In corporate transactional terms I understand that the phrase 'due diligence' was first used in the US in the 1930s when stockbrokers could be liable if they sold shares in companies that hadn't been adequately checked by them. As long as the brokers exercised 'due diligence' in their investigation into the company whose shares they were selling, and disclosed to the investor what they found, they couldn't be held liable for non-disclosure of information that wasn't discovered in the process of that investigation. Not surprisingly, brokers developed standard practices of conducting due diligence investigations into the health of companies whose shares they were trying to place with investors.
We regularly carry out legal due diligence (often abbreviated to 'DD') on target companies and businesses. At the same time, our client's accountant will be carrying out tax and accounting DD, the client may well have another expert carrying out commercial DD (for example into an industrial process that the company uses) and I've also even heard of 'emotional DD' being carried out on the management teams of potential investee companies by US private equity houses. The results of DD can be very revealing and may lead to a deal collapsing or the price being adjusted (invariably downwards). However, DD is only really worth its salt, at least in corporate transactions, if it's backed up with warranties by the seller, often including a warranty that the results of the DD are reasonably accurate. Having a thorough DD report which isn't then backed by warranties doesn't take a buyer very far if it turns out that the DD report is a work of fiction because the seller was 'economical with the truth' (or simply mistaken) when replying to the buyer's DD questions.
So why am I mentioning this? I'm not a devoted viewer of The Apprentice (more an occasional nosey parker) but one of my colleagues told me recently that in the last series of the show, one candidate wanted to be Lord Sugar's partner in a business he doesn't own, another picked £5 million as her projected turnover figure simply because she thought of the number 5 and the third thought he could make money from the people he's planning to put out of business. If these examples are correct, it does make you wonder what this says about Alan Sugar's (and his team's) ability to do basic due diligence, particularly as they've had the candidates' business plans since the application stage of the programme. I suppose it makes better TV if the candidates can be mocked because their business plans are a bit feckless, and I don't suppose Lord Sugar made his money by not doing proper DD, but it's worth noting that DD, while it can often seem like a time-consuming box-ticking exercise that gets in the way of the deal, can be worth its weight in gold. I've often heard sellers of businesses complaining that they thought they had a deal when they shook hands, and now they're being pestered with DD questions from the buyer's lawyer, as if this was a sign that the buyer doesn't trust the seller in spite of the handshake. Of course, the deal will almost certainly have been 'subject to contract and due diligence' and the handshake is the start of the process, not the end. DD's doubly important if you're buying a company or a business using a third party's cash (for example a bank's or an equity investor's) and in that situation the funder will insist on the buyer carrying out DD, backed by warranties, as a condition to the funding being provided.
To end with an example, about 15 years ago I was sent to London to spend the day in a 'data room' (sounds sexy but it was a stuffy windowless room full of lever arch files) doing legal DD on a company that owned and operated a combined heat and power plant (CHP). My client was a large utility company looking to diversify by buying the London company. After about 7 hours of poring over 10 years' worth of the target company's minute books I found an almost throw-away reference to an incident a few years earlier where one of the blades on the CHP's main turbine had sheared off and come crashing at speed through the turbine casing. Disaster had been averted, but mainly by good luck. That discovery, and one or two others, caused my client to pull out of the deal and save an eight figure sum in the process. My client decided that the target company's CHP was inherently flawed, so by paying me to spend the day in London doing legal DD, a fortune had been saved. You have been warned…