11.5 Due Diligence, Fraud Indicators & Transaction Risk Analysis

Due Diligence, Fraud Indicators & Transaction Risk Analysis

Core Practice Standard: Due diligence is investigation pointed at a decision. The client is about to invest, acquire, lend, franchise, partner, or sign, and needs to know what the risk is before money moves. The BSIS outline captures this as Task T16, and the associated knowledge statements are explicitly about credibility, risk, and exposure — not about compiling facts for their own sake. That framing should shape the deliverable: a risk register, each item sourced and rated, plus an explicit statement of what could not be verified.

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Background Check Versus Due Diligence

That last row is the practical hazard. California has many similarly named entities, and confirming the wrong "Pacific Coast Holdings, LLC" produces a report that is accurate and useless. Anchor every finding to a Secretary of State entity number, not a name.

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The Verification Stack

+---------------------------------------------------------------------------+
| 1. IDENTITY      Does the entity exist, and is this the right one?         |
|    -> SOS bizfileOnline entity number, formation date, jurisdiction        |
+---------------------------------------------------------------------------+
| 2. STANDING      Is it entitled to do business right now?                  |
|    -> Active / suspended / forfeited (Rev. & Tax. Code § 23301)            |
|    -> Statement of Information current? Agent for service real?            |
+---------------------------------------------------------------------------+
| 3. AUTHORITY     Is the signer authorised to bind it?                      |
|    -> SI-550 / LLC-12 officers and managers; operating agreement recitals  |
+---------------------------------------------------------------------------+
| 4. LICENSING     Is the regulated activity actually licensed?              |
|    -> DCA licence search, CSLB, DRE, Dept. of Insurance, BSIS              |
+---------------------------------------------------------------------------+
| 5. LITIGATION    What is the dispute history?                              |
|    -> County superior court indexes, PACER, judgment abstracts, liens      |
+---------------------------------------------------------------------------+
| 6. ENCUMBRANCE   What is already pledged or claimed?                       |
|    -> UCC-1 filings, recorded deeds of trust, tax liens                    |
+---------------------------------------------------------------------------+
| 7. REGULATORY    Any securities, sanctions, or exclusion exposure?         |
|    -> SEC EDGAR, FINRA BrokerCheck, OFAC SDN list, federal exclusions      |
+---------------------------------------------------------------------------+
| 8. PHYSICAL      Does the operation exist as described?                    |
|    -> Site visit, premises photography from public vantage, staffing signs |
+---------------------------------------------------------------------------+

The Suspension Check Is Not Optional

Revenue and Taxation Code § 23301 provides that the powers, rights, and privileges of a domestic taxpayer may be suspended, and those of a foreign taxpayer forfeited, for unpaid tax, penalty, or interest, or for failure to file. The consequences are commercially serious: a suspended corporation cannot prosecute or defend an action, and under Revenue and Taxation Code § 23304.1 a contract made while the taxpayer's powers were suspended or forfeited is voidable at the instance of the other party. A client about to sign with a suspended entity needs that fact before signing, not after — and it takes ninety seconds to check.

Licence Verification Means the Regulator

A contractor licence number printed on a proposal proves nothing. Check the Contractors State License Board for status, classification, bond, and workers' compensation coverage; the Department of Real Estate for broker and salesperson licences; the Department of Insurance for producers; the Department of Consumer Affairs search for the several hundred DCA-regulated professions; and BSIS itself for private patrol, alarm, locksmith, repossessor, and private investigator licences. Confirm the licence is held by the entity contracting, not by an individual who happens to work there.

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Fraud Indicators That Cluster

No single indicator proves fraud. Clusters do the work.

Verification routing is the tell. In most transaction frauds the subject controls every channel through which the client could verify — the accountant, the escrow, the references, the "bank contact." An investigator's single most valuable contribution is to obtain the same facts through a channel the subject does not control: the regulator's own website, the county recorder's own index, a phone number obtained independently.

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Scoring and Reporting Risk

Rate each finding on likelihood and impact, and record three things for every entry: what was found, where it came from, and how confident the source makes you. Then state the gaps explicitly. Language such as "no litigation was identified in Los Angeles, Orange, and Riverside County superior court indexes; other counties and federal courts were outside the agreed scope" is precise, defensible, and prevents the client from reading absence of evidence as evidence of absence.

Two discipline points from Content Area 4 apply directly:

• Do not give investment, legal, or accounting advice. Report the facts and the risks; the decision and its professional analysis belong to the client and its advisers.
• Do not overstate. A report that says "the principal has a history of fraud" on the strength of an unserved civil complaint is a knowingly-imprecise report under BPC § 7539(b) and defamatory in a way the litigation privilege will not reach, because a pre-transaction due diligence report is not a communication in a judicial proceeding under Civil Code § 47(b).

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Case Example: The Ninety-Second Check

Scenario: A client is three days from wiring $400,000 to a California LLC for an equipment-leasing venture. The principal supplies audited financials, three enthusiastic references, and a licence number.

What the stack returns. The Secretary of State record shows the LLC formed eleven weeks earlier with a registered address matching a mail-forwarding suite, and status FTB suspended. The Statement of Information has never been filed. The "licence number" belongs to a different entity with a similar name, active, in a different county. Two of the three reference numbers are mobile numbers with no independent listing; the third is a company whose Secretary of State record shows the same manager as the subject LLC. A UCC search shows no filings, which is inconsistent with a leasing business that should own or finance equipment.

The report. Not "this is fraud" — that is a legal conclusion the investigator should not draw. The findings, each sourced: eleven-week-old entity; suspended status with the § 23304.1 voidability consequence; no Statement of Information; licence number belonging to a different entity; two references unverifiable independently and one with common management; no UCC filings consistent with the claimed business model. Gaps stated: audited financials not independently confirmed with the named accountant because the client had not authorised contact. The client's decision follows easily from facts, which is the point.