With the aim of eliminating the unwanted risk of tax, labor and social security succession, any successful M&A process tends necessarily to include an investigation of the target company known as Due Diligence. Regardless of the more or less in-depth scope of these analyses, what they all have in common is the fact that they involve a broad and varied number of advisors, consultants and lawyers and, for this reason, the roles of each workstream are not always well understood.
It is worth emphasizing that the functions performed by legal advisors and tax, labor and social security advisors do not result in an overlap of scope between them. Although the roles of each of these advisors are distinct, the results of their work are complementary and, at the end of the process, strong coordination between these workstreams will underpin the final investment decision by the buyer (buy side) or divestment by the seller (sell side).
In addition to assessing the regularity of the companies’ tax clearance certificates, lawyers will concentrate their efforts primarily on understanding the magnitude of the impact of contingencies already in existence and arising from materialized causes, whether in the administrative or judicial sphere (e.g., a tax assessment notice). Tax, labor and social security advisors from the advisory firm, in turn, will invest their energies in identifying and quantifying risks arising from procedures adopted by the companies, which could result in tax assessment notices being issued against them in the future.
In other words, these advisors will seek to identify hidden exposures (not yet “materialized”) and will perform a role very similar to that of a tax inspector during the course of an audit of the companies. After they have identified and quantified these risks, the results of their work are then submitted to the law firms so that an important Due Diligence stage known as risk assessment (or “prognosis assessment”) can be carried out.
In Brazil, this phase of the work is exclusive to lawyers and aims to qualify the degree of risk of each of the non-materialized points identified and reported in the tax, labor and social security advisors’ report. Note that the lawyers will formalize their opinions based on case law (whether dominant or not), as well as on administrative and/or judicial precedents. Their mission will be to indicate, in an objective manner, whether, in the event of an assessment notice, the final risk of the companies losing the cases is “probable,” “possible” or “remote.”
The outcome of this stage is particularly useful in defining two distinct situations: (i) when risks of highly material amounts are identified and quantified, potentially representing a threat to the outcome of the transaction, and (ii) whenever the buyer seeks to negotiate price retention guarantee mechanisms with the seller, such as amounts that will form an “Escrow Account” or “Holdback.”
In the case of item (i), it is not uncommon for highly significant amounts to be quantified during Due Diligence. If viewed in isolation, these risks could be sufficient to render various transactions unviable from the buyer’s perspective, since they can approach or even exceed the value of the transaction itself. A very common example occurs in relation to the risk of an employment relationship with service providers in technology sector companies. It is a common practice in this segment to hire professionals in this format, whether as a strategy for companies to pay less in payroll taxes or by the choice of the professional providing the service. However, the qualification of this risk as “remote” or even “possible” may be a sufficient element to make the transaction viable once again.
With regard to the guarantee implications mentioned in item (ii), it is fairly common to encounter transactions in which risks classified as “probable” of loss by legal advisors are 100% retained by the buyer, while those classified as “possible” typically follow the practice of retention at a rate of 50% until the five-year statute of limitations has elapsed. Although these percentages are commonly used in the market, there is no specific regulation on this matter and the guarantees can be freely negotiated between buyers and sellers.
If the risks identified during Due Diligence do not actually materialize through assessment notices within the statute of limitations period, the buyer then releases, even if gradually, the amount subject to retention in the transaction (used as a guarantee) in favor of the seller.
Given the foregoing, it is advisable for the Due Diligence process to be treated as a highly specialized undertaking, in which an integrated and harmonious result across the various workstreams will be fundamental to ensuring that the risks captured are fully aligned with reality. In this way, buyers and sellers will be more comfortable that the transaction was completed securely and that the desired scenario of greater predictability will be achieved.
*Alexandre Bragança is an economist, accountant and partner at MCS Markup in the M&A practice, with 20 years of professional experience working at Big Four firms and serving both domestic and international clients.
