It is a well-established practice that companies carry out merger and acquisition (M&A) due diligence using a suite of questions and documentary information requests aimed at establishing legal, financial and reputational risks. However, as enforcement trends in corruption are a relatively recent phenomenon, proper and thorough anti-corruption due diligence is often overlooked.
Global enforcement action for corruption-related offences has reached an all-time high. The US has been leading the way, and it is reported that almost 50% of US corruption-related prosecutions in 2007 were connected to M&A transactions. This increased enforcement trend, not only by US regulators but also by European and other regulators worldwide, is expected to continue for the forseeable future.
Companies contemplating M&A transactions understand the need to avoid acquiring potential legal and financial liabilities with their new company. However, many have not acknowledged the full legal and financial consequences that can flow from failure to conduct adequate pre-acquisition due diligence for corruption. An acquiring company needs to know if there is a ticking time bomb in the target company as early as possible in the process, otherwise it could find itself liable for illegal practices, weaknesses in controls or inaccuracies in books and records. In-house lawyers at purchasing companies should make sure that the company takes steps to safeguard itself and senior executives from criminal prosecution and civil claims.
Do you understand the risks?
- Breaches of anti-corruption legislation or compliance requirements make companies and individuals vulnerable to legal action from prosecutors and litigants.
- New anti-bribery legislation in the UK will introduce a strict liability corporate offence of failing to prevent bribery.
- The threat also comes from overseas law enforcement. For example, the US Department of Justice (DoJ) actively pursues foreign companies and individuals.
- Your company could acquire a tainted and overvalued asset, and inherit either an endemic bribery problem that is costly to rectify (see case study A) or, even worse, a potentially crippling financial penalty.
- Becoming involved in a corruption investigation is hugely disruptive, damaging and costly for those involved.
- The penalties can be severe: large fines, disgorgement of profits, confiscation of assets, public procurement bans, disqualifications, costly compliance monitors and imprisonment for individuals.
- A failure to conduct due diligence can be an aggravating factor, and may lead to higher penalties and prosecutions against a purchaser.
How can you protect your company?
To detect problems during an acquisition, specifically targeted due diligence should be undertaken. Companies must ensure that they assess the complex legal, financial and reputational risks before completion to identify red flags and potential corruption issues. For example, some areas that need careful consideration are:
- business with governments and state-owned organisations;
- operations in sectors or countries where there is a high risk of corruption;
- using high-risk business models, eg conducting business through intermediaries;
- whether there are adequate anti-corruption policies, procedures and training in place;
- high-risk industries, eg defence, life sciences and construction;
- existing reputational issues, allegations or investigations; and
- whether the US authorities might assert jurisdiction over any detected issues under the Foreign Corrupt Practices Act 1977 (as amended).
Case study A: Smith & Nephew (2008)
Smith & Nephew, Europe’s largest medical device maker, acquired a Swiss-based rival manufacturer for £460m. It was only during post-acquisition due diligence that evidence of ‘unacceptable sales practices’ in operations in Greece emerged.
The financial effects were severe. As the facts emerged, the share price plummeted due to concerns about whether the acquisition had been overpriced. Estimates put the value of the drop in revenue due to lost sales at £51m and the drop in profits due to the cost of remedial actions at over £12m.
Case study B: Lockheed Martin (2004)
A proposed $2.2bn acquisition by Lockheed, the global defence company, was abandoned after serious anti-corruption compliance issues were discovered during pre-acquisition due diligence.
Lockheed’s due diligence exercise discovered that the target had paid $2m in bribes and illegal political contributions to the re-election campaign of the president of Benin, made improper payments to agents in various countries, falsified records and invoices, and had serious internal controls deficiencies.
The target company disclosed these matters to the relevant authorities and ultimately paid $28m in penalties for violations of US law, including disgorgement of profits associated with bribes made to government officials in Saudi Arabia and Benin to secure business. It also had to commit to the adoption of a strict compliance programme and external compliance monitoring.
The effective anti-corruption due diligence exercise helped Lockheed to avoid successor liability, and the serious financial and reputation damage that it would have incurred had the acquisition gone ahead.
What happens if you find a problem during due diligence?
As case study B shows, sometimes it is best to pull out of the transaction to avoid attracting successor liability. However, finding corruption problems in a target company does not necessarily mean the end of a deal. Remedial action and early disclosure to the relevant regulator or prosecutor can ensure that the deal proceeds.
In the UK and US, the Serious Fraud Office (SFO) and the DoJ are willing to discuss with the acquiring company any issues discovered within a target to find a way forward. The UK SFO has recently set up a new rulings process. This is an entirely new process in the UK and is still under development. The US has a broadly similar opinion process that enables companies to seek consent to proceed with acquisitions. Such an approach can safeguard the acquiring company against future criminal charges related to activities by the target.
The director of the SFO, Richard Alderman, encourages companies to come forward and discuss any issues. Alderman said:
‘We were told that UK companies seeking to acquire foreign groups sometimes find corruption during the due diligence process. They want to minimise regulatory risk. Our rulings process will enable corporates in those circumstances to ask us about our approach. I want to be able to say that we shall take no action at the corporate level provided that the corporate sorts out the corruption culture in the target company.’
One consequence of this is that, in addition to proper pre-acquisition anti-corruption due diligence, a more thorough review exercise may need to be undertaken after completion. Issues coming to light within a reasonable time frame post-acquisition will be much easier to resolve with the relevant authorities than those that are left to fester.
When corruption is discovered, other connected offences such as fraud, tax evasion and money laundering also often come to the surface, and it may be necessary to make further reports to the relevant authorities. In the UK, an acquiring company may have to make a report to the Serious Organised Crime Agency to safeguard itself and its officers from committing money laundering type offences (that carry maximum penalties of 14 years’ imprisonment).
Discovery of problems at an early stage will give your company a bargaining tool to negotiate a deal that covers the costs of managing and resolving any issues.
Corruption issues carry potentially devastating criminal penalties for companies and individuals, ranging from multimillion-pound fines and confiscation to long terms of imprisonment. There have been too many occasions where companies and individuals have consulted advisers with no experience in this complex area of law, and corruption problems and red flags have been missed. Selecting the right external advisers with the appropriate experience is essential. It is crucial that you obtain advice from regulatory and compliance specialists.
This may mean consulting someone other than your usual corporate advisers, who may have plenty of due diligence experience, but no experience in anti-corruption matters. You need to ensure that the regulatory and compliance specialists you engage can advise on all aspects of global anti-corruption laws, compliance audits, due diligence, compliance obligations, and anti-corruption policies and training. Most importantly, they should be able to demonstrate that they know how the regulators and prosecutors operate, and should have experience in managing disclosure and self-reporting issues. Your legal and financial due diligence must be co-ordinated, and the respective teams should communicate with each other so that no issues slip through the net.
However, it is equally important to remember that anti-corruption due diligence should be tailored to the size of the contract and the extent of the risk. Due diligence does not have to be so extensive that it results in a business relationship or project not being cost effective. The overriding aim of due diligence is a proportionate assessment of the risk to enable a reasoned decision to be made as to whether to proceed with a transaction, make price adjustments, or withdraw. At the end of due diligence you should be able to understand:
- whether there is a high risk of a culture of corruption within the target company;
- how much it would cost to put right any weaknesses in the target company’s policies, procedures and controls; and
- the potential for damage to finances and reputation from any regulatory action and civil claims.
Once armed with the right information and advice you will have a complete picture of the target’s business and have a better understanding of the risks involved in a particular M&A transaction and how to mitigate them.