The New Rules of Investment Due Diligence
An investment might look rock solid, but how do you know if it all checks out? How can you be confident that everything is what it appears to be?
This is where due diligence comes in, and it’s an essential protection for buyers and sellers alike. That’s why the Treasury’s Financial Crimes Enforcement Network, or FinCen, recently passed a new rule to improve financial transparency, and it contains essential lessons for investors.
Here’s a quick review of the basics of investment due diligence, what’s in the rule, and what it means for investors.
What is Due Diligence?
Due diligence is an investigation, audit, or review to confirm facts or details. In the case of investment, due diligence involves confirming all the relevant facts about a potential new investment that would allow the investor in question to make an informed decision.
The good news is that due diligence can be performed with publicly available information. But regardless of the information you reach for, due diligence is always completed before closing a deal to ensure the investor has the right information to move ahead.
In simple terms, it’s a way to analyze and mitigate investment risk.
The practice became widespread after the passage of the Securities Act of 1933. Under that law, brokers and dealers became fully responsible for disclosing material about the investment instruments they sold. To be clear, a broker or dealer is not held liable for information they did not possess or could not have known at the time of sale. They are also not held liable for information that was not discovered during the due diligence process.
Types of Due Diligence
There are several types of due diligence, including:
- Human resources
- Intellectual property
- Strategic fit
For an investor, one of the most important forms of due diligence is financial due diligence, which assesses whether information provided in the Confidential Information Memorandum is complete and accurate. The goal is to understand a company’s (or asset’s) financials inside and out. For a company, for example, this would include an audit of all financial statements in the last three years, major customer accounts, and book and sales pipeline, to name a few.
Why You Need Due Diligence
As an investor, you can’t guarantee returns, but you can do everything in your power to ensure you’re making a good investment based on the available information. And because of that, due diligence is one of the most important things you can do to ensure your money is safe.
Think of due diligence as doing your homework. It’s your chance to sniff around publicly available information to assess whether an investment is as good as it looks on paper. Remember, brokers will always give you hype—it’s your job to read between the lines to make sure an investment lives up to the hype.
Understanding the New CDD Rule on Investment Due Diligence
Here’s the thing: companies do due diligence too, especially when it comes to significant financial transactions. Unfortunately, not all customers are quite what they appear to be. Which brings us to FinCen and the new Customer Due Diligence (CDD) Final Rule.
The new rule is an amendment of the Bank Secrecy Act, which establishes recordkeeping and reporting requirements for national banks, federal branches, federal savings associations, and agencies of foreign banks. The CDD rule specifically aims to bolster financial transparency to prevent criminals and terrorists from disguising and laundering illegal money through the misuse of organizations governed under the Bank Secrecy Act.
Basically, the CDD rule strengthens customer due diligence requirements on the organizational side, strengthening requirements for covered organizations to identify and verify the identity of legal entity customers.
The CDD rule has four requirements, all based around written policies within covered financial institutions which are reasonably designed to:
- Identify and verify the identity of customers
- Identify and verify the identity of the beneficial owners of companies opening accounts
- Understand the nature and purpose of customer relationships to develop customer risk profiles
- Conduct ongoing monitoring to identify and report suspicious transactions, and to maintain and update customer information on a risk basis
Under the rule, covered financial institutions must identify and verify the identity of any individual who owns a legal entity or controls 25% or more of a legal entity.
What the New Rule Means for Investors
For investors, the rule won’t affect you unless you own a legal entity or 25% or more of one. If it does apply to you, the CDD rule requires financial organizations who work with you to verify that you are who you say you are, as well as monitoring transactions to report illicit or suspicious activity.
For most investors, the rule doesn’t really change much. However, it is an essential reminder that due diligence is more than just checking boxes—it can actually be critical in ensuring legal, safe, and productive investment transactions. That way, you can invest with confidence and focus on investments that allow you to grow your wealth.
Your Partner in Smarter Alternative Investment
Investment due diligence might seem like one more hurdle to cross in the process of getting to a good investment. In reality, it’s part of being a smart investor—in fact, it’s one of the smartest things an investor can do in the investment process.
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