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Due Diligence and The Holy Grail — Red Flags

redflag3Compliance professionals love to bandy about the term “red flag.” It is a term with infinite meanings depending on the context. A red flag in a money-laundering context is different than a red flag in a corruption context.

I like to say – not all red flags are created equal. Some red flags are more red than others – or in extreme cases, I use the term “bloody red flag.” (And I am not using the British version of bloody).

In the anti-corruption world, a red flag has a vey specific meaning because the FCPA is crafted in a way to target situations where a company or individuals act or fail to act with “willful blindness.”

As a result, the existence of red flags takes on much greater significance than in other contexts, including money laundering. In the anti-bribery world, a red flag in conducting due diligence (of a third party, acquisition candidate or potential joint venture partner) translates to a circumstance that indicates an increased risk of corruption.

In the FCPA context, the danger of red flags is the risk that a failure to identify, respond and resolve a red flag can lead to a government enforcement action. DOJ and SEC prosecutors have a unique advantage when enforcing the FCPA – the term “knowing” applies to a situation where a person is aware of the high probability of a circumstance, and acts or fails to act in response to the existence of the situation where there is a high probability of an FCPA violation.redflag2

To meet its burden of proof, DOJ and SEC prosecutors can cite (and have cited) the presence of multiple red flags and the actor’s decision to move forward without addressing these risks. The Bourke case is a perfect example of how the statute works – Bourke moved forward in a transaction despite his knowledge of four separate circumstances (or red flags) indicating a high probability of an FCPA violation.

As a result, a Chief Compliance Officer’s challenge, in the presence of a red flag, is to respond to, and resolve, the red flag. That can be done in a variety of ways depending on the red flag.

For example, in response to adverse media suggesting that a third party has engaged in corruption, an appropriate response may be to interview the third party about the corruption allegations, request documents that corroborate the third party’s explanation, and carefully weigh the evidence and credibility of the third party. If documented, this process can create a perfect record of the company’s appropriate response to a red flag.

If the record of the company’s response to the red flag of adverse media is maintained, the government will be hard pressed to cite this red flag as evidence that the company chose to move ahead with the transaction despite the allegations of corruption against the third party. To the contrary, the evidence will show that the company identified, investigated and resolved the red flag, which in the end will negate any inference that the company acted with corrupt intent.

redflagSome red flags are easier to deal with in the due diligence process. For example, if a third party requests that payment for its services be made to a bank account in Malta, an area known for bank secrecy and money laundering activities, the company can respond to the red flag by rejecting the payment request and requiring payment to the third party through more acceptable systems. Of course, the fact that the third party asked for unusual payment arrangements is still a minor red flag, the third party’s agreement to a more traditional means of payment is probably an acceptable resolution of the red flag.

Some red flags can derail a due diligence process – in those circumstances, the company has to realize that doing business with the third party may not be worth the trouble.

For example, if a third party does not want to disclose its ownership information, its non-cooperation is a bloody red flag that cannot be addressed. If the third party is uncooperative in the due diligence process, how can a company expect to conduct business with the third party? These situations cry out for pulling the plug or trying alternative techniques and patience to gain the trust and confidence of the third party.

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