Reputational Due Diligence: Cautionary Tales in M&A
Shedding light on the importance of considering the reputation of a business and its people during M&A due diligence
Due diligence is an important part of any business transaction. The need to understand the financial and legal standing of a company before doing business is a given. But what many times is overlooked is the need to dig into the reputation of the company and its principles. And failure to do so can come back to haunt you in more ways that you might imagine.
We at business intelligence firm MIC Worldwide have seen this firsthand.
MIC Worldwide offers a variety of services, including due diligence investigations. Previously, we were contacted by a company that purchased a call center in a South American city the previous year. Following the one-year anniversary of the purchase, the company conducted an audit of the call center and found that they were missing over U.S. $1 million. They called us in to determine who took the money.
What we discovered presents a valuable case study in the importance of reputational due diligence.
What many times is overlooked is the need to dig into the reputation of the company and its principles, and failure to do so can come back to haunt you in more ways that you might imagine.
A Winding Legal Saga
Following an extensive investigation, we determined that there was no money missing, but rather, there was an issue of overreporting income and underreporting expenses. The General Manager of the call center was paying for some of the bills out of his own pocket, and simply not paying others. He was also creating invoices sent to fake clients. All of this was done to hit his sales goals.
After further digging, we learned that the General Manager was hired at the time the company was purchased to replace the outgoing owner/manager. The general manager was poached from another call center, also owned by an international company. As part of the employment offer, the General Manager had been extended the carrot of 10% ownership of the company if he hit his sales goals in the first year. Unfortunately, the audit was conducted one month after the end of the first year and the shares had already been signed over to the general manager.
Related content: Anatomy of a Deal: Streamlining Due Diligence
As part of the investigation, we spoke with owners of the call center from which the general manager was poached. We learned that they were getting ready to fire the general manager for falsifying invoices to clients, so they were happy to see him move on. We also spoke with former co-workers who described a wide array of illegal and unethical activities conducted by the general manager and found that he had a very poor reputation in the market.
Circling back to our client, we found that they had not conducted any inquiries on the general manager. Their logic was that, since he was already employed at a well-known competitor, there was no need to conduct such an investigation.
Unfortunately, this decision now meant that they had to explain to their shareholders that the call center over-reported their earnings, was in debt more than $200,000 in back expenses to their suppliers, and that 10% of the shares of the company had been signed over to the same individual that had placed them in this position.
A subsequent legal battle with the now-former general manager was undertaken to attempt to regain control of the 10% of the shares. After eight months of litigation, the court ruled in favor of the General Manager, declaring that despite the fraud, the shares had been turned over legally. To add insult to injury, the general manager offered to sell the shares back to the company for $2 million.
At that stage, the shareholders decided to shut down the company.
All of this could have been avoided through a basic reputational due diligence on key talent in the company prior to the purchase. But key members of a company are not the only ones that can have issues with their reputation. At times, it is the company itself.
In another case, we were asked to assist a multinational company facing a significant legal battle over unpaid taxes by a construction company that they had purchased overseas less than six months earlier. According to the allegations, the company overseas had paid out over $1 million in expenses to a fake company, and therefore owed approximately 30% tax on the underreported income, in addition to fines and penalties. Subsequent investigation by the government identified three additional fake companies, bringing the total amount of underreported income to close to $2.5 million.
During our first week of investigations, we found an additional 13 fake companies that had allegedly issued invoices exceeding $12 million. But more important than the amount of the fraud was the ultimate destination of the money paid out: a slush fund controlled by the company and used to pay bribes to government officials in order to be granted contracts. So, in addition to the tax problems, the company now faced significant Foreign Corrupt Practices Act and U.K. Anti-Bribery Act violations, in addition to local corruption charges.
Related content: Protecting Your Business With Contractual Risk Transfer
During the course of our investigation, we found that company was well-known within the local construction market to be in bed with government officials. We further learned that there were several allegations lodged with the Public Works Ministry against the company for being improperly favored in public tender bids for infrastructure projects. Discussions with competitors and industry experts identified almost a dozen projects that had been granted under questionable circumstances.
During our first week of investigations, we found an additional 13 fake companies that had allegedly issued invoices exceeding $12 million.
When presenting our findings to the client, we learned that no due diligence had been conducted on the reputation of the company.
Instead, the client was seduced by the strong financial records of the company and the fact that they had multiple ongoing projects underway. No thought was given to the question of how the projects were granted.
Taking a Proactive Stance
In both cases described above, and many others that we have been called upon to assist, a proactive look at the reputations of the company and its principles prior to moving forward with the purchase would have saved the respective buyers a lot of headaches—not to mention millions of dollars in subsequent investigative and legal fees, in addition to fines and penalties.
Reputational due diligence is not just a matter of probing the C-suite and leadership teams of acquisition targets. Indeed, it must also include an assessment of the reputation of the company itself.
Amid market uncertainty, due diligence must take a front-seat in any M&A transaction—and the role of reputational due diligence cannot be overlooked.