I have no idea. I just came across a DoS doc on the web recently that mentioned it (I posted the extract in another thread I think). I was always under the impression that the consulates did the background check but it's possible KCC passes some on to whatever agency. I assumed the KCC flags would be more in terms of things like not meeting the education/work requirement. I do know KCC can't disqualify you, only the consular officer can do that.
Edit: I thought KCC could disqualify if there have been duplicate entries, but apparently they don't anymore (had in the past) as they may not be seen to be adjuicating decisions; but they notify the embassy if they have found duplicate entries so one would get disqualified then.
Incidentally they also provide software so that the consulate can compare the submitted photograph there with the one on the application, and pick up impostors this way. P26 onwards in this is quite illuminating; it's also a few years old and I guess they have tightened up even more since.
http://books.google.co.za/books?id=...CDcQ6AEwAw#v=onepage&q=kcc disqualify&f=false
And this is also part of the processing, so yes background checks start there:
"The KCC conducts Consular Lookout and Support System (CLASS) name checks on all applicants and submits Visas Eagle Security Advisory Opinion (SAOs) where required. For applicants determined to require a SAO other than a Visas Eagle, an electronic note is made in the case record. You must make the final determination as to whether an SAO is required."
http://www.state.gov/documents/organization/87840.pdf
The bit about flagging the application also comes from the above link:
"The KCC will create a DV immigrant visa (IV) file on the principal applicant and qualifying dependents. These files will be shipped to post prior to the visa interview. In cases where a potentially disqualifying factor has been identified at the KCC during case creation, a note will be made in the electronic case file. The file folder will then be stamped “KCC FPU Reviewed” and a red memorandum noting the existence of the disqualifying factor will be included in the paper file for post action."