By Sue Bury, President &  CEO 1STWEST Background Due Diligence

For a financial services firm conducting due diligence on a borrower, it’s essential to employ best practices for protecting your business’s investment and reputation. One of the more arcane, and often overlooked, is the notion of the “contingent liability.

Contingent liabilities are potential (or off-balance-sheet) liabilities that may or may not have an ultimate negative impact, but could lead to problems down the road. Among other things, these looming pitfalls may dissuade potential investors and creditors from providing financing to a company, or necessitate the drafting of additional covenants to any lending agreement. At worst, they could erupt like Mount Vesuvius and take everyone in their path with them. To draw from current events, last year one of the world’s most successful and well-respected movie studios – The Weinstein Company – was thrust unexpectedly into the spotlight based on the bad behavior of its namesake and founder. The studio is now in bankruptcy, and thousands of people, including more than a few lenders and investors, are likely to lose out because of a contingent liability that went unseen by many, and simply ignored by others.

While applied in many fields, the concept of contingent liability has its roots in the accounting field. Federal accounting guidelines developed by the Financial Accounting Standards Board (FASB) recognize three tiers for determining whether or not a company must disclose a contingent liability on their financial statements:

1. There is a high probability the contingency will occur.
2. There is a reasonable probability the contingency will occur.
3. There is a low probability the contingency will occur.

For the most part, these tiers are used to determine if and how a company must report the contingent liability on their balance sheet (only a low probability event requires no reporting at all). For lending or recruitment purposes, it’s advisable to deviate from these traditional protocols and simply consider whether it is more probable than not that a “triggering event” will occur that turns a potential liability into a real one.

Examples of contingent liabilities may include pending lawsuits, product warranties, or ongoing investigations. However, as many of us probably know, simply being named as a defendant in a lawsuit, or audited by the Internal Revenue Service, is not, in and of itself, evidence of wrongdoing (or an indicator of a “probable” liability).

Identifying contingent liabilities is the easy part; deciding whether there is a 50 percent or greater likelihood of their occurrence is what separates the science of contingency management from the art.

Determining the probability of a contingent liability requires a more nuanced analysis. In the case of a pending lawsuit, for instance, due diligence must include, at the very least, an assessment of the merits of the claim. Have your attorneys read through the discovery files and offered their professional opinion about whether the suit is frivolous or has merit?”

Even that may not be enough, though. Robust contingency management should include searching public records to see if the borrower has a long history of litigation – which is often costly and laborious even when there is no negative judgment levied.

Look for tax liens, past judgments against the firm and of course search news clippings thoroughly for any negative press that could impact brand worthiness.

Incorporating contingent liabilities into your due diligence practices should also include familiarizing yourself with the nature of the business (including any obvious risk factors). Ask yourself questions like:

1. Is the borrower in an industry that has been receiving negative press?
2. Are government regulators likely to apply additional scrutiny to this sector? (i.e. opioid pharmaceuticals)
3. Is the borrower diversified enough to survive a negative contingency impacting one prong of its business?

Lenders should conduct a more expansive assessment of contingent liabilities that could impact not only the value of a loan but have negative blowback on the reputation of their own firm. These would include lapses in personal character of key principals, inconsistencies in a borrower’s resume, controversial statements or positions on social media, and/or a documented history of lying or unstable behavior.

Remember, controlling for contingent liabilities isn’t about avoiding risk. Risk is inherent in the lending industry, and is a key factor in driving margins for the most successful financial service firms. Instead, managing contingent liability is about incorporating enough information into a lending decision to avoid getting caught off guard by something that was hiding in plain sight.

Think of it like this: With spring upon us, millions of green sprouts will soon begin poking through the earth on lawns across America. Some of these will be weeds, but others will be the perennials that you planted last year and lost track of over the winter. You can pull them all up and be done with it. But doesn’t it make more sense to do a little research, learn to the best of your ability how to tell the difference, and root out just the weeds?

Applying the same logic to rooting out contingent liabilities can save your firm a lot of headaches in the future, but you’ll still get to enjoy the blossoms.