Reasonable diligence

What Is Reasonable Diligence?

Reasonable diligence refers to the standard of care that a prudent and competent person would exercise under a given set of circumstances. In the context of finance and legal & regulatory compliance, it primarily dictates the extent of investigation required by parties involved in securities offerings to ensure the accuracy and completeness of information provided to the public. This concept is foundational in preventing fraud and ensuring investor protection. Parties such as underwriters, corporate officers, and directors must perform reasonable diligence to avoid liability for material misstatements or omissions in offering documents like a prospectus. The exact scope of reasonable diligence is not rigidly defined but rather depends on the specific facts and circumstances of each situation.

History and Origin

The concept of reasonable diligence, particularly in the realm of securities, gained prominence with the enactment of the Securities Act of 1933 in the United States. This landmark legislation was a response to the stock market crash of 1929 and the subsequent Great Depression, aiming to restore public confidence in capital markets by mandating greater transparency and accountability. A key provision of the 1933 Act, Section 11, holds issuers, directors, officers, and underwriters liable for misstatements or omissions in registration statements. However, it also provides a "due diligence defense" for certain parties, allowing them to escape liability if they can prove they conducted a reasonable investigation and had reasonable grounds to believe the statements were true and complete⁵.

The Securities and Exchange Commission (SEC), established by the Securities Exchange Act of 1934, further elaborated on the factors influencing what constitutes reasonable investigation. For instance, SEC Rule 176 outlines circumstances relevant to determining whether the conduct of a person meets the standard of reasonable investigation under Section 11 of the Securities Act, including the type of issuer, type of security, and the person's role⁴.

Key Takeaways

• Reasonable diligence is a standard of care requiring a prudent investigation into financial disclosures.
• It is a critical defense against liability, particularly for underwriters and corporate insiders, under the Securities Act of 1933.
• The scope of reasonable diligence is flexible, varying based on the specific circumstances of a transaction or disclosure.
• It serves to enhance transparency and protect investors from inaccurate or incomplete information in securities offerings.
• Failure to exercise reasonable diligence can result in significant legal liability.

Interpreting Reasonable Diligence

Interpreting reasonable diligence involves assessing whether the actions taken by an individual or entity to verify information were sufficient and appropriate given the context. There is no definitive checklist, but rather a flexible standard that considers several factors. For example, a court or regulatory body examining a party's adherence to reasonable diligence might consider the complexity of the offering, the accessibility of information, the professional expertise of the party, and any red flags that should have prompted further investigation. The objective is to determine if the party acted with the care that an ordinary prudent person in a similar position would have exercised to confirm the accuracy of financial reporting and other disclosed information. This standard underpins the principle of full and fair disclosure in financial markets.

Hypothetical Example

Consider an initial public offering (IPO) of a technology startup. An investment banking firm is serving as the underwriter. As part of its responsibilities, the underwriter must exercise reasonable diligence to verify the information in the company's registration statement and prospectus.

Step-by-Step Walkthrough:

1. Review Financials: The underwriter's team examines the startup's audited financial statements, cross-referencing figures with internal company records and projections.
2. Management Interviews: They conduct extensive interviews with key management personnel, including the CEO, CFO, and legal counsel, to understand the company's operations, risks, and future plans.
3. Legal Due Diligence: Legal counsel reviews all contracts, intellectual property, litigation history, and regulatory compliance documents.
4. Industry Analysis: The team researches the competitive landscape, market trends, and regulatory environment specific to the tech industry, validating the company's claims about its market position and growth opportunities.
5. Site Visits: If applicable, they might visit the company's facilities or product development sites.

If, after this thorough process, a material misstatement is later discovered in the prospectus that the underwriter could not have reasonably uncovered through these investigations, they may be able to assert a reasonable diligence defense against Section 11 liability. Conversely, if they merely accepted management's word without independent verification, they would likely be found to have failed in their reasonable diligence.

Practical Applications

Reasonable diligence is broadly applied across various facets of the financial industry and beyond:

• Securities Offerings: In public and private securities offerings, underwriters, directors, and officers undertake extensive investigations to ensure the accuracy of registration statements and offering circulars. This practice is central to compliance with securities laws.
• Broker-Dealer Responsibilities: Broker-dealers are required to exercise reasonable diligence to understand the securities they recommend to clients and to ensure those recommendations are suitable. For example, FINRA Rule 2111, known as the "Suitability" rule, requires a reasonable basis to believe a recommendation is suitable for at least some investors³.
• Mergers and Acquisitions (M&A): While often termed "due diligence," the principles of reasonable investigation apply as acquiring companies scrutinize the target company's financials, legal standing, and operational risks.
• Investment Advisers: Investment advisers have a fiduciary duty to act in their clients' best interests, which includes conducting reasonable diligence on investments before recommending them.
• Corporate Governance: Board members are expected to exercise reasonable diligence in their oversight roles, reviewing company operations, financial performance, and risk management strategies to ensure the company acts responsibly and in the interest of shareholders.

Limitations and Criticisms

Despite its importance, reasonable diligence has limitations. It does not guarantee the complete absence of errors or fraud, nor does it guarantee investment success. The standard is one of "reasonableness," not infallibility. Critics sometimes point out that the subjective nature of what constitutes "reasonable" can lead to inconsistencies or arguments in legal proceedings. Furthermore, the pressure to complete transactions quickly can sometimes limit the depth of investigation that parties can realistically undertake.

Another limitation arises from the inherent difficulty in uncovering sophisticated forms of fraud or intentionally concealed information. Even with reasonable diligence, parties might not discover every hidden risk or misrepresentation, especially if documents are falsified or key information is deliberately withheld. The OECD Principles of Corporate Governance, while advocating for transparency and responsible conduct, acknowledge the complexities faced by boards in overseeing vast and intricate corporate operations, where perfect knowledge may be unattainable². The aim of reasonable diligence is to establish a robust process and good faith effort, rather than demanding an impossible level of foresight or omniscience.

Reasonable Diligence vs. Due Diligence

While "reasonable diligence" and "due diligence" are often used interchangeably, particularly in common parlance, "reasonable diligence" often refers specifically to the legal standard of care required to establish a defense against liability, especially under Section 11 of the Securities Act of 1933. It emphasizes the reasonableness of the investigation conducted.

In contrast, "due diligence" is a broader term encompassing the entire process of investigation, review, and verification undertaken before entering into an agreement or transaction. It can be a contractual obligation or a standard business practice. For example, a private equity firm performing due diligence on a target company is engaging in a comprehensive investigative process that goes beyond merely satisfying a legal defense, aiming to fully understand all aspects of the business. Thus, reasonable diligence is a specific component or standard within the larger framework of due diligence, particularly in a regulatory or litigation context.

FAQs

What is the primary purpose of reasonable diligence in securities law?

The primary purpose of reasonable diligence in securities law is to provide a defense against liability for misstatements or omissions in registration statements and prospectuses, ensuring that parties involved in an offering conducted a good faith and thorough investigation¹. It helps maintain market integrity and protects investors.

Who is typically required to exercise reasonable diligence?

Parties typically required to exercise reasonable diligence include underwriters, corporate directors, officers, and sometimes experts (like accountants or lawyers) involved in preparing portions of a registration statement, as outlined by the Securities and Exchange Commission regulations.

How is the "reasonableness" of diligence determined?

The "reasonableness" of diligence is determined by evaluating the facts and circumstances surrounding the investigation. This includes factors such as the type of issuer and security, the role of the person conducting the investigation, and the presence of any red flags that should have prompted further inquiry. The standard is typically what a prudent person would do in a similar situation.

Can reasonable diligence prevent all investment risks?

No, reasonable diligence cannot prevent all investment risks. Its purpose is to ensure that material information disclosed to investors is accurate and complete based on a careful investigation. However, it does not eliminate market risks, business risks, or the possibility of unforeseen events affecting an investment.

Is reasonable diligence only applicable to large public companies?

While reasonable diligence is prominently associated with public securities offerings of large companies, the underlying principle of conducting a prudent investigation before making a financial decision or providing advice extends to many areas, including private placements, broker-dealer recommendations, and even individual investment banking decisions.