Due diligence

For other uses, see Diligence (disambiguation).

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"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for acquisition.^[1]

Origin of the term "due diligence"

The term "due diligence" first came into common use as a result of the United States' Securities Act of 1933.

This Act included a defence at Sec. 11, referred to as the "Due Diligence" defence, which could be used by broker-dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities.

As long as broker-dealers exercised "due diligence" in their investigation into the company whose equity they were selling, and disclosed to the investor what they found, they would not be held liable for non-disclosure of information that was not discovered in the process of that investigation.

The entire broker-dealer community quickly institutionalized, as a standard practice, the conducting of due diligence investigations of any stock offerings in which they involved themselves.

Originally the term was limited to public offerings of equity investments, but over time it has come to be associated with investigations of private mergers and acquisitions as well. The term has slowly been adapted for use in other situations.

Due diligence in specific contexts

Business transactions and corporate finance

Due diligence can be defined as:

1. The examination of a potential target for merger, acquisition, privatisation or similar corporate finance transaction normally by a buyer.
2. A reasonable investigation focusing on material future matters.
3. An examination being achieved by asking certain key questions, including, do we buy, how do we structure the acquisition and how much do we pay?
4. An examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis."^[2]

The due diligence process (framework) can be divided into nine distinct areas:^[2]

1. Compatibility audit.
2. Financial audit.^[3][4]
3. Macro-environment audit.^[3][4]
4. Legal/environmental audit.^[3][4]
5. Marketing audit.^[3][4]
6. Production audit.^[3][4]
7. Management audit.^[3][4]
8. Information systems audit.^[3][4]
9. Reconciliation audit.

It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions.^[2][5]

In this regard, two new audit areas have been incorporated into the Due Diligence framework:^[2]

• the Compatibility Audit which deals with the strategic components of the transaction and in particular the need to add shareholder value and
• the Reconciliation audit, which links/consolidates other audit areas together via a formal valuation in order to test whether shareholder value will be added.^[2]

In business transactions, the due diligence process varies for different types of companies. The relevant areas of concern may include the financial, legal, labor, tax, IT, environment and market/commercial situation of the company. Other areas include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions.^[6]

The Foreign Corrupt Practices Act (FCPA)

With the number and size of penalties increasing, the Foreign Corrupt Practices Act (FCPA) is causing many U.S. institutions to look into how they evaluate all of their relationships overseas. The lack of a due diligence of a company's agents, vendors, and suppliers, as well as merger and acquisition partners in foreign countries could lead to doing business with an organization linked to a foreign official or state owned enterprises and their executives. This link could be perceived as leading to the bribing of the foreign officials and as a result lead to noncompliance with the FCPA. Due diligence in regard to FCPA compliance is required in two aspects:

1. Initial due diligence - this step is necessary in evaluating what risk is involved in doing business with an entity prior to establishing a relationship and assesses risk at that point in time.
2. Ongoing due diligence - this is the process of periodically evaluating each relationship overseas to find links between current business relationships overseas and ties to a foreign official or illicit activities linked to corruption. This process will be performed indefinitely as long as a relationship exists, and usually involves comparing the companies and executives to a database of foreign officials. This process should be performed on all relationships regardless of location^[7] and is often part of a wider Integrity Management initiative .

While financial institutions are among the most aggressive in defining FCPA best practices, manufacturing, retailing and energy industries are highly active in managing FCPA compliance programs.

Human rights

Passed on May 25, 2011, the OECD member countries agreed to revise their guidelines promoting tougher standards of corporate behavior, including human rights. As part of this new definition, they utilized a new aspect of due diligence that requires a corporation to investigate third party partners for potential abuse of human rights.

In the OECD Guidelines for Multinational Enterprises document, it is stated that all members will "Seek ways to prevent or mitigate adverse human rights impacts that are directly linked to their business operations, products or services by a business relationship, even if they do not contribute to those impacts"^[8]

The term was originally put forth by UN Special Representative for Human Rights and Business John Ruggie, who uses it as an umbrella to cover the steps and processes by which a company understands, monitors and mitigates its human rights impacts. Human Rights Impact Assessment is a component of this.

The UN formalized guidelines for Human Rights Due Diligence on June 16 with the endorsement of Ruggie's Guiding Principles for Business and Human Rights.^[9]

Philanthropy

With origins in the private sector world of business and finance, the term “due diligence” in philanthropy refers to the process through which an investor (or funder) researches an organization’s financial and organizational health and capacity to guide an investment (or grantmaking) decision. The decision to fund or not to fund is based upon a balance of objective data analysis, insight into the general state of organizational health and stability, and intuition. A sound and thorough due diligence review is the process through which all the factors that make up that equation are uncovered and understood. It is the process in which a program officer seeks the “truth” about an organization.^[10]

Hedge funds and FOREX

Due diligence investigation with regard to hedge funds refers to an in-detail review of a hedge fund's activity, conducted in order to ensure that the fund is in compliance with its prospectus. It is a roadmap for existing and potential investors in understanding whether a specific fund will meet his or her investment horizon, risk tolerance and investment strategy.^[11] In a non-exhaustive list, due diligence in the United States would consist of an examination of:

• A fund snapshot
• Disclosed investment strategy
• Historical returns
• Assets under management (a copy of the fund's portfolio from the custodian is usually requested)
• Audited financial statements if the fund is regulated by the U.S. Securities and Exchange Commission (SEC)
• Fund's terms and details
• Regulatory registration if any
• Risk factors
• Valuation

Every investor is going to have different investment horizons and risk tolerance, as well as a strategy preference. It thus follows that there is no "best" hedge fund, but a fund that most closely matches investors' preferences. An investor should almost always:^[12]

• Request consultation from a professional
• Read the fund's prospectus or offering memorandum
• Understand how a fund's assets are valued
• Understand how fees are charged
• Understand any limitations towards the redemption of shares
• Research the backgrounds of hedge fund managers

The term Operational due diligence is often used to describe the due diligence process used by hedge fund investors, particularly where this incorporates, or focuses largely on, operational risks.

Civil litigation

Due diligence in civil procedure is the idea that reasonable investigation is necessary before certain kinds of relief are requested.

For example, duly diligent efforts to locate and/or serve a party with civil process is frequently a requirement for a party seeking to use means other than personal service to obtain jurisdiction over a party. Similarly, in areas of the law such as bankruptcy, an attorney representing someone filing a bankruptcy petition must engage in due diligence to determine that the representations made in the bankruptcy petition are factually accurate. Due diligence is also generally prerequesite to a request for relief in states where civil litigants are permitted to conduct pre-litigation discovery of facts necessary to determine whether or not a party has a factual basis for a cause of action.

In civil actions seeking a foreclosure or seizure of property, a party requesting this relief is frequently required to engage in due diligence to determine who may claim an interest in the property by reviewing public records concerning the property and sometimes by a physical inspection of the property that would reveal a possible interest in the property of a tenant or other person.

Due diligence is also a concept found in the civil litigation concept of a statute of limitations. Frequently, a statute of limitations begins to run against a plaintiff when that plaintiff knew or should have known had that plaintiff investigated the matter with due diligence that the plaintiff had a claim against a defendant. In this context, the term "due diligence" determines the scope of a party's constructive knowledge, upon receiving notice of facts sufficient to constitute "inquiry notice" that alerts a would-be plaintiff that further investigation might reveal a cause of action.

Supplier quality engineering

Due diligence is a term used for a number of concepts involving either the performance of source inspection or source surveillance, or the performance of quality duties such as PVA (Process Validation Assessment) or System Audits with a certain standard of care.

Due diligence in supplier quality (also known as due care) is the effort made by an "SQE" (Supplier Quality Engineer) to validate conformance of product provided by the seller to the purchaser. Failure to make this effort may be considered negligence. This is conceptually distinct from investigative due diligence, involving a general obligation to identify true, root cause for non-compliance to meet a standard or contract requirement.

Criminal law

In criminal law, due diligence is the only available defense to a crime that is one of strict liability (i.e., a crime that only requires an actus reus and no mens rea). Once the criminal offence is proven, the defendant must prove beyond a reasonable doubt that they did everything possible to prevent the act from happening. It is not enough that they took the normal standard of care in their industry - they must show that they took every reasonable precaution.

Due diligence is also used in criminal law to describe the scope of the duty of a prosecutor, to take efforts to turn over potentially exculpatory evidence, to (accused) criminal defendants.

Commercial property

Persons involved in buying, selling, lending, and managing commercial real estate routinely need to perform a variety of types of commercial property due diligence.

Environmental due diligence during commercial real estate and transactions can include Phase I and Phase II Environmental site assessments. Such assessments are often undertaken in the United States to avoid liability under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly referred to as the "Superfund law".

An engineering or property condition assessment (PCA) would include a review of building systems to evaluate deferred maintenance items that can materially affect the operation and value of a property. Building systems would include the foundation, roof, HVAC, electrical, plumbing, vertical transportation, and building envelope (windows and walls). One result of the report is often a cost table showing the immediate and necessary future repairs and their associated costs. As an example the table would show that in 2 years the outside will need painting and that in 5 years the parking lot will need resurfacing. These reports are good for negotiating the price of a property as well as financial planning. They are required as part of securitized lending CMBS

It is also common for due diligence in a commercial property transaction to include securing a title insurance policy regarding the ownership of the property and the encumbrances to which it is subject, and requiring the owner to secure an attornment from each tenant establishing agreement as to lease terms currently in force, and to research the zoning laws applicable to the property, building code compliance of the premises, the existence of any special assessments of property taxes applicable to the property, and the sales price history of the property.

Information security

Information security due diligence is often undertaken during the information technology procurement process to ensure risks are known and managed, and during mergers and acquisitions due diligence reviews to identify and assess the business risks.

See also

• Know your customer
• Public liability
• Data Room, Virtual Data Room
• Model audit
• Bias ratio (finance)
• Operational Due Diligence (ODD)
• Management due diligence
• Foreign Corrupt Practices Act
• Integrity Management

References

1. ^ Hoskisson, Hitt & Ireland, 2004, Competing for Advantage, p.251
2. ^ ^{a b c d e} Gillman, Luis (2010). Due Diligence, a Strategic and Financial Approach (2nd ed.). Durban: LexisNexis. ISBN 9780409046991. 
3. ^ ^{a b c d e f g} Harvey MG and Lusch RF, 1995, "Expanding the Nature and Scope of Due Diligence", Journal of Business Venturing 10: 5–21.
4. ^ ^{a b c d e f g} Kroener PH and Kroener MH, 1991, "Towards more successful Mergers and Acquisitions", International Journal of Technology Management 6(1/2 ): 33–40
5. ^ Gillman (2002), Academy of Accounting and Financial Studies Journal, The link between valuations and due diligence 6(2)}
6. ^ Gary M. Lawrence, Due Diligence in Business Transactions, (Law Journal Press 1994, updated as needed). ISBN 978-1-58852-066-1.
7. ^ [1] WorldCompliance.com
8. ^ [2]
9. ^ [3]
10. ^ Liza Culick, Kristen Godard and Natasha Terk (2004). “The Due Diligence Tool for use in pre-grant assessment”, Grantmakers for Effective Organizations (GEO), Washington DC 20005
11. ^ hedge Fund.net
12. ^ SEC