Investors and Money Laundering Due Diligence Questions
If you want to learn about due diligence, you've come to the right place. This introduction to due diligence covers the basics concerning due diligence.
Due diligence is used to investigate and evaluate a business opportunity. The term due diligence describes a general duty to exercise care in any transaction. As such, it spans investigation into all relevant aspects of the past, present, and predictable future of the business of a target company. Due diligence sounds impressive but ultimately it translates into basic commonsense success factors such as "thinking things through" and "doing your homework".
There are many reasons for conducting due diligence, including the following:
- Confirmation that the business is what it appears to be;
- Identify potential "deal killer" defects in the target and avoid a bad business transaction;
- Gain information that will be useful for valuing assets, defining representations and warranties, and/or negotiating price concessions; and
- Verification that the transaction complies with investment or acquisition criteria.
Lead and co-investors, corporate development staff, attorneys, accountants, investment bankers, loan officers and other professionals involved in a transaction may have a need or an obligation to conduct independent due diligence. Target management typically assists these parties in obtaining due diligence information but because it is unwise to totally rely on management third party consultants such as Astute Diligence are often brought in to conduct due diligence
Initial data collection and evaluation commences when a business opportunity first arises and continues throughout the talks. Thorough detailed due diligence is typically conducted after the parties involved in a proposed transaction have agreed in principle that a deal should be pursued and after a preliminary understanding has been reached, but prior to the signing of a binding contract.
The parties conducting due diligence generally create a checklist of needed information. Management of the target company prepares some of the information. Financial statements, business plans and other documents are reviewed. In addition, interviews and site visits are conducted. Finally, thorough research is conducted with external sources -- including customers, suppliers, industry experts, trade organizations, market research firms, and others.
There is no correct answer to this question. The amount of due diligence you conduct is based on many factors, including prior experiences, the size of the transaction, the likelihood of closing a transaction, tolerance for risk, time constraints, cost factors, and resource availability. It is impossible to learn everything about a business but it is important to learn enough such that you lower your risks to the appropriate level and make good, informed business decisions.
Yes. Too much due diligence can offend a target company to the point where they walk away from a deal. It can also result in "analysis paralysis" that prevents you from completing a transaction or provides time for a better competing offer to emerge. Accordingly, it is important that due diligence be prioritized and executed expeditiously. Appropriate investigation and verification into the most important issues often must be balanced by a sensible level of trust concerning lesser issues.
Time allocated for completion can vary widely with each situation. Many preliminary agreements define the timeframes in which due diligence will be conducted. Time schedules through the closing of a transaction are typically tight -- parties should ensure that adequate time is allocated to due diligence.
Every transaction will have different due diligence priorities. For example, if the main reason you are acquiring a company is to get access to a new product they are developing to accelerate your own time to market, then the highest priority task is to ensure that the product is near completion, that there are no major obstacles to completion, and that the end product will meet your business objectives. In another transaction, the highest priority might be to ensure that a major lawsuit is going to be resolved to your satisfaction.
Due diligence costs are based on the scope and duration of the effort, which in turn are dependent on the complexity of the target business and other factors. Costs are typically viewed as an essential expense far outweighed by the anticipated benefits and the downside risks of failing to conduct adequate due diligence. The involved parties determine who will bear due diligence expense.
Certain activities conducted during due diligence can breach confidentiality that a transaction is being contemplated. For example, contacting a customer to assess their satisfaction with the target company's products might result in a rumor spreading that the company is up for sale. Accordingly, to maintain confidentiality, we often contact customers under the guise of being a prospective customer, journalist, or industry analyst.
A well-run due diligence program cannot guarantee that a business transaction will be successful. It can only improve the odds. Risk cannot be totally eliminated through due diligence and success can never be guaranteed.
In this litigious world, you can be sued for just about anything and failing to conduct due diligence is no exception. Parties involved in a business transaction may find themselves being sued by their clients, investors, customers, employees, suppliers, or other third parties asserting failure to conduct proper due diligence or pursuing a liability that was overlooked or incorrectly assessed by due diligence.
No. However, conducting proper due diligence may serve as a strong legal defense to third-party claims after a transaction closes. Due diligence may also reduce legal issues by alerting a purchaser or investor to potential liabilities that can be mitigated in various ways prior to closing the transaction.
What is Money Laundering?
Money laundering is the generic term used to describe the process by which criminals disguise the original ownership and control of the proceeds of criminal conduct by making such proceeds appear to have derived from a legitimate source.
The processes by which criminally derived property may be laundered are extensive. Though criminal money may be successfully laundered without the assistance of the financial sector, the reality is that hundreds of billions of dollars of criminally derived money is laundered through financial institutions, annually. The nature of the services and products offered by the financial services industry (namely managing, controlling and possessing money and property belonging to others) means that it is vulnerable to abuse by money launderers.
How is the offence of money laundering committed?
Money laundering offences have similar characteristics globally. There are two key elements to a money laundering offence:
- The necessary act of laundering itself i.e. the provision of financial services; and
- A requisite degree of knowledge or suspicion (either subjective or objective) relating to the source of the funds or the conduct of a client.
The act of laundering is committed in circumstances where a person is engaged in an arrangement (i.e. by providing a service or product) and that arrangement involves the proceeds of crime. These arrangements include a wide variety of business relationships e.g. banking, fiduciary and investment management.
The requisite degree of knowledge or suspicion will depend upon the specific offence but will usually be present where the person providing the arrangement, service or product knows, suspects or has reasonable grounds to suspect that the property involved in the arrangement represents the proceeds of crime. In some cases the offence may also be committed where a person knows or suspects that the person with whom he or she is dealing is engaged in or has benefited from criminal conduct.
Are all crimes capable of predicating money laundering?
Different jurisdictions define crime predicating the offence of money laundering in different ways. Generally the differences between the definitions may be summarised as follows:
- Differences in the degree of severity of crime regarded as sufficient to predicate an offence of money laundering. For example in some jurisdictions it is defined as being any crime that would be punishable by one or more years imprisonment. In other jurisdictions the necessary punishment may be three or five years imprisonment; or
- Differences in the requirement for the crime to be recognized both in the country where it took place and by the laws of the jurisdiction where the laundering activity takes place or simply a requirement for the conduct to be regarded as a crime in the country where the laundering activity takes place irrespective of how that conduct is treated in the country where it took place.
In practice almost all serious crimes, including, drug trafficking, terrorism, fraud, robbery, prostitution, illegal gambling, arms trafficking, bribery and corruption are capable of predicating money laundering offences in most jurisdictions.
Can Fiscal Offences such as tax evasion predicate Money Laundering?
The answer depends upon the definition of crime contained within the money laundering legislation of a particular jurisdiction.
Tax evasion and other fiscal offences are treated as predicate money laundering crimes in most of the worlds most effectively regulated jurisdictions.
Why is money laundering illegal?
The objective of the criminalisation of money laundering is to take the profit out of crime. The rationale for the creation of the offence is that it is wrong for individuals and organisations to assist criminals to benefit from the proceeds of their criminal activity or to facilitate the commission of such crimes by providing financial services to them.
How is money laundered?
The processes are extensive. Generally speaking, money is laundered whenever a person or business deals in any way with another person’s benefit from crime. That can occur in a countless number of diverse ways.
Traditionally money laundering has been described as a process which takes place in three distinct stages.
- Placement, the stage at which criminally derived funds are introduced in the financial system.
- Layering, the substantive stage of the process in which the property is ‘washed’ and its ownership and source is disguised.
- Integration, the final stage at which the ‘laundered’ property is re-introduced into the legitimate economy.
This three staged definition of money laundering is highly simplistic. The reality is that the so called stages often overlap and in some cases, for example in cases of financial crimes, there is no requirement for the proceeds of crime to be ‘placed’.
What is Customer Due Diligence (CDD)?
CDD information comprises the facts about a customer that should enable an organisation to assess the extent to which the customer exposes it to a range of risks. These risks include money laundering and terrorist financing. Organisations need to ‘know their customers’ for a number of reasons:
- to comply with the requirements of relevant legislation and regulation
- to help the firm, at the time the due diligence is carried out, to be reasonably certain that the customers are who they say they are, and that it is appropriate
- to provide them with the products or services requested
- to guard against fraud, including impersonation and identity fraud
- to help the organisation to identify, during the course of a continuing relationship, what is unusual and to enable the unusual to be examined;
- if unusual events do not have a commercial or otherwise straightforward rationale they may involve money laundering, fraud, or handling criminal or terrorist property
- to enable the organisation to assist law enforcement, by providing available
- information on customers being investigated following the making of a suspicion report to the FIU.
Consequently a prohibition on setting up anonymous accounts or relationships is the baseline for the international standards.
The basic European and domestic standard
The Third European Directive requires that CDD measures should be applied on a risk-sensitive basis, depending on the type of customer, business relationship or nature of the transaction or activity. Firms must however ‘be able to demonstrate to the supervising authorities that the extent of the measures is appropriate to the risks of money laundering and terrorist financing‘. In line with the FATF requirements the Directive outlines the four parts of customer due diligence, including an explicit requirement for ongoing monitoring. There is a specific requirement to identify the beneficial owners of legal entities and structures and to undertake enhanced due diligence on higher risk customers.
- Who is the customer and what is meant by the identification of beneficial owners?
The application of CDD is required when a firm covered by money laundering regulations, ‘enters into a business relationship’ with a customer or a potential customer. This will include occasional ‘one off’ transactions even though this may not constitute an actual business relationship as it is defined below. A customer/business relationship is defined as being formed when two or more parties engage for the purposes of conducting regular business or to perform a ‘one off’ transaction. The term ’business relationship’ applies where a professional, commercial relationship will exist with an expectation by the firm that it will have an element of duration.
The risk-based approach to CDD
International standards require that a risk-based approach is applied to CDD.
Consequently, the measures should be applied on a risk-sensitive basis depending on the type of customer, business relationship or nature of the transactions or activity. Higher risk categories should be subject to enhanced due diligence.
The risk assessment will determine how much of the information collected needs to be independently verified, as the following examples indicate.
- Only simplified or basic account opening information may need to be collected for a low-balance, low-turnover deposit account. The extent of information that is verified can be restricted to the identification evidence and information concerning source of the funds and the expected frequency of deposits and withdrawals.
- For standard-risk customers, i.e. those who are permanently resident in the country, with a salaried job or other transparent source of income, only the standard information provided may need to be verified.
- Enhanced due diligence should be applied to higher-risk customers/clients. Enhanced due diligence must also be applied to the beneficial owners or controllers of higher-risk companies or structures.
- Quoted companies and their wholly-owned subsidiaries are considered to be lower-risk, requiring only simplified due diligence.
Privately owned companies and other entities, e.g. trusts, are generally assessed as higher risk than quoted companies because they are exposed to a lower level of external scrutiny than those that are publicly owned. For such relationships, the identities of the beneficial owners and controllers must also be verified in addition to verifying the identity of the corporate entity. Beneficial owners may also be executive directors or the settlors of trusts.