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The ABL industry and background investigations... past, present and future
BY JEROME S. OLDHAM
I attended my first Annual Commercial Finance Association Convention in Toronto in 1992. 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. Since then much has changed in the United States and abroad regarding the use of background investigations as part of the due diligence process, with most of the change coming in the last few years. In the time and space provided here, I would like to focus on the events and circumstances that have had the largest impact on the business of performing background investigations in the ABL industry. These "happenings" have altered the frequency and the intensity by which background investigations are brought to bear on an investment decision.
But first a few statistics, the source of which is the Association of Certified Fraud Examiner's Report to the Nation and the 2002 Report to the Nation.
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Fraud and abuse costs US organizations more than $400bn annually.
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The typical perpetrator is a college-educated white male.
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Men commit 75 percent of the offenses.
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Losses caused by managers are four times those caused by employees.
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Median losses caused by executives are 16 times those of their employees.
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The most costly abuses occur in organizations with less than 100 employees.
What is different today?
What has changed is "why" background investigations are done today and "how" they are done differently. The "Why" of the equation may have been best summarized by the late President Ronald Reagan when he said "Trust and verify". Among the top reasons for performing background investigations today as compared to the past are the following:
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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.
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The world is ever more litigious. And litigation costs real time and real money.
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Lenders are more often participating with other lenders and competitors in the same capital structure, sharing increased risk with each other. Participants are relying on the lead lender's due diligence in most cases.
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The world market is a greater target for new business and new business partners, and lenders are more in need of the best worldwide information in order to make an informed decision.
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The media plays a more intense role and is ever more "real time." Lenders must know what the media knows and more.
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Information is more readily available within a time frame that "beats the bell" and at a cost that doesn't "beat the bank."
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Corporate fraud, scandals and corporate governance have become more common in our business vocabulary. Corporate scandals are now front-page news, and the executives convicted of these illegalities against shareholders, investors and lenders are being held accountable.
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Lending decisions are more transactional, less relationship driven. Banking services are often accepted more à la carte, in spite of banks' best intentions to cross sell expanded capabilities.
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Time is more of the essence with competition for the same deal ever more intense. Borrowers and lenders share the same desire for a speedy decision, requiring the fastest due diligence turnaround.
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There are now regulations that require a certain level of background investigation. In the US 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.
Let's examine more closely one of the current events that has lead to one of the most significant changes in US public policy. The USA Patriot Act of 2001 is to the banking and background investigations business what Sarbanes-Oxley has become to the legal and accounting professions... a mandate. It is a mandate to better know your customer or prospect.
September 11 and 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 known as The USA Patriot Act of 2001 (the "Act") in less than one month. The bill, 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 US banking institutions, suggested that the US 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 required 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 US 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. In addition to maintaining the list, OFAC administers and enforces economic and trade sanctions against SDN's and Blocked Persons based upon foreign policy and national security goals. Regulations that have been advanced to satisfy the requirements of the Patriot Act, and others advanced by insurers of financial institutions, set forth certain "know your customer" regulations under rules that were adopted by state and nationally chartered banks and federally chartered saving and loan institutions on October 1, 2003. An individual or business checking or savings account cannot be opened today without a check of the OFAC list.
No singular event in the last 60 years has transformed the US banking industry in the way The US Patriot Act of 2001 has regarding advancing methods of routinely doing business with prospective customers. Information from the OFAC list can be accessed directly through a government database or through a firm that performs background investigations. Clearly, the Act has become a mandate to better know your customer or prospect. A check of the OFAC list must be a routine part of every background investigation performed today.
Corporate fraud and scandals... and the media coverage that comes with it.
Whether by guilt or by association with the guilty, certain companies and the people who run them have become household names to even the casual observer. Not since Michael Milken and Ivan Boesky or the S&L crisis, have more companies and people made the front page and nightly news because of alleged or proven acts of corporate misconduct. These companies and people are all too well known to begin to list them here, and the losses that are attributed to them may be all too familiar as well. What's worse, these happenings have undermined the confidence of the public in certain institutions that were heretofore believed to protect us from the evils of greed and corporate misconduct.
"Data sources, on-site search
professionals and background
investigation firms exist today in
response to the markets' needs
and wants that didn't exist
twelve years ago."
Who would have ever thought twelve years ago that a firm such as Arthur Andersen would have become a casualty of these times?
Behind the headlines are three subplots to these events.
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Firstly, many of the institutions that we have come to believe will protect us sometimes can't or won't... and not always because of disrespect or neglect, but because of their mission or the shear magnitude of the task. Just as in medicine, companies and those who finance them must be proficient at self-diagnosis, a task best handled by those who best know the games that can be played.
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Secondly, regulators such as SEC and NASD do not proactively search the backgrounds of the management of public companies. Their involvement in this area is limited to investigating an alleged violation of policy or law. Therefore, those lending to public entities must initiate this investigation.
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Finally, people who are predisposed to bending the rules or laws beyond their tensile strength will do so until something finally breaks or they get caught. It's an acquired behavior of professional frauds because it's worked for them in the past whereby nothing broke and nobody got caught. Lenders, therefore, must look for patterns of previous acts of indiscretion, a task best performed by those who best know the games that can be played.
Where do we go from here?
Simply put, there are more tools available today to perform background investigations, whether a lender chooses to perform this work in-house or to outsource the effort. Data sources, on-site search professionals and background investigation firms exist today in response to the markets' needs and wants that didn't exist twelve years ago.
The trend today is to outsource this due diligence to professional firms that specialize in this effort. This is primarily due to the following:.
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The need for speed, accuracy and consistency.
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Staffing considerations.
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Volume considerations.
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The need for thorough regulatory compliance.
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The preference of independent third party review.
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In-house underwriters heavier burden to complete multiple tasks within a limited time frame.
The future should mirror the near past in the eyes of this writer. It would seem as unlikely as it would be unnecessary to go back to the old methods of the not too distant past.
A (not so) story book ending
In ending, I would like to draw your attention to an article that appeared in The Wall Street Journal on 8 March this year, the heading of which read "How Troubled Past Finally Caught Up with James Minder." Mr. Minder at the age of 74, and Chairman of Smith & Wesson Holding Corp., "picked up the phone and realized that it was the call he had been dreading for the past 20 years." You see, Mr. Minder was the notorious felon known as the "Shotgun Bandit" in Michigan decades ago. The article goes on... "As a serial armed robber in Michigan, Mr. Minder used a revolver - for a while it was a Smith & Wesson - and a sawed off 16-gauge shotgun. He stole getaway cars and disguised himself with dark glasses, a trench coat and a flat-top hat. He escaped from prison and once terrorized employees at a branch of Manufactures National Bank before stealing $53,000. The dozens of holdups, some done while he was a student at the University of Michigan, earned him notoriety..."
By the way, Mr. Minder did a lot of good after turning his life around, but that's not the point. What he didn't do was come clean with Smith & Wesson before it cost a good brand a lot of headache, and its investors and lender likely a bigger one.
Jerome S. Oldham is Chairman and CEO of 1stWEST Financial Corporation
www.financierworldwide.com - Asset-Lending Review 2004
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