November 15, 2018 Articles

How Integrity Due Diligence Can Protect Your Company from Risk

Lost in this compliance-driven environment is an appreciation of the strategic utility of in-depth IDD work.

By Greg Naviloff

Since the stock market crash of 1929, due diligence has been a vital component of good governance applied to diverse areas of risk faced by corporations. In the last decade, integrity due diligence (IDD) has evolved and become a focal point in response to such regulations as the U.S. Foreign Corrupt Practices Act of 1977 and similar anticorruption laws around the world, such as the U.K. Bribery Act 2010, Chinese Anti-Corruption Laws, the Brazilian Clean Company Act, and the Mexican Anti-Corruption Laws. The steady increase in international commerce is also pushing this trend.

Lost in this compliance-driven environment is an appreciation of the strategic utility of in-depth IDD work, both to improve risk management in the broadest sense and to support better decisions on new investments and partnerships.

IDD: The Basics

IDD is the gathering of independent information to gain an understanding of the risks associated with a third party, along with risks of corruption to which an organization may be exposed internally, during an acquisition, a joint venture, or any partnership agreement. IDD provides a company the means to both identify these risks and confirm (or refute) information provided to them by a third party. As with any due diligence, the goal of IDD is a deeper understanding of a potential partner business, primarily from a corruption risk–management perspective, to proactively mitigate integrity risks.

IDD work is undertaken confidentially and usually without access to any books or internal records of the target. IDD is essentially an investigative process that combines examination of a vast array of public records with in-depth human intelligence gathering through trusted sources on the ground in the relevant jurisdictions. In markets where press freedom is limited or where competitors frequently engage in adverse propaganda to damage their rivals, having a strong intelligence network on the ground is vital.

It is important to note prior to performing deep-dive due diligence efforts that the availability of information from public sources varies widely from country to country. Many countries do not have official public records available through online searches. In some instances, public corporate databases only provide basic company information, such as the name, active status, and registration numbers. In such instances, there is a particularly strong need for “boots on the ground.” This need could range from having a team of people to assist with manually requesting real estate property records, vehicle registration records, etc., all the way to having private investigators physically verify the existence of addresses provided and possibly conduct in-person interviews.

IDD professionals leverage this information in context by ensuring that it is clearly and credibly sourced, weighing its importance and placing it in the context of the transaction in question.

IDD: Focal Points

IDD examines the target company’s operations to identify issues that might pose major, but unquantifiable financial or reputational risks to an acquirer. Examples of major focal points in this phase of the investigation include the following:

  • The existence of any connections between the business and any political figures, as well as how the company interacts with regulators, government entities, etc.
  • The nature and strength of any such connections and whether any of those connections have been leveraged for the benefit of the company
  • The extent, nature, and credibility of any allegations made against the company or its key principals relating to bribery, corruption, money laundering, large-scale tax evasion, fraud, or asset stripping
  • Any alleged connections between the company and organized crime or terrorist groups or any broader risk of exposure to such groups

An underlying feature of IDD focuses on gaining an understanding of any hidden beneficial ownership that might exist within the company. IDD considers these issues within the context of the company’s development, looking at the historical and current roles of the principal founders, how both the strategy and market perceptions of the company have evolved over time, and any track record of partnerships with western companies.

While the above are issues frequently analyzed during an IDD project, the work can also be tailored to address specific concerns, such as labor and employment abuses, environmental matters, or other issues of importance to the parties.

Moreover, IDD is not limited to the target company alone. IDD can also provide a macroexamination of the risks inherent in doing business in a specific country, which is especially useful when a transaction brings your business into a new location for the first time.

IDD Analysis: Risk Areas

Following are some of the key risks that IDD can uncover:

  • Issues of hidden beneficial ownership
  • The potential de facto control, ownership, or leverage exerted over a business by key officials through strong political patronage
  • The selling off of a target company’s assets or of parts of a target business group
  • Leakage of intellectual property or products, leading to the emergence of gray markets or smuggling networks
  • Board members acting as representatives of specific outside interest groups
  • Indications or allegations of mismanagement by key principals of the business (frequently the original founders of a company that have since grown substantially)
  • Credible allegations of significant, corrupt payments to officials
  • Allegations of ongoing fraudulent activity within the company or of previous fraudulent incidents that have been covered up and not properly addressed
  • Overreliance on key political relationships, leaving the company vulnerable to future changes in government
  • Allegations of the use of the business as a conduit for money laundering
  • The existence of well-connected minority investors with a track record of not fulfilling investment promises

This list is daunting, but ignoring these risks is not an option. Understanding the risks in advance—and learning how to prevent or mitigate them—is vital to informed, effective transaction decisions.

IDD Analysis: Potential Consequences of Not Being Proactive

There are a number of consequences that can arise if IDD analysis is not proactively conducted in an acquisition, a joint venture, or any partnership agreement. Your company could face substantial legal penalties, reputational damage, litigation exposure, and financial losses through fraud. The three primary consequences are as follows:

  1. Reputational Damage. A seller could be forced to disclose improprieties to the U.S. Securities and Exchange Commission or the U.S. Department of Justice due to misconduct by the acquired entity. In this case, shareholder value could rapidly diminish, impacting expected returns on the investment.
  2. Impact to the Revenue and Profit of the Acquirer. The expected revenues and profits could dip if the buyer realizes after the purchase that the company being acquired relies on improper payments to secure business or contracts. In addition, if the target company has failed to disclose other factors that might impact revenue or profits, potential litigation could arise.
  3. Vulnerabilities and Ineffective Compliance Programs. If the seller has an ineffective or nonexistent third-party risk-management compliance program in place, failure to identify improper activities by business partners is likely. Without a strong compliance program, certain vulnerabilities may get overlooked, and companies could risk regulatory enforcement actions and potential fines.

Conclusion

IDD can help many companies reduce the likelihood of being susceptible to various business and legal risks. When a company acquires another company, under some circumstances, the acquirer may inherit liabilities related to reputational and corruption risks associated with the acquired company. A thorough IDD can help assess and mitigate these risks early in the process.

Greg Naviloff is a leader within RSM’s financial investigation and dispute advisory practices in the greater Boston, Massachusetts, area.


Copyright © 2018, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).