Retaining a “Risky” Third-Party
Every company has done it. Chief Compliance Officers have had to hold their respective noses and push forward with due diligence to retain a risky third party.
Rather than reject the third party, a CCO convinces him or herself that the company can mitigate the risks by contract representations and warranties, annual certifications, and a plan to monitor and audit the third party in the next three years. The problem with this “rationalization” is that CCOs rarely get around to following up on the third parties they know need to be monitored and audited.
We all have experienced this scenario. Due diligence systems are not inflexible, and they can be massaged to make a risky deal look better or even passable.
Let’s face it, due diligence is an imprecise science. It is hard to predict based on a due diligence review whether a third party agent will break bad or stay in compliance. We all know that some third parties look low-risk on paper but in fact may be higher risk. Some traits and personal risk factors cannot be identified on paper, through a questionnaire or based on open source intelligence.
In some cases, a thorough due diligence reveals few risks but there might be a gut feeling that the third party is not all they are cracked up to be. A third party by definition is not an employee and a company has little control over the third party-s day-to-day activities. I am not suggesting that due diligence is worthless or that there is no way to assess the risk of a third party. To the contrary, I believe in due diligence as a discipline and a comparative technique that provides valuable insight and assessment of future risks. Some of the process involves intangibles relating to a business sponsor, the justification for hiring a third party, the nature of the interactions with the potential third party in the due diligence process, and an overall sense of the third party’s commitment to ethics and compliance. There is no reason to ignore your gut reactions to these factors and others when reviewing due diligence information.
With experience comes wisdom, and I have witnessed due diligence cases where an initial impression may quickly change based on a detailed investigation and uncovering of misconduct and other risk factors. On the other hand, I have conducted due diligence of third parties where there are few risks and further investigation has only confirmed the low risk nature of the proposed third party.
CCOs know there are a few “risky” third parties operating with the business. While it is easy to remind CCOs to monitor and audit these risky third parties, CCOs face a stark reality that they do not have the time or resources to monitor these third parties on an ongoing basis (other than maintaining a database service that notifies the CCO if a significant event involving the third party occurs). As always, the CCO has to prioritize his or her resources, attend to the riskier third parties, and enlist the support of internal auditing to help follow up with some of the risky third parties.
CCOs know how to use sampling and other transaction testing strategies to conduct monitoring and auditing of third parties in order to maximize use of available resources. The term “audit” is not limited to a formal, all-out financial and compliance audit with boots on the ground. There are less intensive type audits that can be conducted with sampling and transaction testing techniques. CCOs should rely on these strategies when needed to leverage limited resources.