by ASHLEIGH TURNER

Sep 25, 2015

The increased regulatory scrutiny over banks and financial institutions means these organisations need to constantly reassess internal decision making policies and counterparty relationships to remain both compliant and profitable. It is critical that organisations perform the appropriate due diligence to recognize any issues before they arise. For due diligence to be effective it requires a robust and efficient process of investigation and remediation.

What is Due Diligence?

Broadly speaking, due diligence is a risk assessment. It is the investigation and / or evaluation of an entity or person, prior to entering into an agreement.

Due diligence is carried out in various departments across Investment banks; M&A, legal, KYC and on boarding. It can arise as a legal obligation, such as required under FATCA or the Anti Money Laundering Regulations, but it is usually a voluntary endeavour undertaken to achieve commercial goals with informed decision making and risk mitigation measures.

While the purpose of the due diligence will determine the scope and depth of the investigation, it can be a lengthy and in-depth process, which may be challenging for Investment banks and financial institutions given the volume of clients they trade and interact with on a day-to-day basis.

The due diligence process can be

operational, financial, or legal in nature. It can range from assessing the creditworthiness or financial health of a counterparty before lending (financial), to assessing the management strategy prior to a merger or acquisition (operational). It is legal due diligence that this article aims to explore:

Legal Due Diligence

This requires a full consideration of all the potential legal risks that a potential / existing client or counterparty may have prior to the signing of a new contract or amendment. The process of due diligence is extremely important to ensure that the intended contract / amendment is legally binding and enforceable.

When carrying out legal due diligence, it is important to complete a thorough review of the entity and the jurisdiction in which it is incorporated.

It may also be necessary to complete a review of the entities organisational documents, such as the Memorandum and Articles of Association, which will need to be assessed to analyse the organisational structure and establish which, if any, shareholder approvals need to be sought.

Once the entities constitution has been determined, the due diligence process is often needed in order to establish whether there are any legal restrictions prohibiting or restricting the entering / renewing of the contact.

If, for example, a bank or financial institution is completing its due diligence prior to entering into a new trading relationship, it is important to establish whether the entity’s constitution allows a party to trade certain securities, and, if so, that this has not been restricted to do so by the entities local laws. These restrictions could be minor, such as the requirement for a licence, or it could declare illegal the trading of certain securities.

India is a good example of a jurisdiction that prohibits some entities from the trading of certain securities without the approval of the Reserve Bank of India. Evidence of such approval is needed as part of the due diligence process. Without it, if a restricted security were traded without the approval of the RBI, the bank or financial institution would be unable to enforce the contract in the instance of its client / counterparty defaulting.

Benefits of Due Diligence

As part of the investigative process that is due diligence, it is also possible to uncover inadequacies in policies, practices or documentation. Identifying these and introducing the changes to tighten the effectiveness of due diligence is a continually evolving process and not a one time exercise.

With the rapid and quick-fire succession of regulation, bombarding financial markets since 2008, due diligence fulfils not only the obligations of initial risk assessment, but it also allows banks and financial institutions to continually review the enforceability of their contracts, agreements, and protocols that they have in place with their clients and counterparties. Having robust but equally efficient processes and automated technology in place is critical to be able to manage these increased regulatory requirements. In parallel, organisations should consider leveraging industry golden sources of documents and data given the duplicative nature of due diligence being performed by every bank and financial institution on common clients they all transact with.