Due Diligence: An Ongoing Concern30 October 2011 by Dr Linda Spedding
Dr. Linda Spedding LL.B. (Hons), LL.M., Ph.D has over 27 years experience of legal practice in national, European and international law. Dr. Spedding is one of very few lawyers who has qualified in three jurisdictions: she is qualified as a Solicitor in England & Wales (1975), an Attorney in the USA (1985) and is also Advocate in India (1989). Based in London, she specialises as an independent international legal and business adviser. In addition, Dr. Spedding is regarded highly as an author and speaker. Her published works, including the Due Diligence Handbook and the Risk Management Handbook are referred to at www.lindaspedding.co.uk and she can be contacted at linda@spedding.org regarding the availability of her publications and more generally. She is also Special International Adviser at ADDP.
linda@spedding.org
Opening RemarksTimes and business priorities are changing at a rapid pace: no longer do organisations aspire to profit for shareholders alone – they are increasingly answerable to other stakeholders. As a result of regulatory and media pressure, in particular transparency, openness and fair play are needed to be successful and sustainable in business. While traditional concepts still exist and are referred to in this article, new meanings are also developing. It is a constant evolutionary process which few organizations can avoid, regardless of size, sector or location. As the media stories demonstrate so vividly decisions are what modern business is all about:
In today’s business world the concepts of due diligence and corporate governance are increasingly important. Both have developed in terms of their scope and meaning. Indeed their application has also come to overlap as a result of the regulatory and voluntary frameworks that are emerging globally. From purely economic roots they have come to encompass many aspects of corporate behaviour. Moreover in view of the corporate stories and scandals that continue to attract media headlines and to demonstrate the need for improved corporate governance in so many parts of the World all organisations – regardless of their size or location – should regard these issues as paramount. An understanding and respect for due diligence and corporate governance make absolute business sense.
Definition of Due DiligenceTraditionally due diligence has involved a process of discovery that is relevant in key business transactions, as well as operational activities. As is seen in more detail below due diligence has become the norm in decision making as regards:
Other business issues
At this stage it is useful to bear in mind the due diligence exercise in the context of other business issues and the general objective to understand the:
The mission of any due diligence exercise starts with verification of the company goals. The goals have to be prepared and be able to be articulated. A statement such as: ‘we want to compete in the bicycle market’ is much too vague and does not provide any support for people who are trying to implement a business plan. Clarity and specificity is much better than vague assumptions and generalities if the business goals are to be understood and achieved. Another important reason for clarity is to enable the due diligence team to be able to recognise when the business is heading off course and when the company is moving ahead – the objective is not to find reasons and justifications to keep going. While there are always exceptions to every procedure, the more business operations are guided by consistent principles, the easier it is to identify the exceptions and determine whether this time such an exception is justified or not. With enough exceptions, a company’s operations handbook needs to be adjusted to embrace this exception as it is now a standard procedure, not an exception.
There are several key objectives for company operations to support a due diligence environment. Ongoing due diligence demonstrates:
Some consideration has been given above to the drivers for the due diligence process mainly in the context of transactions. Mention has also been made of the growing importance of ongoing internal due diligence that supports the corporate culture and good corporate governance positively. In view of reported concerns raised by the high failure integration rate often witnessed in M&A transactions it is useful to consider some of the highlights of the business drivers.
External drivers
External drivers include:
Internal drivers
These include:
Practical issues
In the context of this discussion, practical examples of combining internal and external activities are joint deals, transactions, joint ventures and other relationships. For this work due diligence is actually two-sided. Each company within the relationship will have due diligence to perform:
Bearing in mind the importance of the quality of data, the key is to have each due diligence team determine the level of exposure based on what can or can not be answered. Many deals or negotiations never get past due diligence because there is not enough documentation about the company’s operations. The deal can be filled with risk as there cannot be a total investigation just as there is never a complete investigation of the medical, emotional, financial history for each party to a marriage. There has to be a balance that is part of the risk reward formula for all due diligence activities. For example, in the case of a £50 m deal, not being able to verify a £1,000 transaction may not be worth the thousands that it takes to validate the transaction.
This is where the experience and capability of the due diligence team is essential.
First, they have to possess training and expertise to be able to recognise the important and the unimportant. Second, they need to have the appropriate tools necessary to perform their tasks. The tools can include, but not be limited to:
Other due diligence driversThere are other drivers for the due diligence process that exist and should be mentioned by way of a summary. They are described below.
Macro and micro issues
The company operations have to be able to feed appropriate data into the due diligence mixing bowl. Macro issues include the larger pictures, especially those issues that the company has absolutely no control over. For example, the global economy, global politics and global terrorism are examples of very real issues that have to be monitored with appropriate plans in place and ready to be implemented, the moment that a due diligence alert has been sounded.
If country one, which is a buyer of your goods and services, has a major weather related disaster, a number of events may be triggered. All sales to that country may be suspended, employees may not be reachable or worse, an inventory already in place may be destroyed. Due diligence efforts can include monitoring possible disasters, and if predictable, taking precautions in the days leading up to the event. Another part of due diligence is understanding the potential of such risks occurring and establishing procedures way in advance of any possible catastrophe that has a full set of operational procedures of what to do. The quality control needed by senior management is to verify that such procedures are in place and employees have been alerted and trained.
The interaction with risk management and corporate governance
Risk is the dealing with the unknown. It requires making decisions without all of the facts that are absolutely required to determine the outcome. By way of example, horse racing as a sport provides the gambler with a chance to exercise risk decision making. He can establish all he can about the horse, speed of the track, weather conditions, etc and then make a bet on who he or she thinks will win, place or show. In business, of course, responsible players have to reduce the gambling aspect and lower the risk of being wrong.
Due diligence methods can also monitor situations that can be a level of risk. Airlines know that bad weather can be a risk to any plane. Consequently, it is essential for all aviation personnel be provided with all data about weather between where they are and where they are going. In this way the risk of being hit by lightning, or worse, can be reduced to a manageable procedure. Airline pilots quite frequently request permission from ground controllers to change their altitude to avoid endangering the plane, passengers and people on the ground. The pilots and ground controllers are trained to be diligent about the risk that can lie ahead. In this example, the passengers are merely freight and along for the ride.
Transactional and operational assessmentsTransaction auditing is a well-known component of the auditor’s world. In this activity, the auditor, internal or external, selects some number of transactions to determine their accuracy with the company’s entire processing cycle. For due diligence, it is also essential to be able to identify specific operational transactions – financial or business. For example, if a patent application requires a series of steps then it is essential that each step be documented so that the work can be proven as being completed.
Operational assessments refer to how the company conducts its business. Planning or zoning requirements vary by country and region. International transportation of goods and services has different regulations and requirements than national business activities. The due diligence team is required to be able to access all that encompasses the business – before, during and after a specific business transaction.
Globalisation and stakeholder issuesAs has been touched upon above, globalisation is also a potential mine field filled with places that require guidance and careful management. In some respects the due diligence exercise starts with the knowledge of the company’s desire to do business within another country. The due diligence team takes over to establish the legal, financial and government regulations that need to be understood. Then procedures can be implemented to make sure that company actions fall within the required guidelines. In this case, it is an absolute requirement to perform due diligence prior to commencing any business activity. It would certainly be expensive, in terms of both time and money, to perform due diligence after the fact and reference should be made to the issues that cover the international dimension of due diligence and corporate governance. It should be noted that with the trend in most jurisdictions is for ever-increasing pressure from regulators, security exchanges, and stakeholders there are a growing number of beneficiaries of the due diligence process. When the parties are establishing the methodologies for the due diligence tasks it is important that the user of this information is considered. For example in many places, if a government regulator, there are specific forms and formats for data to be presented. It will be very frustrating and more expensive to have to recast the information multiple times just to conform to the regulator’s penchant for specificity.
Shareholders, investors, and stakeholders can be satisfied with accurate and timely information but generally more concerned with the overview or bottom line. In fact, most would prefer simpler rather than complex information. They may be making decisions about company compliance with a specific regulation, but they are also concerned with understanding the company’s ability to survive and prosper.
It is important to ensure that employees are not forgotten in this process. In many jurisdictions, clerks, middle managers, management and all other related individuals who receive compensation from the company enjoy hearing about the company. Due diligence can include preparation of reports, without violating the rules of privacy and government regulations.
Closing RemarksDue diligence is increasingly becoming a vital component of doing business and should be approached as a key ongoing tool that can serve well the interests of the organizations in many ways.
Due Diligence: An Ongoing Concern Concern by Dr Linda S Spedding ©
Dr. Linda Spedding LL.B. (Hons), LL.M., Ph.D has over 27 years experience of legal practice in national, European and international law. Dr. Spedding is one of very few lawyers who has qualified in three jurisdictions: she is qualified as a Solicitor in England & Wales (1975), an Attorney in the USA (1985) and is also Advocate in India (1989). Based in London, she specialises as an independent international legal and business adviser. In addition, Dr. Spedding is regarded highly as an author and speaker. Her published works, including the Due Diligence Handbook and the Risk Management Handbook are referred to at www.lindaspedding.co.uk and she can be contacted at linda@spedding.org regarding the availability of her publications and more generally. She is also Special International Adviser at ADDP.
linda@spedding.org
Opening RemarksTimes and business priorities are changing at a rapid pace: no longer do organisations aspire to profit for shareholders alone – they are increasingly answerable to other stakeholders. As a result of regulatory and media pressure, in particular transparency, openness and fair play are needed to be successful and sustainable in business. While traditional concepts still exist and are referred to in this article, new meanings are also developing. It is a constant evolutionary process which few organizations can avoid, regardless of size, sector or location. As the media stories demonstrate so vividly decisions are what modern business is all about:
- What sector to operate in?
- Where to operate?
- What type of organisation to establish?
- Who to select as partners?
- Is a merger wise?
- Would litigation be cost-effective?
- Is dissolution necessary?
- maximize profits;
- increase productivity;
- expand distribution channels;
- gain capital capacity;
- extend market reach;
- improve cost efficiency;
- acquire technology;
- make management look better;
- reduce risks;
- aid diversification; and
- control market strategy.
In today’s business world the concepts of due diligence and corporate governance are increasingly important. Both have developed in terms of their scope and meaning. Indeed their application has also come to overlap as a result of the regulatory and voluntary frameworks that are emerging globally. From purely economic roots they have come to encompass many aspects of corporate behaviour. Moreover in view of the corporate stories and scandals that continue to attract media headlines and to demonstrate the need for improved corporate governance in so many parts of the World all organisations – regardless of their size or location – should regard these issues as paramount. An understanding and respect for due diligence and corporate governance make absolute business sense.
Definition of Due DiligenceTraditionally due diligence has involved a process of discovery that is relevant in key business transactions, as well as operational activities. As is seen in more detail below due diligence has become the norm in decision making as regards:
- Joint Ventures
- Mergers and Acquisitions
- Selecting appropriate partners
- Choosing the right jurisdiction or location
- Buying and Selling Assets.
Other business issues
At this stage it is useful to bear in mind the due diligence exercise in the context of other business issues and the general objective to understand the:
- risks and rewards of due diligence;
- repercussions of the analysis; and
- interaction with risk management and corporate governance.
The mission of any due diligence exercise starts with verification of the company goals. The goals have to be prepared and be able to be articulated. A statement such as: ‘we want to compete in the bicycle market’ is much too vague and does not provide any support for people who are trying to implement a business plan. Clarity and specificity is much better than vague assumptions and generalities if the business goals are to be understood and achieved. Another important reason for clarity is to enable the due diligence team to be able to recognise when the business is heading off course and when the company is moving ahead – the objective is not to find reasons and justifications to keep going. While there are always exceptions to every procedure, the more business operations are guided by consistent principles, the easier it is to identify the exceptions and determine whether this time such an exception is justified or not. With enough exceptions, a company’s operations handbook needs to be adjusted to embrace this exception as it is now a standard procedure, not an exception.
There are several key objectives for company operations to support a due diligence environment. Ongoing due diligence demonstrates:
- the company business capabilities;
- the stability of the company, the industry and the overall economy;
- the revenue and expense flows for business operations;
- company support methods;
- risks – business, personnel, economy, environment;
- a clear strengths and weaknesses assessment of the company; and
- specific business continuity issues.
- sustain profitability;
- reduce risk to the company;
- achieve business goals and objectives; and
- improve quality of the business and its life.
Some consideration has been given above to the drivers for the due diligence process mainly in the context of transactions. Mention has also been made of the growing importance of ongoing internal due diligence that supports the corporate culture and good corporate governance positively. In view of reported concerns raised by the high failure integration rate often witnessed in M&A transactions it is useful to consider some of the highlights of the business drivers.
External drivers
External drivers include:
- regulatory issues;
- company standards;
- corporate governance issues and trends;
- investor/lender/stakeholder confidence;
- consumer confidence;
- consumer satisfaction; and
- government compliance issues.
Internal drivers
These include:
- employee satisfaction;
- management satisfaction;
- supplier relationships;
- operational procedures;
- operational implementation; and
- multi-office relationships.
Practical issues
In the context of this discussion, practical examples of combining internal and external activities are joint deals, transactions, joint ventures and other relationships. For this work due diligence is actually two-sided. Each company within the relationship will have due diligence to perform:
- company one will want to investigate and examine company two and vice versa; and
- company two will need to assess company one.
Bearing in mind the importance of the quality of data, the key is to have each due diligence team determine the level of exposure based on what can or can not be answered. Many deals or negotiations never get past due diligence because there is not enough documentation about the company’s operations. The deal can be filled with risk as there cannot be a total investigation just as there is never a complete investigation of the medical, emotional, financial history for each party to a marriage. There has to be a balance that is part of the risk reward formula for all due diligence activities. For example, in the case of a £50 m deal, not being able to verify a £1,000 transaction may not be worth the thousands that it takes to validate the transaction.
This is where the experience and capability of the due diligence team is essential.
First, they have to possess training and expertise to be able to recognise the important and the unimportant. Second, they need to have the appropriate tools necessary to perform their tasks. The tools can include, but not be limited to:
- internet research capability;
- legal data bases – especially for lawyers;
- tax data bases – especially for accountants and lawyers;
- industry perspective and data;
- access to company personnel;
- access to all relevant regulations – securities, government, environment, etc; and
- appropriate computer and resource tools that support this work.
Other due diligence driversThere are other drivers for the due diligence process that exist and should be mentioned by way of a summary. They are described below.
Macro and micro issues
The company operations have to be able to feed appropriate data into the due diligence mixing bowl. Macro issues include the larger pictures, especially those issues that the company has absolutely no control over. For example, the global economy, global politics and global terrorism are examples of very real issues that have to be monitored with appropriate plans in place and ready to be implemented, the moment that a due diligence alert has been sounded.
If country one, which is a buyer of your goods and services, has a major weather related disaster, a number of events may be triggered. All sales to that country may be suspended, employees may not be reachable or worse, an inventory already in place may be destroyed. Due diligence efforts can include monitoring possible disasters, and if predictable, taking precautions in the days leading up to the event. Another part of due diligence is understanding the potential of such risks occurring and establishing procedures way in advance of any possible catastrophe that has a full set of operational procedures of what to do. The quality control needed by senior management is to verify that such procedures are in place and employees have been alerted and trained.
The interaction with risk management and corporate governance
Risk is the dealing with the unknown. It requires making decisions without all of the facts that are absolutely required to determine the outcome. By way of example, horse racing as a sport provides the gambler with a chance to exercise risk decision making. He can establish all he can about the horse, speed of the track, weather conditions, etc and then make a bet on who he or she thinks will win, place or show. In business, of course, responsible players have to reduce the gambling aspect and lower the risk of being wrong.
Due diligence methods can also monitor situations that can be a level of risk. Airlines know that bad weather can be a risk to any plane. Consequently, it is essential for all aviation personnel be provided with all data about weather between where they are and where they are going. In this way the risk of being hit by lightning, or worse, can be reduced to a manageable procedure. Airline pilots quite frequently request permission from ground controllers to change their altitude to avoid endangering the plane, passengers and people on the ground. The pilots and ground controllers are trained to be diligent about the risk that can lie ahead. In this example, the passengers are merely freight and along for the ride.
Transactional and operational assessmentsTransaction auditing is a well-known component of the auditor’s world. In this activity, the auditor, internal or external, selects some number of transactions to determine their accuracy with the company’s entire processing cycle. For due diligence, it is also essential to be able to identify specific operational transactions – financial or business. For example, if a patent application requires a series of steps then it is essential that each step be documented so that the work can be proven as being completed.
Operational assessments refer to how the company conducts its business. Planning or zoning requirements vary by country and region. International transportation of goods and services has different regulations and requirements than national business activities. The due diligence team is required to be able to access all that encompasses the business – before, during and after a specific business transaction.
Globalisation and stakeholder issuesAs has been touched upon above, globalisation is also a potential mine field filled with places that require guidance and careful management. In some respects the due diligence exercise starts with the knowledge of the company’s desire to do business within another country. The due diligence team takes over to establish the legal, financial and government regulations that need to be understood. Then procedures can be implemented to make sure that company actions fall within the required guidelines. In this case, it is an absolute requirement to perform due diligence prior to commencing any business activity. It would certainly be expensive, in terms of both time and money, to perform due diligence after the fact and reference should be made to the issues that cover the international dimension of due diligence and corporate governance. It should be noted that with the trend in most jurisdictions is for ever-increasing pressure from regulators, security exchanges, and stakeholders there are a growing number of beneficiaries of the due diligence process. When the parties are establishing the methodologies for the due diligence tasks it is important that the user of this information is considered. For example in many places, if a government regulator, there are specific forms and formats for data to be presented. It will be very frustrating and more expensive to have to recast the information multiple times just to conform to the regulator’s penchant for specificity.
Shareholders, investors, and stakeholders can be satisfied with accurate and timely information but generally more concerned with the overview or bottom line. In fact, most would prefer simpler rather than complex information. They may be making decisions about company compliance with a specific regulation, but they are also concerned with understanding the company’s ability to survive and prosper.
It is important to ensure that employees are not forgotten in this process. In many jurisdictions, clerks, middle managers, management and all other related individuals who receive compensation from the company enjoy hearing about the company. Due diligence can include preparation of reports, without violating the rules of privacy and government regulations.
Closing RemarksDue diligence is increasingly becoming a vital component of doing business and should be approached as a key ongoing tool that can serve well the interests of the organizations in many ways.
Due Diligence: An Ongoing Concern Concern by Dr Linda S Spedding ©