Due diligence

Due diligence is the investigation or exercise of care that a reasonable business or person is normally expected to take before entering into an agreement or contract with another party or an act with a certain standard of care.

Due diligence can be a legal obligation, but the term more commonly applies to voluntary investigations. It may also offer a defence against legal action. A common example of due diligence is the process through which a potential acquirer evaluates a target company or its assets in advance of a merger or acquisition.[1] The theory behind due diligence holds that performing this type of investigation contributes significantly to informed decision making by enhancing the amount and quality of information available to decision makers and by ensuring that this information is systematically used to deliberate on the decision at hand and all its costs, benefits, and risks.[2]

Development of the term

The term "due diligence" can be read as "required carefulness" or "reasonable care" in general usage, and has been used in the literal sense of "requisite effort" since at least the mid-fifteenth century.[3] It became a specialized legal term and later a common business term due to the United States' Securities Act of 1933, where the process is called "reasonable investigation". Under Section 11b3, a person could avoid liability for an untrue statement of a material fact if they had, "after reasonable investigation, reasonable ground to believe and did believe, at the time", the truth of the statement.[4] The defense at Section 11, referred to later in legal usage as the "due diligence" defense, could be used by broker-dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities. In legal and business use, the term was soon used for the process itself instead of how it was to be performed, so that the original expressions such as "exercise due diligence in investigating" and "investigation carried out with due diligence" were soon shortened to "due diligence investigation" and finally "due diligence".

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

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

Examples

Business transactions and corporate finance

Due diligence takes different forms depending on its purpose:

A due diligence process can be divided into nine distinct areas:[5]

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

In this regard, two new audit areas have been incorporated into the Due Diligence framework:[5]

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 (including the Affordable Care Act) and labor matters, immigration, and international transactions.

Due diligence defence

In the United Kingdom, "proper use of a due diligence system" may be used as a defence against a charge of breach of regulations: for example, under the Timber and Timber Products (Placing on the Market) Regulations 2013[20] and the Environmental Protection (Microbeads) (England) Regulations 2017,[21] businesses may be able to defend a charge of non-compliance with regulations if they can show that they have undertaken supplier due diligence to a necessary standard. References to "due diligence" and the maintenance of a "due diligence system" in the regulation concerning timber are drawn from the European Union's Regulation 995/2010, which covers the legal obligations of "operators who place timber and timber products on the market".[20]

References

Robert E. Hoskisson, Michael A. Hitt, R. Duane Ireland. Competing for Advantage South-Western/Thomson Learning, 2004^
C. E. Chapman. Conducting Due Diligence Practicing Law Institute, New York, NY, 2006^
'Due Diligence' Merriam-Webster entry^

Legislation

With the number and size of penalties increasing, the United States' Foreign Corrupt Practices Act (FCPA) has caused 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:

In the M&A context, buyers can use the due diligence phase to integrate a target into their internal FCPA controls, focusing initial efforts on necessary revisions to the target's business activities with a high-risk of corruption.[15]

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.

In the United Kingdom, the Bribery Act 2010 requires companies using an "adequate procedures" defence to a charge of bribery to have undertaken due diligence on their business partners. Due diligence is described as "knowing exactly who you are dealing with". Official guidance suggests that "ask[ing] a few questions and do[ing] a few checks" can help to protect an organisation from taking on untrustworthy partners.[16]

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[14] and is often part of a wider Integrity Management initiative.

Development of the term

Examples

Business transactions and corporate finance

Due diligence defence

See also

References

Legislation

Human rights

Civil litigation

Criminal law