Detection and prevention of risk from third parties

Companies in many sectors – particularly construction, infrastructure operation, energy and telecoms – interact with a large number of third parties, including their customers, partners, suppliers and commercial agents. A company may have an economic relationship with thousands of third parties each year and potential relationships with more than three times those selected in the same period.

In some sectors – particularly construction – companies can critically depend on third parties. It is not unusual for over 90% of any given contract value to be passed on to these third parties. Some of the types of risk and potential impact that these third parties can bring include:

• If the third party has financial issues during the relationship, it can lead to delays in the work and overall contract delivery.
• If a third party behaves in an overly contractual or argumentative manner, it can lead to delivery delays, additional costs and often the need to dedicate more company resources to manage the third party.
• If a third party is involved in corruption cases (either real or alleged), legal liability may extend to the company and have reputational impact.

We predict that this situation will continue to increase in the coming years. For instance, major construction and infrastructure development companies are increasingly expanding their footprints into countries far from their “home markets”. Major infrastructure development in the coming years will be carried out in emerging markets with potential for higher rates of return and lower levels of national debt. The third parties in these emerging markets tend to be less well known and could bring new risks. A number of countries where large infrastructure construction and investment are expected are highlighted in the following international rankings and lists of transparency indexes for their high levels of corruption.

At the same time, national legislation covering corruption has tightened significantly – one example is the UK Bribery Act 2010, which has an international scope that applies to all companies with UK operations. Overall, regulatory trends increasingly make companies responsible for corruption and bribery carried out by their partners and third parties, with the related penalties and sanctions increasing and having transnational impact. For instance, sanctions include the loss of the company’s ability to undertake contracts in the legislation’s country of origin and the criminalisation of its executives.

However, companies can take steps to mitigate, manage and even create value from this situation. In particular, companies are increasingly using detection and prevention approaches to detect, avoid and manage risk. There are three major benefits to this approach:

• First of all, it allows early identification of potential economic risks. These include financial weakness from a partner or a payment default by a customer, technical issues such as conflicts or delays in recent projects, and compliance issues such as convictions or recent cases of corruption.
• Companies that perform and keep records of their third parties can mitigate their liability if cases of corruption arise afterwards.
• It allows cost optimisation, particularly during the business development phases. The ability to detect counterparty risks in advance implies better allocation of resources and better business decisions.

In our experience all major international construction companies and developers of significant infrastructure projects carry out assessments of their third parties, or at least of some of them. However, this is usually conducted in an unstructured way, without standard procedures, leading to time and cost inefficiencies. To ensure effective and efficient assessments requires the design and implementation of a comprehensive third-party due diligence system.

Based on our experience, we have identified the following key success factors for successfully implementing a detection and prevention system:

• Holistic perspective: all major risk compliance.
• Risk orientation: Focusing analyses only on higher-risk situations.
• Proportionality: The dedication of resources and depth of the analysis must be adequate.
• Independence and objectivity: The information included in the financial and technical assessments must be provided independently and objectively.
• Leverage all available sources of information when assessing third parties.
• Aimed for decision-making: The due diligence analysis of the third party is not intended to “veto” its selection, but should help to decide which third party to select.
• Willingness to anticipate: The earlier the assessment is carried out, the earlier the company will make a decision about the third party, and it will avoid incurring unnecessary costs associated with a potential third-party relationship that is too risky.
• Easy assessment criteria: Criteria have to be easy to apply so that risk level is not a factor subject to interpretation.

 

Authors: Stephen Watson and Javier Serra

Stephen Watson is a Principal at Arthur D. Little based in Cambridge. He has 20 years of experience in risk management in the construction, transport and petrochemical manufacturing sectors.

Javier Serra is Principal at Arthur D. Little based in Madrid. He has 14 years of consulting experience in strategy development and implementation and operational transformation, including risk management topics.

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