Diligencing corruption risk in M&A

Another example: General Electric Co. bought InVision Investment Technologies Inc. in late 2004, but the latter was alleged to have violated the FCPA by making improper payments to local distributors and agents in China. InVision voluntarily disclosed this to the authorities and eventually entered into a non-prosecution agreement with the DOJ before GE finished the acquisition and was fined $800,000.

China focus: Extra caution

China has many unique business practices embedded into is culture. There are several important factors to bear in mind so as to conduct due diligence in a proper—and cautious—manner.

Firstly, many local companies tend to have a relatively low awareness, or appreciation, of the importance of an anti-corruption culture, though this has greatly improved since the government's anti-graft campaign began. Secondly, rapid economic growth has led to an unusually high turnover of personnel. With many employees jumping from one company to the next, a large number of firms have failed to keep consistent records. Thirdly, many Chinese companies have several sets of accounting books and maintain weak standards of internal control. It is not uncommon for businesses to hide illegal payments this way.

Another important consideration is the implication of state-owned enterprises (SOEs) in a transaction. It has been estimated that approximately 70 million people in China are employed by SOEs and may be considered “foreign officials” by a literal interpretation of the FCPA.

Practical solutions

It is essential to conduct a risk assessment of the target to identify high-risk areas of concern or even uncover actual corruption violations. Generally speaking, scrutinizing every detail during the due diligence process is key, and if something doesn't look right, it will pay off to go deeper into the investigation so as to avoid future problems and liabilities.

If the target is in a sector belonging to or controlled by the state, it most likely interacts with many levels of government officials or agencies. The employees themselves may even be officials. This should be an important focus during the due diligence process. Any payments made to and through them should be checked to make sure they are “clean,” which can be a daunting task but crucial, nevertheless.

It is important to understand the operational model of the target. For example, does it use SOEs to distribute or act as its agent? Does it pay through third party intermediaries, a channel that involves a high risk of being used for bribery payments?

When analyzing the target company's books, the acquirer must be aware that corruption payments can be disguised as travel and entertainment expenses, sales and marketing costs or even charity donations. Purchasing false receipts in China is known to be easy, so even examining the authenticity of the receipts may be required.

The buyer needs to check whether any shareholders of the target are government officials or indirectly associated with them (i.e. relatives). If so, this would be under the remit of the FCPA and pose a red flag in the due diligence process. Extra attention will need to be given in this case.

Lastly, it is advisable to interview as many key employees as possible (if they are still with the target). It is common for companies in China to maintain poor written records, and so verbal communication may be the only way to obtain useful information. That said, Western buyers may find this process difficult and some employees may be reluctant to disclose information. One has to be sensitive to local practices, such as keeping in mind that many individuals in China do not consider gift-giving while doing business unethical. To get the most out of these meetings, interviewers must at all times maintain good relations with the executives and interviewees, as well as show cultural sensitivity and fairness.

The due diligence process

The next step is to mitigate the potential risks that arise from the findings. This requires answering two questions: how much due diligence is adequate and when a company should walk away from a deal.

A risk-based approach is necessary. Acquirers should request documents and information, assess the target's risks, evaluate its compliance and make a formal judgment. The due diligence team should:

1. Search public records and media coverage on the target company and its key management, as well as third parties including sales agents and main distributors.
2. Analyze the target's financial data, supplier and customer contracts and other major third party agreements.
3. Conduct meetings and interviews with the target company's executives and management in divisions such as finance, legal, compliance, internal audit, sales and operations.
4. Assess the anti-corruption compliance program, internal controls, books and records, and financial reporting policies and procedures. Check, in particular, whether the target company has a culture of enforcing anti-corruption practices and instilling a compliance culture from the top, as well as if it has a sound anti-corruption training program in place.

If any red flags arise during the due diligence process, the acquirer can pursue an internal investigation, voluntarily disclose its findings to the authorities, renegotiate the deal and monitor future compliance.

The acquirer can request the target company to launch a probe so as to determine the actual magnitude of the problem. At this stage, it is common to involve forensic accountants and external counsel to examine records and interview key employees. Upon conclusion of the investigation, the buyer may then decide whether to proceed with or walk away from the deal.

There are no hard and fast rules to when a company should walk away. The acquirers must simply assess the overall situation from both a financial and reputational perspective and exercise good judgment on whether the firm has the capacity and willingness to handle these issues in both the short and long run, and whether the investment is worth it. But if the inside of a fruit is really rotten, it may be wiser to throw it away for a fresher one.

However, if the company still wishes to proceed, the parties would have to determine whether to disclose the violations to the authorities. By doing so and cooperating with the government, penalties can be reduced and future legal liabilities can be avoided.

With these corruption problems out in the open, the acquirer may want to re-open negotiations to settle for the target's “true value,” which will take into account features of the business tainted by these issues.

Aftermath

Once the deal is closed, the company should immediately begin implementing an effective anti-corruption compliance program as well as regular training sessions. More broadly, instilling a top-to-bottom compliance culture is key. Documenting these preventive measures will be helpful for when future misconduct takes place and the authorities come knocking.

Other practical steps may include obtaining anti-corruption representations and warranties within the sales and purchase agreement to protect potential financial losses, and requiring the target company to suspend or terminate agreements or business relationships with external executives, employees or third parties.

The regulatory climate surrounding corruption and bribery has become extremely harsh. Conducting due diligence is of paramount importance for executing a deal, and failing to do so may result in being burdened with high costs and legal liabilities for years to come. Exercising due diligence in unique local markets, like China, also requires a tailored approach where nuances in cross-cultural business practices must be considered.

Johnny K.W. Cheung, Asia General Counsel,
Generali Insurance Group, Hong Kong

Global economic growth, convenient travel and technological evolution has propelled cross-border M&A to new heights as companies look to expand and enter into new markets. And as more deals take place, governments around the world are stepping up to tighten commercial conduct regulations. In Europe alone, an estimated €990 billion is lost in the economy every year due to bribery activities. Global anti-corruption enforcement is at its peak, and it is unlikely to recede any time soon.

The number of investigations under the U.S. Foreign Corrupt Practices Act (FCPA), together with the number of prosecutions and enforcement actions taken by the U.S. Department of Justice (DOJ) and the U.S. Securities & Exchange Commission (SEC), has increased dramatically in recent years. Huge fines are being imposed. Investors have also witnessed the extra-jurisdictional reach of the UK Bribery Act. And, on the other side of the world, China is carrying out a country-wide anti-corruption campaign against so-called “tigers and flies,” or corrupt state officials. The Chinese government is also closely working with foreign countries to recover assets gained from illicit activities.

Anti-corruption is now a standard of general business conduct. It is critical to comply with the strict rules of engagement, especially in high-risk markets like China.

Costs and risks

There are several critical reasons for conducting anti-corruption due diligence when pursuing an M&A deal:

• Any existing contracts of the target company obtained through bribes may be legally unenforceable if discovered, thus impacting future business.
• Discovery of corrupt practices can impact the business model, including changes to customers, suppliers and use of certain third parties.
• Any business obtained illegally may be lost when bribe payments are stopped.
• Internal investigations in connection with regulatory inquiries can require huge expenses and a large amount of time.
• The cost of implementing an anti-corruption program to align standards with regulatory requests and internal compliance objectives can be very high.
• Other risks include potential criminal charges against management who were involved in illegal conduct.
• Negative findings could also hurt the acquirer's reputation and future investment prospects.

The high costs associated with undertaking anti-corruption due diligence may impact the accurate reflection of a deal's “true value”.

For instance, in 2007, after eLandia International Inc. bought Latin Node Inc. for $26.8 million, eLandia discovered many questionable payments and reported its findings to the SEC and DOJ. The investigation revealed a history of about $2.2 million in bribes paid by Latin Node to Yemeni and Honduran government officials. Not long after the closing of the deal, Latin Node became insolvent and eLandia found itself to have overpaid $20.6 million in excess of the fair market value of the net assets acquired from the target, due to the cost of the FCPA investigation, fines and penalties, as well as loss of business.

Another example: General Electric Co. bought InVision Investment Technologies Inc. in late 2004, but the latter was alleged to have violated the FCPA by making improper payments to local distributors and agents in China. InVision voluntarily disclosed this to the authorities and eventually entered into a non-prosecution agreement with the DOJ before GE finished the acquisition and was fined $800,000.

China focus: Extra caution

China has many unique business practices embedded into is culture. There are several important factors to bear in mind so as to conduct due diligence in a proper—and cautious—manner.

Firstly, many local companies tend to have a relatively low awareness, or appreciation, of the importance of an anti-corruption culture, though this has greatly improved since the government's anti-graft campaign began. Secondly, rapid economic growth has led to an unusually high turnover of personnel. With many employees jumping from one company to the next, a large number of firms have failed to keep consistent records. Thirdly, many Chinese companies have several sets of accounting books and maintain weak standards of internal control. It is not uncommon for businesses to hide illegal payments this way.

Another important consideration is the implication of state-owned enterprises (SOEs) in a transaction. It has been estimated that approximately 70 million people in China are employed by SOEs and may be considered “foreign officials” by a literal interpretation of the FCPA.

Practical solutions

It is essential to conduct a risk assessment of the target to identify high-risk areas of concern or even uncover actual corruption violations. Generally speaking, scrutinizing every detail during the due diligence process is key, and if something doesn't look right, it will pay off to go deeper into the investigation so as to avoid future problems and liabilities.

If the target is in a sector belonging to or controlled by the state, it most likely interacts with many levels of government officials or agencies. The employees themselves may even be officials. This should be an important focus during the due diligence process. Any payments made to and through them should be checked to make sure they are “clean,” which can be a daunting task but crucial, nevertheless.

It is important to understand the operational model of the target. For example, does it use SOEs to distribute or act as its agent? Does it pay through third party intermediaries, a channel that involves a high risk of being used for bribery payments?

When analyzing the target company's books, the acquirer must be aware that corruption payments can be disguised as travel and entertainment expenses, sales and marketing costs or even charity donations. Purchasing false receipts in China is known to be easy, so even examining the authenticity of the receipts may be required.

The buyer needs to check whether any shareholders of the target are government officials or indirectly associated with them (i.e. relatives). If so, this would be under the remit of the FCPA and pose a red flag in the due diligence process. Extra attention will need to be given in this case.

Lastly, it is advisable to interview as many key employees as possible (if they are still with the target). It is common for companies in China to maintain poor written records, and so verbal communication may be the only way to obtain useful information. That said, Western buyers may find this process difficult and some employees may be reluctant to disclose information. One has to be sensitive to local practices, such as keeping in mind that many individuals in China do not consider gift-giving while doing business unethical. To get the most out of these meetings, interviewers must at all times maintain good relations with the executives and interviewees, as well as show cultural sensitivity and fairness.

The due diligence process

The next step is to mitigate the potential risks that arise from the findings. This requires answering two questions: how much due diligence is adequate and when a company should walk away from a deal.

A risk-based approach is necessary. Acquirers should request documents and information, assess the target's risks, evaluate its compliance and make a formal judgment. The due diligence team should:

1. Search public records and media coverage on the target company and its key management, as well as third parties including sales agents and main distributors.
2. Analyze the target's financial data, supplier and customer contracts and other major third party agreements.
3. Conduct meetings and interviews with the target company's executives and management in divisions such as finance, legal, compliance, internal audit, sales and operations.
4. Assess the anti-corruption compliance program, internal controls, books and records, and financial reporting policies and procedures. Check, in particular, whether the target company has a culture of enforcing anti-corruption practices and instilling a compliance culture from the top, as well as if it has a sound anti-corruption training program in place.

If any red flags arise during the due diligence process, the acquirer can pursue an internal investigation, voluntarily disclose its findings to the authorities, renegotiate the deal and monitor future compliance.

The acquirer can request the target company to launch a probe so as to determine the actual magnitude of the problem. At this stage, it is common to involve forensic accountants and external counsel to examine records and interview key employees. Upon conclusion of the investigation, the buyer may then decide whether to proceed with or walk away from the deal.

There are no hard and fast rules to when a company should walk away. The acquirers must simply assess the overall situation from both a financial and reputational perspective and exercise good judgment on whether the firm has the capacity and willingness to handle these issues in both the short and long run, and whether the investment is worth it. But if the inside of a fruit is really rotten, it may be wiser to throw it away for a fresher one.

However, if the company still wishes to proceed, the parties would have to determine whether to disclose the violations to the authorities. By doing so and cooperating with the government, penalties can be reduced and future legal liabilities can be avoided.

With these corruption problems out in the open, the acquirer may want to re-open negotiations to settle for the target's “true value,” which will take into account features of the business tainted by these issues.

Aftermath

Once the deal is closed, the company should immediately begin implementing an effective anti-corruption compliance program as well as regular training sessions. More broadly, instilling a top-to-bottom compliance culture is key. Documenting these preventive measures will be helpful for when future misconduct takes place and the authorities come knocking.

Other practical steps may include obtaining anti-corruption representations and warranties within the sales and purchase agreement to protect potential financial losses, and requiring the target company to suspend or terminate agreements or business relationships with external executives, employees or third parties.

The regulatory climate surrounding corruption and bribery has become extremely harsh. Conducting due diligence is of paramount importance for executing a deal, and failing to do so may result in being burdened with high costs and legal liabilities for years to come. Exercising due diligence in unique local markets, like China, also requires a tailored approach where nuances in cross-cultural business practices must be considered.

Johnny K.W. Cheung, Asia General Counsel,
Generali Insurance Group, Hong Kong