Managing Integrity Risk — The Darker Side of  Business

 Mitigating the rise of potential loss is as important as maximising profits.

Reputational due diligence is becoming a rapidly sought after method of mitigating the risks of doing business especially in Asia where markets often tend to be grey and where business styles are still intertwined between traditional Asian business philosophies mixed with Western corporate ideals.

With the evolution of business expansions and investments to China, India and throughout Southeast Asia, Singaporean companies as well as Singapore based regional offices have already experienced some of the harsher realities of doing business in such markets. The advantages of lowering costs of production and extending bottom lines in these markets have often been overshadowed by the little publicised corporate losses and failures attributed to unstable business partnerships and operational compromises; often a result of poor integrity and the lack of transparency as well as the inability to react swiftly to detect the root causes of the problem. Indeed for every success story told in the media, many corporate failures remain silent not wishing to share the lessons learnt and the simple measures that could have been undertaken to minimise damages suffered.

From professional experience, the corporate mentality in Singapore has shifted drastically to recognise that such integrity risks are part and parcel of doing business beyond these shores. The sense of risk mitigation also stems from trends passed down from best practices instilled by American and European corporations, with strong compliance cultures, who have interests in the region. It is becoming clear that the best way to deal with integrity risk is by preventing it rather than detection, which often involves spiralling legal fees and the use of professional experts, resulting often in unresolved issues and irrecoverable damages.

Executives are wising up and are learning quickly from the experiences of others in the region. Many corporations are conducting reputational due diligences as a measure to mitigate those risks and to at least enter into business agreements with ‘all the cards on the table’. The cost of this preventative approach measures marginally against the varying costs of disengaging from unsuccessful business partners.

Due diligence is a term that has many meanings for different segments of the market and the various professional industries. None, however, addresses the issue of integrity risk and the risk that represents the darker side of business; those that do or attempt to do are superficial and are mainly reliant on public domain information.

Reputational due diligence by scope alone differs in that it provides a more complete overview not just by definition but also by technique and procedure, which is unequalled by any other professional body, be it legal or financial in nature. It represents a mindset that is focused on a simple principle; ‘Can I trust my business partner and will doing business with them affect business both reputationally and operationally?’

Such reputational due diligences often include looking into the following key areas of the business partner’s organisation:

•    reputation and credibility of the directors and shareholders;

•    credibility of operations and ability to deliver;

•    track record and business history; and

•    possible undisclosed relationships.

Reviewing the reputation and credibility of the directors and shareholders often involves examining the individual’s profile, which includes academic qualifications and past positions held. It also involves reviewing for past bankruptcy records, lawsuits, out of court settlements, other disputes as well as criminal records. Where the reputational due diligence differs is that it reviews industry intelligence concerning the business partner, to ascertain the business reputation of the individual to determine if the individual was ever implicated in any investigations or participated in any form of unethical business behaviour.

All known business interests of the directors, either declared or otherwise, are also obtained and scrutinised. Often,
past wound up businesses are thoroughly analysed to identify if the reasons for closure were legitimate and not due to any undisclosed sinister problem. A close review is also undertaken to ensure that the individual(s) at the helm of the business partnering company are truly the main parties in control of the operations and represent the true decision-making authority, and not acting as ‘shadow proxies’ for an undisclosed party.

This work often involves discreet approaches to legitimate and credible business sources, who may have dealt with the individual in the past or who may be familiar with the individual because of proximity either within the same industry or through other associations. Depending on the nature of the business relationship, organisations often have the option of either conducting the review in an open manner or discreetly using ‘pretext approaches’ in which the operatives often pose as interested business partners.

This was the case during a reputational due diligence conducted on a Malaysian director of a Singaporean company supplying spare parts to a client. From initial checks, it was noted that the company remained relatively smooth in its operational capabilities; however, upon reviewing the background of the director, we noted that he maintained an alias, which was not disclosed to the client. When checks were conducted on the alias, we noted an entire history of offences, including charges of fraud as well as several large lawsuits made to the director personally. It was further discovered from our intelligence gathering review that the director had formerly operated a business in Malaysia and that he had used the company as a front to assist an organised crime syndicate in the theft and disguise of stolen vehicles. Upon his release from custody, he had adopted a new identity and started a new business.

Reputational due diligence on companies present a completely different outlook and scope. Generic scope for reputational due diligence should cover at the very minimum the following key areas:

•    business history and track record;

•    corporate structure and shareholder integrity;

•    third party relationships and integrity; and

•    operational, financial and business integrity.

The scope generally reviews the business history and company track record, which would include past performance and operational capabilities. A detailed review of any past lawsuits, disputes and conflicts with regulatory agencies would also be conducted. Often times, the level of work involves a detailed study of the business patterns of the vendor from intelligence gathering exercises combined with an analysis of potential periods in which potential negative impact may have occurred. Such instances may include a sudden departure from a known long-standing contract or the cessation of business in a particular jurisdiction or service line. Intelligence gathering exercises also allow access, where possible, to information relating to possible out of court settlements or damages paid that may go undetected from the public eye.

Shareholder structure and integrity is an essential element in any reputational due diligence, as organisations often assume that the people whom they converse with directly or even based on public record are the actual decision makers or ‘movers and shakers’ in the business partnership. Professional experience has shown time and time again that the existence of silent shareholders and shadow management operated by proxy are common and often used as an additional layer to prevent disclosure of true ownership for a variety of reasons, mostly related to the need to hide past reputational tarnish.

The need to examine undisclosed business relationships is also a significant objective when conducting a reputational due diligence. In fortunate circumstances, such associations can be flagged out by cross referencing ownership and directorship details, including registered residential addresses against key employees in the organisation to uncover potential undisclosed relationships. However, any party with an agenda to hide something will be savvy enough to ensure that such relationships go undetected by not having them appear on public records. Once again intelligence gathering and the ability to obtain and analyse such information is an integral part of the reputational due diligence and represents its key distinguishing strength that sets it apart from the financial and legal reviews.

Integrity risk also transcend across the operational, financial and business areas of the vendor’s organisation. It includes reviewing the stability of its operations and capabilities. Any ‘claim to fame’, accreditations, awards and licences are verified. A ‘business reality check’ is also performed to ensure that there are no inconsistencies in its actual operations compared to its ‘projected figures’. A case conducted in Shanghai by our China offices recently involved approaching security at a vendor’s plant, where it was found that the vendor’s subcontractors had issues with late payments from the vendor and had removed leased machinery from the premise. This sort of information is not exhibited by the vendor or any party hoping for a lucrative agreement to be signed for obvious reasons.

A case, which was recently resolved, involved a particular vendor providing services to an established car 
manufacturer via its local authorised dealership. It was noted by the new regional head of procurement that the vendor was providing exclusive car upholstery services at prices which appeared to be uncompetitive to the extent that similar services procured overseas and shipped locally were  almost on par, if not cheaper.

The vendor had been preferred for a number of years by the local dealership and no anomalies were highlighted. Detailed checks later revealed that the company had only a two-dollar paid up capital and lacked any significant capital investment to suggest that it had the capacity to provide a stable platform for the delivery of the upholsteries. It was revealed that the vendor’s owner was a former classmate of one of the directors of the dealership and that the margins earned by the vendor were phenomenally high, as it only provided cheap labour and used equipment located at another dealership belonging to the same group of companies. In addition, the vendor had suffered several penalties relating to the use of illegal foreign workers by the local authorities.

Checks conducted on the vendor’s other individual shareholder revealed that the individual owned several car related companies in other jurisdictions ranging from leather refurbishment to high-class car audio equipment.

None of these details were communicated to the car manufacturer and remained undisclosed even during the routine audits. The underlying reason to continually use the vendor boiled down to its ability to deliver efficiently and due to its ‘untarnished’ long time 
service record.

The mistake made by many companies is that business agreements are often made on the basis of comfort and assurance at face value, which is understandably common to human nature. This approach to business is ‘old school’ and not reflective of the current risks inherent in Asian business culture today. All entities and individuals have a past; it is just that some have a shadier past than others.

It is important that companies approach business agreements with professional sceptism, with the objective which is to maximise revenue while minimising potential loss. Even in encounters where vendors were found to have had complications in the past, organisations have still engaged them to service contracts; this being done with full disclosure of the background and history, either by volunteering of information or by conducting a reputational due diligence. Applying that to the case of the car manufacturer, the fact that full disclosure had to be discovered via a third party, offers connotations that a preferential arrangement existed between the management of the dealership and the vendor that could prove mutually beneficial to the detriment of the car manufacturer’s reputation. This ultimately lead to further scrutiny 
and  investigation.

Due diligence is one facet of integrity risk management which on its own plays an unparalleled role but it should be noted that there is no 24-carat guarantee that risks are eliminated. On its own or as part of a strategic risk framework, it provides an avenue and channel to manage those risks. In a changing and rapidly evolving business environment, understanding the business partner is key to the success of Asia operations, especially in evolving markets.

Chad Olsen

Hill & Associates

E-mail: chad.olsen@hill-assoc.com