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 been a focal point in response to such regulations as U.S. Foreign Corrupt Practices Act of 1977 and other similar anti-corruption 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.
What is IDD?
As with any due diligence, the goal of IDD is a deeper understanding of the potential partner business, primarily from a corruption risk management perspective and to proactively mitigate such integrity risks. IDD is the gathering of independent information to gain an understanding of the integrity and corruption risks associated with a third party along with risks of corruption an organization may be exposed to internally. It provides companies with a means to both identify these risks and confirm (or otherwise) information provided to them by a third party.
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 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 broader risk of exposure to such groups
An underlying feature of IDD work focuses on gaining an understanding of any hidden beneficial ownership that might exist within the company, which on the surface is not apparent.
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 perception of the company has 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 macro examination of the risks inherent to 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 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, where competitors will frequently engage in adverse propaganda to damage their rivals, having a strong intelligence network on the ground is vital. However, it’s important to note that prior to performing deep dive due diligence efforts, 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 occasions, public corporate databases only provide basic company information such as the name, active status and registration numbers. As a result, a strong need of a network on the ground (i.e., boots on the ground) develops. 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 the possibility of conducting in-person interviews. IDD professionals then put that 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.
What are the risk areas that can be uncovered through IDD analysis?
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 listing of risks is daunting, but ignoring them is not an option. Your company could face substantial legal penalties, reputational damage, litigation exposure and financial losses through fraud. Understanding the risks of doing business internationally in advance—and learning how to prevent or mitigate these risks—is vital to informed, effective transaction decisions.
What are the potential consequences of not conducting IDD analysis proactively?
Following are examples of consequences:
1. Reputational damage
- A seller could be forced by a buyer to disclose improprieties to SEC or DOJ.
- Shareholder value could rapidly diminish.
- Buyer could back out from potential acquisition.
2. Impact to the revenue and profit of the acquirer
- The buyer realizes after the purchase that the company being acquired relies on improper payments to secure business or contracts.
- Pre-existing relationships and their respective contracts are at risk of cancellation due to the change in ownership.
- Potential litigation against the company being acquired could result if conditions that impact the revenue or profitability of the purchased company were not disclosed.
3. Vulnerabilities and ineffective compliance programs
- Some geographic areas lack quality public records or records could be outdated which in turn requires a more thorough approach involving boots on the ground.
- If the seller has an ineffective or nonexistent third-party risk management compliance program in place, failure to identify improper activities that business partners may be conducting is likely.
- As the complexity of the corporate regulatory environment continues to increase exponentially, certain vulnerabilities may get overlooked, and companies could fall victim to serious reputational risk and potential fines.
IDD can help many companies reduce the likelihood of being susceptible to various business and legal risks. Listed below are just a few benefits of implementing a thorough IDD approach:
- Assist companies with their decision-making process as to whether they want to proceed with an acquisition of another company
- Assist companies with identifying areas susceptible to corruption risk within a target company and implement mitigating procedures prior to substantial investment in the target company
- Assist companies with developing an understanding of the competitive landscape they conduct business in
A very key concept is that 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.
