Development Bank of Ethiopia

Due Diligence Assessment Guidelines

March, 2008
 Table of Contents
Page
I. Introduction 2
1.1 Definition 2
1.2 Objective of Due diligence 2
1.3 Focus areas of Due diligence 3

II. Customers Due diligence for Banks 4

2.1 General Remarks 4
2.2 Importance of KYC standards 5
2.3 Essential Elements of KYC Standards 7

III. Due diligence Assessment Guidelines of DBE 11

References 18

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I. Introduction

1.1 Definition

Due Diligence is an examination by investment banks or companys management about

operations, financial condition, competitive position, performance, business objectives and
plan, the labor force, supplier, its customers and the sector of its business of their
customers (business firms).

Another common definition of due diligence is also known as due care, meaning the effort
made by an ordinarily prudent or reasonable party to avoid harm to another party or
himself.

1.2 Objective of Due diligence

In many ways, a business is like an individual, it has a past, a culture and interaction with
many others each day. But like some people, what you see may not represent what that
business is really all about. Many businesses have hidden liabilities and hidden histories or
illicit behavior. Therefore, knowledge and experience in business background investigation
of the client is the crucial factor in staying ahead of the competition, meaning what you
dont know can hurt you more.

Due to failure to make proper due diligence more and more people are forced to facilitating
a business deal end-up in court over.

There are many reasons for conducting due diligence, some of these are:
Confirmation that the business is what it appears to be in order to make the
purchase decision, to establish credit relation or considering a merger.
Identify potential deal killer defects in the target and avoid a bad business
transaction.
Gain information that will be useful for valuing assets, defining representations
and warrants, and /or negotiating price concessions.
Verification that the transaction complies with investment or acquisition criteria

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 1.3 Focus areas of Due diligence

Searching for undisclosed litigation or regulatory problem verifying transactions and terms
with vendors, interviewing former employees about the true condition of the company and
the roles of key staff in the business, verifying receivables are from non-related and
legitimate sources, capable and willing to make payment and verifying ownership of
property, plant and equipments.

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II. Customers Due diligence for Banks
2.1 General Remarks

Supervisors around the world are increasingly recognizing the importance of ensuring that
their banks have adequate controls and procedures in place so that they have to know the
customers with whom they are dealing. Therefore, due diligence on new and existing
customers is a key part of these controls. Without this due diligence, banks can become
subject to reputation, operational, legal and concentration risks, which can result in
significant financial cost. Such as withdrawal of funds by depositors, the inter-bank
facilities termination, claims against the bank, investigation costs, asset seizures &
freezers, and loan losses.

In reviewing the findings of an internal survey cross-border banking in 1999, the Basel
Committee identified deficiencies in a large number of countries know-your-customer
(KYC) policies for banks. When countries were judged from a supervisory perspective,
KYC policies in some countries have significant gaps and in others they are non-
existent. Even among countries with well-developed financial markets, the extent of KYC
robustness varies. Consequently, the Basel Committee asked the working group on cross-
border banking (Group of Banking Supervisors) to examine the KYC procedures currently
in place and to draw up recommended standards applicable to Banks in all
countries.

Following a review of the comments received, the working group has revised the paper
and Basel Committee is now distributing it worldwide in the expectation that the KYC
framework presented here will become the benchmark for supervisors to establish national
practices and for banks to design their own programs.

KYC is most closely associated with the fight against money-laundering at beginning,
but lately the Committees interested to wider it to prudential perspective. Sound KYC
policies and procedures are critical in protecting the safety and soundness of Banks
and the integrity of banking systems. Sound KYC procedures must be seen as a
critical element in the effective management of banking risks.

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KYC require banks to formulate a customer acceptance policy and a tiered customer
identification program that involves more extensive due diligence by going far beyond
safeguarding simple account opening and record-keeping.

The Basel Committee interests in sound KYC standards originates from its concerns for
market integrity and has been heightened by the direct and indirect losses incurred by
banks due to their lack of diligence in applying appropriate procedures. These losses could
probably have been avoided and damage to the banks reputation significantly diminished in
the banks that had maintained effective KYC programs. The KYC standards may need to
be supplemented and / or strengthened by additional measures tailored to the risks of
particular institutions and risks in the banking system of individual countries.

2.2 Importance of KYC standards

Sound KYC procedures have particular relevance to the safety and soundness of banks, in
that:
They help to protect banks from becoming a vehicle for or a victim of financial
crime and suffering consequential reputation damage.
They constitute an essential part of sound risk management by providing the
basis for identifying, limiting and controlling risk exposures in assets and
liabilities.

The absence of KYC standards can subject banks to serious customer and
counterparty risks, especially reputation, operational, legal and concentration risks.
Any of these risks can result in significant financial cost to banks and divert considerable
management time and energy to resolving problems that arise.

1. Reputation Risk
Reputation risk is defined as the potential that adverse publicity regarding a banks
business practices and associations, whether accurate or not, will cause a loss of
confidence in the integrity of the institution. Banks are especially vulnerable to reputation
risk because they can so easily become a vehicle for or a victim of illegal activities
perpetrated (committed) by their customers.

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 2. Operational risk
Operational risk can be defined as the risk of direct or indirect loss resulting from
inadequate internal processes, people and systems, or from external events. Most
operational risk in the KYC context relates to weaknesses in the implementation of banks
programs, ineffective control procedures and failure to practice due diligence. A public
perception that a bank is not able to manage its operational risk effectively can adversely
affect the business of the bank.

3. Legal Risk
Legal risk is the possibility that lawsuits, adverse judgments or contracts that turn out to be
unenforceable can disrupt or adversely affect the operations of a bank. Banks may
become subject to lawsuits resulting from the failure to observe mandatory KYC standards
or from the failure to practice due diligence. Banks will be unable to protect themselves
effectively from such legal risks if they do not engage in due diligence, in identifying their
customers and understanding their businesses.

4. Concentration Risk
Concentration risk mostly applies on the assets side of the balance sheet and it is
discussed from both credit side and liability side.

On the credit side, concentration risk is related to banks exposure to single borrower or
groups of related borrowers. As a common practice, supervisors not only require banks to
have information systems to identify credit concentration but also set prudential limits to
restrict banks exposures to single borrower or groups of related borrowers. Without
knowing precisely who the customers are, and their relationship with other customers, it will
not be possible for a bank to measure its concentration risk.

On the liabilities side, concentration risk is closely associated with funding risk, particularly
the risk of early and sudden withdrawal of funds by large depositors, with potentially
damaging consequence for the banks liquidity. Analyzing deposit concentrations requires
banks to understand the characteristics of their depositors, including not only their identities
but also the extent to which their actions may be linked with those of other depositors.
Therefore, it is essential for managers in small banks not only to know the depositors but

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also needs to maintain a close relationship with large depositors, or they will run the risk of
losing their funds at critical times.
In general, it is important to know these risks are interrelated.

2.3 Essential Elements of KYC Standards

All banks should be required to have in place adequate policies, practices and procedures
that promote high ethical and professional standards and prevent the bank from being
used, intentionally or unintentionally, by criminal elements. Therefore, the banks have to
include the following elements when they design KYC programs.
1. Customer acceptance policy
2. Customer identification
3. On-going monitoring of high risk accounts or loans
4. Risk management
From above mentioned elements, the first two are focused for the title under discussion.

1. Customer Acceptance Policy

Banks should develop clear customer acceptance policies and procedures, including a
description of the types of customer that are likely to pose a higher than average risk to a
bank.
These policies should include factors such as:
- Customers background
- Country of origin
- Public position
- Linked accounts
- Business activities.
Banks should develop graduated customer acceptance policies and
procedures that require more extensive due diligence for higher risk
customers. But, it is important to take care of that the customer acceptance
policy is not so restrictive that to a denial of access by the general public to
banking services.

2. Customer Identification
Banks should establish a systematic procedure for identifying new customers and should
not establish a banking relationship until the identity of a new customer is satisfactorily

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verified. Special attention should be exercised in the case of non-resident customers and
in no case should a bank short circuit identity procedure just because the new customer is
unable to present himself for interview. The bank should always ask itself why the
customer has chosen to establish relation in a foreign jurisdiction.

2.1. General Identification Requirements

Banks need to obtain all information necessary to establish, to their full satisfaction, the
identity of each new customer and the purpose and intended nature of the business
relationship. Banks should never agree to open an account or conduct credit relationship
with a customer who insists anonymity or who gives a fictitious name.

2.2. Specific Identification Issues

There are a number of more detailed issues relating to customer identification which need
to be addressed. Some of these are currently under consideration by the FATF1

1. FATF is Financial Action Task Force . It is inter governmental body

which develops and promotes policies, both nationally and
internationally, to combat money laundering.

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 1. Trust & Nominee Accounts / Clients
Trust & nominee accounts or presentation as clients can be used to circumvent (avoid)
customer identification procedures of the banks. It may be legitimate under certain
circumstances to provide an extra layer of security to protect the confidentiality of legitimate
private customers.

So, it is essential that the true relationship is understood. Banks should establish
procedure to identify whether the customer is taking the name of another customer, acting
as a front or acting on behalf of another person as trustee, nominee or other intermediary.
If so, a necessary and satisfactory evidence of the identity of an intermediary, and of the
persons upon whose behalf they are acting, as well as details of the nature of the trust or
other arrangements should be presented.

2. Corporate Vehicles
Banks need to be vigilant (careful) in preventing corporate business entities from being
used by natural persons as a method of operating with anonymous name/account.
Therefore, in the case of companies, the banks have to know or identify the beneficial
owners, structure of the company, the source of funds and those who have control over the
fund.
3. Introduced Business
The time consuming of identification process, there is a natural desire to limit any
inconvenience for new customers.

In some countries, it has therefore become customary for banks to rely on the procedures
undertaken by other banks or introducers when a business is being referred. Relying on
due diligence conducted by an introducer, however reputable, does not in any way
remove the ultimate responsibility of the recipient Bank to know its customers and
their business. The ultimate responsibility for knowing customers always lies with
the bank. Therefore, the Basel Committee recommends that banks that use introducers
should carefully assess whether the introducers are fit and proper using the following
criteria.
The customer due diligence procedures of the introducer should be as
rigorous as those which the bank would have conducted itself for the
customer.

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 The bank must reach agreement with the introducer that it will be
permitted to verify the due diligence undertaken by the introducer at any
stage.
All relevant identification data and other documentation pertaining to the
customers identity should be immediately submitted by the introducer to
the bank.

4. Politically Exposed Persons

Business relationships with individuals holding important public positions and with persons
or companies clearly related to them may expose a bank to significant reputation and / or
legal risks. Such politically exposed persons (PEPs) are individuals who are or have been
entrusted with prominent public functions, including heads of state or of government, senior
politicians, judicial or military officials, senior executives of publicly owned corporations and
important political party officials.

In countries where corruption is widespread, there is a possibility to abuse their public

powers for their own illicit enrichment through the receipt of bribes, embezzlement, etc by
such persons. So, accepting and working with these corrupt PEP will severely damage the
banks own reputation and can undermine public confidence in the ethical standards of an
entire financial centre, since such cases usually receive extensive media attention and
strong political reaction, even if the illegal origin of the assets is often difficult to prove. In
addition, the bank may be subject to costly information requests and seizure orders from
law enforcement or judicial authorities. Under certain circumstances, the bank and / or its
officers and employees themselves can be exposed to charges of money laundering.
Thus, there is a compelling need for a bank considering a relationship with a person
whom it suspects of being a PEP to identify that person fully, as well as people and
companies that are clearly related to him/her.

Bank should gather sufficient information from a new customer and check publicly available
information, in order to establish whether or not the customer is a PEP. If the person is
identified as PEP, banks should investigate the source of funds before accepting a PEP. It
is recommendable to accept or not the PEP as the bank customer to be the decision of
senior management.

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III. Due diligence Guideline of DBE

In long years of project financing operation of the Bank, DBE more or loss had exercised
identifying of the client, especially in the back ground part of the feasibility study. The
identification of the client up to November 2005 mainly included the educational
background, business performance, experience and managerial capability of the client.
However, these back ground studies have not contributed as such more in protecting the
Bank from fraudulent customers and from immersing in high financial costs because of the
depth of the study, lacking of hard facts and weak accountability of the personals. To
overcome these drawbacks, since November 2005 the Bank has commenced due diligence
assessment and established a responsible and accountable functional work unit for this
purpose, whoever it is at its infant stage as it is evaluated from KYC standards. The
existing due diligence assessment of DBE has the following focus areas.

1. Name and Address of the Promoter and the Project

Under this part the officer states the legal name of the promoter and the project and the
address of the promoter and the project. The address of the promoter and the project
should clearly indicate the where about ness of the promoter and communicating means
whenever the client is required. The communicating means may include knowing of the
exact location of the promoters office and project location, telephone number of office and
cell phone, postal address, fax number, and e-mail address. Ensuring of these addresses
exactly reduce fraudulent customers by some number since such persons are not willing to
disclose their real address and location. Besides its important for due diligence, knowing
the address of the promoter as well as the project is equally important for monitoring project
progress and follow-up.

2. Legal Status of the Promoter (Person or Company)

Legal status includes the legal form of the company (Sole proprietorship, company, NGO,
etc.), date of establishment, article and memorandum of association for companies,
marital status (for Sole proprietorship), Investment license, Trade license & status of
the project (whether it is new or existing).

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The need to know the form of the business emanate from the following issues.
To determine whether the applicant is in the financing categories of the Bank or
not from the perspective of legal formation of business.
To request legally relevant documents for the form of organization.
To decide the type and the strength of due diligence executed.

The importance of establishment date is seen from the following angles.

To see all the legal documents are renewed as the government regulation.
To identify the rules and regulation that concerns them or not, and to confirm
whether the business is established as per rules and regulation of the country.

The need for Article & Memorandum of Association:

It helps to know the members of the company.
It helps to know the business sectors in which the company is engaged.
It helps to know the establishment objective of the company.
It helps to know the power, responsibilities and duties of the general
manager/CEO.
It shows the amount and number of shares that each share holder has in the
company.
To confirm the capacity of the company capital to cover the equity contribution.
To know the organizational structure of the company,
To know the liability of members.

The Importance of Knowing Marital Status (Sole proprietorship)

To protect the Bank from lawsuit by other spouse on common property.
To avoid seizer of the project due to dispute of the couples.
To attract the family attention to project success or to create belongingness of
the project among family members.
The Importance of Investment License
To confirm foreign investors are permitted to invest in the country and to know
its validity.
To accept the tax free pro-forma invoice of the applicant in feasibility study.
To determine stump duty payment of the applicant, i.e. Birr 5 for those
applicants having investment license.

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 To proceed on the new loan applicants request considering the investment
license as trade license.

Importance of Trade License

To know in which business the applicant is engaged.
To confirm the business is legally perform its activity.
To know the capital of the applicant and to cross check with equity contribution.

The Importance of Principal Registration License

To know the operating area of the project.
It helps to register the business.
To check whether the company/ individual is registered to be engaged in
business.

The Need for Title Dead and Site Plan of the Land holding
To confirm the ownership of the land holding.
To define the exact location of the project.
To know the size of land holding.
To register the collateral as pledge.

The need for Construction permit and Authenticated Plan

To avoid risk from an illegal construction.
To be safe from losing compensation during the government needs the area for
other purpose.

The Need for Title Dead of the Vehicle

To confirm the ownership
To register the vehicle

Status of the Project (Existing or New)

To identify whether the business firm carried out its legal commitment, such as
tax and other obligations.
To check the past performance of the business and to determine whether to
finance the project or not.

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 To decide how to accommodate the application of the promoter (as new or
expansion) and apply thereby to process the loan application as per the credit
policy of the Bank.

3. Track Recording of the Share Holder

This part identifies the members of the given company are natural or legal persons. As it is
discussed earlier criminal persons or defaulters can approach the Bank by using the
company as anonymous name. Identifying of each member is the crucial issue when
dealing with company. Once the members are identified and trusted, the next step should
be to make effort to know the share source of the members in order to protect the Bank
from being the victim of money laundering. These issues can be confirmed by cross
checking the ID of the members with addresses stipulated in memorandum of association
and requesting financial statement from their account holding banks. The other point need
due attention is evaluation of their personal business performance if they have any.
Because, the bankrupted individual can approach the Bank with the mask of company and
may create the same problem. The performance of the respective members, therefore,
should be evaluated by requesting the company members to offer audited report by
licensed auditor.

4. Organization and Management Evaluation

The human element takes the greater share in project success or failure. Organization and
Management is the main element due diligence has to focus on. Under this the officer is
expected to make a profound assessment about organization structure of the business,
the competency & characteristic of the management team and the man power
requirement of the business.

Organizational Structure:
In consideration to the form of business (Sole proprietorship, plc, sc, etc.), and the size and
type of the business, it is important to discuss the appropriateness of the organization
structure in place.

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Competency & Characteristic of the Management Team:
Here the relevance of educational background, experience, qualification of each
management team member to the business has to be discussed and appropriate
recommendation should be forwarded if there is any gap. Moreover, the personal
characteristic of the personals has to be also the element of management identification.
One can identify these things by requesting CV of each team member with relevant
document and by collecting personal and business reference from his/her immediate
bosses he/she worked with or managers of business organization he/his interacted.

Availability of Manpower:
The existence of both skilled and unskilled labor as per the requirement of the business
also has to be checked. The wage rate and salary scale of the project proposal are also
evaluated as per the prevailing market situation.

5. Credit Relation Checking

This part looks the credit history of both the business and its owners. Identification of the
credit performance of the business and its owner protects the Bank from being accessed by
defaulters or non-credit worthy clients. Specially, this day plcs are wrongly used as mask to
non credit worthy persons, therefore, checking each of the share holders in the company is
very important. Under identification process the following points should have to get due
attention.
Type of the business by which he/she secured the loan.
The type of the loan facility.
The status and the position of the loan.
History of credit performance.
Collateral offered for previous creditor.
All information listed above can be obtained by requesting his/her previous
creditor and credit information center. One thing here to note is not to forget
that checking of credit relation with our Bank.

6. Financial Requirement of Investment

The major task officer has during checking of business plan is that to identify and evaluate
the relevance of each investment items for the intended project and whether the value of

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each investment item is supported with three genuine and updated pro-forma invoices from
different suppliers or other technical documents like bill of quantity or purchase documents,
etc. Here the critical point is how to confirm the genuineness of the document. This can be
possible by communicating with the supplier, by authenticating the invoices and cross
checking with Research Department findings or proceeding to evaluate by the Bank
Engineering Department.

7. Technical Aspects
Technical documents that are important for engineering estimation and loan appraisal are
also expected to be collected at this stage.

Engineering documents and their importance:

Blue Print (Architectural, Structural, Electrical, Sanitary, soil test,
structural analysis for beg projects) helps to know the size, shape and
design of the construction, and to determine material requirement of the
construction. It is important to review construction units in line with the
project nature.
Take off sheet reduces the time taken to calculate the material
requirement of the construction and over looking of some construction
parts when trying to calculate from blue print.
Bill of quantity tells the cost of building by giving additional price
information.
Machinery and Equipment:
All three pro-forma invoices should have the same specification and
detail information about payment arrangement, value date, delivery
arrangement(CIF, FOB), turnkey agreement if any, capacity etc.
Every Procurements above $ 1,000,000 requires international bid
conducted documents.
Indicating the selected machinery and the criteria for selection (capacity,
price, technology etc.)

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Other Sensitive Issues
Conflict of interest should be checked, meaning the relation of the
supplier and the loanee should be identified to avoid the over invoicing of
the pro-forma to minimize their equity contribution and from using the
project as market may be low quality product of their business.
Confirmation of the availability of required utilities (water, telephone,
power, accessibility, etc) in the project area.
Row material availability and their location advantage
Environmental issues should be checked to reduce the risk from seizer of the
project in related to environmental protection.

8. Identified Risk Areas

Based on the above assessment the officer has to comment on the following risk
issues.

Management
Experience
Availability of skilled labor
Others

Marketing strategy
Pricing of product
Quality of product
Destination market
Market size & preference
Delivery time issues

Technical
Technology (choice)
Technology require skill
Others

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 Reference

ASG, Due Diligence & Business Background Check, Internet.

Basel Committee, Directive on Customer Due Diligence for Bank, Internet

Basel Committee on Banking supervision, Customer due diligence for Banks, Internet

Development Bank of Ethiopia, Due diligence Format, The Bank policy.

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