Private Equity and the Gathering Anti-Corruption Storm

Whether due to the financial crisis or sheer fact that many of today’s investment opportunities are global in nature, the number of foreign anti-corruption probes has grown at an alarming rate. We entered 2011 on the heels of a record year for investigations conducted by the Securities and Exchange Commission and the Department of Justice. Recently, it was reported that Kraft became the subject of a Foreign Corrupt Practices Act probe in India, Tyson Foods was investigated over an acquisition it made in Mexico, and IBM reached a $10 million settlement with the SEC over internal control provisions of the FCPA. These and other high-profile cases have resulted in a renewed focus on anti-corruption laws at a time when companies are expanding their operations globally and a higher percentage of total revenues resides overseas.

CRACKDOWN ON CORRUPTION

The crackdown on FCPA violations and other corruption is part of a larger enforcement trend that stretches from the U.S. to Europe. Congress has enacted sweeping new reforms on Wall Street, such as the Dodd-Frank Act and the Consumer Protection Act, which among other things include whistleblower provisions intended to thwart corporate fraud.

In 2010, the SEC created a new unit dedicated solely to the enforcement of the FCPA, while Lanny Breuer, the DOJ’s assistant attorney general for the Criminal Division called for a “new era of FCPA enforcement.” As a result, both the number of enforcement actions and size of monetary fines have surged. Compared with 2009, last year saw the number of enforcements soar by 85 percent. The SEC brought more FCPA cases than ever before in 2010, against 23 entities and seven individuals, producing more than $600 million in disgorgement and civil penalties.* The DOJ imposed $1 billion in fines related to FCPA-enforcement actions, the largest in the history of the Act.** In all, eight of the top 10 corporate fines in FCPA history occurred in 2010, including against the UK aerospace company BAE Sytems PLC ($400 million), the Italian oil and gas company Eni S.p.A. and its Dutch subsidiary Snamprogetti Netherlands B.V. ($365 million), the French engineering and construction company Technip SA ($338 million) and the international telecommunications giant Alcatel-Lucent SA ($137 million).

Enacted in 1977, the FCPA makes it illegal for publicly traded companies to pay foreign government officials in order to help them obtain or retain business. Historically, private equity has been largely unaffected, at least in terms of direct prosecution, by anti-corruptive liability, and the FCPA. However, in the past few years compliance has begun to play a more prominent role in the sector. This shift can be attributed to the increased inflows into emerging markets, which have become a breeding ground for new investment opportunities. Firms are shifting their attention to Brazil, Africa, and Asia where potential returns can outpace those in more mature western markets. Yet, investments in companies located in emerging markets expose investors to a greater degree of risk as these economies frequently lack the anti-corruption infrastructure common in developed countries.

As a result of exposure to emerging markets and the increase in investments made by sovereign wealth funds in private equity, the industry is taking notice and recognizing that its overseas dealings may result in risk exposure. As a result, private equity firms may begin to re-evaluate how well internal compliance programs – both on a firm-wide level and as it relates to potential acquisitions – stack up with the FCPA and other anti-corruption laws that have been enacted recently around the world, such as the UK Bribery Act. Countries such as Germany, Italy, France, South Africa and Japan also have their own laws or are planning to enact some form of anti-bribery regulations.

WALL STREET REFORMS AND A NEW ERA IN ANTI-CORRUPTION

How did we get here? Earlier this year, the SEC launched an investigation into several financial firms for their relationships with sovereign wealth funds around the globe. Sovereign wealth funds, owned and/or controlled by foreign governments, have drastically expanded their exposure to the U.S. by investing in private-equity firms and other financial institutions. In 2010, sovereign wealth fund assets grew to $3.98 trillion, up 11 percent, according to Prequin. Nearly 60 percent of these funds invest in some form of private equity. Often, these funds represent a vehicle whereby private-equity investors may gain access to investment in foreign companies.

As private-equity funds continue to expand into fast-growing emerging markets, the sovereign wealth-fund issue will continue to represent an area of concern. Regions considered high-risk include China, Indonesia, Vietnam, South America, Brazil, Africa, and Eastern Europe. However, no part of the world has been unscathed.

Anti-corruption issues may surface in any number of operational decisions made by a private-equity firm. Activities such as attracting capital from a sovereign wealth fund, opening an office in a foreign country, and gaining approval as an investor in a foreign entity require clearing regulator y hurdles. Additionally, any instance in which a government requirement must be satisfied increases the risk that a private- equity firm may be scrutinized for potential unlawful influencing of government officials.

Surging growth in investment in high-risk emerging markets and the rewards for identifying illegal activities contained in various new whistleblower provisions may usher in a new era in FCPA enforcement within the financial services industry. Private-equity firms should consider the SEC’s position on anti-corruption and recognize that the agency could assume an even more aggressive stance in combating violations. As a result, private-equity firms may have to increase measures aimed at cur tailing risks associated with existing portfolio companies, as well as taking a more aggressive approach toward pre-closing due diligence in new overseas investments. The costs for financial buyers are high, and include criminal and financial sanctions.

SIZING UP THE RISKS

For private equity, firms also face the prospect of corruptive practices at the portfolio-company level. Private-equity firms can gain risk exposure as a result of the activities at the businesses in which a firm invests. Beyond the risks that may inure to the private equity firm as a result of any corporate governance responsibilities it may have with respect to its portfolio companies, corruption at a portfolio company can greatly influence divestitures made by a private equity firm, and greatly impact its exit strategy. In some cases, for instance, a prospective buyer could insist that the portfolio company have a robust compliance program in place as a condition to a transaction.

Frequently, the companies in which a private-equity firm invests are not well-established, and lack the infrastructure necessary to facilitate an effective anti-corruption program. Practices in some foreign countries that would be considered violations of the FCPA are viewed as “normal” ways of conducting business in the local country, irrespective of whether such practices comply with local law. Thus, simple reliance on an organization’s management or employees’ instincts to “do the right thing” is fraught with danger.

Regulators have previously employed industry-wide sweeps as a vehicle to identify FCPA violations. Industries that have typically been subjected to such investigations are those that are tightly regulated (pharmaceuticals, medical products, etc.) or situated in high-risk regions areas (such as Eastern Europe or South America), where the prevalence of government corruption is regarded as high.

DUE DILIGENCE: ASKING THE TOUGH QUESTIONS

Given the increased scrutiny, the due-diligence phase represents an opportunity for private equity firms to reduce risk. Here, a comprehensive review of an acquisition target and its business relationships can help to identify any red flags. Red flags could include the target’s management team’s standards of ethics, the nature of the company’s third-party relationships, and its ties to government officials. A private equity investor should review the existing compliance program within the target company.

Greater attention during due diligence can enable firms to make more prudent decisions as to whether or not to proceed with a transaction. In many cases, however, the identification of a potential corruption problem may not be a reason to pull out of a transaction. The mere existence of corruption risk or a deficient anti-corruption compliance program does not mean that violations have occurred. Also, findings in the due-diligence phase may provide an opportunity to identify the extent of the problem. Perhaps the potential issue is limited to one or a few employees and is not symptomatic of a larger problem. If the risks are widespread in the company, new compliance procedures may be implemented. In some cases, a concern may be identified, yet it may not be possible to determine its potential impact prior to an acquisition. At a minimum, due diligence enables a firm to fix a problem or be more selective in the transactions into which it enters. As part of any due diligence, difficult questions must be asked:

Does the target possess a formal anti-corruption policy, and if so, have its employees been trained?
Do the company and its employees have a particular tie with the local government or possess certain licenses?
Does the entity possess an exorbitant number of outside consultants or advisers, and have these relationships been analyzed?

FCPA, CORRUPTION AND THEIR IMPACT ON THE DEAL

Unfortunately, there is no “one-size-fits-all” approach to FCPA compliance. For instance, the establishment of a comprehensive anti-corruption program is not the panacea for private-equity firms. Rather, when engaging in an investment opportunity or transaction, a more prudent approach is to conduct a thorough risk assessment of the entire situation that accounts for all of the different risk factors involved. Those include the nature of the underlying business, the geographic territories in which the target does business, its interaction with governments, the amount of goods and persons that travel and go through customs and immigration, the use of licenses and permits in its business operations, and so on.

The real risk for private-equity firms lies in identifying a problem at the eleventh hour (or never at all). Besides delaying a transaction’s closing, deals may be re-priced or their terms renegotiated. Worse yet, a private-equity firm may fail to factor into its pricing decision a significant underlying risk. For example, if the historical operating results of the target company were dependent upon corruption, cessation of such practices may impair the target’s ability to implement its business strategy, sustain historical profitability, or improve upon it. And, once a deal has closed, successor liability is such that private equity firms and their directors may be liable for anti-corruption violations even if they were committed by the company they acquire before the acquisition.

In some cases, a firm may be able to work with the U.S. government to negotiate an agreement that protects it from or limits liability, while allowing it to proceed with a transaction. A 2008 Department of Justice opinion (Opinion Procedure Release No. 08- 02) offers guidance in this area. That opinion provided some relief to the acquirer of a business due to the practical limitations of detecting all corruption at a target during the due diligence process.

FORGING AHEAD WITH THE DEAL

In certain cases, a private-equity or other financial buyer may be best served by moving forward with a transaction despite the perceived risks. It may choose to take action following the completion of an acquisition, such as hiring a new compliance officer or anointing a third party to evaluate and improve the company’s compliance program. Whatever course of action a firm may take, it is prudent that the cost of developing a transparent compliance program in the target be built into the economic models behind the transaction.

Perhaps the greatest benefit to a private equity investor in addressing anti-corruption risk is preventing what once was an attractive investment from becoming a potential liability. A deal may present a sizable opportunity for returns, but could result in a private equity firm being on the hook for violations that occurred many years earlier, and to which it had no culpability. By developing an understanding of anti-corruption issues involved in an acquisition, including a review of the target and third par ties before the deal closes, private equity firms can dramatically decrease the economic risk associated with a given transaction.

HANDLING AN ANTI-CORRUPTION ISSUE

Private equity firms must be proactive in how they address compliance. Identifying risk is only a small part of risk mitigation. Firms must implement procedures that can effectively reduce risk to acceptable levels in their businesses. Re-mediating the risk of anti-corruption threats through proper internal controls requires effective compliance programs and experienced professionals. Those professionals should be deployed across the globe and be well-versed in the language and business practices in the country in which the portfolio company or acquisition target resides. It’s also important for firms to be aware that because problems can surface in real-time, they too, must be prepared to respond and evaluate risks quickly.

Often, the initial instinct of those discovering a corruption problem is to assume it is limited to a particular transaction, region, or portfolio company. Yet, it may well be symptomatic of a larger problem. A silver lining in an anti-corruption investigation is its ability to foster a more extensive analysis of the organization’s risk exposure. The firm has an opportunity to delve deeper into its global operations and businesses to identify red flags before they evolve into serious problems.

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