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Justice and SEC Clamping Down on Corrupt Practices: Beware of the Conduct of Strategic Partners

Aug 18, 2007
Today's state of affairs for private equity sponsors in the arenas of public relations and politics is challenging at best, and a private equity sponsor who is exposing itself to corruption or corrupt partners are inviting criticism and worse. Private equity firms should be aware of actions the U.S. Department of Justice ("DOJ") and the U.S. Securities and Exchange Commission ("SEC") have taken recently under the 1977 U.S. Foreign Corrupt Practices Act ("FCPA"). They should also consider their potential of becoming a target of this Act early in any dealings. Of special note is the settlement in General Electric's recent purchase of the oil and gas services company Vetco International. Alberto Gonzales, U.S. Attorney General, made obvious that enforcement of FCPA is a top priority and will remain so.

FCPA risk assessment is challenging in M&A deals due to the extensive FCPA reach. Identification and of FCPA-related exposures and evaluation of the risk should be an requirement of any due diligence in a multinational M&A deal--there will be severe consequences of exposures that arise from receiving or selling assets that will cause a benefit from corrupt practices, and a private equity sponsor should make evaluation of this risk paramount.

Statute History

In the 1970s, many U.S. companies (which included many Fortune 500 companies), disclosed the practice of making large and substantial "questionable payments" to foreign officials. These officials included politicians, parties, and more. Amendments to the U.S. securities laws that prohibited bribing non-U.S. officials, required U.S. issuer's records show accurate details of of the company's asset disposition, and required accounting methods with controls built in to thwart bribery and other corrupt practices was enacted by the U.S. Congress.

FCPA Anti-Bribery Provisions

To offer payment or benefits to a non-U.S. government official in exchange for business advantages or other favors is a crime under the FCPA. The standard is "knowing," and avoiding information that would alert a responsible person to think that there is bribery indicates liability. This applies to the activity of employees and subsidiaries, as well as brokers, agents, distributors, partners, and intermediaries like travel agents and law firms.

A person covered under FCPA who avoids the knowledge that an intermediary such as a distributor ahs paid or will pay a bribe to a non-U.S. official is subject to the same kind of prosecution as a company that avoids knowledge of employees who make those payments and promises.

A foreign official, according to the statute, is anyone who is employed by a non-U.S. government entity full time or part time. This includes employees of corporations owned by a state, civil servants, municipal governments, provincial governments, and educational entities owned by a government. The term also includes any candidates for public office, employees of some international organizations (including the EU, UN, and OAS), political parties and their officials, African development banks, Asian development banks, the International Committee of the Red Cross, and the WHO.

Any benefit conferred may be viewed as a trigger for the statute's provisions by U.S. regulators, according the FCPA. Payments to relatives are included in these triggers, including travel benefits for an official's family members, contributions to officials' charities, etc.

The requirements and provisions for the statute apply to anyone who ussues a registered security, including ADRs on a stock exchange. They also apply to corporations that reside in the U.S. or have a principal office and place of business in the U.S., a U.S. citizen or resident including holders of green cards serving anyplace in the world, and any others performing acts that will touch U.S. concerns. Almost anything that is concerned with the U.S. can set off jurisdiction by the U.S.

Provisions for Internal Controls

FCPA's record keeping provisions and accounting guidelines were written to deal with the SEC-registered corporations' ways of disguising and hiding payments and bribes, such as listing those bribes as consulting expenses or travel costs of non-U.S. officials.

There are two regulations the FCPA rules impose on books and record keeping.

1. Any company with registered U.S. securities must make and maintain records, books, and accounts that accurately and reasonably reflect the details of all transactions and disposition of the property and assets of the company.

2. The company must also create and maintain internal accounting systems that have sufficient controls to assure officials that all transactions are within the authorization of management, and that recording is done within "generally accepted accounting principles." Although there are no penalties for violations that are technical, inadvertent, or insignificant, willful concealment of any form of misconduct by altering the books and records is a violation of FCPA.

An interesting feature of these provisions is that in the case of a civil liability, the parent company does not need to have any knowledge or suspicion specifically that the books or records contain misleading information. The appearance of the innocence of the bribery alone is enough to bring FCPA regulations to bear even if the parent company has no knowledge of the actions. The parent company is also liable for any failures of its subsidiaries for internal control.

The FCPA does not have a threshold of "materiality" for record keeping, books, and internal controls. Even though the records and books only need to be "reasonable," Section 404 of the Sarbanes-Oxley Act doesn't apply so the resulting inaccuracies from less diligent control can bring the regulations to bear, especially if there is bribery involved.

FCPA Enforcement

Many U.S. and foreign companies are becoming aware of the results of not complying with the FCPA. These are serious and have a huge impact on these companies, thereby raising the alert systems of businesses that may be affected by FCPA actions. The DOJ imposes fines and orders of disgoregement that sometimes exceed tens of millions of U.S. dollars, and can also include fines for criminal activity. Recently the Titan Corporation paid more than $28 million as a punishment for corrupt payments that surfaced during its merger with Lockheed. Three of Vetco's subsidiaries plead guilty to and a fourth entered a deferred prosecution agreement; the fines were $26 million and was the largest in the history of the FCPA.

The investing public will view criminal convictions of a U.S. registered corporation negatively, and there could be a host of side effects of the convictions as well, such as loss of U.S. government contract eligibility, benefit programs, and licenses. They may also suffer increased liability for taxes and face other lawsuits related to the conviction, such as those arising from provisions of the Racketeer-Influenced and Corrupt Organizations Act. There may also be proceedings to void any agreements procured during the period of the corrupt activities.

Companies that are suppliers for the U.S. government or are regulated by or closely related to it (such as defense, pharmaceuticals, financial services, etc.) will feel huge ripples of a criminal FCPA conviction. It could affect their participation in U.S. funded medical insurance programs (Medicare, Medicaid, etc.), and could lose the opportunity to bid on defense contracts and other government contracts. Financial firms can also lose the opportunity to serve as pension fund advisors or broker-dealers, and may be required to forfeit licenses to sell insurance in this country.

Consequences limited to U.S. soil may be only the tip of the iceberg as well. Businesses in the countries that signed the OECD anti-bribery convention may find they are subject to criminal proceedings as well as civil proceedings in the U.S. as well as their own country of origin, not to mention the other jurisdictions where they may be guilty of corrupt acts. PE buyers will also find that the impact of these proceedings will affect management teams, and individuals involved in the acts or conspiracies can suffer many years of imprisonment and fines on both the civil and criminal levels. There may also be numerous collateral results that will affect the business negatively for many years.

M&A Deals and Risk Allocation Considerations

The wide scope and breadth of FCPA when coupled with lack of testing judicially, has created quite a few unusual challenges for sellers and buyers who could end up exposed to corrupt practices of their own or another's business. For one, these sellers and buyers must identify potential risks and exposures, and evaluate those risks--however, this may be difficult to do for many reasons. Sellers and buyers have to negotiate these risks like they would any other business liability, and where there is a stock and merger agreement in progress these risks will determine much of the shape the distribution of risk will take.

However, even where the buyer can negotiate a good position with regard to FCPA exposure, there is still the collateral legal and financial risk associated with being part of any recorded business deal where fault may lie with a seller. Even if all the risk of FCPA liability is assumed by a seller, U.S. regulators may still charge both the seller and buyer of the corrupt business practice, especially if the buyer has a history of FCPA violations. Once a scheme for bribery or corrupt business is exposed, all benefits and commercial goods may be lost or at least significantly deteriorate. Truly, the best protection for a buyer may simply be to pay a lower price for the business.

Due Diligence and FCPA Regulations

PE, as other buyers, are interested in identifying and eliminating FCPA problems and other anti-corruption issues before the finalization of any purchase price or financial terms. The parties must create a due diligence plan and review it carefully to determine potential risks, as with any other potentially problematic deal.

Here are some things an effective FCPA plan for due diligences must account for:

1. The definitions of non-U.S. officials and benefits covered.
2. How FCPA applies to these officials and agents.
3. How the FCPA affecst acquisitions and mergers.
4. The liability and want of standards applicable to a parent company's violation of bookkeeping and records requirements.
5. The increased exposure of the Internet and the resulting limits of protection by anti-bribery provisions.

Steps a PE sponsor should take as part of any due diligence program include:

1. Assessing the risk of FPCA violations in countries where the target business or subsidiaries reside or operate.
2. Analyzing the particular industry for possible disproportionate violations of FCPA regulations, such as defense contractors, natural resources, or pharmaceuticals.
3. Evaluating the risk of any people who are associated with the target company, such as unethical managers.
4. Carefully reviewing the internal audit reports and other investinations conducted, including by security, legal departments, and any other documents by other legal counsel of the target.
5. Identifying all senior officials elected in the country of the target company, and comparing those names with a list of people the company has paid money to.
6. Interviewing all managers and employees of the seller or target company that may have had any contact with influential officials.
7. Reviewing all reports, records, and analyses of audits prepared eternally, such as by accounting firms.
8. Hiring an investigation firm to review all risks and ways that the target company may have paid bribes.

Although these steps are designed to reveal any potential FCPA-related risks, the most important thing a buyer can do is inspect the target's own FCPA compliance program. Even though a thorough and tough-minded program of compliance is the best way to fend off liability, they can reduce significantly the risk of financial liability arising from the activities of individuals within a normally-compliant company that may be paying corrupt monies to officials in other countries. In other words, the most effective and important thing for a buyer in assessing the target company is to review how seriously the target took its own FCPA-related risks and exposures before the M&A transaction talks by inspecting the target's FCPA compliance program.
About the Author
Robert Masud, Esq. is the principal of Masud & Company LLC, a law firm for the world of business, finance and the internet.
Find out how our lawyers can help you at http://www.masudco.com.
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