Then & Now...

Background Investigations In the ABL World

"Trust, but verify."  Perhaps the words of the late President Ronald Reagan best summarize a prudent approach to background investigations in the asset-based lending industry.  The following article discusses how and why the process of this important aspect of due diligence has evolved over the years.

By Jerome S. Oldham

Reprinted from the July/August 2004 Issue, Vol. 2, No. 7

"Then" for purposes of this article is fall of 1992, the first time I attended an annual Commercial Finance Association meeting, which was in Toronto.  I was doing my own due diligence on the commercial finance/asset-based lending industry to determine how the industry approached the subject of evaluating the backgrounds of prospective management teams and companies.  "Now" is... well, a day in June 2004, with sufficient time for me to complete this article before the print deadline.       

Lenders like to know the bottom line, so here it is.  "Then," lenders placed a tremendous value on the backgrounds of the people who ran their prospect businesses.  They felt the same about the background and reputation of the target entities that they were pursuing.  "Now," lenders feel the same way.  So what's different?  Much is different, but it's not in the importance of the issue.  The difference is in what has happened in twelve very short years regarding how the business of doing business works, how the "world-business" works, and to some greater extent, why lenders place more emphasis on due diligence in this area. 

Why Is the Process Different?       

What has changed is "why" this important component of the due diligence is done today and "how" it is done differently.  The "Why" of the equation may have been best summarized by the late President Ronald Reagan when he said "Trust, but verify," and the late Winston Churchill who said, "Sometimes there is nothing left to do but what's required."  In other words, it is prudent and it may just be required.       

But, more specifically, why is background information more important today than ever before?  What has happened in the last twelve years that has caused background investigations to be performed more frequently?        

Among the top reasons for performing background investigations today are the following:

• Company owners and managers are involved in more businesses than ever before, many of which are across state or country borders and may involve different and multiple partners.

• The world is ever more litigious.

• Lenders are more often co-participating with their peers and competitors in the same capital structure, sharing increased risk with each other.  As the "lead" lender, participants are relying on this lender's due diligence in most cases.

• The world market is a greater target for new business and new business partners, and lenders are more than ever in need of the best worldwide information in order to make an informed decision.

• The media plays an ever more intense role and is ever more "real-time."  Lenders must know what the media knows and more.

• Did I say the world is ever more litigious? And litigation costs real time and real money.

• Information is more readily available within a time frame that "beats the clock" and at a cost that doesn't "beat the bank."

• Corporate fraud and corporate governance have become more common in our business vocabulary.  Corporate scandals are now front page news, and the executives convicted of these misdeeds against shareholders, investors and lenders are being held accountable.

• Lending decisions are more transactional, less relationship driven.   Banking services are more à la carte, in spite of banks' best intentions to the contrary.

• Time is even more of the essence.  Borrowers and lenders share the same desire for the fastest decision and due diligence turn-around.  Hence, the need is for faster intelligence, including background information.

• Competition for the same deal is ever more intense.  Lenders are better at identifying prospects that need to be qualified.  The best and fastest information means that the lender can pursue more business.

• There are now regulations that require a certain level of background investigation.  There were no federal statutes twelve years ago that required a state or national bank or federally chartered savings and loan institution to check a list for terrorists, international narcotics traffickers or those engaged in the proliferation of weapons of mass destruction before opening a bank account.

A closer look at the last item on this list reveals a most significant change in public policy in today's environment. It's part of both the "why" and "how" discussed herein.  The USA Patriot Act of 2001 (the "Act") is to the banking and background investigations business what Sarbanes-Oxley has become to the legal and accounting professions... a mandate. In the case of background due diligence, the Act is a mandate to better know your customer or prospect.

The USA Patriot Act of 2001

As a result of the attack on the World Trade Center and the Pentagon on September 11, 2001, Congress enacted an anti-terrorism bill in less than one month.  The bill, which was signed into law on October 26, 2001, requires enhanced money laundering detection procedures, authorizes the detention of aliens and alters the standards for searches and seizures and information sharing between government agencies.  In addition, Section 326 of the Act, relating to verification of identification of account holders of U.S. banking institutions, suggests that the U.S. Secretary of the Treasury prescribe regulations setting minimum standards for financial institutions and their customers that apply in connection with the opening of a bank account.  These regulations require that certain procedures be adopted by financial institutions to insure compliance, including consulting lists of known or suspected terrorists or terrorist organizations to determine whether a person seeking to open an account appears on any such list.       

Accordingly, the U.S. Department of Treasury's Office of Foreign Assets Control (OFAC) provides a list of Specially Designated Nationals (SDN's) and Blocked Persons - individuals and entities that are known terrorists, targeted foreign countries, international narcotics traffickers or those engaged in activities related to the proliferation of weapons of mass destruction.   OFAC administers and enforces economic and trade sanctions against SDN's and Blocked Persons based upon foreign policy and national security goals.  Specifically, the regulations that have been advanced to satisfy these requirements, and those subsequently advanced by insurers of financial institutions, set forth certain "know your customer" regulations under rules adopted by state and nationally chartered banks and federally chartered saving and loan institutions on October 1, 2003.       

The bottom line is this - include a check of the OFAC list as part of your routine background due diligence on persons and entities.  This information can be accessed directly through a government database or through a firm that performs background investigations.

The bottom line is this - include a check of the OFAC list as part of  
your routine background due diligence on persons and entities.

The Fair Credit Reporting Act

Another factor in both the "why" and "how" of performing background investigations is the Fair Credit Reporting Act (FCRA).  This government regulation establishes minimum federal standards regarding collecting and disseminating financial information for a fee.  Businesses that provide financial investigation services are considered consumer credit reporting agencies or bureaus under the FCRA, and, therefore, are subject to all of the requirements of the FCRA.  The FCRA is designed to protect consumers from the assemblage, maintenance and dissemination of inaccurate or unfair credit information and the misuse of credit information.  Background investigation reports on individuals provided by third-party investigations firms are usually considered to be "consumer reports" as defined by the FCRA and, as such, must be used for a "permissible purpose" under the FCRA.  Of importance to lenders is that the following are among the permissible purposes defined in Section 604 of the FCRA:

• In response to a court order.

• In accordance with the instructions of the consumer.

• If the report is to be used in connection with a credit transaction involving the consumer, for evaluating the extension of credit to a consumer, the collection of an account, employment, the underwriting of personal insurance or any other legitimate business purpose.  There are strict guidelines regarding notification to consumers and requirements regarding consumer authorization for obtaining certain kinds of information under the FCRA.  The work of asset-based lenders traditionally falls under the permissible purpose guidelines, but lenders should go to great lengths to be sure that the background investigations firm that they employ is aware of, and follows, all requirements of this regulation.

How Is the Process Different?

Simply put, there are more tools available today to perform background investigations, whether a lender continues to perform this work in-house or chooses to outsource the effort.  Data sources and on-site search vendors exist today in response to the markets' needs and wants that didn't exist twelve years ago.       

The trend has been to outsource this due diligence.  This is primarily due to the following:

• The need for speed, accuracy and consistency.

• Staffing considerations.

• Volume considerations.

• The need for thorough regulatory compliance.

• The preference for independent third party review.

• Underwriters' heavier burden to complete multiple tasks within a limited time frame.

Trust and Verify

This applies to background investigations' methodology as well. It is highly recommended that a dual search methodology be employed by background investigations firms that conduct the research - that is, on-site public record searches being performed in conjunction with on-line data base searches when establishing or verifying histories of criminal and civil litigation, tax liens, judgments and bankruptcies.  On-line databases reach further and deeper than ever before, but can still be inaccurate and incomplete.  Unmotivated county, state and federal employees that may not view the work of search firms as their highest priority can handicap on-site searches of public record information.  Together, a combination of these two approaches best covers the landscape.