“Due-Diligence and Validation, Part I”

“Due-Diligence and Validation, Part I”
Published – © 2014 Dr. Mark D. Lurie/RSI (all rights reserved)

 To start, first we need to know what the term “Due Diligence “means:

 Merriam-Webster’s[i] Definition of “Due Diligence”

1:  the care that a reasonable person exercises to avoid harm to other persons or their property

2:  research and analysis of a company or organization done in preparation for a business transaction (as a corporate merger or purchase of securities)

Wikipedia’s®[ii] Definition of Due Diligence

1. An investigation of a business or person prior to signing a contract, or an act with a certain standard of care.

It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for an acquisition.

The theory behind due diligence holds that performing this type of investigation contributes significantly to informed decision making by enhancing the amount and quality of information available to decision makers and by ensuring that this information is systematically used to deliberate in a reflexive manner on the decision at hand and all its costs, benefits, and risks.

For simplicity sake, Due Diligence in this article will be referred to as “DD” unless it will be required to use the entire phrase.

There are hundreds of “definitions of what Due Diligence is, and within those definitions it may or may not address the specifics of the “category” that the DD is addressing, but inn almost all cases it is dealing with something related to a financial transaction.

It may be from real estate sales to merger contracts between companies that need to have DD performed; however DD is one of the most abused buzz words, let alone most people don’t have a clue on how and when its real application(s) should be used and how.

The definition has been highly diluted over the past ten years and is not limited to “financial” matters. DD is also known as:

  • Researching
  • Investigating
  • Weighing risks versus results
  • “Gut-feel”
  • Auditing
  • Validating
  • Confirming
  • Proving
  • Proofing
  • Double-checking
  • Getting information from the “horse’s mouth” and with your own eyes
  • Checking records
  • Interviewing personnel, management, owners or C-Management
  • Finding out the real reasons for whatever project or consideration is being contemplated

The list goes on and on, and many of these terms have been known and used for years.

DD is typically associated with the financial realm since it usually addresses major projects were large sums of revenue are involved, and of course there is a risk involved.

Yet, DD can be nothing more than checking over your spelling of a letter you’re going to send out, or seeing a trucker going over the straps that secure his load of lumber that he is carrying.

Our definition of Due Diligence is nothing more than “Validating that evidence, facts, and information, in various forms presented is what it is.” Plain and simple.

Narrowing it down even simpler, “It is a matter of verifying that what is represented is correct.”

Now, taking that into account, and just giving it a name of “Due Diligence”, it could apply to something as simple as matching the number of crates of tomatoes against the delivery slip. Twelve crates counted – the delivery slip shows twelve crates delivered.

However, there can be variations to this simple scenario, such as twelve crates were received, but one was damaged.

This does not change the fact that Due Diligence was performed, or whatever you wish to call it. Perhaps it is time to call it what it really is, and that is “Validating” the information. Due Diligence does have the relevance of having such work performed in an “expeditious” manner, but in fact it doesn’t mean that at all. We have seen the results of Due Diligence performed over and over again with companies that apply pressure to get it done as “quickly as possible”. This is an invitation for ending up with mediocre results (that will not be seen right away), but more of an invitation for disaster.

The word “Diligence” means just the “opposite” than speed or “expeditious” handling of the examination of whatever project, financial or otherwise, is to be subjected to.

The “real” meaning of “Diligence” is simple:

“Careful and persistent work or effort”

Some other words associated equally with “Diligence” are:

  1. Conscientiousness
  2. Hard work
  3. Concentration
  4. Effort
  5. Care
  6. Meticulousness
  7. Thoroughness
  8. And the list goes on and on…

These are not just words, but a clear and present reminder that Diligence DOES NOT mean speed or expediting of whatever was demanded to be gone through. Again, it means just the opposite.

So if the “TRUE” meaning of Due Diligence was enforced, the process would be exceptionally slow, careful and thorough putting it simply. If this would have been the case with “many” of the IPO start-ups, the monitoring and validation of the Enrons and BCCIs, how many of these disasters could have been avoided or exposed BEFORE they became irrevocable disasters?

Since 1970, Due Diligence become the number one phrase used in the financial world, and coincidently, where some of the largest disasters started to surface their ugly heads.

Now, when our company hears the request for due diligence to be performed, the client or company we are working with is under NO illusion of how we view it. It is something that is not to be completed as a race, or under pressure of the proverbial “gun against the head” C-Management demands.

True Validation (not due diligence) is not governed by time constrains where it cannot be performed to the quality and expectations of the standards required. If there is a time limit of that “great deal”, and you have to make a decision in 24 hours or “loss” it, walk away.

Major mergers, acquisitions and dispositions are not done in minutes, but if to be properly done, it will take weeks and months, with massive examinations and research to be performed, and performed again. The number of factors to take into consideration is massive, and from those more questions can arise. Then there are the issues that surface where information does not match up.

“The number of variables are exponentially related to the problems and issues that surface through Validation.”[iii]

As any project that requires “Validation”, to “any degree”, there will always exist a conflict between the “qualities” of the Validation of information versus the timeframe in which the “alleged” Due Diligence has to be performed.”[iv]

We have personally seen too many transactions, purchases and business dealings that have gone wrong, terribly wrong just because of the speed (e.g. pressure applied on the people, employees and agencies) and impatience of performing the Validation properly.

In many cases, it is the one item, that single piece of information that takes a bit, more time to properly acquire that the party performing the DD decides to “override” and disregard that “would” be the “deal-breaker”. It could be an item that needs to be acquired, by written request that deals with levies, liens, back taxes, Uniform Commercial Code (UCC) filings (where states still are not automated with that information) that takes a few weeks to acquire.

We have seen title searches performed improperly on equipment, vehicles and even entire buildings/property. In all cases, speed is a killer.

The issue is no matter how “good looking” a deal is, if the Seller is attempting to apply more pressure on the Buyer, in any manner, we recommend putting the brakes on immediately. That applies even more so with auctions, which, in almost all cases have a “hold harmless” clause as well as “as is” in their own agreements.

For large financial acquisitions and dispositions, there is no such thing as “rushed” DD.

Yet, it is common to want to push the deal through as soon as possible. Taking a conservative approach is a wise step. Being “proactive” in your Validating of “ALL” critical information must be done before the revenue changes hands.

Law suits typically take three to five years, and since it will be most likely a “civil” action as the result of finding out, too late, something was definitely wrong, could end up costing you tens, if not hundreds of thousands of dollars. In the end, you may get a judgment that is worthless to collect on as well. It is truly a “risk”.

Go back to the common sense approach when planning to purchase or sell real or personal property, whether it be business-related or not. Perform your Validation of the information needed to “verify” all key aspects of what you are acquiring, or what the responsibilities and liabilities are in selling what you will be dealing with.

Of all the terms that define DD, we would stress the two, most important factors:

  1. Being “meticulousness” with your validation of facts and submitted materials that need validation. Double-checking should be a normal step. Questioning “anything” that appears to be irregular, or takes time in acquiring should automatically place a “governor” on the Validation process.
  2. The “thoroughness” of your work must be unquestionable. We use the term, “best reasonable efforts” when it comes to Validation. There is NO guarantee that such research and analysis that goes into Validation will be perfect. There is no such thing as perfection; however taking into account reasonableness is what we are dealing with here. That means “best reasonable efforts” to validate the information needed to make the proper decision to buy or sell what you’re dealing with, regardless of the size and nature of the property or item in question.

If you examine court cases, especially focusing on the prosecution side, building a case is based upon evidence. Evidence is categorized into various groups from “direct” to “hearsay”.

With the case loads being massive, trials, especially criminal trials that are usually moving at a much faster pace, the requirement of validating evidence is crucial for making or breaking a case.

As the evidence comes in, it is reviewed, analyzed and decisions to use or reject it is made. When pre-trial hearing and meetings between the defense counsel and the prosecutor take place, specific evidence will be produced and in many of the cases will trigger the potential for plea bargaining.

This is for two reasons. The first is just time. To go through trial is expensive for both parties, and the prosecution may not have the strongest of cases just on the basis of the limitation of solid, validated evidence. There is also the issue of hundreds upon hundreds of cases waiting in line to be heard.

On the other side, the defense may have limited funds to work with, or the evidence is so strong it could potentially result in a much more serious verdict and sentencing. It will all be based upon a number of variables, but the main component is the validation of evidence by both sides.

Now, if DD is performed carefully by the defense, the information gleaned from such research may result in a dismissal, or a better plea bargain agreement, since the prosecution has to consider having their evidence undermined. Again, it all comes down to the quality and validation of information acquired.

In proposing an acquisition of a company by another, the amount of information that needs to be reviewed and validated is massive. The reasons for DD is quite simple, but the materials to acquire and review may be allusive (intentionally or unintentionally).

There is also the issue of acquiring original documents that (a) may not be available due them no longer existing (due to statute of limitations, or just age), or (b) may require submission of acquiring certified copies from agencies, such as Secretary of State, the Internal Revenue Service, State Tax Commissions, etc.

Attempting to rush “validation” by bypassing such documentation could be disastrous.

In addition, there is the accounting end that will need to be reviewed and validated. Payroll and accounts receivables/payables to mention a few. Legal claims and the status of any litigation.

Truly performing cost accounting to validate the profitability of the company is mandatory.

Then there is the issue that always must be questioned: Is what is being represented truly honest? If you determine that statement to be paranoid, you are right and wrong. It is a matter to ALWAYS question the validity of any financial or business information being presented when you’re/your companies’ revenue is at risk.

Acquiring a business, in reality, is like a marriage. There is specific baggage you may find out about after-the-fact which could end up as a major liability, and even create litigation against your own company or yourself.

As an example, this is a common issue with payroll and businesses that utilize “contract labor” as their primary workforce. Many of the validations performed by our company, when it comes to “contract labor” representations, have been found to be (1) intentionally fraudulent; (b) unintentionally done wrong (however, ignorance does not count as a consideration in a court of law, or with tax agencies); or (c) a general oversight in procedures.

In any one of the cases mentioned, the responsibility can potentially fall to the company that acquires the business unless specific indemnifications and special conditions are included in the purchase agreement; however “enforcement” of such arrangements, conditions, terms and conditions are as good as the paper they are written on.

If the matter requires litigation, your company will still have to deal with the liability “until” things are sorted out, and if you have to go to court, it could be years. Regardless, performing DD carefully would pick this type of business “land mine” and identify the risk (and its level of liability(s)).

“The rule that must be followed is the more complex the business dealing, the more complex the job being undertaken, the business acquisition that will require massive amounts of revenue to complete the purchase, the slower and more systematic the DD process must be.”[v]

In Anti-Money-Laundering (AML), government agencies (both domestic and international) must perform exceptional DD and validate every lead, every road taken where funds movement has taken place. The investigation and researching of each and every entity that was involved.

Each and every person that was involved, and their own backgrounds (in depth). It is like peeling back an onion. Layer after layer, slowly, carefully and not by-passing anything because of time limitations. The decision to bypass is like the one time you decide to go over the speed limit, you get pulled over. It seems to be like a curse, but in fact crime, and those involved directly or indirectly with it, as counting on the fact that (1) most will NOT perform DD completely; (2) that those doing the investigating are being pressured and will bypass much of the information; and (3) those doing the work will not drill-down deep enough to put the puzzle pieces together which would build a stronger, clearer case.

In the case of Enron, we received (intentionally) thousands of boxes of computer printouts and computer generated materials. What people did not realize, this was not information that they wanted to shred, but PRODUCE! Why? Because it would require the allocation of a serious number of people to go over each and every box of data.

Yes, the bottom line was that it reflected 2+2 = 5, but the key was WHO was the person or persons that intentionally generated such information and what was their role in puffing up financial statements and regulatory reports? Moreover, WHY were so many of the regulatory reports overlooked? Again, because DD was NOT performed to standard.

In the case of BCCI, the level of fraud, corruption and criminal activities was global. However the way it was able to circumvent almost every, single government agency, from the SEC to Interpol, was by producing such vast amounts of data that validating it would take months, even years to do.

Why months and years? Because the DD was being addressed “reactively”. The law enforcement agencies, even when cooperating with each other, we addressing the methodology of examining and case-building against BCCI “reactively”.

“Reactive Methodology is literally a guarantee of Validation failure. In “every” case, reactive strategies, procedures and policies have assured chaos, improper validation of materials, oversights of various degrees of severity, and most important, assumptions that are misleading or dead-wrong.”[vi]

Any form of Validation or DD must be consistently planned, designed and implemented “PROACTIVELY” for it to have best, reasonable effort of success. This is not an assumption – this is a proven fact.

A simple example is whether or not a company has a “disaster plan”. If they don’t, and a disaster takes place, they will “react” to it. Needless to say, the organizing and dealing with each facet of the disaster will be done on-the-fly, be chaotic at best and will be a quick-fix for issues that require permanent solutions.

There will be little-to-no mitigation of the major issues and losses, let alone effects on clients and personnel. It will be like a domino effect in the end. One problem producing another, and another, with allocating personnel in a manner that would be totally without logic. The end result will be financial losses, getting back on-line slower (if recovery is possible) and a massive stress level that is not conducive to business.

On the other-hand, a “proactive disaster plan” is designed to address a disaster WHEN it happens, not IF. It is designed to have a structured, well through-out and VALIDATED methodology, set of strategies, systems and procedures to follow.

The results is a “controlled” and logical set of steps to follow to MITIGATE the effects of the disaster; bring the business operation back on-line as soon as possible with the least amount of effort and stress; and to MITIGATE the effects to the clients and personnel.

What does DD or Validation have to do with a “Proactive Disaster Plan”?

It is a matter of performing DD with each facet of the business; identifying the weaknesses and bottlenecks WHEN a disaster would take place; addressing the most logical personnel to take charge and what to do in each division or department; the steps and chain of command to be followed; and the list goes on and on; however it comes down to VALIDATING the plan and it’s detail.

To challenge its structure and methodology to make sure, using best, reasonable effort that it is the most effective plan that is possible to produce with the most likely potential of success.

Validation and DD is used in almost ALL aspects of our personal lives, let alone heavily dependent upon in businesses of all types, government agencies and components within infrastructures (regardless if they we local to executive branches) and are not limited regardless if it is domestic (United States) or global. There is NO boundaries to DD and Validation.

In our next report, we will address what we consider Validation to be and what it is comprised of. This will include, but not be limited to the steps and processes to consider, the mandatory research that should be required, what to do when “snags” are encountered, and then address sample cases addressing various types of acquisitions, dispositions, sales and purchases.

Footnotes and credits:

 [i] An Encyclopedia Britannica, Inc. Company

[ii] Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization.

[iii] Dr. Mark D. Lurie

[iv] Dr. Mark D. Lurie

[v] Dr. Mark D. Lurie

[vi] Dr. Mark D. Lurie

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