Due diligence

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Due Diligence is a term used for a number of concepts involving either the performance of an investigation of a business or person, or the performance of 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]


[edit] Origin of the term "Due Diligence"

The term "Due Diligence" first came into common use as a result of the Securities Act of 1933.

The US Securities Act included a defense referred to in the Act as the "Due Diligence" defense which could be used by broker-dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities.

So as long as broker-dealers conducted a "Due Diligence" investigation into the company whose equity they were selling, and disclosed to the investor what they found, they would not be held liable for nondisclosure of information that was not discovered in the process of that investigation.

The entire broker-dealer community quickly institutionalised, 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.

[edit] Due diligence in business transactions

In business transactions, the due diligence process varies for different types of companies. The relevant areas of concern may include the financial, legal, labour, 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 labour matters, immigration, and international transactions.[2]

[edit] Due diligence in 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.[3]

[edit] Due diligence for hedge funds

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. [4] In a non-exhaustive list, due diligence would consist of an examination of:

  • A Fund snapshot
  • Disclosed Investment Strategy
  • Historical returns
  • Assets under Management (A copy of the funds portfolio from the custodian is usually requested)
  • Audited Financial statements if the Fund is SEC regulated
  • 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: [5]

  • 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

[edit] As a concept in civil litigation

Due diligence in civil litigation is the effort made by an ordinarily prudent or reasonable party to avoid harm to another party. Failure to make this effort may be considered negligence. This is conceptually distinct from investigative due diligence, involving a general obligation to meet a standard of behavior. Quite often a contract will specify that a party is required to provide due diligence.

It is not correct to confuse due care and due diligence. Due care should be spelled out in full as duty of care. It is a legal concept by itself. Duty of care may be very wide, far reaching, and also a grey area subject to argument. Basically, parents owe their infant a duty of care in everything. As the infant grows to be a child, to be an adolescent, an adult, the duty of care and its scope become less and less. Fundamentally, a duty of care is a moral duty to care. When legal acknowledgment is extended to this moral obligation, then this duty becomes a legal requirement. Inversely, the legislature sets the duty in the statute. Then we consider this duty as legal and amoral ["a-", without, not having to consider the moral aspect].

When read carefully, care is the passive mode; diligence is the active mode.

First the duty of care (due care) arises, making it a requirement. In order to fulfill this duty, due diligence is exercised. The flow may be continuous, but these two concepts are different. When due diligence is called for, then there will be a set of demands to be complied with, depending on the context. For example, before a surgery, what should be done and who should be present in the theater? After the surgery, what must be done to the patient, equipment, facilities?

As a matter of independent inquiry, whether by a court of law or professional body, the line of investigation is: (1) Is there a duty of care? How is this duty of care imputed? (Previous case law, statute, new case) (2) If the duty of care exists, what are the applicable standards? In other words, what due diligence (and the components that go to make it a comprehensive due diligence) is required?

The last issue is always considered in light of specific circumstances of the case. If brain surgery is involved, the standards are those required of competent brain surgeons. If deep sea welding is involved, the standards are those required of competent deep sea welders. In an auction of a Picasso, due diligence standard must be comparable with an international auctioneer to authenticate an art object. In the sale of a diamond, due diligence may be necessary from human rights and political aspects. As such, expert opinions are often considered.

[edit] For 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 (Safety, Quality and Environment) professional 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.

[edit] As a criminal defense

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 offense 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.

[edit] Environmental 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".

[edit] Information security due diligence

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.

[edit] See also

[edit] References

  1. ^ Hoskisson, Hitt & Ireland, 2004, Competing for Advantage, p.251
  2. ^ Gary M. Lawrence, Due Diligence in Business Transactions, ( Law Journal Press 1994, updated as needed). ISBN 9781588520661.
  3. ^ 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
  4. ^ hedge Fund.net
  5. ^ SEC
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