An ethics assessment should be essential for any due diligence

Due diligence is a term most commonly used for the process whereby a potential purchaser evaluates a target company for acquisition. It is an investigation into a possible investment that includes reviewing financial records, major agreements entered into, as well as anything else deemed material to the sale. Offers to purchase are usually dependent on the results of a due diligence analysis.

The importance of a due diligence – as with many other business processes - is well illustrated by its failures. A high-profile example was the due diligence conducted for Hewlett-Packard (HP) on Autonomy, a UK software company. HP subsequently claimed that Autonomy had inflated the value of the company prior to the takeover, which led to a write-off of more than $8.8 billion. Similarly, US machinery manufacturer Caterpillar was forced to make a $580 million write-down after accounting misconduct was uncovered at ERA’s Zhengzhou Siwei subsidiary.

While a breach of ethics is central to these accounting scandals, ethics has a further relevance for a due diligence. A due diligence should serve to confirm all material facts and is intended as a means of preventing unnecessary harm to the purchaser in a transaction. Where the target firm's ethical culture is poor, or non-existent, the facts can be skewed and manipulated, and the purchaser can be exposed to significant future risks. Such risks range from liabilities and penalties associated with fraudulent practices to having to address and change the target company’s unethical culture. The difference between an ethical and unethical company is so noteworthy that ethics - or, specifically, a lack of ethics - should be considered a material fact in any acquisition.

Conducting an assessment of the target organisation’s ethical status as part of a due diligence can add considerably to the depth of insight into the company. For an ethics assessment to add this value, it is crucial that it is an accurate and reliable assessment. This rests on three factors.

Firstly, an instrument should be used that will produce correct and trustworthy results. The effectiveness of a tool such as the Ethics Monitor survey is that it taps into employees’ knowledge as a way of surfacing and uncovering unethical behaviour. Although there are cases when knowledge of wrongdoing is limited to the perpetrator, in most cases there are other people within the business, most frequently the employees, who know, or at least suspect, that something is not right.

Secondly, the results must have a high level of credibility. To realise this, the results should be based on the experiences and perceptions of all employees (including management and executive directors) and key stakeholders - or at least the vast majority. The views of the board of directors or a small sample of employees are too limited to be considered a credible and representative result.

Thirdly, an ethics rating should be conducted by an independent third party. This adds to the reliability of the assessment and avoids any suggestion of manipulated results. An independent third party can also offer the assurance of confidentiality and anonymity to allow respondents to share their views freely without fear of reprisals.

As part of its contribution to a due diligence, an ethics assessment should quantify the target organisation’s ethical status in the form of an ethics rating and provide in-depth insight into the ethics throughout the organisation (for example, relative to leadership and across branches, departments and work levels) to identify areas of strength and vulnerability. The assessment would further illustrate what can be done to remedy the ethical weaknesses and leverage the ethical strengths, as well as serve as an effective risk analysis.

There are five additional issues that should be investigated to evaluate a target company’s operational ethical status.

For all but small companies, an organisation should have set up a Social and Ethics Committee in accordance with the Companies Act, 2008, and this Committee should already be operational. Whether the Committee is viewed as a “tick box” compliance exercise or is expected to add real value would be a relevant insight.

A further pertinent question is whether the target company has an ethics strategy and clearly identified ethics goals. In the absence of an ethics strategy and clear goals, at best, initiatives and actions to create an ethical workplace are likely to be fragmented and lose the benefits that an integrated approach can deliver. At worst, ethics will not be included as an agenda item for strategic or operational decisions.

Thirdly, a firm should be reporting on its ethics and ethical performance in a clear and accurate manner. Not only is this mandatory for Social and Ethics Committees but it is also a specific recommendation of King III.

A further issue to investigate is how well the target company manages its ethics. For instance, do they follow an integrated approach or does it amount to a collection of disjointed initiatives and systems? Is ethics managed proactively or reactively after there is a failure of ethics? It is managed regularly or on an ad-hoc basis? These are all important questions to ask before an acquisition.

And lastly, does the target company provide ethics training to ensure it adequately addresses ethical challenges and maintains a high level of ethical awareness? Effective ethics training is a prominent way of establishing a high level of ethical awareness, which contributes significantly to building and maintaining an ethical culture.

The inclusion of ethics in a due diligence is especially noteworthy because it serves both parties. For the target organisation with a sound ethical culture an ethics assessment clarifies the value of the company’s ethical capital. For the purchaser it offers an increased level of assurance and security about the proposed transaction: An ethical assessment after all goes to the heart of that which is a material in a due diligence - what kind of a business am I buying, and can I feel secure that I am making the right choice?

By Cynthia Schoeman
Published in Directorship, December 2013