Due diligence: two important words for all those who wear the white hats

RMA Journal, The, Oct, 2004 by Harris S. Berger, William F. Gearin

* Frequent turnover of management or directors, especially the CFO.

* Appointment of obviously unqualified persons in key audit or finance posts to avoid having improper transactions or practices challenged.

3. Financial reporting.

* Customer is reluctant to provide requested information or financial statements, or provides fictitious or conflicting data, or provides information that may be difficult or expensive to verify; unexplained delays occur in receipt of financial information.

* Unexplained or frequent changes in outside audit firm; use of audit firm outside local market for unclear reasons.

* Reluctance by customer to grant permission for bank to speak with outside audit firm.

* Customer's financial statements, tax returns, and financial profile do not reconcile.

* Reluctance by customer to give outside auditors needed data.

* Frequent changes in accounting methods, accounting inconsistencies, or irregularities; presence of overly aggressive, troublesome, or unusual accounting practices.

* Frequent accounting adjustments, which may serve to smooth over temporary business problems.

* Occurrence of unusually large or profitable transactions recorded at or near the end of an accounting period.

* The company continuously exhibits positive trends, consistently exceeding that of competitors, especially in a difficult or declining industry.

* Unexplained inventory shortages or receivable adjustments; unexplained deterioration in sales, earnings, or cash flow, or inability to generate cash flow while reported revenues and earnings continue to grow; inconsistent movements in the relationships between sales and receivables, and between inventory and accounts payable.

4. The transaction.

* Customer refuses to disclose loan purpose, the purpose cannot be clearly determined, or the stated purpose makes no economic or practical sense.

* Customer references special arrangements or unwritten deals that bank is told cannot be discussed due to confidentiality agreements, or domestic or foreign laws.

* Intended loan purpose is to generate questionable profits or tax benefits, or purely to justify dividends, bonuses, or commissions.

* Proposed transaction appears to be less than at arm's length, or lacks appropriate expected documentation.

* Proposed loan is to an offshore company or to a company or affiliate with income from bank secrecy havens, or loan is to be secured by obligations of offshore banks.

* At the request of the borrower, proposed collateral (typically cash, securities) is to be held by third parties instead of the bank, for unclear reasons.

* Proposed loan is to be supported by a third-party guarantee, where the borrower's relationship with the third party remains unclear or lacks a sufficient substance to justify the guarantee.

* Borrower submits engineering or feasibility studies for a proposed project to be financed from firms unknown to the bank or its industry experts.

Verify, Verify, Verify

The common theme in these red flags as well as in due diligence measures is that there is no substitute for the verification and validation of all customer information, as well as the verification of all sources of borrower/investor funds. Quite simply, if the transaction cannot be understood by the lender, or if it makes no sense, it may be appropriate to walk away.