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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 Standard may refer to: Flags * Colours, standards and guidons * Standard (flag) In heraldry Heraldry () is a broad term, encompassing the design, display and study of armorial bearings (known as armory), as well as related disciplines, such ...
. 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 an
acquisition Acquisition may refer to: * Takeover, the purchase of one company by another * Mergers and acquisitions, transactions in which the ownership of companies or their operating units are transferred or consolidated with other entities * Procurement, fi ...
. 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.


Etymology

The term “due diligence” means "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. It became a specialized legal term and later a common business term due to the United States’
Securities Act of 1933 The Securities Act of 1933, also known as the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, and the '33 Act, was enacted by the United States Congress The United States Congress is the legislature ...
, where the process is called "reasonable investigation" (section 11b3). This Act included a defense at Section 11, referred to later in legal usage as the “due diligence” defense, which could be used by
broker-dealerIn financial services Financial services are the economic services provided by the finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation a ...
s when accused of inadequate disclosure to investors of
material information A material is a matter, substance or mixture of substances that constitutes an object. Materials can be pure or impure, living or non-living matter. Materials can be classified based on their physical property, physical and chemical property, che ...
with respect to the purchase of
securities A security is a tradable financial asset A financial asset is a non-physical asset In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or i ...
. 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 Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the differe ...

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. Originally the term was limited to public offerings of equity investments, but over time it has become associated with investigations of private mergers and acquisitions as well.


Examples


Business transactions and corporate finance

Due diligence takes different forms depending on its purpose: # The examination of a potential target for merger, acquisition, privatization, or similar corporate finance transaction normally by a buyer. (This can include self due diligence or “reverse due diligence”, i.e. an assessment of a company, usually by a third party on behalf of the company, prior to taking the company to market.) # A reasonable investigation focusing on material future matters. # An examination being achieved by asking certain key questions, including, how do we buy, how do we structure an acquisition, and
how much do we pay
how much do we pay
? # An investigation of current practices of process and policies. # An examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The due diligence process (framework) can be divided into nine distinct areas: # Compatibility audit. # Financial audit. # Macro-environment audit. # Legal/environmental audit. # Marketing audit. # Production audit. # Management audit. # Information systems audit. # Reconciliation audit. 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. In this regard, two new audit areas have been incorporated into the Due Diligence framework: * 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. 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 The Affordable Care Act (ACA), formally known as the Patient Protection and Affordable Care Act, and colloquially known as Obamacare, is a United States U.S. federal law, federal statute enacted by the 111th United States Congress and signed i ...
) and labor matters, immigration, and international transactions. Areas of focus in due diligence continue to develop with
cybersecurity Computer security, cybersecurity, or information technology security (IT security) is the protection of computer system A computer is a machine that can be programmed to carry out Sequence, sequences of arithmetic or logical operations a ...

cybersecurity
emerging as an area of concern for business acquirers. Due diligence findings impact a number of aspects of the transaction including the purchase price, the representations and warranties negotiated in the transaction agreement, and the
indemnification Indemnity is a contractual obligation of one party (indemnifier) to compensate the loss incurred to the other party (indemnity holder) due to the acts of the indemnitor or any other party. The duty to indemnify is usually, but not always, coextensi ...
provided by the sellers. Due Diligence has emerged as a separate profession for accounting and auditing experts and is typically referred to as Transaction Services.


Foreign Corrupt Practices Act

With the number and size of penalties increasing, the United States'
Foreign Corrupt Practices Act The Foreign Corrupt Practices Act of 1977 (FCPA) (, ''et seq.'') is a United States federal law The law of the United States comprises many levels of codified and uncodified forms of law, of which the most important is the nation's Constituti ...
(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: # 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. # 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 and is often part of a wider Integrity Management initiative . 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. 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 The Organisation for Economic Co-operation and Development (OECD; french: Organisation de Coopération et de Développement Économiques, OCDE) is an intergovernmental economic organisation with 38 member countries, founded in 1961 to st ...

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”. The term was originally put forth by UN Special Representative for Human Rights and Business
John Ruggie John Gerard Ruggie (born October 18, 1944) is the Berthold Beitz Professor in Human Rights Human rights are moral principles or normsJames Nickel, with assistance from Thomas Pogge, M.B.E. Smith, and Leif Wenar, 13 December 2013, Stanford ...
, 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, 2011, with the endorsement of Ruggie's Guiding Principles for Business and Human Rights.


Civil litigation

Due diligence in civil procedure is the idea that reasonable investigation is necessary before certain kinds of
relief Relief is a sculptural technique where the sculpted elements remain attached to a solid background of the same material. The term ''wikt:relief, relief'' is from the Latin verb ''relevo'', to raise. To create a sculpture in relief is to give the ...
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 Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debto ...

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 prerequisite 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 A statute of limitations, known in civil law (legal system), civil law systems as a prescriptive period, is a law passed by a legislature, legislative body to set the maximum time after an event within which legal proceedings may be initiated. In t ...
. 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 knowledgeIn law, knowledge is one of the degrees of ''mens rea'' that constitute part of a crime. For example, in English law, the offense of knowingly being a passenger in a vehicle taken without consent (TWOC) requires that the prosecution Legal burden of p ...
, 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.


Criminal law

In
criminal law Criminal law is the body of law Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its environ ...
, due diligence is the only available defense to a crime that is one of
strict liability In criminal law, criminal and Civil law (common law), civil law, strict liability is a standard of Public liability, liability under which a person is legally responsible for the consequences flowing from an activity even in the absence of Tort, ...
(i.e., a crime that only requires an
actus reus ''Actus reus'' (), sometimes called the Element (criminal law), external element or the objective element of a crime, is the Latin term for the "guilty act" which, when proved beyond a reasonable doubt in combination with the ''mens rea'', "guilt ...
and no
mens rea ''Mens rea'' (; Law LatinLaw Latin, sometimes written L.L. or L. Lat., and sometimes derisively called Dog Latin Dog Latin, also known as Cod Latin, macaronic Latin, mock Latin, or Canis Latinicus, refers to the creation of a phrase In everyd ...
). Once the criminal offence is proven, the defendant must prove on balance 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 Exculpatory evidence is evidence Evidence for a proposition is what supports this proposition. It is usually understood as an indication that the supported proposition is true. What role evidence plays and how it is conceived varies from field t ...
, to (accused) criminal defendants. In criminal law, “due diligence” also identifies the standard a prosecuting entity must satisfy in pursuing an action against a defendant, especially with regard to the provision of the Federal and State Constitutional and statutory right to a speedy trial or to have a warrant or detainer served in an action. In cases where a defendant is in any type of custodial situation where their freedom is constrained, it is solely the prosecuting entities duty to ensure the provision of such rights and present the citizen before the court with jurisdiction. This also applies where the respective judicial system and/or prosecuting entity has current address or contact information on the named party and said party has made no attempt to evade notice of the prosecution of the action.


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 e.g. under the Timber and Timber Products (Placing on the Market) Regulations 2013 and the Environmental Protection (Microbeads) (England) Regulations 2017,Environmental Protection (Microbeads) (England) Regulations 2017, SI 1312/2017
/ref> 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.


See also

* Bias ratio (finance) * , *
Duty of care In tort law A tort, in common law jurisdiction, is a civil wrong (other than breach of contract) that causes a claimant to suffer loss or harm, resulting in legal liability for the person who commits the tortious act. It can include intenti ...
*
Hydropower Sustainability Assessment Protocol The Hydropower Sustainability Assessment Protocol (HSAP) is a global framework for assessing the sustainability of hydropower Hydropower (from el, ὕδωρ, "water"), also known as water power, is the use of falling or fast-running water to ...
* Integrity management * Management due diligence * Model audit *
Non-disclosure agreement#REDIRECT Non-disclosure agreement A non-disclosure agreement (NDA), also known as a confidentiality agreement (CA), confidential disclosure agreement (CDA), proprietary information agreement (PIA) or secrecy agreement (SA), is a legal contract o ...
* Operational due diligence (ODD) *
Standard of care Standard may refer to: Flags * Colours, standards and guidons * Standard (flag) In heraldry Heraldry () is a broad term, encompassing the design, display and study of armorial bearings (known as armory), as well as related disciplines, such ...
*
Vetting Vetting is the process of performing a background check A background check is a process a person or company uses to verify that an individual is who they claim to be, and this provides an opportunity to check and confirm the validity of someone's ...


References

{{DEFAULTSORT:Due Diligence Corporate finance
American legal terminologyThis category is intended for legal Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its environme ...
Criminal law {{CatAutoTOC Public law Common law, Criminal law Law by issue, Criminal law Criminal justice, Law Law by type ...
Contract law Business terms Mergers and acquisitions