the risk management blog

Due Diligence as a Way of Life

The phrase “Due diligence” sounds complicated but in reality, it is simply the process of doing your homework before you make a major commitment, either on a business or personal level.  Due diligence can be as simple as just asking the proper questions and making sure that a situation is “not too good to be true.”  This idea of checking into the facts behind a transaction to ensure it is fairly valued is the source of the old adage, “let the buyer beware.”[i]

Most of us practice due diligence even though we may not think of it that way.  For example, most people these days will do some research on the internet before making a major purchase, like buying a car.  We scan websites to get an idea of a fair price, the dealer cost, and any low interest financing deals so we can be prepared to counter the ”rock bottom price” offered by the car salesman.   In this process, we are doing our “due diligence” to get the best deal possible.

Due Diligence as a Defense

There are important legal uses of the term “due diligence.”  It began as a term describing a legal defense in the Securities Act of 1933.  Its purpose in that Act was to give broker-dealers a defense against an accusation that they had not disclosed information in a securities transaction.  If they had performed “due diligence” in researching the company, they could not be held liable for information they did not discover.[ii]

The term has now been applied to a large number of mostly business and corporate finance-related transactions.  For example, a due diligence investigation would be conducted by a company seeking to acquire another company. This kind of investigation would likely include audits by licensed professionals of the following areas:  compatibility of business operations; financial operations; legal and regulatory affairs; marketing operations; production facilities; management personnel; information systems operations and security; and financial reconciliation.[iii]

In these applications, due diligence has a defensive character.  The reason to perform it is to avoid an adverse outcome of some kind, most often a financial loss in a transaction.  However, as the concept has become better known, people have begun to use due diligence in many contexts, including issues in their personal lives, like relationships and jobs.  You do your due diligence to “avoid being taken.”

Bernie Madoff and the Evasion of Due Diligence

Nobody offers a better reason why you should be doing due diligence on your personal and financial affairs than Bernie Madoff.  Admittedly, he is a rare case! But the lesson his example gives is that unscrupulous actors, or even just incompetent ones, throw up barriers to your discovering the facts behind a transaction.  You need to be diligent in performing your due diligence.

Once upon a time Bernie Madoff thrilled investors.  He was making returns for them in the range of seven to ten percent per year when average investment returns were in the three to five percent range.   This “too good to be true” fairy tale ended abruptly on March 12, 2008 when Mr. Madoff pled guilty to running a massive Ponzi scheme that cost his investors more than $50 billion in losses.[iv]  Many of the investors were wealthy individuals, but huge losses were incurred by corporate investment advisors and mutual funds who failed to conduct a proper due diligence of Mr. Madoff’s operations.

The failure to conduct such a review was even more surprising because there were numerous “red flags” that should have alerted investors that there were potentially serious problems with Mr. Madoff.  Yet the lure of doubling their rate of return allowed even these expert investors to blind themselves to troubling practices.  Investors allowed Mr. Madoff to:

• provide trade confirmations three to five days after trades were made rather than daily as promised;
• use weighted averages rather than individual trade prices on trade tickets for securities claimed to have been bought or sold;
• use a small auditing firm with dubious ability to audit a $65 billion fund; and
• permit Madoff’s relatives to hold senior positions in the firm.

These are just a few of the approximately twenty red flags that were detailed in later court cases.[v]   The age old hope to get a better deal than anyone else cost investors $50 billion.  You have to do your best to get the real truth of the matter—and then believe it.  The deal may actually be “too good to be true.”

Due Diligence in Everyday Transactions

On a personal level, it is important to conduct your “due diligence” whenever you are going to commit your hard earned money or time to an endeavor.  One of the most significant financial outlays any of us will make is the purchase of a home.  Proper due diligence in this case should be proportionate to the long-term financial commitment involved, and to your specific status.

Most buyers would look at property taxes and title, and want a housing inspector to help avoid incurring expensive repairs from hidden defects.  A family with children may want to check out the rating of the schools in the area for themselves, but also because good schools make the house a better resale.  One of my friends actually did “due diligence” on the neighbors on either side of a home he wanted to buy.   He wanted to make sure they were “good folks.”

Another personal area to conduct due diligence involves a new job offer. Before you accept that job offer and move to a new location, you might want to check to see if the new company is financially stable.  What about the new industry you will be working in?  Does it have a favorable forecast for the future?  And then what about any employee benefits that you may have or want to negotiate prior to being hired?  All of these areas involve a significant amount of due diligence on your part prior to accepting a new position at a new company.

Due Diligence Makes Trust Possible

In closing, make sure you do your own “due diligence” in situations where you are being called upon to trust someone else.  Question everyone before you hand your hard earned money to someone to “invest.”  Always follow up on references provided and go outside of the provided reference pool to make certain you are dealing with a legitimate entity.  Make sure you check professional licenses and industry disciplinary actions.  Lastly, apply what one of my old law professors called “the smell test.”  If the “deal” initially smells bad to you, it probably is.