What is satisfactory due diligence under the Foreign Corrupt Practices Act (FCPA)? That question seems to be more important after the Huffington Post’s story on Unaoil and the subsequent release of the Panama Papers. However, both of these events largely focused on the “who” part of due diligence and the need to know whom you are doing business with going forward. However there is another important question which does not come up as often in due diligence, which is how?
How does a particular third party perform its services with or for your company? If it is on the sales side of things, how can a third party help you make sales? If a third party comes through the Supply Chain, how do their products or services meet the needs of your company? If the third party has a closer business relationship, such as a joint venture (JV), teaming agreement or other similar arrangement, you may well need a much deeper understand of how this third party does business because the relationship may well become so close you will be intertwined with the party. It may mean more than simply does their how product work but how does this third party conduct themselves and their business?
The questions beyond simply who were made clear in a Wall Street Journal (WSJ) article by Christopher Weaver and John Carreyrou, entitled “Deal With Theranos Haunts Walgreens”. It turns out that Walgreens left a gap by “never fully validating the startup’s technology or thoroughly evaluating its capabilities”. The clear message is if you are going to partner with a technology company which is going to change your business model, you best make sure the technology works. Moreover, if a potential JV partner refuses to show you its technology, how it keeps records, its financials relating to the products and services you are contracting for and generally tries to hide from you the very thing you are buying into; you should not walk but run away from the deal.
This article detailed the lack of steps and miss-steps by Walgreens when entering its partnership with Theranos and how these actions have caused Walgreens to consider its $50MM investment in Theranos as something it will never recoup, caused Walgreens reputational damage and potentially subjected it to civil liability. As the reporters noted, “The relationship is now in tatters, making Walgreens an extreme case study of what can go wrong when an established company that craves growth decides to gamble on an exciting and unproven startup.”
One might think that if you are investing in a technology company that provides medical testing, the investor would want to see the laboratory where the testing is performed. It turns out that Walgreens representatives were never allowed to tour, let alone review the labs where the results of Theranos pinprick blood tests were run. A Walgreens consultant, Paul Rust, who was sent to Theranos to do a quality control data review said, “It was a very strange situation. The results were actually really good, but I was never allowed to go into the lab. I have no idea that the results I saw were run on the Edison devices or not.” He went on to say that he was “led to believe that they were being run on the Edison.” Yet even Rust was surprised no Walgreens representatives had been allowed to view Theranos labs.
Interestingly, when Theranos did provide the test results to Walgreens representatives, the results came back with ““low” and “high” values rather than numeric values. As a result, Walgreens couldn’t compare results from the Theranos machine to any commercially available tests.” Once again, this was something which Walgreens should be sought additional information on.
Yet even when Walgreens’ consultants, assisting the company in evaluating Theranos and the proposed transaction, voiced and wrote up their concerns, they were not passed along to Walgreens management. The article reported, “In a report later in 2011, the consultants concluded Walgreens needed more information to assess the partnership. Those findings and reports by other consultants were kept from many Walgreens officials, including some directly involved in the negotiations with Theranos.”
Walgreens made another classic mistake in the due diligence process; they took comfort when a competitor was allegedly considering a similar venture with Theranos. The article said, “Some executives were comforted when Theranos said Safeway Inc. had agreed to host blood-drawing sites at some of its supermarkets. If Safeway trusted Theranos, then Walgreens could, too, the Walgreens officials believed.” How often have your heard that some other company is considering or has approved them through due diligence and a decision was based on the alleged actions of an alleged party.
Walgreens hamstrung itself from managing the relationship after the contract was signed by agreeing to contract terms that prevented Walgreens from auditing or even viewing “Theranos clinical data or financial records”. Finally, and perhaps most damagingly, there was a complete lack of communications between the two companies about the issues that have bedeviled Theranos. The article concluded, “Walgreens shelved the expansion plans after the Journal reported in October that Theranos did the vast majority of tests it offered to consumers on traditional lab machines. The Journal also reported that some former employees doubted the accuracy of a small number of tests run on Edison devices. One of the most recent setbacks came in mid-April when the Journal reported that regulators had 3½ weeks earlier proposed banning Ms. Holmes from the lab-testing industry. The drugstore chain’s senior executives found out from the news report.”
In the FCPA, most companies understand the need to know with who they contract for sales or vendor related issues. They also understand the need to know why they should do business with a proposed third party (IE., a business justification). However the need to perform an investigation into how the third party can actually deliver what they are contracted to do is equally important. Moreover, even with the most robust due diligence, there are still additional steps which a company must engage in to properly manage third parties. Most compliance practitioners believe that compliance terms and conditions should be a part of every contract and there is really no debate that an audit clause and material breach of contract provision should be included.
The Walgreens imbroglio around Theranos points out why such clauses are mandatory. If you do not have them, you do not have the ability verify what you may or may not have been told in due diligence. Finally, managing the relationship after the contract is signed is where the rubber hits the road. If you only obtain a due diligence report and insert compliance terms and conditions, you will have done nothing to test whether the third party is actually performing as it has agreed to under the terms of the contract.
Perhaps if Walgreens had inquired into the how Theranos performed its medical testing it would not find itself in the situation it is in now.
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© Thomas R. Fox, 2016