Ten most com­mon red flags un­cov­ered dur­ing due dili­gence probes of ac­qui­si­tion tar­gets

Kyiv Post - - Business Focus - BY OK­SANA FARYNA [email protected] Kyiv Post staff writer Ok­sana Faryna can be reached at [email protected]

The main task of any due dili­gence probe of an as­set or po­ten­tial busi­ness part­ner is to un­cover any po­ten­tial red flags – hid­den risks, li­a­bil­i­ties and po­ten­tial con­flicts not clearly seen on the sur­face.

For the sell­ing side in a merger & ac­qui­si­tion deal, for ex­am­ple, it is only nat­u­ral, ex­perts say, to boost the sale price by pro­vid­ing a rosy picture of the as­set be­ing of­fered. A more ac­cu­rate view of the as­set can re­veal risks that un­der­mine the value of the as­set.

Ex­perts in­volved in pro­vid­ing due dili­gence ser­vices say that much de­pends on the pe­cu­liar­i­ties of each spe­cific trans­ac­tion be­ing con­sid­ered. Each, they say, has a unique “bou­quet” of risks de­pend­ing on the in­dus­try.

But, there are trends. By polling lawyers and other firms in­volved in pro­vid­ing due dili­gence ser­vices, the Kyiv Post put to­gether a list of Top 10 most com­mon prob­lems of­ten un­cov­ered.

Be­low is a glance at what red flags are com­monly found in Ukraine.


The tar­get’s share­hold­ers may not have prop­erly for­mal­ized ti­tle to their shares, or the tar­get may not have prop­erly for­mal­ized ti­tle or lease­hold to as­sets crit­i­cal for the tar­get’s busi­ness. The tar­get’s as­sets or shares may also be pledged or oth­er­wise used as debt se­cu­rity.

A po­ten­tial in­vestor has to pay at­ten­tion to whether the seller has good ti­tle to his shares, and whether the com­pany has good ti­tle to all of its key as­sets. This is es­pe­cially im­por­tant for a coun­try like Ukraine where even a seem­ingly mi­nor de­fect may be used as grounds or lever­age by third par­ties, for ex­am­ple cor­po­rate raiders, to cause trou­ble in the fu­ture.

Li­censes and per­mits

Li­censes are of­ten im­prop­erly is­sued by gov­ern­ment or trans­ferred into con­trac­tual joint ven­tures. There could be a dis­pute over va­lid­ity of the li­cense or where the li­cense is set to ex­pire; and there is un­cer­tainty as to whether the li­cense would be re­newed. There is a risk that state au­thor­i­ties will im­pose sanc­tions for such vi­o­la­tions.

Land plots and real es­tate is­sues

Com­pa­nies may use agri­cul­tural land for in­dus­trial pur­poses. This is il­le­gal. It is also very fre­quent that con­struc­tion of real es­tate as­sets takes place with­out nec­es­sary con­struc­tion per­mits. Such risks may be enough to tor­pedo the trans­ac­tion at hand, or could lead to se­ri­ous neg­a­tive con­se­quences es­pe­cially in case of po­lit­i­cally-driven dis­pute.

Tax risks

One of the hard­est is­sues is tax com­pli­ance. Although tightly reg­u­lated by the laws of Ukraine it is very hard to fore­see po­ten­tial risks and is­sues which may be re­vealed by a tax in­spec­tion. More­over, ac­cord­ing to the re­cent prac­tice, tax au­thor­i­ties are likely to be over-dili­gent dur­ing such in­spec­tions, un­der pres­sure to boost tax re­ceipts.

Po­ten­tial in­vestors should check com­plete­ness of com­pany’s tax li­a­bil­i­ties and any risks for ad­di­tional tax au­dits and penal­ties es­pe­cially in case of us­ing tax op­ti­miza­tion schemes.

Salaries in en­velopes

Some in­ter­na­tional in­vestors are shocked to dis­cover that a Ukrainian busi­ness they wish to pur­chase has over­es­ti­mated its level of profit through bla­tant tax eva­sion schemes. A com­mon scheme used by busi­nesses with many em­ploy­ees is to avoid pay­ing hefty pay­roll taxes. Salaries are paid un­der the ta­ble, in en­velopes through un­re­ported cash. In ad­her­ing to higher stan­dards of busi­ness prac­tices, many Western in­vestors seek to pay salaries legally. For this rea­son, the in­vestor may be re­quested to cover the po­ten­tial tax li­a­bil­i­ties be­fore a sale is closed. An­other op­tion is to cal­cu­late the un­der­stated tax li­a­bil­ity into a price re­duc­tion or in­clude a clause in the con­tract which re­quires the seller to cover tax li­a­bil­i­ties that may arise.

Vi­o­la­tion of en­vi­ron­men­tal pro­tec­tion, an­ti­monopoly law

Is­sues re­lated to en­vi­ron­men­tal pro­tec­tion obli­ga­tions should be re­viewed care­fully. It is com­mon that tar­gets per­form their busi­ness ac­tiv­i­ties with­out all nec­es­sary en­vi­ron­men­tal pro­tec­tion per­mis­sions and doc­u­men­ta­tion.

These risks are man­age­able, how­ever. They may in­volve ad­min­is­tra­tive fines im­posed on the com­pany. An­other risk is re­lated to the vi­o­la­tion of an­ti­monopoly law, which could be se­ri­ous enough to cause reg­u­la­tors to not ap­prove of the trans­ac­tion.

It is com­mon knowl­edge that in Ukraine the only way for many com­pa­nies to re­ceive their en­ti­tled Value Added Tax re­funds is to pay a sub­stan­tial kick­back to au­thor­i­ties. If a Ukrainian com­pany can­not re­main prof­itable with­out VAT re­funds (this is the case with many ex­porters), an Amer­i­can in­vestor, for in­stance, might be forced into prac­tices pro­hib­ited by the Amer­i­can law and there­fore would have to stay away to avoid sanc­tions in U.S. Amer­ica’s fa­mous and ag­gres­sively en­forced For­eign Cor­rupt Prac­tices Act (FCPA). This U.S. leg­is­la­tion makes it a crime un­der fed­eral law for of­fi­cials of Amer­i­can com­pa­nies, or their sub­sidiaries abroad, to en­gage in such prac­tices as bribery and kick­backs.

Un­of­fi­cial ar­range­ments with lo­cal au­thor­i­ties some­times pro­vide ad­van­tages to the tar­get’s cur­rent own­ers. How­ever they may not be avail­able to the new own­ers of the busi­ness. It is also very com­mon in Ukraine that a busi­ness’ re­la­tions are main­tained by one or few top ex­ec­u­tives. The com­pany’s stand­ing could change no­tice­ably when these ex­ec­u­tives leave the com­pany.


Cor­rup­tion and fraud Per­sonal ar­range­ments Poor qual­ity of fi­nan­cial in­for­ma­tion



of many Ukrainian com­pa­nies are weak and in­com­plete. IFRS fi­nan­cial re­port­ing stan­dards are rarely used. In con­trast, many com­pa­nies in Ukraine hold sev­eral ac­count­ing books: the ones they show tax au­thor­i­ties when evad­ing taxes, the real picture and what they show in­vestors. As a re­sult of these nu­ances, it can be chal­leng­ing to get an ac­cu­rate as­sess­ment of a do­mes­tic busi­ness’s fi­nan­cial stand­ing.

Some­times, man­age­ment or em­ploy­ees skim prof­its from within the com­pany by not re­port­ing de facto sales done on the job – pock­et­ing the cash in­stead. Com­pany own­ers are not al­ways in­ter­ested in show­ing prof­its in Ukraine, where taxes are rel­a­tively high. So, they trans­fer price profit through trad­ing com­pa­nies to their off­shore com­pa­nies lo­cated in tax havens. There could be un­re­ported li­a­bil­i­ties and com­mit­ments, undis­cov­ered bank­ing loans and other fi­nan­cial obli­ga­tions.

Vi­o­la­tion of pri­va­ti­za­tion process

Many as­sets in Ukraine were once state-owned, but have since been pri­va­tized. Of­ten, these ten­ders were not trans­par­ent, un-com­pet­i­tive and rigged. If the orig­i­nal pri­va­ti­za­tion deal was not trans­par­ent enough, own­er­ship of the as­set can be chal­lenged by the state or other in­ter­ested par­ties, such as em­ploy­ees who worked at the busi­ness when it was state owned.

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