The Five Components of Due Diligence

The five labels come from the sponsor outline, which offers them as examples rather than a closed set. The rule guidance broker-dealers (BDs) follow does not sort its practices under these labels, so each practice below sits under the component it best matches.

What Counts as Financial Data?

• Historical financial statements of the issuer and its affiliates, with particular focus on statements audited by an independent accountant and the related auditor letters to management
• Trends shown by the financials
• The issuer's internal audit controls

Real-world example: A representative reviewing three years of audited statements notices revenue climbing steadily while accounts receivable climbs even faster. That trend, not just the raw numbers, is what the investigation should catch.

What Counts as Industry and Operational Data?

• The industry the issuer operates in, that industry's prospects, existing or potential regulatory restrictions, and the issuer's competitive position
• The issuer's governing documents (charter, bylaws, or partnership agreement), its authorized stock, any restrictions on its activities, and, for a corporation, whether it has perpetual existence
• Contracts, leases, mortgages, and financing arrangements, plus contractual arrangements between the issuer and its management, employment agreements, and stock option plans
• A physical inspection of a sample of the issuer's assets and facilities
• Third-party geological, engineering, or land-use reports
• For an energy development or exploration program, expert opinions from engineers, geologists, and others. The guidance treats these as necessary for judging whether the investment is suitable before a representative recommends it
• The issuer's regulatory or disciplinary history, including a credit check
• How long the issuer has been in business, and whether the focus of its business is expected to change
• The business of the issuer's affiliates, and the extent to which an affiliate's cash needs or other expectations might affect the issuer's own business prospects

What Counts as Management and Employee Relations?

• Management's expertise for the issuer's business
• The extent to which management has changed or is expected to change
• Management's regulatory or disciplinary history
• Loans or transactions between the issuer or its affiliates and members of management that could be inappropriate, or could otherwise affect the issuer's business
• The qualifications and integrity of the board of directors or similar body
• The amount and form of management compensation, who determines it, and whether it creates conflicts of interest

Exam Tip: Gotchas

• "Management and employee relations" due diligence covers management's background, expertise, turnover, board qualifications, and compensation conflicts. It is not a separate rank-and-file human-resources review.

What Counts as Research?

Research is independent verification that does not rely solely on issuer-supplied material:

• Contacting the issuer's customers and suppliers about their dealings with the issuer
• Inquiring about pending litigation
• Checking the issuer's past securities offerings and how they performed, without treating past success as a guarantee, particularly for a blind-pool or blank-check offering

Exam Tip: Gotchas

• "Research" is not a synonym for "financial data." Financial data is the numbers the issuer supplies; research is the independent verification the firm performs on its own, through sources other than the issuer.

What Counts as Product Development and Expansion?

• The issuer's business plan or business model and management's forecast assumptions
• The viability of any patents or other intellectual property the issuer holds
• Testing financial models against information from representative assets to validate projected returns, break-even points, and similar figures
• Requesting the financial models used to generate projections or targeted returns, and keeping a file summary of that analysis, including the results of any stress tests on the issuer's assumptions

What Should You Check on Exam Day?

• Sort a scenario's facts into the right component before answering. A revenue trend is financial data; a customer phone call is research; the two are commonly swapped as wrong-answer traps.
• Do not narrow "management and employee relations" to a human-resources reading. It tests background, turnover, board quality, and compensation conflicts.
• Expect a stem to test that audited numbers still need trend analysis and internal-control review, not just a read of the bottom line.
• Recognize that testing financial models against representative-asset data belongs to product development and expansion, not to financial data.