Stakeholder Due Diligence

3rd June 2020

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Furnishing decision makers with relevant background intelligence enables them to make sound investment decisions whilst knowing their compliance and regulatory concerns are protected.

 

Your judgment regarding the appropriateness of a company listed on a stock exchange, alternative market, or private equity investment, has a crucial role to play in maintaining the quality, reputation and the integrity of your company, the market and, or investment.

Accordingly, the quality of due diligence performed on directors, stakeholders, beneficiaries, and the companies themselves, applied by an adviser, broker, private equity team, or qualified executive (advisers) in assessing such information is vital.

Advisers should also be reminded that any individual making a false statement in order to gain employment or a voluntary position, is a criminal offence under Sections 2&3 (False Representation and Failure to Disclose) of the UK’s Fraud Act 2006, and can carry a maximum sentence of ten years’ imprisonment. 

 

Meaningful

Due diligence procedures on key stakeholders should be applied consistently for any listed market admission, the take-on of an existing listed company from another adviser, and the appointment of a new director or significant shareholder to an existing listed company or related to a private equity investment.

As a starting point, due diligence on potential directors should be meaningful, undertaken to help advisers assess their appropriateness rather than simply as a “tick box” exercise to satisfy a regulatory process.

Rightly, background checks on directors and other stakeholders should be based on an adviser’s reasonable judgment as to what information it requires to make an informed decision on an individual’s suitability to be a director.

Advisers should assess their ability to remain unbiased in their initial evaluation and weigh up whether outsourcing the information gathering process to an independent specialist would be more appropriate.

Financial regulators would expect advisers on the Alternative Investment Market (AIM) for example, to use a “range of sources” when undertaking due diligence, including a “suitable director’s questionnaire (DQ), web-based general searches, Companies House or similar overseas checks, interviews, reviewing references etc”.

Yes, some checks in the United Kingdom are relatively easy to perform and can be conducted in-house, but what does “web based” and “general searches” or “similar overseas checks” actually entail?  Do advisers have the time and appropriate resources to conduct these checks?

In our experience, background checks into senior executives and new hires entails rigorous interrogation and analysis of information gathered from a range of open sources. These sources include, but not limited to:

  • subscribed databases

  • historical press articles

  • company registries

  • civil and criminal litigation searches

  • an examination of public records and documents

  • insolvency histories

  • independent reference checks

  • employment and education verifications

  • social media platforms

  • deep web sources

  • and where possible and appropriate, criminal record checks.

When appropriate, the open source information gathering described above should be performed in appropriate jurisdictions and in key languages, depending on where the director or stakeholder has had a corporate or residential presence.

When it comes to overseas’ directors in particular, financial regulators would expect it to be “the norm rather than the exception” for an adviser to undertake third party due diligence.  The objective of third-party due diligence is to provide substantive and reliable independent information which will be beyond what advisers are able to ascertain from normal desktop searches. Most importantly, third party due diligence will be performed in the relevant language or languages, rather than relying exclusively on data gathered from English-language sources.

 

Consideration

Having gathered the key findings from the background checks and due diligence exercise, an adviser should take a step back, review and consider all the issues arising from the information it has assembled. Any issues and recommendations should be shared with an appropriate person and challenged by experienced members of the firm who, where possible, are independent from the transaction team.

It is critical to identify and challenge all the potential risks uncovered from the background checks, as the additional cost for supplementary research phases is minimal compared to the possible losses incurred from a bad business decision.

Where issues of concern are raised, the adviser must reconcile these by way of further reasonable enquiry from the director or stakeholder, and then verify and evaluate the responses given.
 

If any concerns arise that cannot be reconciled, the adviser should consider how it will impact upon their appropriateness, and with the integrity of the market and reputation of the client in mind, its governance responsibilities.  In some situations, an adviser will have to conclude that the individual is not suitable to be a director or stakeholder of the company.

 

How much due diligence is enough?

In 2002, Yahoo discovered that CEO Scott Thompson could not have obtained the bachelor’s degree in computer science from Stonehill College he had declared on his application form, as the course was not offered until four years after he graduated. In 2018, the world’s largest luggage maker, Samsonite, also announced its CEO had stepped down following allegations he lied on his resumé.

A Canadian businessman John Davy was appointed the CEO of the New Zealand television network, Maori Television Service. He was dismissed less than seven weeks later when it was discovered that his CV was almost entirely fabricated, including claims to hold an MBA from "Denver State University" which turned out to be a counterfeit certificate and degree being sold online.  Two months after being dismissed, Davy was jailed for eight months in New Zealand, after pleading guilty to one charge of using his CV "to obtain a benefit or privilege”.

These are just three high-profile examples whereby market leaders took for granted the claims of their most senior executives’ CVs, only to later realise the deception and face the consequences. This resulted in not only an expensive exit, but, most importantly, it had an embarrassing impact on the company’s public image affecting its share price and recovery. Skeletons can be found in even the safest closets.

Advisers or independent third parties should interrogate the individual’s CV, DQ, application forms and corporate history, not only to verify the information provided, but to specifically identify adverse information and risk such as undisclosed information, regulatory red flags, conflicting findings or false or exaggerated statements, and report these findings to the adviser or transaction team.

Having the right background information allows organisations to work with confidence, compliance, and assurance.

Our recent research – derived from 600 completed background checks performed by the TenIntelligence team during 2018/19 – categorised the results of each check using a simple traffic light system. Each background check received a status of Red, Amber or Green, depending on the severity of the findings: Red showed a significant red flag had been found; Amber confirmed that discrepancies were identified; whilst Green meant there were no issues identified on their CV or application form.

The results of our research was that a total of 69% of cases were identified as having an Amber flag, meaning we identified an undisclosed or inaccurate finding during the open-source phase, indicating a further investigative phase was required or the research scope should be expanded into additional jurisdictions.

During the due diligence process, most directors and stakeholders are given the opportunity to disclose such adverse findings on their DQ or application form; yet, often our self-preservation instincts kick in and we choose to fabricate, conceal or ignore the truth.

This defence mechanism was highlighted during our research, as we identified a further 6% of cases that highlighted Red flags, including allegations of insider trading, sexual harassment, fraud, drug taking, undeclared insolvencies, court litigation, compulsory liquidations, ties to sanctioned individuals and companies, criminal convictions, and Politically Exposed Persons. Clients had been poised to appoint professionals who at first glance seemed like the ideal candidate, but after a little digging turned out to be less than desirable.

This clearly demonstrates the need for background checks to help safeguard your organisation’s reputation.

 

Industry Insight: Source Intelligence

An independent analysis of a director or stakeholder’s character should also be considered to assess the appropriateness of their professional background. One of the best ways to obtain this information is by speaking directly with former colleagues, clients and senior management. A process we call Industry Insight.

We have recently seen a substantial increase in requests for Industry Insight research and interviews complementing our background checks and due diligence.

The driving force behind this seems to be an increase in regulatory requirements and scrutiny as well as “good governance”. A large proportion of the Industry Insight interviews we conduct are in relation to senior executive hires or directors of listed companies; as well as listed companies themselves. 

Advisers tend to utilise this source intelligence offering for:

  • board directors who are new to the listed market sector

  • all their international stakeholders and directors

  • enhanced due diligence best practice

  • a later phase if an amber or red flag is identified during the first phase of background checks.

But what does Industry Insight entail and why is it such a vital part of Enhanced Due Diligence?

Industry Insight is an investigative research tool that complements and adds value to quantitative information in respect of the individual director or stakeholder.  It provides clients with a deepened understanding and valuable context when trying to identify sensitive or adverse information.

Conducting Industry Insight interviews requires skill and a great deal of preparation to obtain quality responses.  A standard framework of questions is a useful start, but the interviewer also needs to know when and how to adapt lines of questioning or to probe for further information or explanations.

It is also important that the credibility and relevance of the interviewee is thoroughly researched beforehand.

The interviews can be face-to-face, although telephone interviews are more common as they are more time/cost effective and not restricted geographically; and especially now, with new “Covid Secure” measures in play.

In most cases the individual director or stakeholder will provide authorisation for our team to perform such interviews. The provisions of protecting personal data will need to be carefully considered. 

 

No more Google searches

When 75% of our background checks identify Red or Amber flags, a simple Google search is not enough.

Whether it is through an in-depth interview with a former colleague which reveals criminal activity or undeclared financial issues identified through official records, relying on a Google search to identify these kinds of risks is unwise – none of the red flags we identified during the 600+ background checks in 2018/19 were found through just a Google search.

Our study proved that using standard search engines will not recover subscribed data from the deep web or hidden behind pay walls. Collect meaningful information, spot the flags and report appropriately.

Detailed examination of databases, online resources, and interviews with carefully chosen individuals and sources, is the only way companies can be certain to minimise risks when engaging with a new stakeholder, senior hire, partner, investment, or business. 

In summary, continue to apply a risk based approach, evaluate your research sources, review whether your background checks processes are fit for purpose, consider outsourcing to an independent party and always challenge any discrepancies found in the due diligence to help maintain integrity.

Acquire the best information so you can make assured decisions.

 

This article was contributed by Ten Intelligence Limited.

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