Heed Due Diligence Lessons & Red Flag Warnings

CUNA’s Directors’ Newsletter
April 6, 2009 | COMMENTS

After liquidating a $360 million asset Michigan credit union in 2007, the National Credit Union Administration (NCUA) directed its Office of Inspector General (OIG) to determine the causes of the failure, the resultant loss to the National Credit Union Share Insurance Fund, and to assess the NCUA's and Michigan State Supervisory Authority's supervision of the credit union.

The OIG's final report found that credit risk and strategic risk were major factors in the credit union's failure. Management and the board didn't adequately manage and monitor the credit risk within its loan program, largely outsourced to a third party.

In addition, executives made strategic decisions that put the credit union's continued financial viability at significant risk, the report points out. In particular, the credit union:

• Failed to exercise due diligence in its third-party lending relationship;
• Allowed the lender to concentrate a majority of the credit union's loan portfolio in a speculative Florida real estate construction project;
• Allowed the lender to make construction loans to applicants outside the credit union's approved field of membership;
• Misclassified construction loans and violated NCUA's member business loan limits;
• Failed to provide adequate liquidity controls in its asset/liability management policy; and
• Failed to develop or follow adequate plans to guide the direction of the credit union and the Florida construction loan program.

The OIG also found NCUA and state examiners "may not have adequately monitored or reacted prudently or timely to trends indicating the safe and sound operation of [the credit union] may have been in jeopardy."

Last year CUNA formed a Due Diligence Task Force, in response to regulatory concerns over how best to meet credit unions' due diligence responsibilities involving third-party vendors.

It recently issued the "Third-Party Vendor Management Guide" to help credit unions successfully negotiate and manage these relationships.

Henry Wirz, chairman of the task force and CEO of SAFE Credit Union in Sacramento, Calif., notes the guide offers best practices and:

1. Assists credit unions in evaluating whether a new third-party relationship is consistent with your strategic plan; and then
2. Establishes a process to manage that relationship just as you would manage an employee.

Potential Red Flags

An important component of negotiating third-party relationships is to pay attention to potential red flags.

According to the CUNA guide, red flags are anything that your credit union believes are warning signs. Red flags can come in many forms--from intentional deceit to lack of knowledge. They don't mean you can't deal with the vendor. They simply mean you need to investigate further to ensure that you have a good comfort level with the vendor.

Some common red flags include:

• Hearing the great sales pitch. Never select vendors because you like the salesperson. It's a red flag if you hear, "We like this salesperson better."
• Being ahead of your time. The most advanced product or service may not be the ideal for your credit union members. The "latest and greatest" should raise a red flag.
• Making or saving tons of money. Whenever unreasonable financial expectations are the primary consideration for a deal, pay attention. Base any deals on reasonable financial expectations.
• Doing business with relatives or friends. It's a red flag when you hear phrases such as "this is my brother or my best friend or the sister of a board member." Never base a business arrangment solely on these relationships.
• People helping people. Keep in mind vendors may not automatically support the credit union philosophy. Don't fall into the trap of thinking they always have your best interests at heart.
• Unanswered questions. Don't give a vendor the benefit of the doubt for failing to answer your request-for-proposal questions. Often they intentionally don't answer because it would put their company in an unfavorable light. Remember that no questions should ever be off limits.
• Failure to benefit both parties. If the agreement is very one-sided, it's a red flag. Neither side should agree to a contract that doesn't have sufficient benefit for all parties.
• ALPHA-BETA. Be very skeptical of any vendors who wants you to be the first to use their product or service, especially if it's critical to your operations. In cases where you can't find a fully tested product or service, be sure to add additional protective language allowing you to terminate the contract.
• They are taking care of it. It's always a red flag when you ask questions and you're told someone else is taking care of it. This often means no one is taking care of it. Ask to see what's being done.
• Too good to be true. Any deal that is unbelievably good is probably just that and should raise a red flag.

The bottom line: Trust your instincts. If an answer or relationship doesn't seem right, for whatever reason, keep looking until you have enough information to be comfortable with your decision.

The task force guide is available at cuna.org, select "Due Diligence Task Force." For due diligence exam guidance, visit ncua.gov.