Risk-based due diligence of third-party intermediaries: a scorecard approach

by DLA Piper
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Companies operating internationally often engage numerous – sometimes even thousands – of third parties around the world to help facilitate their business. Alongside the growth of such relationships,  the risks posed by them have taken on new significance with the rising tide of anti-corruption and anti-bribery enforcement actions throughout the world.

As a direct consequence, the importance of third-party due diligence cannot be understated.  Indeed, the level and thoroughness of third-party due diligence that a corporation undertakes is a factor that  the United States Department of Justice and the Securities and Exchange Commission expressly consider when they are deciding whether to prosecute and enforce alleged violations of the Foreign Corrupt Practices Act.

Therefore, ensuring that you complete proper due diligence can make the difference between a third-party relationship that truly adds value to a company and having to tackle expensive, time-consuming and, in the worst case, disastrous problems that may arise in the wake of actions a third party may take on behalf of your company.

The DOJ and SEC have stated that the degree of diligence “may vary based on industry, country, size and nature of the transaction, and historical relationship with the third-party.”[1]  But, practically speaking, what does risk-based due diligence mean?  And how can a corporation engage in risk-based due diligence in a comprehensive but cost-efficient manner?

In this article, we define key factors around risk-based due diligence and then provide a basic scorecard to guide you to a general understanding of the levels of risk posed by third parties who may be providing services for your company in your international operations.

KEY FACTORS IN RISK-BASED DUE DILIGENCE

Understanding the basics

Risk-based due diligence is the process by which a corporation determines what level of due diligence to complete based upon the level of risk posed by a third party.

Third parties include, among others, sales agents, distributors, suppliers, resellers, consultants, service providers, customs brokers, lobbyists and joint venture partners.

Key issues to consider in assessing risk include high-risk locations and industries. A third party that conducts business in a high-risk location or industry, or both, should raise a red flag.

A useful tool in identifying high-risk locations or industries is the Corruption Perceptions Index (CPI), created by the global organization Transparency International. The CPI measures the perceived levels of public sector corruption in 176 countries and territories worldwide.

Region-specific: Even in countries that are low-risk based on CPI, particular regions may suffer from higher levels of corruption than other regions.

  • Certain industries historically tied to corruption are regarded as high-risk industries.
  • When these two factors overlap, so that a third party is both in a high-risk location and a high-risk industry, the risk of corruption is exponentially greater.

Government interactions

Because interactions with government officials remain at the heart of anti-corruption compliance, the level and type of interactions in which the third party will engage with the government are also key considerations.

High-risk interactions often involve, among others:

  • Engaging directly with government officials to secure government contracts and other forms of authorization
  • Engaging with government officials to secure sales to governmental customers
  • Engaging with state-owned enterprises (SOE).

Particularly risky is a close relationship between a third party and a government or political official linked to the transaction at issue.  Key considerations:

  • Why was a particular third party selected? 
  • What other types of interactions, outside of those directly related to the transaction, does the third party have with the government official in question?

Categorizing the third party

Certain basic characteristics of third parties are key to categorizing the levels of due diligence that are required, including the third party’s:

  • Scale of operations
  • Level of expertise within the relevant industry

Terms of the relationship

Particular topics arising during contract negotiations with a third party are also useful indicators in determining the level of due diligence warranted, including:

  • The form of payment the third party requests
  • Types of discounts the third party requests
  • Transparency regarding expenses and accounting
  • Compliance with FCPA and local anti-bribery laws

A SAMPLE SCORECARD FOR COMPARING THIRD PARTIES

Once you have addressed these basic issues, how do you categorize third parties to determine which ones need closer scrutiny?

Although far from exhaustive, below is a scorecard providing sample markers against which to compare third parties.  Most third parties likely will not fit neatly into any one category when all factors are considered, but patterns can be drawn from such factors.

THIRD-PARY SCORECARD

 

 

Issue

Low Risk

Medium Risk

High Risk

 

High-Risk Locations and Industries

 

 

 

 

High-risk location?

CPI score above 70

CPI score between 50 and 70

 

CPI score under 50; or region of country, with even higher CPI ranking, more susceptible to or known for corruption; or country with heavy government involvement in industry

High-risk industry?

 

No known historical ties to corruption

Moderate level of historical ties to corruption or, for newer industries, potential susceptibility to corruption

 

Known historical ties to corruption

Government Interactions

 

 

 

 

Amount of direct engagement with government officials

 

The amount of direct interaction with government officials is commensurate with normal business operations rather than specialized situations (e.g., product approval)

The amount of direct interaction with government officials is moderately more than for normal business operations, or minor engagement with government customers

Frequent interactions with government officials (e.g., involvement with product approvals, more than a small number of government customers)

 

Type of interaction with government officials

 

Limited or no direct interaction with individual government officials (e.g., dealing mostly with government bodies, or through formal channels)

Infrequent but moderately close interactions with government officials (e.g., infrequent but still some meetings with government officials)

More involved interactions with government officials (e.g., frequent meetings, meals/entertainment, sponsored events)

Types of Third Parties

 

 

 

 

Scale of operations

Global third party with name recognition

 

Perhaps not a brand name, but sophisticated entity with sufficient organizational scale

 

Not a well known entity and/or small/local organization

 

Level of experience

10+ years of experience in industry for which services are sought

 

5-10 years of experience in the industry for which services are sought

 

0-5 years of experience in the industry for which services are sought

Terms of Transaction

 

 

 

 

Payment terms

Hourly based or flat fees commensurate with industry standards; payment by company check delivered to the third party’s normal place of business in the name of the third party.

Less than simple (albeit potentially proper) payment terms involved (e.g., discounting structures, rebates)

 

Performance-based payments; offshore payments; unusual discounts; requests for advance payment

 

Records and compliance

Comprehensive and professionally audited record-keeping practices and robust compliance program

Good professional record-keeping, although perhaps not at a fully audited level, and moderately robust compliance program

Moderate to poor record-keeping practices and limited or no compliance program

 

COMPLETING APPROPRIATE DUE DILIGENCE

Based on the level of risk associated with the third party at issue, a corporation should conduct an appropriate level of due diligence.  While, generally speaking, a high level of due diligence is necessary for high-risk third parties and a lower level of due diligence is likely sufficient for lower-risk third parties, the appropriate level of due diligence will vary based on the circumstances surrounding a particular third party.

Following are some potential methods for carrying out due diligence at various levels:

  • Low-level diligence:  Third-party questionnaire and related follow-up; review summary financial statements and other background documents; conduct general online research and review publicly available information.
  • Medium-level diligence:  In addition to the aforementioned, perform a background check of the third party, including a more extensive review of publicly available information (e.g., government database search); interview the third party’s senior management; conduct a more extensive review of relevant documents and financial records.
  • High-level diligence: In addition to all the aforementioned, conduct interviews of employees beyond senior management – e.g., personnel in the field who would be involved in the engagement; review facilities; comprehensively review relevant documents and financial records; conduct a background investigation that includes inquiries beyond publicly available information (e.g., interview industry sources).

A PRACTICAL, REASONABLE APPROACH

By engaging in risk-based due diligence methodically, a company can introduce practicality and reasonableness to the often daunting task of examining its current and prospective relationships with third parties.

Moreover, conducting such due diligence can sufficiently limit risk for the company and comply with government expectations, while maintaining the value that third-party relationships are intended to bring to the company’s business.


[1] DOJ and SEC FCPA: A Resource Guide to the U.S. Foreign Corrupt Practices Act , p. 60 (November 2012).

 

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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