Can you rely on a due diligence if it doesn’t take ethics into account?

When Parliament approved the Financial Intelligence Centre Amendment (FICA) bill at the end of February this year, a LexisNexis article on the Polity website noted that “Accountable institutes are facing growing legislative pressure to ensure that their due diligence efforts on clients are stringent enough to uncover unethical transactions …”. This highlights the need to include ethics as a core facet of any due diligence. But how often is ethics actually a part of a due diligence? More specifically, Is the value of its inclusion and the risk of its exclusion recognised?

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

The importance of a due diligence – as many other business processes – is well illustrated by its failures. There are a number of high-profile examples. In 2015 Barclays Bank UK was fined £72 million by the UK’s Financial Conduct Authority for failing to conduct proper due diligence checks on a group of ultra-high-net-worth clients who used the bank to move £1.88 billion of funds in 2011 – 2012. The due diligence conducted for Hewlett-Packard (HP) when it acquired Autonomy, the UK software company, in 2011 subsequently led to HP claiming that Autonomy had inflated the value of the company prior to the takeover. This, in turn, led to a write-off of more than $8.8 billion related to allegedly fraudulent accounting at Autonomy.

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, for example in regard to a sale, and it is intended as a means to prevent unnecessary harm to either party involved in a transaction. But, in the absence of an ethical culture, the facts can be skewed by the company being sold. The acquisition can also pose significant future risks to the purchaser. This can range from liabilities and penalties associated with fraudulent practices to having to change the company’s entire 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.

Conducting an assessment of the organisation’s ethics as part of a due diligence can add considerably to the depth of insight into the target 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 or practices. Although there are cases when knowledge of wrongdoing is limited to the perpetrator, in most cases there are other people within the business who know, or at least suspect, that something is not right.

Secondly, the results must have a high level of credibility. To realize this, the results should be based on the experiences and perceptions of all employees (including management and executive directors) and hence the ethics assessment should allow all these stakeholders to contribute their views. The views of the select few on the board of directors are too limited to being viewed as a credible, 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 comeback.

As part of its contribution to a due diligence, an ethics assessment should quantify the organisation’s ethics to produce an ethics rating for the business and provide in-depth insight into the ethics throughout the organisation – relative to leadership and across branches, departments and work levels - to identify areas of strength and vulnerability. This not only illustrates what can be done to remedy ethical weaknesses and to leverage ethical strengths, but also serves as an effective risk analysis.

There are five additional issues that should be investigated to evaluate the status of a company’s operational ethics.

1. If the company is operating in South Africa, has it set up an effective Social and Ethics Committee in accordance with the Companies Act? This implies that the Committee is not viewed as a mere compliance exercise, but is expected to add real value.


2. Does the company have an ethics strategy and clearly identified ethics goals (which, if not done previously, should have been done by the Social and Ethics Committee)? In the absence an ethics strategy and clear goals, initiatives and actions to create an ethical workplace are likely to be fragmented and loose the benefits that an integrated approach can deliver.


3. Does the company report on its ethics? It should, as ethics reporting is a specific recommendation of King III and King IV^TM and a requirement for the Companies Act Social and Ethics Committee.


4. How does the company manage its ethics? 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?


5. Does the company provide ethics training to maintain high levels of ethical awareness and, crucially, to ensure its people (executives and employees) are equipped to deal with ethical challenges and dilemmas effectively..

The optimal value of the inclusion of ethics in a due diligence should be to increase the level of assurance about the value of the seller’s ethical capital: In fact, the seller with a sound ethical culture should insist on an ethics assessment to clarify that value. The inclusion of ethics is also important to minimize the risk of future problems. Although it may not be possible to prevent other scandals by means of better due diligence, ensuring that the due diligence is the best it can be should be a recognised goal.