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Due Diligence
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An Introduction to the Due Diligence Process

The process of due diligence is an essential component of many deals, including a venture financing deal, an IPO, or a bond offering. Failure to complete a thorough and proper due diligence investigation could result in the deal failing or lawsuits from investors, shareholders, or the U.S. Securities and Exchange Commission (SEC).

Due diligence involves examining all material business, legal, financial, and accounting information about a company. It is a tedious and time-consuming process that often falls to the more junior lawyers on a deal team.

Due Diligence Begins in the Electronic Data Room

The company usually uploads materials to an electronic data room. The company is typically provided with a request list of material business, legal, financial, and accounting information that should be provided to its deal counterparts.

Some of the documents and categories of documents typically uploaded to an electronic data room for any company include:

  • The company’s charter, bylaws, and other corporate formation documents
  • Board meeting minutes and company resolutions
  • Employment agreements
  • Intellectual property: evidence of patents, copyrights, and trademarks
  • Information on the compensation arrangements for the executive officers
  • Material litigation/complaints filed against the company
  • Real estate leases or ownership documents
  • Customer contracts, supplier contracts, and other material contracts the company has entered into
  • Recently filed tax returns
  • Audited financial statements and financial projections
  • The company’s code of ethics and/or policy manual
  • A description of financing arrangements, including loans and credit agreements
  • Material environmental and health and safety reports
  • A description of permits, licenses, and governmental approvals held by the company
  • A list of insurance policies entered into by the company
Due Diligence Accounting
Photo by Dan Dimmock on Unsplash

Roles of the Parties

The lawyers take the lead in coordinating the due diligence and prepare the initial information request list. The company must work closely with their legal counsel to provide documents and ensure the accuracy of information provided. They must also be alert to follow-up requests for additional information.

A core component of the due diligence investigation is the back-up process. Lawyers often ask for back-up data to substantiate certain quantitative data in the provided documents. Thi is particularly true of industry statistics, market share data, demographic data, and financial and operational data about the company.

Avoiding Liability Under the Federal Securities Law

An inadequate due diligence process can result in liability under the U.S. federal securities laws. There are a few specific provisions that are commonly implicated:

  • Section 11 of the Securities Act of 1933 creates liability for any material misrepresentations or omissions contained in a registration statement filed with the SEC.
  • Section 12(a)(2) creates liability for any material misrepresentations or omissions contained in a prospectus. It is similar to Section 11, except it applies to a prospectus rather than a registration statement. A prospectus is addressed to a wider audience than a registration statement.The company files a registration statement with the SEC for their review and comment, with investors intended as an additional secondary audience. A prospectus is addressed to existing and potential shareholders as the primary audience.
  • Finally, Section 10(b) of the Securities Exchange Act of 1934 and the related Rule 10b-5 is broadly applicable to all securities offerings in the United States. It makes it unlawful in the context of an offer or sale of securities to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.” Rule 10b-5 is one of the most of important rules when it comes to securities fraud cases. Litigation brought by private parties often relies on Rule 10b-5.

Due Diligence Documents: Comfort Letters, CFO Certificate, and Negative Assurance Letters

A comfort letter is a critical part of the due diligence process. An independent auditor or accountant typically prepares the comfort letter. The comfort letter assures the recipient of the financial soundness of the company. The comfort letter can provide protection against potential liability under the federal securities laws.

A document signed by the company’s Chief Financial Officer also may be part of the due diligence review process. Commonly called a CFO certificate, this document will attest to the accuracy of the statistical, financial, and other information not covered by the auditor’s comfort letter.

A negative assurance letter, sometimes referred to as a 10b-5 letter, is usually required to attest to the accuracy of the disclosure in the documents the company provided. It is based on the counsel’s good faith belief in the accuracy of the information based on the due diligence performed.




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Carpenter Wellington PLLC

Carpenter Wellington PLLC

Ryan Carpenter serves as Attorney and Managing Director of Carpenter Wellington. Ryan advises clients across a broad set of corporate and commercial matters.

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