Due Diligence

Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party.

Due diligence became common practice (and a common term) in the United States with the passage of the Securities Act of 1933. With that law, securities dealers and brokers became responsible for fully disclosing material information about the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution.

The writers of the act recognized that requiring full disclosure left dealers and brokers vulnerable to unfair prosecution for failing to disclose a material fact they did not possess or could not have known at the time of sale. Thus, the act included a legal defense: as long as the dealers and brokers exercised "due diligence" when investigating the companies whose equities they were selling, and fully disclosed the results, they could not be held liable for information that was not discovered during the investigation.

Due diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies that are considering acquiring other companies. Due diligence by individual investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it. Commercial due diligence considers a company's market share and competitive positioning, including its future prospects and growth opportunities. This will consider the company's supply chain from vendors to customers, market analysis, sales pipeline, and R&D pipeline. This can also encompass a firm's overall operations, including management, human resources, and IT.

Hard due diligence is concerned with the numbers and data found on the financial statements like the balance sheet and income statement. This can entail fundamental analysis and the use of financial ratios to get a grasp on a company's financial position and make projections into the future. This type of due diligence can also identify red flags or accounting inconsistencies however, Hard due diligence, which is driven by mathematics and legalities, is susceptible to rosy interpretations by eager salespeople.

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