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Overview: Due Diligence in Real Estate

Published on : 23 Sep 2014
Author(s):Jennifer Leader,Sunil Thacker

Law firms in Abu DhabiObvious, really, yet “performing due diligence” is a phrase readily associated with the legal industry. Reminding ourselves of the basic definition realizes that we each “perform due diligence” hundreds of times per day. We might check the weather forecast or traffic reports before leaving the house, read reviews before selecting a film to watch, research a company before applying for a job. It is unlikely that we would enter a car showroom on a whim and select a vehicle based on aesthetics, or turn up at the airport and pick our holiday destination at random. The fact that these relatively minor tasks require the application of such due diligence goes some way towards emphasizing the caution that should be exercised before entering into a major project.

A major project involving construction and real estate, for example. Or entering into a joint venture. Or, on an even greater level, both.

Let us imagine that Company A (a developer) wants to build and sell a hotel. Before any construction could even be considered Company A would need to find a suitable plot of land and secure the appropriate permissions, consents and NOCs, not just for the sale and purchase of the land but also for the construction and operation of a hotel thereon. These tasks alone would be subject to thorough checks and analysis before the project could go any further. If Company A was to source a plot and entered into a provisional sale and purchase agreement with the seller then it would need to ascertain certain information before any definitive agreement could be executed, namely:

  • Are there any issues with the title? Is it restricted in any way? Does the seller have the sole and absolute right to sell the land and transfer the title?
  • For what uses has the land been approved? Are there any restrictions or approvals in place affecting the intended use of the land as a hotel?
  •  Is access to utilities such as water, sewage, electricity etc available?
  • Is access to the land restricted in any way? Do access routes already exist? Does the title include any responsibility towards maintaining existing access routes?

As the definition suggests due diligence requires a great degree of care and attention, meaning that Company A will have to do more than simply ask the seller to confirm the above. In order to be thoroughly conscientious Company A’s lawyers should correspond with the seller on its behalf, request all and any documentation pertaining to the ownership, title, use and history of the land and thoroughly study the same so as to ascertain whether or not there are any issues which may affect the purchase of the land or Company A’s intended usage. However, in order to minimize the risk of issues and complications arising during the project, Company A and its lawyers would be sensible to summarize the entire scope of work from purchase to construction to completion, and request all relevant information required for due diligence at the outset and before the signing of any definitive agreement. In doing this Company A’s lawyers would be in a position to advise against the transaction should any issue seem to counter Company A’s interests.

Now let us imagine that Company A decides that it wants to develop a bigger, more structurally complex hotel in Dubai. After considering their finances and resources, Company A decides that achieving this objective would be far more realistic if it joined forces with Company B, another developer also desirous of building and selling a large state-of-the-art hotel in Company A’s country of choice. Company B additionally has finances and resources which, when combined with those of Company A, would be sufficient to allow for the successful completion of the project. Company A and Company B, therefore, agree to enter into a joint venture.

Clearly, the practicalities of the purchase of land, construction of the hotel and sale of the same would be little different to those involved in Company A developing its original hotel as above, and thorough due diligence would still be required to this effect. However, Company A now has the additional task of considering all the factors relating to Company B which may affect the venture, such as:

- Is Company B sufficiently financially secure? Is it likely to encounter financial problems which would affect the venture?   Past liabilities of Company B and disclosures on such Past liabilities.

- Is Company B already involved in any joint ventures with other companies and, if so, what are the details of these? Are there any conflicting business issues?

How verifiable are the resources that Company B is proposing that it brings to the project?

- What is the structure of Company B? How is it managed?

- Who are Company B’s customers, suppliers, clients and trading partners? Are they able to verify that Company B is capable of maintaining a sound working relationship?

- Is Company B involved in any legal or public issues which may affect the venture, or have any detrimental effect on   Company A by association?

- How successful are any previous or ongoing development projects in which Company B has been/is currently involved?

This is by no means an exhaustive list, and requesting documentation pertaining to Company B’s past and present state is by no means the full extent of due diligence. Throughout their working relationship Company A and Company B are likely to encounter each other’s trade secrets and intellectual property – provisions will, therefore, need to be agreed in advance so as to ensure the protection of each company after the venture has ended, and series of contracts and agreements will inevitably be needed in order to govern each company’s rights, obligations, liabilities and duties throughout the venture and thereafter.

From a professional standpoint, it has been observed in many instances that parties to a joint venture agreement tend not to adhere to joint-venture terms. For instance - Company A in present case owns a piece of land and Company B has the technical know, means and experience to develop, construct and market the property – a joint venture would naturally result from the synergies existing between Company A and Company B whereby Company B saves in terms of investing financial resources to develop the property on Company A’s land and Company A saves itself from time and labor to construct a property. It is important to state here that although joint venture contract can regulate the relationship between Company A and Company B in this case, Company B enjoys a dominant position once it has assumed possession of land. Briefly, the joint-venture agreement between the parties provided:-

a. Company B shall be solely responsible towards construction, completion, and handover of the project;

b. Company B shall set up the joint escrow account in name of Company A and Company B with JKL Bank and all sale consideration    shall be credited into the escrow account;

c. 60% percent of the saleable area to be owned by Company B and 40% to be retained by Company A;

d. Marketing and pricing decisions to be agreed upon mutually by both the parties.

The cursory reading of the above terms may suggest that these terms are fair and adequate to regulate the relationship of respective parties. However, once Company B assumes occupation of the project site and commences actual construction, Company A i) cannot consider termination of joint venture agreement as it may be subject to penalties and damages towards losses sustained by Company B towards construction works; ii) has no control over construction, contracting or building works; iii) is responsible towards terms, liabilities, and obligations imposed under joint venture agreement. Interestingly, Company A’s dominant position will affect Company B to a much more significant level. Say, for instance, Company A fails to open a joint escrow account for any reason or; delays construction of property on account of some dispute with contractor or project manager or is subject to court proceedings thereby affecting joint venture agreement, or unilaterally engages in sale and marketing of units developed. Although Company A may have the option to bring an action against Company B for its breaches, the cost, expense, and length of proceedings will run against the interest of Company A and its management. To this extent, if parties have agreed to be governed pursuant to DIFC Law, Company A may get some relief as DIFC Courts have wide powers to pass necessary orders including injunction under clause 22, Chapter 5 of the DIFC Court Law (Law number 10 of 2004).

The benefits of entering into this joint venture may well be remarkable and far beyond those attained by Company A’s sole venture, but it is only through thorough due diligence that Company A will be able to sensibly ascertain that entering into the relationship is in its best interests. And given the wide scope of work of both the desired project and the definition of the relationship between the entities it is inevitable the completion of due diligence will in itself be an enormous task.

Proceed, Company A, but proceed with caution.

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