Due Diligence: Trust But Verify

Due diligence is the investigation that a reasonable person would make in good faith to ascertain the facts in a situation or to determine the truthfulness of assertions. Depending upon the circumstances and issues at stake, this inquiry may be quite broad and detailed. Due diligence is a legal principle in numerous areas including, for example, information security, philanthropy, corporate finance, business transactions generally, and personal relationships.

If a court determines that an individual or entity failed to exercise due diligence, the court will typically not grant this person relief. This is especially evident when the true facts could have been determined, or a transaction's accompanying signed agreement states that neither party is relying upon the representations of the other. While "lack of reliance" language may seem like harmless legalese boilerplate, the implications may be quite serious. Always involve experienced professionals in negotiating and understanding your agreements.

A recent decision by an Appellate Court in Illinois involved an alleged difference between $17.5 million paid and a $49.8 million value due to a lack of due diligence by the seller of a one-third interest in a business to the other co-owners (Willis Capital LLC v. Belvedere Trading LLC). In brief and simplified summary, the one-third selling owner was a firm wholly owned by an individual. In the course of negotiating the sale, the seller requested an appraisal but the prospective buyers replied "that an appraisal was not necessary because they did not want to sell their interests in the company." The buyers did not reveal that they had previously commissioned an appraisal of the seller's interest in the firm, but had asked that a written report not be prepared. After three hours of negotiations, a selling price of $17.5 million was reached, representing the seller's capital account balance plus one year's share of trading profits.

The resulting written sales agreement contained a section entitled "Mutual General Releases." This section released all claims that the parties might have against each other, and stated "that each party fully assumes the risk that the facts or law may be other than they believe." Furthermore, the parties agreed "that they are not relying upon any promise, inducement, representation, statement, disclosure or duty of disclosure of the other party in entering into this agreement." They agreed that they were not fiduciaries in the negotiations and that "this agreement supersedes all prior written and verbal agreements and understandings." Additionally, if either party sued to enforce the agreement, "the prevailing party shall be entitled to recover its reasonable legal fees and expenses."

Approximately three years after the sale, the seller discovered the existence of the undisclosed appraisal. The seller then obtained an independent appraisal, resulting in the allegation of an approximately $32 million underpayment and this resulting litigation.

The selling plaintiff not only lost the lawsuit but the trial court awarded the purchasing defendants $172,391.75 in fees and costs.

The Appellate Court upheld the trial court's judgment in favor of the defendants, noting that the seller had sufficient information at the time of the agreement to determine the correct value but failed to exercise due diligence. The Appellate Court wrote: "We understand Willis's [the seller's] feeling of being cheated by its former partners and the assertion that it was lulled into accepting a grossly reduced amount for its share of the Belvedere company." However, "because of its business experience Willis knew, or should have known, that an appraisal of the value of the company was necessary prior to selling its shares, given the magnitude of the transaction." "Empathy aside... we cannot extricate Willis from the natural consequences of a bad business decision." The only consolation that the Appellate Court offered the seller was a reversal of the fees and costs since the litigation was technically not concerned with enforcing the sales agreement.

The necessity of due diligence is emphasized in numerous cases. While fraud or active concealment of the truth may overcome an asserted lack of due diligence, it is incumbent on a plaintiff to show that her or his active quest for truth was prevented or interfered with by the defendant. Occasionally a court will consider the differences in education, experience, or sophistication between the parties. However, "trust but verify" is a good motto in the business environment as well as in intimate personal relationships. Always involve experienced professionals in your specific business and personal transactions.