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ow important is the character component of the investment decision? What kind of integrity deficiency should cause a lender to rule out or veto a deal? Here's a cautionary real-life tale. According to her resume, "Dr. Sharon Smith" had sterling credentials for playing the leadership role as creator of, and spokesperson for, a revolutionary line of nutritional supplement products. She had a doctorate in nutritional chemistry and a successful clinical nutrition practice for many years. Dr. Smith appeared as a regular guest on a major-market television show as a nutritionist and holistic health expert. She was extensively published, sat on the advisory board of an internationally respected healthcare company and was married for years to a world-renowned chemist.

The investors in her newest venture came to her through a new, but seemingly credible, contact. The investors and their management put their faith in "the product" mostly because of "the person" who, in addition to her distinguished background, possessed a persuasive and charismatic personality. They had been to her estate home in Hawaii on several occasions by the time they made their initial investment and were impressed by her knowledge of chemistry and nutrition. Friends and contemporaries revered her, as did the independent chemist chosen to formulate and manufacture the products she was developing. In addition, a nationally recognized distributor had made a commitment to the initial distribution of this unique product through its network of strategically located distributors - a commitment designed to insure early and continued market recognition, success and profitability.

The fraud

Sometimes you get fooled. Sometimes the prettier the box, the uglier its contents. Shortly after the investors committed to an initial funding, they got their first indication that this confident, credentialed, educated, articulate and persuasive woman was not exactly who or what she represented herself to be. Nervous about being discovered going into the important first meeting with the proposed bankers, she made a cautionary comment regarding her Ph.D. to the company's president. A disclosure by the company president to the equity sponsor and lender led to a thorough background search and subsequent revelation - Sharon was a fraud. She didn't have the Ph.D., M.S. or B.S. However well read she was in her fields of study, she was not the "credentialed" expert she represented herself to be. She was a phony, a liar, a fraud and a con artist. She became "Dr." Smith when another invented profession of hers, that of a botanist, failed her. A change in geography, a change of name, a divorce and serious course study in chemistry motivated and facilitated her transformation to Dr. Smith. Others to whom she had represented herself as Dr. Smith over the last 15 years also had been defrauded. No one took the time to question her background. In fact, it's probable that her ex-husband, the real chemist and 25 years her senior, never knew of her deception while they were married; or, if he did, maybe he just chose to look the other way. He died before the truth was revealed. 

Jerome S. Oldham is the founder of 1stWEST Companies and president of 1stWEST National Corporation, Denver, CO.  He is a member of the CFA Education Foundation Advisory Board.

The legal consequences

What's more, lawyers from two securities firms advised the officers and investors that no measure short of fully extricating Ms. Smith from the company would absolve them of direct personal liability should a lawsuit be successfully brought against her and the company as a result of her misrepresentations. Furthermore, lenders and equity sponsors would have been compromised if the fraud had gone undetected or undisclosed by the owners and corporate officers.

In short, as long as Ms. Smith was affiliated with the company in any official capacity or as a "control" person in its ownership structure, the remaining executive officers and owners could forever be directly and strictly held accountable.

On the advice of legal counsel, the officers and owners demanded that Ms. Smith leave the company and give up her ownership interest in exchange for a generous severance package. Ms. Smith denied any impropriety and refused to leave without legal action being brought. Appropriately, the potential equity sponsor and lender walked away from the deal.

The financial consequences

The potential equity sponsor and lender suffered no adverse financial consequences because of the early detection of the "character flaw." Such was not the case for the officers and investors who were left to work out the problem. They brought a lawsuit against Ms. Smith to remove her from the company in order to minimize their financial exposure. She continued to deny any improprieties. She then countersued the company, its officers and owners for breach of contract, slander and coercion. The lawsuits took two years to settle - in favor of the officers and investors, but not without substantial legal costs and even more damaging costs to the business and its owners, including the loss of their reputation with potential investors, lenders, industry experts and consultants and the loss of key retail and vendor relationships.

Had the background investigation been performed prior to the initial investigation, all this could have been avoided.

The lesson

Investigate the financial, business and ethical character of the prospect early in the due-diligence process, whether you are providing debt or equity capital.

Always underwrite the "character component" of the deal, and never trust your intuition without supporting information. Information is truly power, but only if acted upon. Information and knowledge, working together, are essential in the effective underwriting of a deal.

Other " killer" character issues

Resume fraud is but one common example of how lenders and investors can be compromised. Other categories of character issues that may kill a deal include:

• Undisclosed "financial issues" of the business prospect, management, owners or directors - whether a privately or publicly held company. Don't assume that just because it's a publicly held company that all financially responsible parties involved have passed all necessary scrutiny.

• Undisclosed "affiliated businesses" of the business prospect, management, owners or directors. Significant "contingent liabilities" may lie in wait in these "other" business affiliations.

• Undisclosed other "contingent liabilities" such as pending civil or criminal court cases.

• Undisclosed "direct liabilities" such as tax liens, judgments, or court orders.

• Undisclosed "personal acts of indiscretion."

Use of the word "undisclosed" is usually just another way of saying that you have been lied to, absent a brilliant excuse for amnesia. At this level, a withhold is usually the same as a lie and is a serious character flaw. Regardless, if the nature and circumstance of an undisclosed issue can be overcome, then the daunting task of managing any remaining financial risk is still left to deal with. If what remains is a quantifiable financial issue, then this may be manageable through the loan structure. Otherwise, walk away.

Other "killer character" examples

The following list represents but a few additional examples of recent investigations that further demonstrate possible " killer character" issues:

• Defrauding shareholders: Thirty days prior to reporting a loss and filing bankruptcy in the subject public company, several executive officers sold their stock. The sale, valued in the millions of dollars, took place within days of the restriction period being removed from their stock.

• An undisclosed criminal conviction: One of the principals of the subject company was tried and convicted of engaging in a sexual liaison with a minor and convicted of concealing a hidden weapon - two unrelated incidents.

• An undisclosed legal issue: The president and CEO of a prospect company was under investigation for bankruptcy fraud in another state. The federal investigation alleged the transfer of assets and their conversion to cash during a preference period, to the detriment of all secured parties.

• An undisclosed financial issue: The president of a U.S. public company with a very complex ownership structure, and subsidiaries with operating divisions in foreign countries, had been censored and barred from managing a public company in Canada for ten years by the Canadian regulatory and security authorities.

• An undisclosed bank fraud/felony: The majority owner of the prospect company had previously been convicted of bank fraud wherein he falsified the accounts receivable and inventory records provided to his lender in order to overstate the borrowing base, defrauding the lender of millions of dollars.

• An undisclosed personal act of indiscretion: The president of the prospect company was tried and convicted of shooting an endangered species in a public park.

General underwriting considerations - the "4 C's" revisited

So then, where does the analysis of "character" fit into the overall underwriting process? And, how important is it?

Collateral, capacity, conditions and character have become known by lending traditionalists as the "4 C's of Credit." (Actually, another less acknowledged "C" - connections - has gotten more than one loan approved.) The character component of the credit decision seems to be the most difficult to consistently assess, especially in the transactional loan business - traditionally the business of the asset-based or secured lenders. When looking at the character component of your newest deal prospect, remember that its about to be another lender's old piece of business. Ask how unhappy the existing lender would be to be out of the deal. If everything else in the due-diligence effort looks good at this point, maybe the existing lender is just delighted to be rid of the characters that own or manage your prospect's business. Character assessment is often a sensitive area to work within for many lenders, primarily for one of the following reasons:

• Competition: Without question, the loan market is very competitive. Therefore, the lender doesn't want to begin the process on a negative consideration and doesn't want to be at a competitive disadvantage by asserting yet another unruly due-diligence requirement that the market won't bear. The market is in step with this issue today as well, so don't be so concerned. Besides, conscientious underwriting should always override this concern.

• Tradition: Underwriting the collateral, the capacity and the financial condition of the borrower is a customary and acceptable part of the traditional underwriting process. Questioning or investigating someone's character or integrity is not. Moreover, the methods used today are different than those used even in the recent past. Tradition is being overruled by reality. Get in step with what is required in order to make the most informed decision.

• Art vs. science: Assessing the character of the business and its principals is an art, not a science, and something most difficult to quantify. Hire other professionals to assist in the due-diligence with collateral appraisals, field exams, collateral control, etc.

• Value judgment: Character assessment requires making a value judgment. Make the necessary decision and communicate to your prospect why you made the decision, even if it's because you discovered that he is a phony, a thief or just too litigious for your appetite. After all, it's your money until it goes out the door. It's your right to make a responsible value judgment.

• Information accessibility: Making a value judgment about someone's reputation can only be done with the most comprehensive and accurate information available, which usually cannot be obtained directly from the prospect. It is unusual to have an employee or officer of the prospect company disclose a matter of personal indiscretion about the prospect during a field exam or interview. Moreover, matters relating to "off-balance sheet" contingent liabilities of the prospect or its principals may not be known to the employees or management being interviewed.

• New methodology: The methodology required to effectively make a character judgment has changed significantly over the recent past. Reliance on an independent outside source to effectively search out and validate information to make the necessary character judgment is a prudent part of the due-diligence process today for even the most sophisticated of lenders.

A few truths to live by

• Establish standards to live by - some "absolutes" and incorporate them into your underwriting loan policy.

• Don't make exceptions to policy, no matter what the connection.

• Back up your best intuition with the best information.

• Things are not always what they appear to be.

• Always be willing to walk away from a deal.

• Remember that it is management that ultimately repays the loan.

• Fully investigate the character component. The last "C" is just as important as the first three.

• Finally always maintain your sense of humor because, when the collateral is gone and you're left to work out the deficiency with a known felon who has ravaged his last three ventures and committed untold acts of indiscretion, you'll need it!