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Since my first Annual Commercial Finance Association Convention in Toronto in 1992, much has changed regarding the usage of background investigations as part of the due-diligence process. Most of the change has occurred in the last seven years.  Let's look at a few of the happenings that have had the largest impact on the business of performing background investigations in the asset-based lending industry.  These events have altered the frequency and the intensity by which such investigations are brought to bear on an investment decision. First, a few statistics. The source: The Association of Certified Fraud Examiners' "Report to the Nation" and the "2002 Report to the Nation."

• Fraud and abuse cost U.S. organizations more than $400 billion annually.

• The typical perpetrator is a college-educated white male.

• Men commit 75 percent of the offenses.

• Losses caused by managers are four times those caused by employees.


• Median losses caused by executives are 16 times those of their employees.

• The most costly abuses occur in organizations with less than 100 employees.

September 11, 2001 

As a result of the attack on the World Trade Center and the Pentagon on September 11, 2001, Congress enacted an antiterrorism bill known as The USA Patriot Act of 2001 (the Act) within a month. The bill requires enhanced money laundering detection procedures; authorizes the

detention of aliens; 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, suggested that the Secretary of the Treasury prescribe regulations setting minimum standards for financial institutions and theircustomers 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 Treasury Department's Office of Foreign Assets Control (OFAC) provides a list of Specially Designated Nationals (SDNs) 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 SDNs and Blocked Persons based upon foreign policy and national security goals. Regulations 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, business checking or savings account cannot be opened today without a check of the OFAC list. 

THE SECURED LENDER

The U.S.A. Patriot Act - unlike any other event in modern times - has transformed how the banking industry must act in 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

Whether by guilt or by association with the guilty, certain companies and the individuals 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 corporate scandals have undermined the confidence of the public in institutions heretofore were believed to protect us from the evils of greed and corporate misconduct. Who would have thought that a firm such as Arthur Andersen would have become a casualty of these times?

Behind the headlines are three subplots to these events:

• First, many 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 sheer magnitude of the task. Companies and those who finance them must be proficient at self-diagnosis.

• Second, regulators such as the SEC and NASD do not proactively search the backgrounds of the management of public companies. Their involvement in this area is limited to an alleged violation of policy or law. Lenders to public entities, therefore, must initiate this activity.


• Finally, people predisposed to bending the rules or laws will continue to do so until something unravels or they get caught. It's an acquired behavior of professional scammers because it has worked for them in the past. Lenders, therefore, must look for patterns of previous acts of deception. 

Losses, losses, losses

As noted, fraud and abuse cost U.S. organizations more than $400 billion annually. This is a major happening and a major embarrassment to any lender faced with an avoidable loss. It is fair to say that losses over the last seven years due to corporate fraud and misrepresentation are unprecedented. Undiscovered corporate misconduct and misrepresented backgrounds of owners and managers of portfolio companies have ended lending careers and cost many lenders millions of dollars and loss of business reputation. 

In ending, I would like to draw your attention to an article that appeared in The Wall Street Journal on March 8 of this year, the heading of which read "How Troubled Past Finally Caught Up With James Minder." Mr. Minder, 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 flattop hat. He escaped from prison and once terrorized employees at a branch of Manufacturers 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 before it cost a good brand a lot of headache, and its investors and lender a bigger one. 

A few truths to live by

• Establish written background-investigations guidelines to live by and follow them.

• Back up your best intuition with the best information. 

• It's always management that ultimately repays the loan. 

• Always be willing to walk away from a deal. 

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

THE SECURED LENDER

Jerry Oldham is co-founder, Chairman & CEO of 1stWEST Financial Corporation, Evergreen, CO. Mr. Oldham has a broad senior management background in banking, corporate and real estate finance. He is on the Governing Board of the CFA Education Foundation. He can be contacted at j.oldham@1stwest.com.