Due diligence provides lenders with a comprehensive understanding of the risks associated with lending money to a business. For the applicant, there may be legal implications reflected in the process and ultimately in any finance agreement that results.
What Due Diligence Covers: Financial, Legal, and Compliance Areas
Due diligence is far more than just reviewing the latest set of company accounts. It’s a meticulous review of all financial, operational, legal and compliance aspects of a business to arrive at the most informed lending decision possible.
Financial markets are complex, and most lenders follow robust due diligence processes to ensure that their lending and the businesses they lend to are compliant with regulatory requirements and legal standards and to make sure that the money they lend is repaid.
A lender will consider a business’s operations and credit history to verify that an investment is sound and to establish terms that reflect the level of risk associated with it.
Its a common misconception that due diligence only applies to lenders. Actually due diligence in its simplest terms means ‘checking what you’re told’, ‘know who you’re dealing with’, ‘not taking anything on face value’, ‘running an objective assessment’, and more. Businesses and business people will be doing ‘due diligence’ in its simplest terms on each and every transaction, each and every day- assessing whether anything stacks up from a cost; benefit perspective, whether there is ROI, whether the strengths, weaknesses, opportunities and threats have been accurately assessed and weighted in the decision making process of others on behalf of the business, and whether ultimately proper judgement has been exercised in any conclusion.
Legal Liabilities and Potential Risks Identified During Due Diligence
It’s often thought that Due diligence is confined to establishing a company’s financial health, but is just one element of what’s involved. Lenders are not just looking at the numbers, they are looking for the long-term viability and health of the business and if, for example, the business had serious litigation or some failure to comply with its regulatory obligation, then no matter how well it was doing in the short term they would be less likelyto lend due to the long-term risks to that business..
Therefore, Due diligence encompasses not just financial analysis but also the evaluation of licences, contracts, and legal documents as well as the relevant processes and procedures in place to ensure ongoing compliance.
Governance and Management: Signals Lenders Look For
Another essential aspect of due diligence, aside from the finances, is the company’s governance and management structure.
For a lender to risk their money they will want to know that the key company officers are knowledgeable and have demonstrable experience or qualifications for their roles. A lender will also examine the overarching framework in place for governance and compliance.
No business is without its challenges, and a lender wants to feel confident that the leadership team have a proper long-term plan in place and if and when challenges arise are well- placed to navigate these to protect and promote financial stability and profitability of the business.
Collateral and Security: Verification and Valuation
Collateral is a means by which lenders can safeguard their investment in the event of a default by the borrowing company.
A lender will identify potential collateral assets and then need to verify their legal ownership and value to ensure their security interest is protected. This could include Real Property, such as premises, assets such as a website or intellectual property such as a brand,copyright or patent.
Regulatory Compliance and ESG
Compliance with industry-specific regulations is a crucial aspect of due diligence for both lenders and borrowers. These regulations may impose extra obligations on the financing process.
Financial institutions are themselves required to assess the social responsibility and environmental impact of their lending.
Environmental, Social, and Governance (ESG) considerations also examine the borrower’s practices to see if they meet specific sustainability standards and don’t create adverse environmental or human rights impacts.
The Due Diligence Process: What to Expect
Unlike a residential mortgage or a personal loan application, the borrower plays a proactive role in the due diligence process. There will be an initial request for information, but additional communication and data may be required whilst the lender makes their assessment.
Alongside hard-copy documents and financial statements, discussions may also occur regarding the business direction or the purpose of the loan. The lender will want to know about other loan obligations the company may have and their current status.
Your statements and representations to the lender, whether verbal or in writing, are likely to influence their financial decision and you must be very careful what you say both orally and in writing is true and accurate. The lender will in all likelihood ask you to sign something to confirm their accuracy, but whether this happens or not, you need to be aware if what you say is not true and accurate, this could result in the lender having a claim against you in, for example, misrepresentation…
Examples of important representations could be verifying that the company is incorporated correctly, that the directors have the necessary authority to transact the loan, and that the company’s accounts are accurately prepared and authentic.
There is also a catch-all confirmation that you have not misrepresented information or misled the bank throughout the due diligence process, and that nothing has been presented or omitted that would alter the bank’s decision to lend.
While it can be tempting to just ‘sign the paperwork’ to get the funds your business requires, the legal consequences of doing so can be very serious.It is vital that you properly understand the consequences and take independent legal advice before you sign it — see our commercial contract dispute page for contract review and dispute guidance.
Risk Management: Safeguards and Ongoing Monitoring
These terms of the contract are promises you make to the lender known as Covenants.Covenants protect the lender and are part of their risk management policy. Covenants vary from one loan to another and are part of the loan’s terms and conditions.
The lender may ask you to carry out or not to carry out a particular action or operation as part of a covenant. Typical covenants include maintaining specific financial ratios, a requirement to provide regular financial reports, or a restriction on additional debt.
The consequences of breaching a covenant are more severe than a general clause in the loan agreement.
Lenders can also mitigate risk using credit insurance policies, which protect against the borrower’s default. For international businesses, political risk insurance can offset the risk of government actions in foreign jurisdictions.
Monitoring encompasses internal threats and challenges, such as management inadequacy or operational inefficiencies. It also involves being vigilant against external risks, such as regulatory changes or economic downturns.
Regular reviews of the company’s performance after the loan are crucial for identifying emerging risks before they become significant problems. It provides lenders with the opportunity to intervene proactively before a minor issue escalates into a more serious one.
Frequently Asked Questions
What Is a Lender’s Due Diligence?
Due diligence is a comprehensive and collaborative process by which a lender works with a business to establish the feasibility of a loan. The lender’s assessment of the company’s health identifies the level of risk and dictates whether to lend and on what terms.
How to Do Due Diligence on a Business?
Due diligence will vary from transaction to transaction. What is appropriate will vary depending on context and what is involved. There is no 1 stop shop approach to this and circumstances of the proposed transaction or deal, as well as your position in that transaction, need to be carefully considered. An experienced commercial lender will have a vastly different to a private individual considering lending a sum on a secured or unsecured basis.
When a lender undertakes due diligence on a UK company, it usually involves a review of its business operations, legal status, and financial health. Central to this is the analysis of the company’s financial statements, but this is only part of the process. Other lenders may not undertake such a comprehensive due diligence approach, accept there is far higher risk to them, but then also Taken as a whole it means examining various and usually all aspects of the business, with ongoing monitoring after a loan is approved.
Litigation following failures of Due Diligence From Helix Law
With all the due diligence in the world, sometimes things go wrong. Where that happens losses can be incurred that need to be recovered. It might be advice should have been given that wasnt, or that you were persuaded a deal involved X and Y, but it turned out to be Z. Perhaps promises and agreements were entered into, and were then reneged upon. Our commercial litigation team regularly act in litigation and disputes where something has gone wrong. We don’t get involved in transactional work unless there is a problem.
Our commercial litigation team at Helix Law act nationally in disputes including property and financial transactions, where something has gone wrong. Losses can be significant. If you are in that situation and are looking for advice and assistance, contact our team today for advice and support. We’d love to help resolve your problem.
