Avoiding Due Diligence Failure: Follow Up on All Red Flags

Posted by Philip Segal on September 11, 2012

This blog takes no position on the malpractice allegations by HSBC that its law firm, Troutman Sanders, dropped the ball on its due diligence of a borrower who ended up costing the bank $75 million when the borrower put fake securities up as collateral. You can read about the lawsuit here and here.

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A key portion of the allegations is that Troutman was tipped off to some inconsistent information when it was checking into the faked collateral, but didn’t investigate further or tell its client about the red flag waving brightly before its eyes.

Whatever really happened in this case, we find it’s worth reminding clients and those who may become clients that if something doesn’t seem right during due diligence, you have to assume that it isn’t right.

This can take some doing. We’ve written before about how the smarter you are, the easier it will be to convince yourself that it’s OK to do what you want to do, in our entry  JPM, Feynman and Investigations. We’ve also written about need to be on guard regarding people who come well recommended from third parties, in Due Diligence on Expert Witnesses: Assume the Worst.

Due diligence shouldn’t be about digging for dirt that you hope will be there – as in litigation – or that you hope won’t be there – because you want your client to close the deal.

It’s about being on guard for the unexpected and reporting exactly what you find. It should never be “good news” or “bad news.” Never mind that your client will be angry that you’re wrecking a deal, or that the major witness on the other side appears to have no skeletons in his closet. All a good investigator is doing is presenting findings. Whatever you think your client wants, in the end telling the truth about what you find is the only way to go.

For a good starting checklist on a solid approach to due diligence, see our entries In Plain Sight: Corporations and Public Records and Scratching the Surface: Due Diligence and Public Record Searches.

Due Diligence for Employees and Small Businesses: Turnaround is Fair Play

Posted by Maria Matasar-Padilla on August 31, 2012

GettyImages_77384047.jpgOne of the biggest misconceptions about due diligence is that it is a one-way street.  People assume that either they are scrutinized or doing the scrutinizing, but never the twain shall meet.  But this shouldn’t always be the case. In some instances, the person under the microscope also has a responsibility to make sure that they subject the other party to thorough due diligence. 

Take the future employee or the new member of an organization. Applicants for jobs, executives under consideration for management positions, people tapped to join the board of a corporation or a nonprofit realize that every new hire could either help an organization thrive or cause it irreparable harm.  And so people make their resumes available, provide a list of references, sign consent forms for more invasive analyses and then anxiously await to hear what the search unveils.

But just as the organization will be judged by the people it hires, employees are judged by the company they keep.  To ignore any potential red-flags risks being deemed guilty by association. In order to look out for their own best interest, potential future employees need to do some due diligence of their own.

  • Is the company or group reputable?  Does it face any criminal allegations or civil suits? What sort of public relations issues has it dealt with? Are there any crises brewing?
  • Are the people they will be working with well-respected and trustworthy?
  • Is the company fiscally responsible? No one wants to find out that the company finances are going south when a paycheck bounces. 

The sense of being under the microscope is magnified when money is on the line. Small business owners pondering private equity offers know that in order to obtain any funding, they have to consent to having their financial past and present probed.

But sellers don’t always consider that they have some due diligence of their own to do.

A recent New York Times article, “Owners Should Know What They’re Getting With Private Equity” summarizes the numerous issues small business owners ponder when weighing private equity offers.  First and foremost, small business owners have to do due diligence on the private equity firm. As Michael A. Smart, a managing partner of the private equity firm CSW bluntly advises small business owners, “I’m doing diligence on you, you should do diligence on me.” 

This is about more than money.  Private equity firms promise expertise, connections and experience to tap into new markets. Small business owners have to make sure that they can deliver. So, what sort of due diligence should small businesses do on private equity investors?

  • Background checks
  • Talk with former clients. Ask what sort of value the investors added. Did they deliver what they promised?
  • Speak with members of corporate boards where the firm’s investors are active.

Knowledge is power, and the more knowledge a small business owner has going into a deal with a private equity firm, the more likely they are to get what they bargained for. 

In Plain Sight: Corporations and Public Records

Posted by Maria Matasar-Padilla on July 18, 2012

GettyImages_108269630.jpgClients are often surprised to learn how much corporate information is on the public record.  Of course, public companies are forced to disclose a lot more data than private ones, but it's still possible to learn about private companies using smart and thorough public records searches. 

And there’s more to learn than just what assets a company holds.  For example, determining what the organizational chart is at a corporation, including who reported to whom and on what projects they collaborated may help an attorney trying to create a witness list for a case.  A law firm doing due diligence for an acquisition may want to know if a company has been sued, and by whom.  They will also want to hear what current and former company insiders have to say about the company’s ins and outs.  A non-profit  interested in naming a corporate executive to its board of directors may want to make sure that the company the executive works at doesn’t have any skeletons in its closet in the form of embarrassing litigation, financial irregularities or regulatory failures. 

So what can a client expect from a public records search for a corporation? Below is a list of just some of the available information:

  • Secretary of State corporation records: Corporate record filings from individual Secretary of State offices will sometimes include information on where the company was originally registered, the names and addresses affiliated with the company, including any parent company or any other companies doing business under different names (knows as “DBAs” for “Doing Business As”).  These records will indicate if the company is still in good standing in the state, having paid all the necessary fees and provided updated copies of appropriate paperwork, perhaps including any important changes in leadership.  Public records of the state where a company is doing business will help identify where it was originally registered.  Incorporation records are often publically available for a small fee and detail the company’s original structure and its key players. 
  • Real property records:  A search of property records (usually at the county level) using the corporation’s official name, or, if relevant, any of its DBAs, may help determine the corporation’s real property.  In addition, property records usually detail mortgages and whether there are any liens pending.
  • Personal property rolls: Some state and local governments tax businesses on their personal property, requiring corporations to declare their assets to determine how much they owe.  In some cases, these financial records are publically available.  
  • UCCs: Companies file Uniform Commercial Code (UCC) records when they enter into a secured borrowing transaction with another company or an individual.  The records detail the transaction, including what the borrower declared as collateral.  This information may help determine what assets a company holds.  UCCs are filed at the state and local levels.
  • Intellectual property: The U.S. Trademark and Patent Office databases detail any trademarks and patents a company has filed with the federal government.  In addition, company copyrights can be searched via the U.S. Copyright Office databases.
  • Securities and Exchange Commission filings: If the company is a public company, SEC filings will provide information on the company’s financials, as well as any accounting issues or regulatory concerns that have to be addressed or explained.  Also, records may list current or former employees, executives or board members worth interviewing.
  • Litigation: There should be a criminal and civil litigation search on the federal level, as well as any state where the company does business. Such searches may be time consuming if the company has various locations, but it is worth being thorough.  Litigation searches will also help expose if there are any judgments against the company, and trial records may help uncover individuals at odds with the company who may be willing to shed light on any potentially damaging company information.  They could be former employees or simply adversaries whose litigation uncovered important company information.  In many cases, we also find it helpful to search lower courts as well at the county or city levels.
  • Former employees: Former employees of a corporation are often worth interviewing.  Some databases provide names of all employees their records indicate are somehow affiliated with a particular company.  The results may require some culling, but better too much than too little.
  • Media searches: Learning what sort of press coverage a company has received is invaluable.  Any press coverage that ranks the corporation in relation to its competitors may prove helpful in anticipating problems or concerns.  Pay close attention to how the company’s financial standing is represented in the press—whether these analyses are correct or not, public perception of a company is valuable information. Similarly, it is important to review local press coverage of the city and state where a company is based or headquartered.  Local coverage can be a lot more thorough, and in some cases, more critical than national coverage.  Furthermore, any articles that quote company employees and executives, or press releases about the company may provide leads on people worth tracking down to learn more about the company’s inner workings.
  • Regulatory and licensing records:  If a company is in a business regulated by the state or federal government (or even a municipal government), the inspection certificates and any records of regulatory violations may be available to the public.  This could entail filing a Freedom of Information request on the state and federal level, which may be time-consuming, but helpful nonetheless.
  • Fire inspection records: City governments may have on file fire inspection certificates detailing when a company was last inspected and whether any fire code regulations were found.  
  • Political contributions: While corporate political contributions are not always transparent, at a bare minimum contribution search engines may provide information on the politicians and causes companies have supported.
  • Security/Terrorism sanctions: Make sure to run all the company names through the U.S. Treasury’s Office of Foreign Assets Control list, as well as Interpol, the International Financial Action Task Force and UN Sanctions lists.

Due Diligence For Current Employees

Posted by Maria Matasar-Padilla on May 31, 2012

Companies are saving recruiting and advertising costs by hiring from within.  But they still need to invest in due diligence and make sure that internal promotions are vetted with the same rigor as external hires.

We’ve written before about the challenges of hiring in our article "Hiring Due Diligence Should Include an Attitude Check." Every employer has their wish list for a job candidate, but there are usually two constants: the candidate has to be well qualified to meet the demands of their new position; and they have to be a good fit in the company.  In most cases, you can’t be sure that an employee will satisfy both requirements until they’ve been on the job for a while.  This means that every outside hire is a gamble.

And, according to a recent study from the University of Pennsylvania’s Wharton School of Business, an outside hire might be an expensive gamble at that.  Published in the journal Administrative Science Quarterly, the study determined that outside hires tend to be paid 18% more than internal employees in comparable roles.  Which would be tolerable if they did a better job than internal hires.  But the study also compared the performance reviews of new and internal hires, and found that at least for their first two years on the job, external hires tend to do a worse job than established candidates.  The study’s author, Wharton associate professor Matthew Bidwell, explains that the difference may be attributable to the difficulties inherent in integrating new hires into a company.

It would seem that the solution is to promote internal candidates.  After all, they have already adapted to the corporate culture, so that’s not an issue.  And with the proper training and monitoring mechanisms in place, companies can ensure that employees obtain the skills and experience necessary to succeed in new positions.  An added bonus: The shift to hiring from within also cuts down on recruiting and training costs. 

But as we wrote in the entry "Background Search for All: Lessons From the Alleged Archdiocese Theft," recruiting from within is not without its dangers.  Many firms are willing to invest in thorough due diligence of new hires, scrutinizing their resumes, verifying their previous education and employment history and running expansive background checks.  But the same level of scrutiny may not be applied to internal candidates.  After all, it could be assumed that candidates were scrutinized when they were first hired.  So, presumably more vetting would be unnecessarily expensive or intrusive.

This assumption would be a mistake. 

Companies should have due diligence policies in place that scrutinize internal promotions with the same level of rigor as new hires.  For instance, internal candidates may have been hired when a less expansive vetting process was in place.  They were therefore not previously subject to intense scrutiny.  A promotion would be a good time to remedy this oversight. 

Many companies and organizations reserve their more rigorous vetting for people who hold certain posts.  They might save money on due diligence costs by limiting background checks to employees who work with minors, handle finances or have access to sensitive or confidential information.  These companies need to make sure that all internal hires filling these positions be checked anew.  Any candidates originally hired to posts that did not require a background check should not be eligible for promotion until they are thoroughly scrutinized. 

In some organizations, only senior level hires are subject to expansive due diligence.  In contrast, lower level hires will only have to endure a cursory resume and employment history check.  Therefore someone who is promoted from within to fill a senior-level or management position may need to be rigorously re-vetted. 

Companies should remember that saving money on due diligence of internal hires may be tempting, but doing so could be at their own peril. 

Sorting and Unsorting Facts

Posted by Maria Matasar-Padilla on April 19, 2012

GettyImages_78456509.jpgContext matters. We know this instinctively, and yet somehow we forget.  We still tend to assume that facts live in their own separate bubbles. So when we research and analyze, we warily keep our findings in separate categories—information on person A separate from information on person B, which are both separate from facts uncovered about company C.  We go to great lengths to avoid any cross-contamination because that may be messy or unwieldy and keeping things tidy is so satisfying. 

But investigations are lots of things, and tidy is not one of them.  Investigations are filled with loads of information which could be put into more than one category or, maddeningly, into no category at all.  Investigators have to patiently wade through all that data, perhaps indulge in categorizing at first to help keep track of data, but then get rid of the categories and start to put things together.  Only then can the dots be connected.  Finally, a full picture emerges.    

But how to connect the dots?  How to avoid being overwhelmed when you feel like you’re drowning in data?  We’ve sung the praises of chronologies in our blog entry, The Putin Plot and Investigative Timelines, as a good way to see the big picture. But this is especially true when a time line is built using facts from all sorts of different categories.  Exploding those categories, taking those facts and putting them into a new context, may be the best way to make sense of information that might otherwise appear irrelevant or unrelated. 

Take this example:

We recently investigated an executive who a few years ago gave quit claim to his wife of their family home in Pennsylvania.  At first this transaction didn’t seem to fit into the narrative we were uncovering about his personal life.  So we made a note of it and when it happened, figuring for the time being that it was nothing more than a savvy financial decision done for personal tax purposes. 

But this turned out not to be the case once we analyzed what was going on around the same time at one of the companies the executive headed.  Within weeks of the quit claim transaction, one of the companies was sued for several million dollars by another corporation.  The plaintiff corporation alleged that it had been defrauded and accused the defendants of negligence.  Although the executive was not named in the suit, he was implicated because he directly oversaw the transactions at the center of the plaintiff company’s claims. 

Suddenly that quit claim, which initially seemed to be separate and apart from the executive’s professional life, made sense in the context of what was going on at his corporation.  Given the timing, the transfer of this very expensive home to his wife suggested the executive was attempting to shed his assets in anticipation of being held personally liable in the lawsuit. 

Then throw in the fact that the case was settled a mere 20 days after the suit was filed.  Although the terms of the settlement were kept confidential, the timing suggests that the defendant corporation was happy to make the concessions necessary to settle the litigation rather than risk having the case proceed. 

While we don't know for sure if this is the case, initial analyses suggest that these three facts combined—the quit claim, the lawsuit, and the settlement—are as close to an admission of liability as a savvy, well-represented executive is likely to make.  But the full picture emerged only after we were willing to set aside the categories we’d created and place all the facts into new and different contexts.  

New Employee Character Checks: A Gut Check is Not Enough

Posted by Maria Matasar-Padilla on January 23, 2012

GettyImages_78621733.jpgYou have an opening in your company.  You get a slew of resumes for the position, you interview a number of candidates, and then you finally narrow it down to two people: One has experience that’s right on the mark, but during the interview you had glimpses of an attitude that might not mesh with your corporate culture.  The other person is lacking a number of important skills, but it seems that she makes up for her shortcomings with an energy and attitude you admire.  She seems like a real go-getter who will be a good fit among your staff.  So what do you do?

We’ve seen this debate played out in the blogosphere repeatedly (here’s one example, and another), and usually folks tout character over skills.  The reasoning?  Skills can be taught, but character cannot.  But if you’re the person doing the hiring, how do you make sure that your impression that someone has a good character is right?  Or if you’re an attorney who’s looking for a reliable witness, how do you make sure you pick one whose credibility won’t be ruined by proof of a less than upstanding character?

Is this as simple as confirming that the candidate’s resume is accurate?  Determining that someone must have good character because they didn’t lie on their resume is setting the bar pretty darn low.  So do you just resort to Googling the candidate or witness?  Checking their Facebook page or Twitter feed?  We’ve pointed out more than once that assuming everything you need to know about someone can be found on the Internet is just not true.  You don’t get a full picture of someone just because you saw their listing on LinkedIn or scrolled through their pictures on Facebook—expect perhaps that they have yet to master the social networking site’s privacy settings. 

So is this instead an “I know it when I see it” sort of assessment—where you base your decision primarily on your “gut,” your “instinct,” or some sort of “hunch” about the candidate’s character?  Maybe you’re a great judge of character with a wonderful track record who can trust your instinct without reservation.  But for most people, that’s rarely the case, especially those who are new to hiring or who don’t have a lot of experience selecting witnesses for a case. 

The truth of the matter is that being a good judge of character is sort of like being funny: everyone thinks they are but we all know that’s not always true.  I don’t mean to suggest that instinct isn’t valuable—sometimes it’s all we’ve got and more often than not it’s worth heeding a “bad feeling” about someone.  But we’re talking about pretty high stakes here, and it would be good to base an important decision on more than a hunch. 

This is where a good investigator is invaluable.  Every worthwhile investigator will look beyond the Internet and do various in-depth database searches.  But those who really know what they’re doing know that that’s not enough.  They know that ultimately they have to get on the phone and start interviewing people.  They will talk to those old employers, track down ex-colleagues, and get the skinny from friends, classmates and co-workers.  Sure this might generate some gossip, and some of it may or may not be true.  But combined with smart and thorough database searches, this approach will provide a much clearer picture of your candidate’s character, helping you make a genuinely informed decision.  

Fire your accountant, financial advisor and lawyer too?

Posted by Philip Segal on January 16, 2012

A thought-provoking column in the Wall Street Journal here that argues in favor of routine changes of auditors got me thinking.

If we should change our auditors on the grounds that they get too close to us and are afraid to displease us for fear of losing our business, why shouldn’t the same thing apply to other professionals we hire over long periods? Say, financial advisors and even lawyers?

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The case for firing auditors is that even though companies hire them and are responsible for paying them, auditors are really there to deliver what can often be “bad news” to company management keen to suppress unpleasant facts from public view. When bad decisions get translated from company spreadsheets into annual reports, bonuses get cut and executives get fired.

So instead of giving independent advice, auditors work for the same company for so long that they end up being “co-dependent,” says the Journal’s Jason Zweig.

Would that ever affect a lawyer or a financial advisor? At least with financial advisors, there are independent benchmarks that can compare your investment returns to those of similarly placed individuals. You can see whether or not your annual fee helps you beat an index, and you can shop around to see if your advisor’s fee is excessive.

What about lawyers? They are bound to a code of ethics, but so are accountants. Lawyers can’t just ignore wrongdoing, but accountants too are supposed to blow the whistle on that kind of thing. The problem arises in life’s hundreds of shades of gray, between best possible behavior and reportable criminal activity.

Many a lawyer reading this can easily recall putting down the phone after an uncomfortable call with a major client who has just instructed that lawyer to do something that gives the lawyer pause. The lawyer might think to himself: “Is it ethical to do this?” but then go ahead and do it anyway. If it just passes the smell test, how many lawyers tell their clients they are treading a very fine line? We hope some, but does yours?

Changing auditors can be a real pain, which is why companies don’t like to do it. Barriers to entry can be high because there are only four big firms to service the world’s largest companies, and because it can take a new audit team a long time to get up to speed on a complex set of accounts.

That can be true of personal investment portfolios and legal issues, but often a lawyer is not tasked with taking care of every aspect of a company’s or individual’s set of legal issues.

So if you don’t feel like firing your longtime attorney or other professional, at least do what you might with your trusted physician. Get the occasional second opinion.

World on a String

Posted by Philip Segal on November 04, 2011

The world is getting smaller in many ways, including for fact finders looking to get information about companies.

Sometimes, the company across the street will file more information about itself halfway around the world than it will in its own jurisdiction. With a computer or a good person on the ground far away, the information can be yours in a matter of minutes or hours.

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Most people know the way this usually works: a company from a country with rotten disclosure wants to raise money in the U.S., and so is subject to the rigorous reporting requirements by the Securities and Exchange Commission. Foreign companies can be forced to disclose executive pay packages, and that can sometimes give you the name of a private company the executive gets his pay sent to. Great stuff, and only available because the government forces the information out of the company.

But what about the other direction? Companies from the U.S. or other jurisdictions that have great disclosure, which nonetheless turn over more information overseas than they might at home?

Two cases in point:

Last month the EU unveiled legislation to require “transparency” from “extractive companies,” which means companies that dig or pump stuff out of the ground or chop down trees. Even private companies that ordinarily would have no major reporting requirements to non-shareholders would have to disclose payments they made country-by-country.

A time-honored gift to U.S. investigators is Companies House in the United Kingdom. Private companies from anywhere in the world that want a presence in the U.K. have to register. You get names of directors, addresses, shareholder information and financials.

So the next time you have to look up information on a company, ask not only where the company is incorporated. Ask also: “where does it do business?”

Apple's Directors in Focus

Posted by Philip Segal on October 07, 2011

Now that Steve Jobs is gone, attention turns to Apple’s Board of Directors (1), a group that’s been criticized in the past for being too deferential to Jobs, as made clear in this Wall Street Journal Story.

Steve Jobs was a business genius, but are these directors good at doing their jobs to inform shareholders and stand up to a strong CEO if necessary, or are they the kind that like to take a fee and then not do as much directing as they should? Remember, many great and famous people were on the Board of Enron. They sat on the board during that company’s Apple phase of being among the world’s growth leaders, but also during its implosion.

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What boards do Apple’s directors sit on in addition to Apple’s? Are they as hands-off with those other companies as they are reportedly were with Jobs? Are they too distracted by their primary distinguished careers to do a hands-on job at Apple? These are questions worth asking if you’re thinking of putting them on your board, or if you’ve invested in a company they direct that isn’t blessed with a CEO of Jobs-like vision.

(1) Apple’s independent directors are:

William V. Campbell is the Chairman of Intuit, Millard Drexler, Chairman and CEO of J. Crew; Al Gore, former U.S. Vice President; Andrea Jung, CEO of Avon Products; Arthur Levinson, former chairman and CEO of Genentech; Ronald D. Sugar, former chairman and CEO of Northrop Grumman. 

The Silence of the Communicators

Posted by Philip Segal on April 25, 2011

Apple, Google and Amazon are in the communications business, but their leaders all need to take some courses at Hamburger University to learn how to communicate with their customers.

Any trial lawyer or investigator will tell you that WHEN something happens can be at least as important as the event itself.

Take the responses to three of the largest news stories of the past week:

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1)  the revelation that iPhones and Droids transmit the location of the phones back to phone makers Apple and Google several times a day;

2) The partial breakdown of the Amazon “cloud” of servers that house prominent websites across the country. A whole of bunch of websites were down for a prolonged time;

3) The savage beating by two women of a third woman in a Baltimore McDonald’s caught on tape and widely viewed across the U.S.

ReadWriteWEb’s initial review of Amazon was not good. A little bit of updating as the crash wore on, but nothing an ordinary person could look at and understand.

And days after the Wall Street Journal reported that Apple and Google were regularly collecting data as to the location of the owners of their handsets, Apple remains mute. Google defended its policy, but on its website there was nothing that an ordinary customer could easily find to read that would give comfort. Readers of the Journal were told that Google’s advice was to perform a “factory reset” to insure the kind of privacy many may have thought they already had with a Droid phone.

This locational data that Apple and Google have access to is valuable. The stuff scientists can figure out about us based on where we are is astounding, and frightening if that information were to be used against us.

Contrast this corporate pattern of behavior with the episode revealed over the weekend when two women were caught on tape giving a severe beating to a woman at a McDonald’s restaurant in Baltimore. The revolting footage was made worse by the inactivity of bystanders who chose not to come to the aid of the beaten woman.

How easy was it to see what McDonald’s thought of this? Very. Right on the website’s media center was a prominent statement that the company was shocked at the incident and would investigate. You typed mcdonalds.com, and two clicks away you were at the statement.

Marketing experts will tell you that if you don’t have an “elevator speech” ready to go about your business (a 30-second answer to the question “What does your company do?”) then you’re not ready for primetime. In this case, Apple, Google and Amazon didn’t have elevator speeches ready to go.

Not having an elevator speech can mean one of two things: you’re unprepared for the question, or worse yet, you have no clear idea of what you think (or what you think it’s safe to say).

Here is where timelines are so important. If McDonald’s had waited a month to express outrage at this incident, the timing would have overtaken the content in importance. We might think McDonald’s was not really annoyed at the beating, but was responding in a way that a lawyer or consultant advised was prudent. That could still be the case, but the quick response by McDonald’s could also mean that it truly is incensed that its franchised restaurant staff failed to rescue the helpless victim of a beating.

What about Apple’s timeline? Whatever Apple ends up saying about the tracking features of the iPhone, how good will we feel about all the information Apple has on us when the company can’t even comment on one of the most discussed stories in the world at which it’s at the center.

For Apple, Google, and Amazon, the time for the elevator speech has passed. The doors have closed and we - the customers - will need to be reached in a different way.