Due diligence

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.

Due diligence can be a legal obligation, but the term more commonly applies to voluntary investigations. It may also offer a defence against legal action. A common example of due diligence is the process through which a potential acquirer evaluates a target company or its assets in advance of a merger or acquisition. 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.

The term "due diligence" can be read as "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, where the process is called "reasonable investigation". Under Section 11b3, a person could avoid liability for an untrue statement of a material fact if they had, "after reasonable investigation, reasonable ground to believe and did believe, at the time", the truth of the statement. The defense at Section 11, referred to later in legal usage as the "due diligence" defense, could be used by broker-dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities. 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 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,^[when?] 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 (M&A) as well.

Due diligence takes different forms depending on its purpose:

A due diligence process can be divided into nine distinct areas:

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.