What is Due Diligence?

What is Due diligence? 

In the context of primary capital markets, due diligence is the process of verifying the completeness and accuracy of the information contained in, or incorporated by reference in, the offering document (or prospectus) for a new issue of bonds or shares. It is carried out by the issuer, the underwriters, and may also include legal counsel and auditors. It is an essential component of a capital market transaction.

Why does due diligence matter?

• It can help with the drafting of the disclosure in the prospectus
• It can ensure that the general duties of disclosure are satisfied
• It may reduce legal and reputational risk
• It can ensure that there are no legal or other barriers to the offering
• From a US perspective:
  • It can help establish a due diligence defence under Sections 11 and 12(a)(2) of the Securities Act of 1933
  • May also protect against the suggestion of fraud under Rule 10b-5 of the Securities Exchange Act of 1934

What are the risks to underwriters?

The risks vary depending on where the offering is taking place – with much greater liability being attached to offerings directed at investors based in the U.S. 

In the UK, the disclosure requirements for securities admitted to trading on an EEA Regulated Market are set out in the UK Prospectus Regulation, which currently closely tracks the EU Prospectus Regulation.

For offerings in the US, the Securities Act of 1933 prohibits offers and sales of securities unless a registration statement is in effect. A registration statement consists of the offering prospectus plus additional information that issuers are required to file with the SEC but do not have to deliver to investors.

What are the factors determining the nature and extent of due diligence?

• Disclosure requirements of the relevant stock exchange
• Other regulations, such as sales into the US pursuant to rule 144A
• Market practice
• Characteristics of the issuer:
  • Size
  • Trading history
  • Jurisdiction
  • Industry sector
• Type of security being offered
• Nature of the instrument
• The investors being targeted