Anti-Corruption Due Diligence in Mergers and Acquisitions Dubai Summit on Anti-Corruption Enforcement and Compliance 14 October 2009 Rindala Beydoun
Introduction • There is no doubt that anti-corruption due diligence is a critical element in M&A transactions. • However, a 2009 KPMG study revealed that only 36% of U.S. executives think the M&A FCPA due diligence performed by their own companies is “adequate.” • Enforcement actions and penalties are increasing and management cannot rely only on legal and financial diligence to discover corrupt practices.
Establish Risk Profile of Target • The first step in performing anti-corruption due diligence is to establish the target’s risk profile. • A company’s risk profile is based upon: • its business model • the geographical locations where it conducts operations.
Target’s Business Model • Companies with the following characteristics have higher risk profiles because they are more susceptible to corruption: - frequent interactions with governments and/or state-owned companies - involvement in heavily regulated industries or reliance on regular government intervention - dependence on third parties to conduct a significant portion of their business • Corruption is more prevalent in certain industries (e.g. oil and gas, aerospace, defense, pharmaceuticals).
Target’s Geographic Location • Corruption is widespread in certain countries and companies that do business in these countries have a higher risk profile. - Transparency International’s Corruption Perceptions Index (CPI) is a helpful resource in assessing the level of corruption in the location(s) where the target operates.1 - The CPI approximates the level of corruption in every country and ranks countries accordingly. 1 Transparency International is a non-governmental organization focused on addressing corruption worldwide. The organization was founded in Germany in 1993 and is composed of approximately 100 national chapters. Further information can be found at http://www.transparency.org/.
MENA CPI RANKINGS India ranks 85th in the world with a CPI score of 3.4 and Pakistan ranks 134th in the world with a score of 2.5.
Due Diligence Process • After the target’s risk profile is determined, in-depth anti-corruption due diligence should begin. • A frustrating fact is that conducting successful due diligence is most challenging in the jurisdictions where it is most vital!
Due Diligence Process(continued) • Information on the target should be gathered using a wide variety of means, including: - due diligence questionnaires - searches of public records - inquiries to the acquirer’s government - personal interviews • In instances where the level of potential risk is high, an investigative firm and/or forensic accountants should be retained.
Due Diligence Process(continued) • Suspicious payments and other evidence of potential corruption are known as ‘red flags’. • Every red flag should be thoroughly investigated and the scope and intensity of the due diligence process should be increased if red flags are identified.
RED FLAGS • The transaction or the contracting party is in a country where there is widespread corruption • The transaction or the contracting party is in a country that has a history of bribes and kickbacks • The transaction or the contracting party is involved in or with an industry that has a history of FCPA violations and/or corruption • The contracting party refuses to agree to comply with the FCPA, the principles set out in the OECD Convention, or equivalent applicable anti-corruption legislation
RED FLAGS(continued) • The contracting party has a family or business relationship with a government official • The contracting party has a poor business reputation • The contracting party insists that its identity remain confidential or refuses to divulge the identity of its owners, directors, or officers • A government customer recommends or insists on use of a particular intermediary or consultant • The contracting party does not have offices or a staff • The contracting party does not have significant experience
RED FLAGS(continued) • The contracting party insists on unusual or suspicious contracting procedures • The fee or commission to be paid to the contracting party is unusually high • The payment mechanism to be utilized is secretive or unusual • The contracting party submits inflated or inaccurate invoices • The contracting party requests cash or bearer instrument payments
RED FLAGS(continued) • The contracting party requests payment in a jurisdiction outside its home country that has no relationship to the transaction or the entities involved in the transaction • The contracting party asks that a new customer be granted an excessive credit line • The contracting party requests unusual bonus or special payments • The contracting party requests an unusual advance payment
Approval of Findings and Retention of Due Diligence Records • Due diligence results should be presented to the acquirer’s compliance officer and general counsel for their approval at the conclusion of the investigation. • Records should be carefully documented and retained so the acquirer can demonstrate that it performed comprehensive diligence on the target.
Governing Legal Framework • Multiple and different anti-corruption regimes may cover the target prior to the acquisition and the new subsidiary following the transaction. • Counsel familiar with the anti-corruption regimes in the jurisdictions where (i) the target does business and (ii) the acquirer is based or its securities are listed must play a key role in the due diligence process.
Governing Legal Framework(continued) • 38 countries (none of which are located in the MENA region) are signatories to OECD Anti-Bribery Convention and have enacted implementing legislation, including the USA (Foreign Corrupt Practices Act) and the UK (Anti-Terrorism Crime and Security Act 2001). • Many countries in the MENA region have laws prohibiting corruption but the relevant statutes are generally dispersed between several pieces of legislation (the UAE is in the process of implementing a comprehensive anti-corruption law).
Governing Legal Framework(continued) • The DOJ uses the FCPA to combat corruption worldwide.
Policies and Procedures, Training, Auditing and Internal Controls • An important aspect of due diligence is reviewing the target’s existing anti-corruption program. • A company with an anti-corruption program featuring the following would be less likely to have corruption issues: - senior management involvement with anti-corruption compliance - designated compliance officer overseeing the anti-corruption program - practice of giving each employee a copy of the company’s anti-corruption policy - regular anti-bribery training for employees
Policies and Procedures, Training, Auditing and Internal Controls(continued) - anonymous reporting mechanisms - practice of having employees and agents sign anti-corruption compliance certificates - practice of performing due diligence on agents and requiring agents to enter into written agreements that include anti-bribery representations and audit rights - prohibition on agents hiring subagents without the permission of the company - practice of reviewing payments made to agents to ensure such payments are reasonable and consistent with market rates
Historical Risk Issues • One aspect of the due diligence investigation should be identifying any prior instances of corruption. • Such issues could arise during the review of: - government investigations, settlements or plea agreements - internal investigations - internal audits - annual reports/disclosures
Historical Risk Issues(continued) • Even if there is no risk of successor liability associated with a prior infraction, past corruption should serve as a warning about the target’s culture and may indicate that the target’s business depends on corrupt practices. • The manner in which the target previously responded to an incident of corruption can help the acquirer gauge if the target’s management is committed to rooting out corruption.
The Significance of Discovering a Violation • There are numerous reasons to consider walking away from a transaction if potential violations are discovered: Successor Liability- An M&A transaction will generally result in the target passing its liabilities to the acquirer and most buyers do not wish to be subject to hard-to-quantify penalties and litigation expenses. Valuation of Target- If a substantial portion of the target’s business is based on unethical behavior, bringing the target into compliance with anti-corruption laws could reduce its valuation considerably.
The Significance of Discovering a Violation(continued) Delay in Closing- The discovery of a violation generally delays transactions because it often requires additional due diligence to be performed and the renegotiation of the deal. Other Risks- Other risks associated with acquiring an entity that has violated anti-corruption laws include: - damage to the acquirer’s reputation - increased government scrutiny - heightened risk of shareholder and other lawsuits
Lockheed-Titan Transaction • Lockheed Martin’s acquisition of Titan Corp. is one of the largest transactions derailed by the discovery of anti-corruption law violations. • In 2004, Lockheed agreed to acquire Titan for $2.2 billion.
Lockheed-Titan Transaction(continued) • During Lockheed’s pre-transaction due diligence investigation, it discovered that Titan had funneled more than $2 million to the president of Benin in connection with a wireless management contract. • Due to the significant penalties Titan faced, including being barred from doing business with the U.S. government, Lockheed walked away from the deal. • In 2005, Titan was given a $13 million penalty and required to institute an FCPA compliance program.
GE-InVision Transaction • The discovery of violations does not have to be a deal breaker in every case. • In 2004, GE agreed to acquire InVision Technologies. • Pre-acquisition due diligence later revealed that InVision’s agents had bribed officials in China, Thailand and the Philippines.
GE-InVision Transaction • These violations were disclosed to the DOJ and InVision was forced to pay a $800,000 fine. • However, the DOJ agreed not to prosecute GE and its soon-to-be-formed subsidiary for the violations that it voluntarily reported and GE went ahead with the acquisition.
Pros and Cons of Disclosure to Authorities • Anti-corruption regimes do not generally require companies that uncover violations to disclose them to the authorities though other statutes may require disclosure under some circumstances. • The DOJ and the U.K. Serious Fraud Office (SFO) encourage companies to voluntarily disclose violations. • The decision on whether or not to report corrupt behavior to the authorities is a delicate matter and it requires clear communication between the acquirer and the target.
Pros and Cons of Disclosure to Authorities (Pros) • Avoid Risk of Involuntary Disclosure- It’s preferable for an entity to make a disclosure about itself rather than have regulators, an employee or a third party do so. • Avoidance of Prosecution – Voluntary disclosure may cause authorities to decide not to prosecute a company (the DOJ and SFO have stated that whether or not a violation was self-reported is a factor that prosecutors will consider). • Mitigation of Penalties – If the authorities decide to prosecute a company, the penalties ultimately assessed may be reduced if the company voluntary disclosed its violations.
Pros and Cons of Disclosure to Authorities (Cons) • Delay in Transaction – Alerting the authorities leads to new investigations and increased due diligence demands, often causing the closing to be delayed. • Risk of Additional Violations – The investigation(s) launched by the authorities may uncover additional violations that the due diligence process did not previously reveal. • Benefits of Disclosure Not Guaranteed – It is not assured that the authorities would reward voluntary disclosure with leniency.
Evaluating Public Disclosure Obligations • If the acquirer learns that the target previously violated anti-corruption laws, the acquirer must then determine whether or not applicable securities laws require it to publicly disclose this information. • A company that fails to report such information despite a requirement to do so would subject itself to additional sanctions and potential shareholder lawsuits.
Role of Outside Counsel • Outside counsel should perform the following roles related to the due diligence process: - leading the due diligence investigation on the target - advising the acquirer on its potential liability under applicable anti-corruption laws in the event that the transaction is consummated
Role of Outside Counsel - advising the acquirer on how to proceed if violations are uncovered - ensuring that the terms of the purchase agreement sufficiently protect the acquirer from any successor liability due to corrupt practices of the target - implementing a new anti-corruption compliance program for the new subsidiary following the acquisition