Due Diligence Tips

by: Smith and Howard

December 4, 2014

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Related-party transactions played a major role in accounting scandals that happened at Enron and Tyco International. These scandals led to the Sarbanes-Oxley Act of 2002 and prompted auditors to take a closer look at related-party transactions and financial relationships. Such scandals aren’t unique to large public companies that engage in complex business transactions, however. In fact, they’re even more prevalent among small private companies without auditors and financial analysts to scrutinize their financial results.

With small businesses, lenders must act as gatekeepers and scrutinize related-party transactions as part of their regular due diligence procedures. If not, their loan portfolios may be at risk.

A case of out-of-control nepotism

Dan is the second-generation owner of a trucking company in Ohio. When profits took a nosedive five years ago, Dan blamed increasing gas prices and the recession. But his lender, Joan, suspected that out-of-control nepotism was partially to blame. So, she started asking questions.

It turned out that almost everyone on the company’s payroll was a friend or relative. His brother, Don, owned a body shop that repaired most of Dan’s fleet. The company’s facilities were leased from his sister, Dana. His older sister, Donna, was the bookkeeper for all of the family’s businesses. Even Dan took a hefty salary and ran personal expenses, such as trips, country club dues and auto lease payments, through the business.

After reviewing all of these related-party transactions, Joan recommended that the struggling trucking company switch to an unrelated accounting firm for more objective financial advice to help turn things around. He agreed, and the new CPA discovered that many disclosed related parties were grossly overpaid.

For instance, he recommended that Dan replace two underperforming salespeople (Aunts Polly and Ginny) with one unrelated salesperson who cost half as much in salary expense and sold twice as much business. The CPA also showed Dan comparable for-lease properties and was able to negotiate lower lease payments with the company’s landlord (his sister, Dana).

Moreover, the new CPA found several undisclosed related-party transactions — which Dan himself was unaware of — that were occurring at above-market rates. For example, the controller purchased insurance from a girlfriend without Dan’s knowledge. After receiving quotes from two unrelated insurers, Dan’s company was able to lower its annual insurance premiums by more than 20% without compromising on coverage. The controller was also providing trucking services to his son’s manufacturing company at half-price without Dan’s approval, causing the company to lose approximately $10,000 per month.

Beyond the numbers

Dan’s hypothetical trucking company might seem like an extreme example. But nepotism is more common than most people think — and it’s often less obvious than this example suggests. Material related-party transactions and relationships, especially those that are undisclosed or occur outside the normal course of business, put lenders at risk of being misled.

Borrowers should disclose every related party, even if there are no transactions between the company and its related party. These relationships include a company’s shareholders, directors, and officers, as well as their friends, family members, and any commonly controlled entities.

Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized or zero-interest loans, and subsequent repurchase of goods sold — also might signal that a company is engaged in material unusual or undisclosed related-party transactions. These arrangements can increase the risks of fraud and legal violations, putting lenders at increased risk of default and, therefore, warranting increased attention.

Lenders should ask for more details on every related-party financial relationship and transaction, including its nature, terms and business purpose (or lack thereof). Consider the possibility that related-party relationships may be used to fabricate transactions that are fraudulent or without economic substance.

Outside expertise

A lender may not always have the training or source documents to fully understand how a borrower’s related-party transactions work. Most times, these transactions are legitimate and a normal part of a small business’s operations.

But always trust your instincts. If you suspect something is awry, consider asking the borrower to hire an independent accounting firm to conduct an agreed-upon-procedures engagement to confirm (or invalidate) your suspicions about related parties.

For more information please contact a member of our lender services team at 404-874-6244.

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