An interview with Mark Goddard, Diligence International LLC's Regional Director CIS, in 'Compliance Monthly'.

Due diligence is rising up the compliance officer's agenda. Whether your firm is a boutique investment house or a large bank, it has become increasingly important to know your customers and to understand the source of their wealth and the regulatory risk they pose. As Mark Goddard, Regional Director CIS at Diligence International LLC, explains: "Pre-economic crisis some institutions would conduct due diligence at a very low level as a matter of course just to push a deal through, but post-crisis the attitude is quite different. Before the recession due diligence was more of an issue in emerging markets, and while those markets still present the biggest challenge because of the lack of formal records and the reliability of them when they do exist, it's now almost as much of an issue in first world markets."

Moreover, in today's challenging market conditions, a proper understanding of the due diligence process can add value to a business, he believes. "Whereas organisations would have turned down opportunities in the past on a very superficial, open source understanding of someone's background, now they feel a real need to understand their customers at a deeper level because they are pitching to a smaller customer base or market," he explains. "In the current climate firms are reluctant to dismiss potential clients based on their own examination; instead they are employing proper due diligence processes to fully understand the risks that clients present."

THE PROCESS

These deeper due diligence processes involve a closer analysis of a client's source of wealth and their background, including looking for evidence of litigation or potential criminal activity that has taken place in the client's past and putting it into context. To achieve this level of scrutiny many firms will employ external due diligence professionals.

Mr Goddard explains the process that his firm undertakes on behalf of its financial services clients. "We first ask the firm for as much detailed identification information as possible about the ‘subject' [the potential client]," he says. "Without such detailed information it can be difficult to identify the specific individual, particularly as there are a lot of less well-known and less well-covered individuals now coming through the system who are new entrepreneurs." Getting the most out of the process therefore requires firms to outline and understand the identification information required, and to develop means of reliably obtaining it. "It often comes down to the skill of the firm in terms of obtaining information in a way that's acceptable to the management of a potential client," adds Mr Goddard.

The next stage of the process is to verify the identification information against formal records, determining whether the subject has held a directorship, shareholding, membership of public bodies, membership of political parties, or whether they have made donations politically. "This covers the key ‘red flag' areas about political association, source of wealth, directorship, shareholdership, reputation in the market, and litigation records," he explains, adding: "To a certain extent you can check criminal activity because there are certain ways you can also identify whether someone has received a criminal conviction or prison sentence in the past."

This, he says, is the very minimum that firms should be doing. Taking due diligence a stage further involves talking to human sources who can provide a real indication about a person's integrity, the roles that they've been in, and their commercial record. "We can then look, for example, at whether they have expressed support for a political party, and if they have what does that mean?" says Mr Goddard. "Is it that they have contributed, or offered public support? Is it something that nine people out of 10 in that particular sector or organisation are doing, or is it a cause for concern because they are taking their political aspirations a step further?"

RISK APPETITE

Of course, employing a third party to undertake due diligence on your behalf can establish the facts surrounding a potential client, but it is up to the individual firm to then decide whether this information fits in with its risk appetite. There's no "off the shelf solution" when it comes to applying due diligence. "An international financial institution would not deal with someone who is politically exposed because they would have a remit that doesn't allow politics to be involved in investment," explains Mr Goddard. "But a private organisation may not have a problem with that provided they understand that the subject is a person of integrity, is not acting with a conflict of interest, and that there's a perfectly legitimate assumption that they can hold a political office and commercial interest at the same time under the prevailing laws of that country."  

As such, there is an important role for compliance to play in first establishing a firm's risk appetite and then interpreting the results of a due diligence exercise and applying them to that risk appetite. Moreover, a firm's approach to risk might determine whether it views due diligence as a one-off process exclusively for new clients, or as something that is ongoing and applied to existing clients on a regular basis. Diligence LLC would argue that ongoing monitoring is important, particularly in emerging markets where circumstances can change rapidly, but again, whether the risk justifies the additional cost will depend on the firm and the type of clients it has. "Many organisations will keep monitoring the environment where their clients are coming from, for example through press monitoring, but it's not necessarily a fail-safe to controlling risk," says Mr Goddard. He suggests that ongoing monitoring is not essential for every single client, but advises that, for clients where there are "some issues" it is worth undertaking regular monitoring, perhaps every second quarter.

PRESSURES

Conducting the level of checks described above is not a trivial exercise. Indeed, very basic checks on a prospective client could take between five to seven working days to complete, while a more in depth investigation could take up to 15 to 20 working days or more.

This can create tension between the compliance function, keen to ensure that due diligence has been properly executed, and client facing staff, who are understandably keen to "close the deal" with a prospective client. "The reality is that the subject is probably looking at three or four other organisations or competitors," concedes Mr Goddard, "so if one of them is saying that they can close everything within 10 working days rather than 20 it puts pressure on the customer-facing staff."

Compliance, he argues, should be wise to this problem, and should help in supporting the client relationship. "It should be made clear to the client that these checks are being carried out because of regulation," he suggests. "It should be clearly explained that by default there has to be a period of waiting while those checks are carried out."

Like so many things in the area of risk, the correct response to these challenges will likely be firm-specific, but Mr Goddard has noticed a general trend, across the spectrum of financial services firms, towards a deeper consideration of these issues. "Due diligence is largely about the individual organisation's attitude to compliance and regulation, and whether they see it as something to be embraced or something that is a barrier to business," he says. "But the obvious damage that has occurred to companies due to a lack of due diligence has changed things enormously, and the accountability of financial institutions towards shareholders and towards what are effectively public shareholders has increased greatly. We certainly haven't met any financial institutions that view due diligence as a box-ticking exercise."