DUE DILIGENCE

Generally, due diligence is the care that people with normal discretion employ in all of their dealings in order to avoid damage to others or to themselves. In business, the term refers to the prudent inspection of anything intended for purchase. It echoes the Latin axiom caveat emptor, or "let the buyer beware."

Due diligence as practiced in business has evolved from the legal application of the concept, which relates to the care that may be reasonably expected based on the relative facts of each "special case." This concept is also referred to as reasonable care, due care, and ordinary care.

Although the legal definition of due diligence allows for several degrees of care and is open to interpretation, the commercial application of the term corresponds more closely to the legal category "special diligence." Special diligence involves the particular skill of a businessperson, which must be done well and performed better than that of a non-specialist or ordinary person. Therefore, due diligence in business refers to an assessment of the degree of risk involved in potential courses of action, especially investments, by specialists such as accountants and attorneys.

Due diligence can apply to virtually any business transaction and is sometimes legislatively required. For example, lenders maintain due diligence when they perform background checks for loans ranging from home improvement loans and mortgages to large-scale commercial finance packages. Individual investors investigate the soundness of stocks, bonds, and mutual funds by examining prospectuses, reading third-party reports in trade journals, and consulting investment rating services and surveys.

Underwriters are required by law to conduct due diligence on all public offerings they bring to market. They must verify the facts presented by issuers in registration statements, prospectuses, and other offering materials. Underwriters can be held liable for any misstatements in offering materials unless they can prove that they conducted sufficient due diligence.

MERGERS AND ACQUISITIONS

Due diligence is used most frequently in reference to mergers and acquisitions. The concept and practice of due diligence lapsed during the 1980s, when an acquisitions and mergers frenzy precluded prudence on the part of many buyers. As Russ Banham cautioned in a December 1993 Risk Management piece, "What may appear to be a neatly wrapped corporate package becomes, upon buying, a Pandora's box of financial hardship." The consequences of these hasty purchases were sometimes painful, other times devastating. A February 1995 article in Management Today cited Ferranti's 1987 acquisition of International Signal & Control as a "classic example of neglect in this matter." The acquirer's failure to detect its target's falsification of several important pending contracts led to "the demise, liquidation, and break-up of a once highly respected British company."

The pace of mergers and acquisitions slowed in the early 1990s, only to reach record levels by the end of the decade. As the likelihood of litigation increased, acquirers became more diligent and began pursuing several categories of due diligence. Financial due diligence, a commonly investigated factor, involves analysis of fiscal soundness through research on past performance, current economic health, and management personnel. Commercial due diligence refers to the evaluation of a target's competitive position in its market. Legal due diligence, which determines the validity of the transaction, has grown increasingly important in light of globalization. Companies and investors accustomed to operating in one jurisdiction may need to consider the legal limitations of another locale as well as applicable international trade laws. Environmental due diligence grew more pertinent in the wake of the 1986 federal Superfund Amendments Reauthorization Act (SARA), which extended the definition of parties responsible for environmental remediation to include lenders, creditors, and shareholders related to the property. Both legal and environmental due diligence were hot topics in the 1990s, because either could uncover hidden, yet potentially expensive, aspects of a given transaction.

In the cases of mergers and acquisitions, due diligence is often performed internally by corporate attorneys and accountants. A due diligence team may consist of experts in government regulation, human resources, risk management, information technology, the environment, taxes and accounting, and operations.

Experienced buyers create detailed due diligence checklists, enumerating pieces of information that should be obtained or verified before a transaction can be completed. However, each company, industry, and transaction has its own unique risks and concerns. Both the proliferation of acquisitions and mergers and the increasing risk of incurring litigation have fueled the establishment of strategic research consultancies, third-party organizations that investigate and subjectively analyze potential investments throughout the business world.

An expanded, operational definition of due diligence also includes a period of self-analysis on the part of the acquiring company. The due diligence period is a time to gather information, both externally and internally, to enable the acquiring company to assess all of the risks associated with the proposed transaction. It involves not only challenging the representations made by the targeted company, but also examining the acquiring company's own understanding of the targeted company. Ultimately, due diligence will reveal whether or not an acquisition is appropriate. Due diligence has become an essential part of every company's growth strategy and can even apply to the process of identifying potential acquisition targets.