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International Law

: Misleading Advertising Law

What "Due Diligence" Means

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Image by Mike Licht, NotionsCapital.com via Flickr

Purchasers of franchises and investments are often told to perform pre-purchase "due diligence".

"Due diligence" is essentially a defence avail to the sellers of securities to the public for making materially misleading representations to the public, that is the due diligence defence allows the sellers to avoid liability for lying."

The phrase "due diligence" appears throughout this blog - but with complete knowledge of the irony of the term.

The practical import of "due diligence" in context of purchasing a franchise or a security means doping out the difference between what the advertising material leads you to believe and what the actual contract says according to the FDD, or prospectus.

Chris Addy, writing at Risk without Reward, demonstrates how tricky this type of due diligence can be for vetting securities.

"A key recent change to US tax provisions, contained in the "Emergency Economic Stabilization Act" of 2008, is the long threatened and now real elimination of tax deferrals for US hedge fund managers.

Under this mechanism, US managers were able to defer incentive and / or management fees earned in their offshore funds for up to 10 years. As such, the fee income could grow on a tax free basis.

We have commented on this structure before. Our particular concern has always been that some managers have adopted very elaborate deferral schemes. At face value, most investors simply assume that when a hedge fund manager says that they have, say, $100 million in deferred fees invested in the offshore fund, that those funds are invested alongside external shareholders and are at risk with the fund's strategy pari passu.

Not so. Some managers take advantage of an ability to reference deferred fees to "other assets" (as another example of "prospectus creep", most leading law firms now automatically write this provision into fund offering documents.) "

Uh, so the funds invested offshore are actually the hedge fund's fees. Cute. Yet another sneaky lawyer trick.

(Thanks to Naked Shorts for the reference to Chris Addy.)