Addressing FCPA issues in emerging market deals
April 2011 | TALKINGPOINT | FRAUD & CORRUPTION
FW moderates a discussion looking at FCPA issues in emerging market deals between Glenn Pomerantz at BDO, James Walker at Richards Kibbe & Orbe LLP, and Gary DiBianco at Skadden, Arps, Slate, Meagher & Flom (UK) LLP.
FW: Can you explain why Foreign Corrupt Practice Act (FCPA) issues might be a cause for concern when acquiring emerging market companies? Is corruption and bribery still a pervasive problem in the BRIC countries?
Walker: Different corporate and compliance cultures, decentralised and inconsistent contracting procedures, and antiquated or opaque accounting practices are just some of the reasons that US companies wishing to acquire an emerging market company should be concerned about FCPA issues. BRIC countries are of particular interest because of the notable growth in their economies, although much of this growth has been in the industries where fraud and bribery can be found. Indeed, Transparency International’s 2010 Corruption Perceptions Index suggests that corruption and bribery still are perceived to be pervasive problems, revealing that out of 178 countries surveyed, with 178 being the country ranked most corrupt, Brazil ranked 69th, Russia 154th, India 87th, and China 78th.
DiBianco: Based on various factors, emerging markets continue to have an elevated perceived risk of corruption. Accordingly, enhanced diligence on corruption risks is frequently appropriate when considering a transaction in such markets. Regulators in the US and Europe have increased levels of sophistication regarding the nature of perceived risks in different geographies. For example, recent settlements identify risks in Brazil that are focused on customs clearance and duties. In India and China, past investigations have focused on payments to secure licences and permits or to ensure contract renewals with government entities. In Russia, investigations and settlements have examined payments to intermediary entities as a conduit to government officials or principals in state owned enterprises.
Pomerantz: In many emerging markets, including the BRIC countries, there is a confluence of circumstances which makes corruption risk greater. Industries, such as healthcare, oil & gas, and textiles, among others, which are privately owned in the United States and in Western Europe, are owned or controlled by the state. In addition, many of the emerging market countries have a history of controlling governments, with little transparency, which fostered a culture of corruption. Finally, the fault in this does not all lay on the side of the emerging market. There is a great deal of money to be made in emerging market economies and, as a result, companies seeking to do business with the government have a strong motivation to pay bribes. With regard to BRIC countries, bribery is clearly a problem. One need only look at enforcement actions over the past year to ascertain that corruption is alive and well in each of the BRIC countries.
FW: To your knowledge, has there been a rise in aborted or renegotiated deals due to FCPA problems?
Pomerantz: FCPA risk is increasingly a focus of the pre-deal due diligence process, as it should be. There is no doubt that deals have been both terminated or, more often, renegotiated as a result of an FCPA issue discovered during this process. Our specific experience is more in line with renegotiated deals and deferrals of transactions than outright termination.
Walker: Approximately 63 percent of the companies surveyed in the recent Deloitte LLP ‘Look Before You Leap’ survey identified corruption issues as the cause for renegotiating or aborting merger deals in the past three years. These survey results are consistent with the daunting financial penalties incurred recently by companies whose subsidiaries engaged in corrupt practices, including the $5m in civil and criminal fines Tyson Foods agreed to pay this February because of payments by a Mexican subsidiary to government officials, and the combined $137m in fines and disgorgement Alcatel-Lucent S.A. agreed to pay in December 2010 relating to gifts and payments paid by subsidiaries to foreign officials in several countries. Lack of knowledge that the acquired company’s subsidiaries paid bribes to conduct business will not shield the acquirer from successor liability, and therefore renegotiating or aborting a deal upon the discovery of FCPA problems often is warranted.
FW: How important is the due diligence process to detecting potential FCPA liabilities at a target company?
DiBianco: Pre-transaction diligence is important and has several goals. First and foremost, it is to find out whether there are questionable payments, improper accounting entries, or controls weaknesses that could create liability. Second, due diligence has a prophylactic aspect: an entity should satisfy itself that it took prudent and reasonable steps to identify potential risks. If none are discovered pre-transaction, but an issue arises later, the due diligence procedures will form the basis for arguments that no liability should be imposed after the transaction is completed. Third, with an expectation of ‘day one’ compliance following an acquisition or investment, an acquirer should use pre-closing diligence to identify steps to be taken after closing to minimise forward-looking risks.
Pomerantz: Risk-based, FCPA-focused due diligence should be part of pre-closing evaluation in any acquisition or merger where the target does business overseas with state-owned enterprises or interacts with foreign government officials. The successor liability aspects of the FCPA and its potentially draconian penalties necessitate that an acquirer subject to the FCPA’s jurisdiction undertake anti-corruption due diligence. This due diligence process will not only mitigate the FCPA risk of the transaction itself, but will also educate the acquirer on the steps it will need to undertake to integrate the acquisition target into its own anti-corruption program and should allow that integration process to occur more efficiently. The risk assessment will define the scope of the procedures to be undertaken.
Walker: A thorough due diligence assessment can be crucial to a successful emerging market company acquisition. Failure to conduct an effective anti-corruption assessment is comparable to buying a house without inspecting it for structural problems, mould, or any other condition that could be expensive to remediate. Similarly, without proper due diligence and an FCPA risk assessment, a potential acquirer will be unable to accurately value the target company and exposes itself to successor liability if the US government uncovers corrupt practices post-closing. The US Department of Justice and SEC expect companies to conduct pre-acquisition due diligence and voluntarily disclose the discovery of misconduct. In fact, one determinant of the extent of successor liability for past acts by an acquired company is the extent of the due diligence conducted and effectiveness of any remedial steps implemented by the acquirer.
FW: What information can be revealed by analysing payment structures, gift-giving, third-party relationships and contracts? What should companies seek to identify?
Walker: Review of a target company’s contracting practices, payments and gifts policies, and its relationships with third parties may reveal red flags that will inform the potential acquirer’s risk assessment. The potential acquirer should be comforted if the target has implemented a robust process for vetting of contracts by legal and accounting controls staff, but concerned if vendor payments have been directed to other jurisdictions or shell entities and the company has had no effective process for verifying services rendered. Any third-party vendor that refused to include anti-corruption language in a contract or otherwise certify anti-corruption compliance, refused to give clear responses to questions about relationships with government officials, or did not appear qualified for the work for which it was engaged should be looked at closely. Gift policies should provide clear guidelines and require close scrutiny for even indirect gifts to anyone who may be deemed a government official.
Pomerantz: All of these areas are ripe with FCPA risk. Whether evaluating a target company or as part of a company’s own anti-corruption risk assessment, policies and procedures relating to payment structure would normally include controls over vendor, agent and other payee master file additions and changes as well as proper segregation of duties, controls over payments to offshore accounts and requirements of written contracts with higher risk third parties. Acquirers should pursue regular testing of the controls applicable to gift giving, payments to third party agents, distributors and facilitators. Additionally, the acquirer should undertake risk-based substantive testing of transactions with special attention paid to variances between payment amounts and other disbursement characteristics as compared to the underlying written contract between the parties. With regard to third party relationships, it is important that the target company have procedures in place to learn as much as possible about third parties with whom it does business. Additionally, contracts with third parties should have audit rights, as well as anti-corruption language, in which, among other things, the third party agrees that it will not engage in corrupt activities, that it will adhere to all applicable laws and will require its employees to undergo anti-corruption training.
FW: How can companies assess any deficiencies with anti-money laundering controls? Is this a major area of FCPA risk?
Pomerantz: For entities subject to anti-money regulations, there can be a great deal of overlap between anti-money laundering and FCPA risks. First, FCPA is one predicate offense for a US money laundering charge. Second, bribe schemes, by their nature, will more often than not involve efforts to disguise loan payments. Third, both money laundering and FCPA violations often involve overseas payments. And fourth, interactions with politically exposed persons (PEPs) is a concern for both crimes. Therefore, where applicable, deficiencies in anti-money controls may expose financial institutions and other entities subject to anti-money laundering regulations to FCPA risks. The assessment of anti-money laundering controls has some of the same components involved in assessing a company’s FCPA controls. This includes an evaluation of the risks faced by the institution, a review of the processes in place and an assessment of whether the controls are appropriate to address these risks.
FW: Can screening procedures and background investigations on existing management provide valuable insight into FCPA liabilities? Should this be an essential part of acquiring any emerging market company?
Pomerantz: Background checks on existing management as well as the company’s third party agents, distributors, facilitators and joint venture partners are commonly performed when new relationships are formed. Acquirers should perform background checks, on a risk basis, during due diligence and periodically thereafter. This process may include conducting checks on management when the individual’s responsibilities change and simply refreshing checks on individuals and companies that present a higher risk of corruption. These procedures are important both in revealing whether there are any indications of corrupt dealing by management personnel, as well as any relationships with government officials which may present corruption risks.
Walker: One of the first steps to implementing an effective FCPA compliance program is ensuring that the ‘tone at the top’ exemplifies a culture of integrity and compliance.
Determining whether existing management exhibits the right ‘tone’ is important to the anti-corruption risk assessment. This includes background checks of top executives for past involvement in criminal or civil proceedings, checking country and regional networks to assess management’s reputation in the country and region, and retaining a qualified investigative service when necessary to provide an assessment of key personnel against in-country corruption risks. Interviewing personnel in the country about existing management will further inform the assessment. In addition, the acquirer should conduct background checks and screening of proposed candidates to fill key positions post-acquisition.
DiBianco: Business intelligence research and investigations should be tailored to the particular risks of a transaction. For example, where a potential target is a listed company with an established corporate history, background investigations on the management may not be necessary, and resources may be better focused on the target’s third party agents, consultants or distributors. In instances where the target has a less robust corporate profile, a background investigation should be considered. The investigation may identify past disputes, conduct or connections that would not be otherwise apparent. If the investigation does not reveal negative information, it constitutes an important and additional record of the diligence that was undertaken in the event that an issue arises after the transaction.
FW: What other steps can buyers planning M&A strategies in developing nations take to minimise risks and exposures and understand the full extent of FCPA violations?
DiBianco: Anti-corruption diligence should be closely integrated with financial and business diligence of the target, because corruption risks should be evaluated in the context of the target’s specific business practices, business locations and control structures. A potential buyer should understand the specific business environment of the target. For example, if the buyer already operates in the target’s jurisdiction and sector, it should use its own experience and risk assessments in evaluating the target’s risks. Understanding relevant investigations and settlements related to the particular jurisdiction and sector also will provide insights on risks. At the level of the target’s business, a potential buyer should assess the target’s control and compliance structure, relationships with government customers, relationships with regulators, and third party relationships.
Pomerantz: Due to the evolving nature of anti-corruption regulations and the disparate regulatory interpretations, what is viewed as ‘best practices’ is also evolving. One compliance practice that we uniformly recommend is substantive testing of transactions. An acquirer should not shy away from rolling up their sleeves and conducting a risk-based review of higher risk transactions. Careful use of data analytics may also identify patterns and anomalies that require further review. An M&A transaction does not usually necessitate an investigation, but certain investigative procedures lend themselves to effective M&A anti-corruption due diligence. The anti-corruption controls of many companies on their surface appear compliant, but substantive testing often reveals that things are not as they appear.
Walker: There are other steps that buyers planning M&A strategies in developing nations might consider. First, obtain a comprehensive picture of the extent to which the target company’s business necessarily requires interaction with government officials. Second, identify the relevant anti-corruption laws applicable in the local jurisdiction and the target company’s history of compliance. Third, determine whether facilitation payments are the norm in the jurisdiction and if so whether the target company’s facilitation payments comply with the FCPA exception. Fourth, gain a comprehensive understanding of any local company sponsorships. Finally, check the Transparency International’s Risk Level index for the country in which the target is located.
FW: To what extent should a buyer aim to separate one-off FCPA violations at a target company from a culture of illegal activity? In your opinion, is there a difference or should a buyer look to abandon any deal that might expose them to the slightest risk of FCPA liabilities.
Walker: If a close review of an FCPA violation reveals that the incident truly is one-off, rather than indicative of a larger problem, and the pricing of the company properly incorporates knowledge of the past violation and a thorough risk assessment, then the one-off violation should not necessarily cause the buyer to abandon a deal that otherwise fits within the company’s strategic and compliance objectives. The real question is whether the corporate culture at the target company either is, or can easily become, one where the risk of future FCPA violations is minimal. A potential acquirer should be mindful that the cost of an FCPA investigation goes beyond a financial settlement with the government – it also includes legal and forensic fees incurred in the investigation, the opportunity cost when company employees are diverted from company business to attend to investigative demands, and reputational costs.
Pomerantz: All else being equal, a one-off FCPA violation discovered in the due diligence process may be less significant and less likely to result in the termination of a deal than would the conclusion that there is a culture of corruption in the target.
However, there are a variety of factors which come into play in assessing the one-off violation and the impact on the M&A transaction. Some of these factors include the person or people involved in the ‘one-off’ corrupt transaction; the size of the contracts, including as a percentage of the target’s overall revenue, obtained through the violation; the size of the bribe involved; and, if discovered by the target’s management, the steps taken to address the violation. If for instance the contract involved was large and high-level management were implicated in the corrupt activity, the FCPA risk to the company would be much greater and therefore the acquisition becomes less attractive.
DiBianco: A specific instance of past non-compliance should not necessarily scuttle a transaction. If an instance of past misconduct is identified, and determined to be isolated, associated liabilities can be addressed through appropriate allocation of risk in the transaction. If diligence identifies improper payments to secure a key asset of the target – such as property or development rights or a material, long-term contract – a potential buyer should carefully assess whether the asset will remain tainted either by future demands for improper payments or by having been secured through corrupt means. In such circumstances, regulators could take the position that revenues from the asset are subject to civil disgorgement or criminal forfeiture. Absent ongoing ‘taint’ of an asset, past incidents of misconduct can frequently be remedied by enhancements of controls and policies following closing, that are targeted to the particular risks and conduct identified during pre-transaction diligence.
Glenn Pomerantz, CPA, CFE is a partner at BDO in New York. He has over 25 years of forensic accounting, auditing and consulting experience. Mr Pomerantz leads BDO’s Anti-Corruption Compliance and Investigations practice, specialising in anti-corruption compliance, due diligence and investigations. He can be contacted on +1 (212) 885 8379 or by email: email@example.com.
James Walker is a partner at Richards Kibbe & Orbe LLP where he concentrates in internal investigations, white collar criminal defence, civil litigation, and professional liability. Mr Walker represents audit committees, audit committee directors, corporate officers, and other professionals in criminal, SEC, and FINRA investigations of potential violations of securities laws and Foreign Corrupt Practices Act, and in related civil litigation. He can be contacted on +1 (212) 530 1817 or by email: firstname.lastname@example.org.
Gary DiBianco is a partner in the London office of Skadden, Arps, and heads the firm's London-based Corporate Investigations practice. He has extensive experience defending criminal and civil investigations, conducting internal investigations, and providing compliance and due diligence advice. His experience in anti-corruption matters includes global internal investigations, responses to multi-jurisdictional regulatory and investigative inquiries, and defence of parallel international enforcement actions and shareholder litigation. Mr Dibanco can be contacted on +44 (20) 7519 7258 or by email: email@example.com.
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