DUE DILIGENCE

Due diligence is a legal term that describes the level of care or judgment that a reasonable person would be expected to exercise in a given situation. The term finds application in a wide range of business settings, including mergers and acquisitions, occupational health and safety, environmental impact assessments, supplier and vendor relationships, asset purchase decisions, and employee hiring or promotion practices. Performing a due diligence analysis in such situations helps managers make informed decisions and reduce the risks incurred by the business. "Real due diligence analyzes and validates all the financial, commercial, operational, and strategic assumptions underpinning the decision," an analyst for Price Waterhouse Coopers told Mondaq Business Briefing. "Due diligence is a strategy to reduce the risk of failure, as well as the embarrassment of discovering what underlies spectacular success," Herrington J. Bryce added in Nonprofit Times.

In the area of workplace safety, employers have a responsibility to exercise due diligence in eliminating hazards and creating a work environment that minimizes the risk of accidents or injuries. In fact, due diligence is the legal standard used to determined whether employers can be held liable under occupational health and safety laws. Employers are generally not held liable for accidents if they can prove that they took reasonable precautions to protect workers from injury. Companies can establish due diligence by putting workplace safety policies and procedures in writing, providing appropriate training to employees, and holding managers accountable for following safety guidelines.

Due diligence also applies to the process of making investments, whether personal investments in shares of stock, corporate investments in technology, or the purchase of one company by another. In the area of mergers and acquisitions, a due diligence analysis is an important part of the process of evaluating potential investments and confirming basic information before entering into a transaction. "Quite often, a proposed merger or acquisition gets canned or valued down following conflicts over intellectual property rights, personnel, accounting discrepancies, or incompatibilities in integrating operating systems," wrote Lee Copeland in Computer World. "The process of researching, understanding and, in some cases, avoiding these risks is known as due diligence."

When a business makes a purchase offer of any kind, it is often a matter of policy to make the offer contingent on the results of a due diligence analysis. This analysis might include reviewing financial records, hiring experts to examine the assets in questions, and taking other reasonable steps to make sure that all questions are answered and expectations met. Experts suggest that sellers also perform due diligence analysis prior to entering into a transaction. Going through this process helps sellers be prepared for any questions that might arise out of the buyer's due diligence analysis, and also gives sellers a basis on which to evaluate the merits of potential purchase offers.

Although the legal concept of due diligence endured for half a century, it came under siege in the early 2000s following a spate of accounting scandals and revelations of deceit and ethical lapses by senior executives at major corporations. "The issue of due diligence arises whenever a financial transaction generates questions, such as: How could this have happened? How could this have gone undetected for so long?" Bryce noted. Rather than dismissing due diligence as an outdated concept, however, some analysts argued that such incidents underlined the importance of due diligence as way for managers to be informed about and exercise judgment over all transactions that affect the welfare of the business.

In a critique of traditional due diligence practices for Mondaq Business Briefing, Charles F. Bacon warned that traditional due diligence tends to be reactive. For example, senior management might order a due diligence analysis after making the decision to purchase a competitor. "In effect, they bought the car and now that the tires are getting kicked, they don't want to hear about the bad transmission or leaky gaskets because that would tarnish the fun of deal-making," Bacon explained. Instead, he recommended that businesses take a systemic approach to due diligence starting at the top and incorporating due diligence into all organizational decision-making. The ultimate goal is to create a culture of due diligence in which all employees are encouraged to question and explore the implications of financial and strategic decisions.