Due Diligence

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The subject of DUE DILIGENCE is related to a need for research before making important decisions. Buying a house is one of those major decisions for most people. "Due Diligence" as in-depth research is commonly known is often related to stock investments, environmental research and many other areas where it is critical to look deeply into a subject before making any decisions, especially those that involve long term financial considerations. 

You deserve to know about a potential new home in detail before the closing. A       Diligent inspection provides Insight to the property. Call 281-480-3388       for an appointment.

 

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The following is adapted from an article that appeared in the 1995/1996 edition of The OFC Reports and was written in late 1995, but these thoughts seem as valid today as when they were written.

Some Thoughts on Due Diligence

James P. Duffy, III

    A little more than a year ago, a German colleague took me to task at a meeting where my American clients were talking about the need to do "due diligence". He likened the process to an American virus that rapidly infected business world-wide. Naturally, the Americans in the room took exception. The German business people were less than enthusiastic about the process. But they felt the need for more information about the transaction they were considering. Thus, they did not support my colleague. So, it was agreed there would be some effort made at due diligence.

    My colleague was quite correct about the origin of due diligence as far as I know. The term due diligence is mainly a creature of the American securities laws. These laws impose very strict liabilities on the issuers of securities that are sold to the public and all those who assist in the process. American courts have carved out some exceptions to these liabilities in certain cases where the parties behaved responsibly and tried to meet the disclosure standards of these laws. The standard of care was called due diligence, and it quickly became a term of art. Today, its use extends far beyond underwriting transactions. It is used any time the law imposes duties of careful investigation or for private reasons, the parties to a transaction want to be as informed as reasonably possible about all of its material aspects.

    Brushing this history aside, the concept of due diligence has been with us from the very beginning of transactions between strangers. The Roman's said, "buyer beware". Others said, "know the people with whom you do business". This practical advice forms part of the general process by which reasonable business people inform themselves about the transaction they are contemplating so they may satisfy themselves, their superiors, their shareholders, or their principals that the transaction is what it appears to be. The Americans may have come up with a catchy name in "due diligence", but, contrary to what my German colleague believed, they did not invent the concept. They just popularized it.

    More recently, we have seen a new aspect of due diligence in the growth of money laundering legislation that is over taking world financial markets. Most money laundering laws have as their common feature the requirement that a financial institution must actually know its customer. This knowledge can not be superficial. It must be real knowledge of the beneficial owner of an account or the initiator of a transaction. The failure to meet this standard can give rise to criminal liability.

    Due diligence is also creeping into the pure management sphere. Whether the managers of Barings' Singapore operations will escape criminal liability will no doubt depend in large part on whether they can prove they exercised due diligence in their management of those operations, including, in the supervision of the employee operating the accounts that gave rise to the problems that brought this venerable institution to its knees. Unfortunately, this is sometimes an after the fact evaluation made by prosecutors, regulators, and courts with the full benefit of hind sight.

    Exactly what is due diligence anyway? To begin, it is basically common sense coupled with a reasonable degree of skepticism. It does not mean you can not trust anyone or rely on experts. In fact, good due diligence does both to a very great degree. However, it does mean you can not rely on the report of a colleague or an expert if you know, or have reason to believe, it is not accurate or complete in any material respect. Nor is it possible to rely on a report, even if prepared in utter good faith, that is so hastily prepared no reasonable person could have made a satisfactory investigation of the matters reported on. Similarly, you can not rely on the report of a subordinate if it is clearly beyond his or her competence to perform. Thus, due diligence requires a considerable amount of seasoned good judgment and appropriate investigation of the material elements of the transaction.

    An example might be useful to illustrate a point. In a celebrated case American securities lawyers commonly call Barchris, a major accounting firm assigned a very junior auditor to perform an extremely difficult task. Not unexpectedly, the inexperienced auditor did not measure up. The court found the firm liable to investors who were injured by the accounting firm's failure to discover serious problems with the financial statements it was auditing. To make matters worse, the junior auditor ignored or overlooked what the court considered to be very obvious warning signs. In those situations, the court concluded the accounting firm knew, or should have known, of the problems.

    In sum and substance then, due diligence charges the investigator with knowing what a reasonable, good faith investigation would have revealed under the circumstances. If this knowledge would have prompted a reasonable person to take action that was not taken due to a failure of due diligence, the investigator will ordinarily be liable to anyone injured by the failure, provided the investigator owes a legal duty to that person. Sometimes this legal duty comes about by the legal relationship of the parties, such as, an accountant or a lawyer hired specifically to make sure the transaction passes muster. Sometimes, the duty is imposed by law, such as, by the American securities laws or by money laundering laws.

    In any case, when there is a duty to exercise due diligence, and the requisite standards are not met, the liabilities can be severe. If a sizeable transaction is involved, even a small percentage diminution in value due to a failure of due diligence can lead to a claim for a large sum. While a professional can protect against this potential liability through appropriate insurance, the best protection is careful, thorough, and well documented work by people competent to perform the task at hand. When it is necessary to rely on the investigations of others who are not employees or partners of the investigator, the report should so state. Since negligent reliance on such a report will not protect against liability, the investigator should not rely on reports without a good basis for doing so.

    At the end of the day, my German colleague was just plain wrong in his feelings about due diligence. It is common sense and good business. It is really nothing new, but it is a refinement of centuries of what have become to be considered good business practices. It may be an effort to impose a higher standard on those who hold themselves out as being experts, but this is certainly not offensive when one considers the fees these experts usually expect for the exercise of their expertise. Most important, in a world where it is becoming increasingly more difficult to know the people with whom we do business and the true nature of our transactions with those people, due diligence is essential to insure integrity in our transactions. This integrity is essential to the proper functioning of business.

� December 15, 1995, James P. Duffy, III, all rights reserved

Diligent Inspections represents the interests of families purchasing homes. You need to have your property inspected before closing to safeguard your interests. The inspection report and review give you a change to have your "eyes open" in relation to the property conditions. Call (281) 480-3388 now to set up an appointment.

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