Companies should investigate target companies to assess compliance risk under the Foreign Corrupt Practices Act

The number of investigations under the US Foreign Corrupt Practices Act (FCPA), together with the number of prosecutions by the US Department of Justice (DOJ) and the US Securities and Exchange Commission (SEC), have hit record levels in the past few years. Huge fines have followed these investigations, including a record $1.65 billion in total fines and penalties imposed against Siemens Corp. from separate German and US prosecutions. Because of its broad application, the FCPA creates unique risks for multinational corporations (MNCs) and US companies doing business abroad, especially in high-risk countries such as China.

The FCPA is particularly important when considering mergers and acquisitions (M&A) because an entire transaction can fall apart if the risk is not discovered at the appropriate time or managed properly. In recent years, many FCPA cases arising from M&A transactions have yielded dramatic results, such as the collapse of Lockheed Martin Corp.’s proposed $2.2 billion acquisition of Titan Corp. in 2004. In another case, three Vetco International Ltd. subsidiaries were fined $26 million in 2007 because they made about $2.1 million in corrupt payments to Nigerian government officials. The large fine, in part due to one of the subsidiaries’ prior 2004 FCPA conviction, raised issues of successor liability when General Electric Co. (GE) acquired Vetco Gray in 2007. Further, the June 2008 DOJ opinion regarding FCPA liability in the context of a proposed corporate acquisition by Halliburton Co. underscores the importance of anticorruption due diligence of M&A targets that operate in high-corruption environments and sets forth key elements of a due diligence investigation that may, in appropriate circumstances, be sufficient to protect an acquirer from successor liability for FCPA violations.

M&A deals have been a common way for foreign investment to enter the Chinese market in recent years. As US companies’ M&A transactions in China have increased, so has the risk of FCPA violations. Several high-profile cases of FCPA enforcement involving M&A transactions have been related to corruption committed in China. For example, in the GE/InVision case, InVision Investment Technologies Inc. allegedly violated the FCPA by making improper payments to local agents or distributors in China and other Asian countries. InVision disclosed these potential violations to the DOJ and SEC after GE announced its intention to acquire InVision in March 2004. InVision entered a non-prosecution agreement with the DOJ before GE acquired it and was fined $800,000. The post-merger company also reached a settlement with the SEC, under which GE-InVision agreed to disgorge the $589,000 in profits arising from the alleged FCPA violations and pay pre-judgment interest of $28,703 and a $500,000 civil penalty.

FCPA risk in China remains high due to certain Chinese business practices and industry sectors that remain state-owned or controlled. With the US government’s focus on the FCPA, US companies acquiring Chinese businesses should conduct anticorruption due diligence on the target company to identify potential FCPA risks. The process of due diligence will help to establish the true value of the acquisition target and determine whether bringing the post-merger company into compliance could jeopardize the acquirer’s profitability or result in criminal liability for past violations.

FCPA implications for key issues in the M&A context

In M&A transactions, successor liability for prior FCPA violations is an increasingly important issue. An acquirer that does not perform effective due diligence on a proposed target risks being held accountable for past FCPA violations. In a stock transfer or merger, the successor company is generally held liable for past violations of the target company. But in some circumstances, successor liability may attach in an asset purchase. For example, one of several broad exceptions to the general rule of no successor liability in the context of an asset purchase is when the purchasing entity is merely a continuation of the selling corporation. The parties may use the purchase agreements to specify which liabilities transfer with assets. Therefore, diligence requires a nuanced inquiry into the facts and circumstances regarding the specific M&A transaction.

Acquirers should consider conducting anticorruption due diligence in various M&A contexts. If the acquirer itself is already subject to the FCPA anti-bribery provisions or the books and records provisions, it should consider due diligence because of concerns about liability for pre- and post-acquisition conduct. (If the acquirer is not subject to the FCPA, but the target company is, the acquirer should conduct anticorruption due diligence because it may be responsible for the past unlawful conduct of the newly acquired subsidiary.) Minority investors looking for short-term exit channels may want to consider the impact of FCPA noncompliance on IPOs, because once a Chinese company becomes an issuer under US securities laws, it is subject to the FCPA. Financial advisors to M&A deals should also consider FCPA due diligence for reputational reasons.

In most cases, sellers and buyers need to conduct anticorruption due diligence. Usually, buyers seek to avoid acquiring liability for past or present FCPA violations, ensure that the seller covers the costs of violations, and maintain the maximum value of the acquired entity by retaining key personnel, contracts, markets, and relationships. Sellers need to conduct due diligence to ensure that their disclosures regarding material contractual provisions, such as representations, are not misleading and to assess their FCPA compliance programs and other internal controls to determine whether the sales price could be challenged because of unknown FCPA problems.

The DOJ’s opinion released in June 2008 regarding Halliburton’s approach to an M&A transaction also indicates the DOJ’s expectations of parties seeking to avoid potential FCPA liability in a proposed M&A transaction. Halliburton requested the release of the opinion procedure pertaining to its proposed acquisition of Expro International Group plc because, as a result of UK bidding restrictions, Halliburton had insufficient time and inadequate access to information to complete standard anticorruption due diligence before closing. The opinion indicates that the DOJ expects US companies in similar circumstances to go to significant lengths to avoid potential liability when entering into transactions, particularly when they are unable to establish that foreign transaction parties are free of corrupt behavior. At the same time, the opinion shows that the DOJ recognizes that US companies’ due diligence may have to accommodate the legal restrictions of other countries.

Strategies for effective anticorruption due diligence in China

Conducting effective anticorruption due diligence is particularly difficult in China for several reasons. First, acquisition targets in China tend to have a low appreciation of the importance of anticorruption compliance. Second, with the high employee turnover of recent years, most Chinese companies have not kept complete records. Third, most Chinese companies have weak internal control systems and may have falsified accounting records. Often, different versions of accounting books are kept for different purposes. For example, one version of the accounting books may record every payment the enterprise makes for internal record-keeping purposes, while another version of the accounting books hides illegal payments and is shown to auditors or officials during inspections. Also, the lack of public information resources makes independent checking of relevant company information difficult. Nonetheless, there are ways to overcome or mitigate these difficulties.

Identify high-risk areas

The first step of effective anticorruption due diligence is to conduct an initial risk assessment of the target company to identify areas of high risk or actual corruption violations. It is important to identify and distinguish different types of M&A targets in terms of FCPA implications. For example, in China, if a target company is in a sector that is state-owned or -controlled, such as energy, oil and petrochemicals, telecom, transport, auto, construction, financial services, or healthcare, the businesses of the target may have frequent interactions with government agencies or government officials for regulatory approvals. In such cases, this aspect of the target business should be a focus of the due diligence.

Understand the target’s business model

As part of the initial assessment, acquirers should seek to understand the operation of the target’s business. For example, an acquirer should check whether the target relies heavily on sales through joint ventures with Chinese state-owned enterprises, distribution partners, agents, consultants, or other intermediaries because corrupt payments are often made to government officials through these channels. The acquirer needs to analyze the target’s existing internal control and accounting systems, review the target’s organization chart, and identify all employees who interact with government officials.

Interview employees with care

Interviewing identified employees (prior to the acquisition, if possible) is a vital step, especially since information is rarely recorded in written documents in China. Even if employees are made available, obtaining useful information from them may be difficult. This is because most Chinese companies are accustomed to doing business through a network of value-laden relationships, and cultivating such relationships through gifts and entertainment is not necessarily considered unethical in China. Under such circumstances, discussing potential corruption issues with Chinese employees, and sometimes even associating the word “corruption” with their familiar business practices, may offend and alarm them. To maximize the benefits of such interviews, interviewers should maintain good relations with the executives and potential interviewees and show sensitivity to cultural differences by, for example, clarifying the context of the investigation in the native tongue of the locality and engaging in a few pleasantries before asking formal investigation questions. It is also helpful for the investigator to appreciate and understand the accepted local business practices and not to appear judgmental.

For an investigation of Chinese companies, sometimes obtaining senior management’s support may facilitate the investigator’s interview work, as employees tend to defer to higher-level managers and officers. Interviewers will also need to understand local attitudes toward investigations, as anticorruption due diligence is a foreign idea to many Chinese employees, and they may see it as an adversarial proceeding more than a neutral internal investigation. And since some US legal concepts, such as attorney-client privilege, are not available under PRC law, interviewers should emphasize confidentiality to interviewees and give them clear instructions not to discuss the interview with others.

Create a due diligence checklist and look for red flags

Information from the initial assessment is critical for designing a due diligence checklist that is suitable for Chinese companies. Usually, the key areas of the target company to look into during due diligence include: sales and marketing expenses; travel and entertainment expenses; the shareholding structure of the target, its subsidiaries, and affiliates; employee records and the target’s salary and bonus payment system; use of consultants and agents; corporate governance culture and structure; and charitable donations. Bribes in China can take many forms. In addition to traditional suspicious categories of expenses, such as rebates, sponsorships, and entertainment, gifts that come in the guise of traditional customs, such as elaborately packaged moon cakes, may entail FCPA risks.

The acquirer needs to check whether any shareholders of the target are government officials or associate directly or indirectly with government officials. Such indirect associations may take the form of beneficiary shareholding arrangements, such as using nominee shareholders to hold shares on behalf of the real beneficiaries through trust arrangements. Also, some Chinese companies may use fictitious tax receipts or salary payments to nonexistent “ghost” employees to mask bribery payments. All of these are red flags that merit investigation during the due diligence process.

In addition, conducting an independent check of red flag issues identified in the key areas and the target companies’ legal compliance through public information sources is an important supplement to the due diligence process. Although China’s public information search system is under-developed, releases from relevant PRC government agencies, such as the National Bureau of Corruption Prevention, can be valuable. Lists of convicted bribers are available for public search at most provincial-level procuratorial organs. Relevant industry regulatory authorities, such as municipal health bureaus, compile blacklists of companies caught in bribery. If public information is unavailable, employing private investigators may also be necessary. In all cases, companies should retain counsel familiar with common Chinese corporate practices.

With all of this information in hand, due diligence can move to the next stage, which typically includes more detailed interviews with the principals and the use of forensic accounting firms to verify the financial records of the target. Effective due diligence findings should be concluded by combining the investigative results from the concerted efforts of various teams.

Due diligence is a “must”

Investors acquiring companies in China must conduct anticorruption due diligence to avoid successor liability for past or potential corruption violations. Without such diligence, past FCPA violations could affect the timing and successful completion of M&A transactions. The risk of regulatory enforcement action and the resultant impact on the liability and reputation of the successor company may also be high. With appropriate strategies, a well-tailored due diligence effort can elicit sufficient information to determine an acquisition target’s real and perceived risk of FCPA violations and the true value of the transaction. It can also help the acquirer develop reasonable expectations of any post-acquisition compliance costs. Finally, in cases where concerns about a proposed M&A deal cannot be clearly resolved, sophisticated counsel familiar with SEC and DOJ practice and well-versed in Chinese business practices should be used to weigh different options, from voluntary disclosure to a DOJ opinion request.

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What Constitutes an FCPA Violation?

In broad terms, the Foreign Corrupt Practices Act (FCPA) prohibits corruptly promising, giving, authorizing, or offering anything of value to foreign government officials, political parties or party officials to obtain, retain, or direct business. The jurisdictional reach of the statute is broad—the anti-bribery provisions apply to “issuers,” which include US public companies and non-US companies that issue American Depository Receipts, and “domestic concerns,” which include corporations and other businesses that have their principal places of business in the United States or are organized under the laws of a US state or territory, US citizens and US resident aliens (wherever located), and non-US corporations and non-US citizens who commit acts in the United States in furtherance of an FCPA violation.

A “corrupt” payment can include any effort to improperly influence virtually anything that a foreign official does in his or her official capacity, from approving a contract to granting licenses related to investment services, issuing visas, acting on tax matters, or making decisions in connection with government approval of a merger or acquisition. “Something of value” is construed broadly and encompasses gifts, meals, entertainment, and travel and accommodations for foreign officials. Payments made indirectly to foreign officials through third parties, such as agents, are also prohibited if they could not be made directly.

The FCPA’s “books and records” and “internal controls” provisions require issuers to keep accurate books and records in reasonable detail that reflect the true nature of all transactions, regardless of whether the transactions pertain in any way to corruption. Parent companies are strictly liable under the civil provisions of the FCPA enforced by the SEC for ensuring that their subsidiaries, affiliates, and controlled joint ventures comply with these books and records provisions.

Richard Grime and Bingna Guo[/box]

[author]Richard Grime is partner, O’Melveny & Myers LLP, in Washington, DC. Bingna Guo is associate, O’Melveny & Myers LLP, in New York. The views expressed are those of the authors and do not necessarily reflect the views of the firm or any of its clients.[/author]

Posted by Richard Grime and Bingna Guo