What Is Due Diligence?

by Thomas Fox

What is due diligence? When did due diligence begin? What does it really mean to perform due diligence? Further, how do you tie the information that you obtain in the due diligence process into your ongoing compliance program? I thought about those questions in the context of two very different types of information that I recently came across.

The first is Professor Donald Kagan’s 24 lecture series on Ancient Greece. Kagan, a professor at Yale, is considered to be one of the pre-eminent American scholars on Ancient Greece. I downloaded this lecture series on iTunes U, from the selection of Open Yale courses. For a non-Eli, such as myself, to have access to the lectures of Professor Kagan is a treat beyond words.

The Athenian democracy had many interesting features. The entire citizenship of Athens elected its leaders annually. One of the interesting features of the Athenian democracy was that before each election there would an exhaustive background investigation into each candidate, including their financial dealings, legal proceedings, military service and other relevant factors which might provide information on their character and fitness to hold office. After their one year tenure, there would be an audit of the former office holders’ finances to determine if anything was askance or if there was evidence of bribery and corruption. All of that sounds like a fairly robust program to determine the qualifications of a leader beforehand and then a backend determination if there was any indicia of bribery and corruption which could be further investigated if required.

Lest you think that there was no management of politicians during their term, there were 10 votes annually on whether a leader was doing his job. If there was a majority vote against the politician, he would have to go court to defend himself by proving that he was performing his job correctly and going to court in ancient Athens, meant a trial before the entire body of eligible voters. If the politician lost, he was thrown out before the end of his one year term. If he won, he reassumed his elected duties.

So the ancient Athenians had pre-election due diligence, management of the relationship during their annual term and then a post-relationship audit. Not too bad a system, particularly when you consider that it was developed over 2500 years ago.

The second item of interest was an article in the New York Times (NYT), High & Low Finance column of Floyd Norris, entitled “Intersection of Fraud and Traffic Violations”. The article was quite fascinating. It reported on a study by Robert Davidson, who teaches accounting at Georgetown University, along with Aiyesha Dey, of the University of Minnesota, and Abbie Smith, of the University of Chicago. Norris reported that “Their results are reported in a paper, “Executives’ ‘Off-the-Job’ Behavior, Corporate Culture and Financial Reporting Risk,” which is to appear in the Journal of Financial Economics.”

The bottom line is that if your company’s Chief Executive Officer (CEO) “likes to drive too fast, watch out. He may be more likely to commit fraud.” However, (and perhaps counter-intuitively) “If he lives too high on the hog, worry about whether he is paying enough attention to work to catch fraud being committed by his subordinates. And there may be a greater chance that the company is making mistakes in its accounting, though not fraudulently.”

The authors used some interesting investigative techniques for their paper. First they examined “fraud cases that the Securities and Exchange Commission [SEC] filed over the years — covering frauds that began between 1992 and 2004.” Next, the “researchers looked for other companies that were as similar as possible to the companies that were caught. Those companies were of similar size, had similar balance sheets and similar prefraud stock market performance as the fraudulent companies and were in the same industries.” This netted them “109 companies where fraud was detected and 109 similar ones where it was not.” The next step was the one that I found the most interesting, “The academics then hired private investigators to check out the bosses. They looked for past criminal records, including traffic violations, and they searched public records to see which cars, homes and boats the chief executives owned.”

Norris reported that while “The statistics are far from conclusive — 109 is not a large number — but they may take on a little more weight from the decision of the researchers to investigate an additional 164 chief executives. They came from 94 companies that were forced to restate their financial statements but were not accused of fraud by the S.E.C., and from 70 others chosen at random from the universe of companies that did not have fraud or accounting errors.” Norris believes what the report “could indicate is that people who are willing to violate one set of social norms are more likely to be willing to violate far more serious ones.”

I do not think that his last statement would be too controversial. However, the research went further. The authors of the report “also set out to if what they called unfrugal chief executives run companies that are fundamentally different from those run by bosses who spend less on themselves. To determine that required decisions on just what constituted unfrugal behavior. They settled on a definition involving ownership of homes, boats and cars, which is available from public records. Chief executives were deemed to be unfrugal if they owned a car that listed for more than $75,000, a boat that was more than 25 feet long or a house worth more than twice the average cost of a home near the company’s headquarters.”

Once again, the report findings seemed interesting. The researchers found that “Unfrugal chief executives are no more likely to commit fraud than their colleagues, but they are more likely to run companies where others commit fraud, and they are more likely to run companies that are forced to restate their financial statements.” In other words, they were playing with their expensive toys and not watching the shop.

Norris concludes his piece with the following, “I don’t think any of this proves that a traffic ticket should disqualify someone from running a public company. And it appears that most fraud is committed by chief executives who have no previous record of criminal behavior, so that is hardly the only thing a board should monitor. But the evidence may indicate that boards should routinely run background checks on top officers and on those being considered for such positions. If someone does have a bunch of traffic tickets, or worse, that could be an indication that deeper consideration is needed before that person is given control of a public company.”

I think that Norris has correctly articulated one of the key issues for any compliance practitioner in the due diligence process. What is the analysis that you should use? The FCPA Guidance provides a list of red flags which should be very large warning signs for a company in creating a business relationship with a third party. But beyond this well-known list of red flags, which information is relevant in assessing a third party, corporate CEO or other executive or simply a new hire. Does the fact that someone had a business failure and filed bankruptcy or has a low credit score mean they are prone to corruption? Or does that mean they have an entrepreneurial bend that would be an asset in a company? How about if they went through a major health issue and their health care provider and insurance carrier got into such a dispute over payment it affected the person’s credit score? What about multiple marriages, does that demonstrate a lack of stability?

So while Norris’ article does raise perhaps more questions than it has answers, you can take some solace in knowing that the due diligence process you have in your company is not new. The ancient Greeks used in 500 BCE.

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.

© Thomas Fox, Compliance Evangelist | Attorney Advertising

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Thomas Fox

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