Due Diligence of Foreign Entity
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Important ITAT-Mumbai Ruling on Section 56(2)(x) Important ITAT-Mumbai Ruling on Section 56(2)(x) All blog, Income tax April 25, 2025 In a...Understanding International Due Diligence Search
When two or more companies transact with one another, it is important that the parties are fully aware of the legal, financial, and commercial health of the transacting parties. The transactions could range from a lending transaction where a lender is interested in knowing about the borrower or it could be an acquisition transaction, where the investor is interested in establishing the investee company’s good standing. Usually, the lawyers advising on the commercial transactions would undertake due diligence searches on behalf of the transacting parties, instead of merely relying on information provided by the target company.
The process typically involves a comprehensive review of a company’s legal, financial, and commercial aspects, including its corporate structure, ownership, financial statements, contracts, regulatory compliance, intellectual property (IP), litigation history, and reputation.
Law firms will typically use third-party services, to undertake these searches so that they can make an informed decision on behalf of their clients. As more and more companies have now become global, with business interests in several jurisdictions, the due diligence process has become more involved. The service company undertaking these searches will not only need to have expertise in the jurisdiction where the parent company is located, but it will need to have an understanding of what information about a legal entity is available in several other countries/ jurisdictions where subsidiaries or branches may be located. The extent of information as well as its availability greatly varies between countries, thereby making this information gathering process even more challenging.
Conducting due diligence on international third parties is now considered a leading practice for companies operating in international jurisdictions. Laws such as the US Foreign Corrupt Practices Act (FCPA), UK Bribery Act and guidance from multinational organizations all advise companies to "know" their foreign counterparts. While the need is clear, there is no regulatory guidance specifying a minimum level of due diligence to be conducted. This ambiguity can make it tempting for companies to take a cursory swipe at due diligence; review one database, check the "all-clear" box, and enter into a business agreement.
As evidenced by US Securities and Exchange Commission (SEC) and US Department of Justice (DOJ) judgments in which US companies have been faulted for not performing sufficient due diligence, a cursory approach will no longer suffice. Increasingly, companies are expected to conduct a deeper, more systematic assessment of potential international business agents and partners that involves collecting information from the business partner, verifying the data, and following up on identified "red flags. " This article reviews regulatory guidance on the sufficiency of background research, explores options for information-gathering, and provides factors to consider in the due diligence process.
While there is no law or regulation specifically defining what is “sufficient” international due diligence, the guidance and examples of enforcement actions discussed above do provide some indication of leading practices. Generally, companies can consider several steps in their investigation of a potential int'l 3rd party, including:
1. Require the third party to disclose information on a questionnaire.
2. Use a risk-based approach to verify the information provided and independently identify adverse information.
3. Take action on any identified "red flags" uncovered in the process.
Background research methodology
Once the above information is collected, the company should conduct an assessment to determine the level of risk presented by each third party. A number of factors should be considered, including the type of relationship, corruption risk associated with the jurisdiction, interaction with government officials, compliance regime, and known adverse information about the third party. These factors may also vary depending on the industry in which the third party is operating.
Third parties typically are divided into three categories: high-, medium-, and lowrisk. High-risk third parties include those located in a country with a considerable risk of corruption, those having significant interaction with government officials, or those for which red flags have been identified in the due diligence process. Medium-risk third parties are those that may have a lesser degree of contact with government officials, such as lawyers or accountants, yet are located in a high-risk jurisdiction. Low-risk third parties might include vendors of goods and services that are not acting in an official capacity for the company
The methodology for third-party background research will depend on the subject's risk ranking. Figure 1 shows examples of the factors involved in the riskranking process and three representative levels of background checks commensurate with those risk levels.
Companies should strongly consider hiring an outside firm to conduct background research to benefit from access to sources otherwise not available and to demonstrate independence in the vetting process. When vetting a representative who has a high degree of contact with government officials, or one located in a high-risk jurisdiction, single-database resources will likely be to be insufficient. Similarly, public record resources in many countries may be to be sparse and unreliable; instead, local resources may be required for record retrieval and for human source inquiries regarding the reputation and background of the subject. Professional investigators may help lower the risk of overlooking important information and provide credibility that the approval process was conducted independently of commercial interests.
The International Due Diligence Process and its Biggest Challenges
In the current globalized environment, companies often have business interests outside of their domestic jurisdictions of incorporation. For instance, many companies have subsidiaries or branches or investments outside the US. Therefore, the risks for a US company are not limited to its activities in the country. Rather, they extend to all jurisdictions that it operates in, and the due diligence process needs to cater to this expanded scope. However, it is important to not only expand the scope but also customize it to the type of business and the complexity of the foreign jurisdictions it will cover.
Here are some of the challenges that an international due diligence process must address:
1. Legal and Regulatory Differences
Different countries have different legal systems, regulatory frameworks and compliance requirements. Understanding and navigating these differences requires specialized legal expertise and localized knowledge. This can impact the ability to assess compliance, identify legal risks and ensure the legitimacy of transactions.
2. Language and Cultural Barriers
Language differences can complicate the due diligence process, requiring translation of documents and effective communication with local stakeholders. Cultural differences can also affect how information is presented, understood and negotiated. Misunderstandings or misinterpretations can lead to errors in the due diligence process.
3. Data Accessibility and Reliability
Access to accurate and reliable data can be challenging in some international contexts. This includes obtaining financial records, legal documents or business performance metrics. Some jurisdictions have less transparency or lack robust systems for maintaining records, complicating the validation of information.
4. Local Business Practices and Norms
Business practices vary across cultures, and what is considered acceptable in one country may not be in another. This can include practices related to corporate governance, employee relations, environmental standards and even corruption or bribery. Understanding these practices is crucial for assessing risks and ensuring compliance with international regulations, such as the Foreign Corrupt Practices Act or the UK Bribery Act.
5. Geopolitical and Economic Risks
International due diligence must account for geopolitical risks, such as political instability, government changes or trade tensions, which can affect business operations and future prospects. Economic risks, including currency fluctuations, inflation or economic downturns, can also impact the valuation of international assets or companies.
6. Time Zones and Logistical Complexity
Coordinating due diligence activities across different time zones can be challenging, leading to delays and communication issues. Additionally, travel restrictions (especially in the context of global health crises like the COVID-19 pandemic) can make on-site inspections and face-to-face meetings difficult.
7. Intellectual Property and Data Protection
IP rights and data protection laws vary by country. Ensuring compliance with these regulations, especially regarding data privacy and security, is critical. Different jurisdictions may have varying levels of protection for IP, impacting the assessment of risks and opportunities.
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FAQs
The due diligence process is a critical step in many business contexts, particularly in mergers and acquisitions, venture capital, private equity, real estate transactions and corporate partnerships. Its importance stems from its role in helping the parties involved in a transaction assess risks, uncover hidden issues and make informed decisions. Public record due diligence involves researching and gathering information from publicly available sources to assess risks, validate information and gain insights into a company, individual or asset.
Public record due diligence often involves examining a wide range of public records, including legal documents, court records, financial filings, regulatory reports, etc., as detailed below:
Corporate Records
Reviewing corporate records helps establish the legal existence and structure of a business entity. This may include checking business registration, articles of incorporation, bylaws, shareholder agreements and annual reports. This process ensures that the company is in good standing and compliant with corporate governance requirements.
Financial Filings
In the US, publicly listed companies are required to file financial reports with regulatory bodies like the Securities and Exchange Commission. Analyzing these filings (e.g., 10-K, 10-Q, 8-K or annual reports) can provide insights into a company’s financial health, profitability, cash flow and liabilities. It also helps identify any significant financial risks or irregularities. Internationally, many countries require even private limited companies to file their financial statements with the corporate registry.
