Role of Due Diligence in the Upcoming Scenario

We are aware of the term Due Diligence, as we are frequently coming across during our audits. But how many of us, really know what it pertains to. If u want to know its exact meaning and implications, continue reading.

Meaning of the Connotation ‘Due Diligence’

In simple words we can describe the word Due Diligence as the art or a state of mind, which we employ, while engaging in some Investigations or associated engagements.

The term was first introduced in Securities Act 1933, passed by the United States.

Consider the situation for better understanding:

In case when a Company goes for Public issue, it is customary to employ Brokers for issue of capital. Suppose the Public has subscribed the shares from the brokers thinking that the disclosure made by the brokers are accurate, in respect of the company.

In case it was found to be otherwise, the public can make responsible the brokers for providing wrong disclosures regarding the company. This is what, usually happens.

But, the climax changes if the Brokers would have employed Due Diligence.  Here the term gains significance. Now in such a case the brokers cannot be held liable for any wrong disclosures made by them, because they would have enquired about the company in the manner prescribed under Due Diligence.

Now it becomes easy to explain the term.

Considering the above example, Due Diligence can be defined as a course of action or sequential process which is to be employed by a person for studying the relevant areas and their implications before contracting with the entity or engaging in some activities.

Coverage of the Term

As referred previously as a sequential process, it may differ, depending upon the significance and requirements of the work involved. The process will differ from entity to entity, engagement to engagement, but the basic idea behind it will remain the same.

When it relates to a corporate, it pertains to all the components of the corporate.

For ex- it may include Financial aspects, Regulatory aspects, Legal aspects, Taxation environment, Insurance and other labour welfares, Intellectual property, Personal properties, immigrations, international transactions, etc, which are being carried out by the entity previously or presently. It is mainly used with the prime motive of pre-looking at different segments of the business, before contracting with the segments.

As a Tool to unearth Corrupt practices

It is very useful in discovering the corrupt practices performed within the entity as such. When a person wants to   carry out the process of Due Diligence, he should follow the following rules:

Initial Due Diligence

    This is the first and Foremost step while stepping into the process. In this step, the person who is going to contract with the entity assesses the overall risk involved in the business of the entity. This step the following steps:

§         Assessing the risk involved, in the entity’s business if the Contract is made.

§         Evaluating its impact on the other services provided by the entity.

§         Connect the Business risk with the market risks to know the degree of unavoidability of risk involved.

§         Finding measures to simplify the risk involved and take decisions accordingly.

These steps should be carried out before establishing a relationship with the entity.

i.e. it should be done by a prospective contractor and not after   establishing a relationship with the entity.

Continuing Due Diligence

      This is a secondary and a continuing step towards the performance of the entity. After establishing the relation with the entity, the person still carries on his investigations to find out any unfair means carried on within the entity.

§         Evaluating periodically the entity’s relationship with the Foreign entities, in the ordinary course of business and unusual transactions.

§         Discovering any illicit or unfair activities out during the course of business and finding corrective measures.

These are the investigative measures to be carried out as long as the relationship exists between the person and the entity.

Situations demanding its use

1)      A Broker or an issue house acting as an intermediary in public subscription of shares of a Corporate.

2)      A supplier or a distributor going to contract with the company.

3)      A Financial Institution while granting loans to a corporate.

4)      Persons involving themselves in purchasing or selling a property, land, or any other Commercial property needs to conduct Commercial Due Diligence.

5)      Auditors involved in certain audits.

Factors to be considered by a Prospective Investor before investor

It is a roadmap for existing and prospective investors in understanding whether a specific fund will meet his or her investment horizon, risk tolerance and investment strategy.

He must do some homework before investing:

1.      Consider and evaluate the entity’s past performance in the past years.

2.      Request the certification from professional in cases, when found necessary.

3.      Read the Prospectus carefully and the memorandum issued.

4.      Understand the market risks involved.

5.      Consider the Financial statements of the entity to find out whether any defaults regarding repayment have been made by the entity.

6.      Check out whether the compliances have been made as per the regulatory requirements.

Due Diligence as a Defense

Can, the concept of Due Diligence be raised as defense in litigations?

The answer is, yes.

Both in Civil and Criminal Law, it can be raised as a point of Defense.

In cases of litigations arising due to the professional negligence, which was a strict liability, the defensee can very well raise the concept of Due Diligence.

Consider the initial example:

Case

Suppose, after investing in the shares of a corporate, the public found that, there was some misstatements or wrong disclosures made by the brokers, and they go for a suit against them for the same.

When such a plea is raised against them, we discussed that the brokers cannot be held liable, if they have employed Due Diligence. Now we will see how the brokers can escape.

Fact

There is a strict liability on the part of the brokers to disclose all material facts and not to misrepresent any facts, particularly when engaged in public dealings. So it’s a strict liability on their part to ensure everything is in public interest. For ensuring it, they must take all necessary steps, which a professional should take, while dealing with public money. They should take all reasonable precautions to prevent the illicit act from being committed. It is not sufficient that they have taken normal standards of care to prevent it, from a layman’s view. They should take the precautions from a professional’s view point.

Conclusion of the Case

Here if the brokers are able to prove that beyond doubt, they have done everything possible to find anything illegal and to prevent the act from being committed, then it adds in their favour in the court of law.

In the present scenario, Due Diligence achieves a lot of significance, as lot of frauds are committed. Here we cannot survive unless some investigations and disclosures are carried out for engagements. So if the professionals make use of these tools in their entirety, so as to reduce the susceptibility of the errors and frauds, then it would be much more easier for the public to rely upon things. Thus Due Diligence plays a very significant role in the emerging economy.