Due diligence is a quintessential step in a share acquisition transaction. It is the process by which the acquirer conducts a detailed inquiry into the affairs of the target before it decides whether to proceed with the acquisition. Since the acquisition will require the acquirer to assume a financial risk, it would be prudent on its part to obtain sufficient information on the conduct and affairs of the target, and to mitigate those risks to the extent possible.
If the target happens to be a listed company, the justification for due diligence becomes less compelling or, at least, its scope limited. Because a target is subject to strict disclosure norms imposed by securities regulation that require it to keep the market informed of all material developments, the acquirer could make the acquisition decision based simply on publicly available information. However, such an idealistic assessment tends to break down in practice as acquirers making significant investments will want to seek information from the target that may very well be in excess of what is in the public domain.
At the same time, due diligence in listed company acquisitions encounters certain regulatory barriers in the form of insider trading regimes. Due diligence in such a scenario perpetuates information asymmetry that militates against the goal of the insider trading regime, as it undermines market integrity. By giving an acquirer inside information during due diligence that is unavailable to other investors, the acquirer enjoys preferential treatment that may be against the interests of the other shareholders of the target. It is this disparity that gives rise to more fundamental questions that strike at the heart of the intersection between the need for due diligence to promote share acquisition transactions that may be value-enhancing in nature for the company as a whole (including its shareholders), and the information asymmetry created by the process that makes the very same shareholders vulnerable to the actions of the acquirer with superior information regarding the target.
In a working paper ‘Due Diligence in Share Acquisitions: Navigating the Insider Trading Regime’, I examine the underlying friction between the need to facilitate due diligence in share acquisition transactions that will place inside information in the acquirer’s hands, and, at the same time, the need to ensure that such information is not misused by the acquirer to the detriment of the other shareholders, a matter that insider trading regimes regard as sacrosanct. In analysing and seeking to resolve this tension, the paper draws upon examples from three jurisdictions, namely the UK, Singapore and India.
The core argument is that, from a theoretical perspective, the due diligence objective of acquirers can be reconciled with the goals of insider trading regimes in order to preserve the interests of the target shareholders as long as certain restrictions are placed on the conduct of the acquirer. Due diligence temporarily causes information asymmetry whereby the acquirer becomes privy to inside information that is unavailable to the other shareholders, but parity can be restored if the acquirer (or the target) is required to publicly disclose any such inside information to the market before the acquirer proceeds with the transaction (a phenomenon referred to as “cleansing”). This must be accompanied with the condition that the acquirer cannot trade in the target’s shares while it is in possession of inside information, nor can it disclose that information to any other person. The only advantage the acquirer gains is that it is able to examine the affairs of the target and then decide whether it wishes to proceed with the transaction or not. If it does decide to proceed, it must give up any informational advantage through a cleansing announcement. This can be considered a “win-win” situation whereby the acquirer is motivated through the due diligence exercise to embark on a transaction that may be beneficial to the target and its shareholders, but at the same time it must relinquish its informational advantage before it actually acquires the shares so that a similar level of information is available to all shareholders at that stage.
The paper finds that while the UK, Singapore and India have adopted the aforesaid broad policy framework within their respective insider trading regimes, there is not only disparity in the level of detail in the regulations to achieve this framework, but, in many cases, these regimes do not fully address the entire range of protections required for the framework to function effectively.
Umakanth Varottil is an Associate Professor at the Faculty of Law of the National University of Singapore.