REPUTATIONAL RISK

What due diligence is meant to do is to protect you before you buy. Caveat emptor! Unfortunately, the banks and funds have concentrated on white-collar executives cramming themselves into a large boardroom for a long discussion, possibly punctuated by lunch and drinks. Bankers, financiers, accountants, lawyers, technical specialists and backup staff all enter into the fray. This makes the due diligence a top-heavy, unwieldy and often ineffective process. This is because there are people of the like mindset who are often intent on take-over or merger.
Ambiguous evidence and management stubbornness can override the due diligence findings, even in the face of corporate failure. Risk appetite overrides the limit for bearing risk – eventually they give up after the event failure. During 1999–2000, 11 556 US M&A cases of >51 % equity were announced. Only a tiny proportion, 383, did not complete as the project momentum carried most through.
Most M&A failed to meet their targets. Management stubbornness or self-interests against shareholder benefit (a k a “agency theory”) are attributable. One major perk could be a larger salary or bonus upon M&A; bigger workforce and more sales and revenue. Based on fulfilling sales and growth performance targets, the CEO’s stock options start to kick in. Such remunerative packages are deceptive and only lead to executive greed, further putting the company at risk.
The innate greed pattern, coupled with the short-term tenure of the CEO, lead executives to extract as much out of the company rapidly before a forced exit. CEOs have a temptation to get a percentage of an ever bigger pie – that pie becomes commensurately larger under M&A. A leader’s overambition creates an overvalued company within M&A, whose chances of success are loaded against it. This subsequently leads to a boom–bust cycle in the share price.
The case around the directors’ table may for be clear for M&A, but the damage and failure afterwards are visible for all.
How can we improve on the due diligence process? Due diligence can work, but not for every firm. We can instigate a more flexible “slimmed down” due diligence. Due diligence can be cheap and quick, a rapid detective investigation, not an expensive boardroom affair.
It can progress from simple elements such as:
Internet search on name e.g. local community website or Google.com.
Check for name in library or newspapers.
Check criminal record or court appearance in public office and legal documents.
Asset liens and tax judgements.
Real-estate holdings in property register.
Trawl companies documents for record of directorship and holdings in other companies.
Call in a private investigator.
Gathering together the findings, with the accounting experts’ input, we can track the company’s health or movements in a risk map.
Post-Andersen and Sarbanes–Oxley, there is some doubt that they will reveal the true corporate health in a timely and accurate fashion for interested investors. Both the US Sarbanes–Oxley Act and European legislative directives are designed to make CEOs and accountants more accountable when signing financial statements. These legal moves stand or fall on the crux of whether these key staff signed a financial statement knowing of any irregularities. The auditing industry is still very concentrated in the Big Four, even after corporate audit and management consultancy are split. Apart from the lack of choice, there is also the spectre of these four companies having the same type of operational procedure, more or less, from each other. Buying one company’s auditing services instead of another does not necessarily represent a qualitative improvement, nor a substantial quantitative discount in the daily rate charged.
The current legal and accounting system militates against swift justice and compensation for those who have suffered loss.
In 1998 there were nearly 2 million pending civil tort cases. The cost of the U.S. tort system for 1999 was over $200 billion. . . . The RAND Institute for Civil Justice studied transaction costs and determined that about 43 cents on the dollar goes to the plaintiff. The other 57 cents goes to transaction costs, which include attorney fees paid by the plaintiff.
All professions are policed by their own institutions to some extent. This does not mean that billed rates are reduced. There are associations of bankers, insurers, lawyers, accountants etc. There is some recourse for complaint and reporting breach of contract or trust. The lawyers, for example, have the Law Society, while accountants have the Joint Disciplinary Tribunal. A client’s complaint is not always satisfactorily resolved by any means, but it is usually an inexpensive way to whistle-blow on the professional. It is a cost-effective manner, but often not the end process, to start getting compensation. It would be better not to get ensnared in the first place, so you need an alert system.