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Due diligence is the process of systematically researching and verifying the accuracy of a statement.
The term originated in the business world, where due diligence is required to validate financial statements. The goal of the process is to ensure that all stakeholders associated with a financial endeavour have the information they need to assess risk accurately.
When due diligence involves the offering of securities for purchase, as in an IPO (initial public offering), specific corporate officers are responsible for the proper completion of the process, including the issuer, issuer’s counsel, underwriters, CFO and the brokerage firm offering shares. Because of the delicate nature and importance of such judgments to the prospects for the performance of a company’s equities in the public market, there is a strong emphasis on neutral, unbiased analysis of both the current financial state and future prospects of the firm in question.
An individual investor performs due diligence by studying annual reports, Securities and Exchange (SEC) filings and other relevant information about a business and its securities. An investor verifies the material facts related to purchasing the investment and determines whether it fits his return requirements, risk tolerance, income needs and asset allocation goals. For example, an investor may read the company’s last two annual reports, several recent 10-Q’s and any independent research available. He can then develop a sense of where the business is heading, what market factors may affect the stock’s price and how volatile the stock is. The investor then has guidance on whether the investment is right for him, and how much and when to purchase it.
Due diligence came into being when the U.S. Securities Act of 1933 was passed. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose material information made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting the dealers and brokers, the Act included a legal defence stating as long as the dealers and brokers exercised due diligence when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.
Due diligence in merger and acquisition (M&A) transactions may take several months of intense analysis, especially when the target firm is a large business with a global presence. The buyer wants to ensure it knows what it is buying, what obligations it is assuming and the nature and extent of the target company’s contingent liabilities. The buyer also must be aware of problematic contracts, litigation risks, intellectual property issues and more. This is especially true in private company acquisitions, where the target business has not been scrutinized in the public markets and the buyer has little means of obtaining pertinent information from public sources.