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Increasing Role of Forensics in Due Diligence

With increased liability of directors and calls for transparency, reporting requirements have magnified the relevance of micro-level due diligence.

The famous contract law principle ‘caveat emptor’ – Buyer Beware – is often used in commercial transactions involving M&A and other financial and strategic investment deals. Information asymmetry between a buyer and seller necessitates robust due diligence exercise on targets and promoters pre and post such transactions. While traditional methods of due diligences help in uncovering broader business, financial and legal risks, recent times of increased liability of directors, calls for transparency, and reporting requirements have magnified the relevance of micro-level due diligence.

Forensics has emerged as an important and effective tool for conducting comprehensive due diligences and helping investors have a microscopic view of target companies, their assets, liabilities, compliance gaps, suspicious transactions including those with related parties, investigations, shams, and corporate frauds, if any. The following trends are noteworthy:

Post-closing compliance audit: While pre-closing findings from a due diligence help an investor take an informed decision and allocate risk in transaction documents, it is important to also consider post-closing compliance audits in light of the sunset period associated with indemnity claims. Such an exercise also can be a mitigation tool for the company and/or the new owners to protect them from exposure to the risk of a continuing offence, as deemed knowledge could be attributable to them.

Criticality of electronic evidence: During investigations, authorities first and foremost target the IT systems of the company to gather electronic evidence and bolster cases against individuals and organisations, more so in cases of competition, income tax, CBI and SFIO matters. While existence of back-up data in a company’s archives could attribute knowledge and amount to deliberate concealment of facts, a lack of diligence and failure to maintain appropriate risk management systems can trigger consequent liabilities. This makes it critical to identify any damaging data through a vendor diligence exercise.

Counterparty KYC and due diligence: Another aspect that businesses need to consider is keeping checks and conducting appropriate KYC/due diligence on counterparties to contracts. If one is aware that its counterparty is engaging in any activity that could be considered as an offence of bribery, corruption or the like, and the same is connected to the business of the entity in any manner whatsoever, non-disclosure of such information and continuing to deal with such counterparty could be construed as deliberate concealment and amount to abetting the offence, which is punishable under Prevention of Corruption Act, 1988.

Risk on nominee directors: Investors and their nominee directors are increasingly insisting on regular audits and compliance health checks. Duties of directors as codified under Section 166 of the Companies Act, 2013 (Act) do not distinguish between an executive and a non-executive director, which increases the risk for the latter even when they have a rather limited role in day-to-day management. Although the term “officer in default” applies only to executive directors under the Act, independent and non-executive directors (including nominee directors) can also be held liable under section 149(12) of the Act if acts or omissions by a company: (i) occur with the knowledge of such independent and non-executive directors that are “attributable through board processes”, and with the consent or connivance of such independent and non-executive directors; or (ii) where such independent and non-executive directors have “not acted diligently”.

CONCLUSION

Companies routinely generate large amounts of information on a daily basis, which creates a digital footprint of possible compliance gaps that can prove damaging in subsequent investigations. The onus is on organizations to deploy effective tools – including forensic analysis – to discover such gaps in order to analyze and mitigate present and future risk.

Standard Bank case: This case demonstrates the consequences that can be faced by companies and/or their parent group for not following appropriate KYC/due diligence processes while consummating deals. Standard Bank Group Ltd, a publicly owned company registered in South Africa, was also the ultimate parent of Stanbic Bank Tanzania Ltd, a Tanzanian company based in Dar es Salaam (“Stanbic”).

Stanbic was not licensed to deal with non-local foreign investors in the debt capital markets and such role was to be undertaken by Standard Bank. Standard Bank and Stanbic put forward a proposal by which they would be mandated to raise funds for the Government of Tanzania by way of a sovereign note private placement. Though the potential for corruption practices in this kind of a deal was huge, it was found that Standard Bank had failed to prevent bribery and had not conducted KYC and due diligence on counterparties where obvious red flags for bribery risk were present.

It was found that applicable policies at Standard Bank did not provide sufficient specific guidance and the company did not undertake an enhanced due diligence exercise to deal with the presence of any corruption red flags regarding involvement of a third party in the said government transaction. The case was resolved through the mechanism of a deferred prosecution agreement (DPA) and the requirements falling upon Standard Bank to fulfil were interalia payment of compensation of USD 6 million plus interest of USD 1,153,125, disgorgement of profit on the transaction of USD 8.4 million and payment of a financial penalty of USD 16.8 million.

Contact:

Tushar Ajinkya

E:

Ankita Kashyap

E:

www.elplaw.in

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