What Private Equity Needs to Know About the FCPA

These developments appear to signal a new regulatory interest in private equity firms, but it remains unclear how extensively U.S. enforcement authorities will continue to scrutinize the financial services sector. Nevertheless, in light of these developments, private equity firms and hedge funds should consider measures to remain compliant with the FCPA's mandate.

A Few Basics

Private equity firms and hedge funds should understand some basic constructs when it comes to protecting themselves from FCPA liability.

1. A Private Equity Firm Can Face Either Civil or Criminal Liability Under the FCPA

The SEC's jurisdictional reach under the FCPA is typically limited to “issuers” ' any company with securities traded on a U.S. exchange. See 15 U.S.C. ” 78m. However, private equity firms and hedge funds are not immune from FCPA scrutiny simply because they are privately owned or are not traded on public exchanges. The SEC, as well as the DOJ, takes a broad view of agency principles and vicarious liability theories. U.S. enforcement authorities, including the SEC, may have jurisdiction to investigate an American company even though it is not publicly traded. If a privately owned firm invests in a publicly traded company, for example, the SEC may have grounds to initiate an investigation based on violations committed by the investment company. Further, the DOJ's jurisdiction under the FCPA is broader and is not limited to issuers, but includes any business, whether publically traded or not. Thus, any financial organization (even if it is entirely privately owned), and all of its principals or agents, may be within the jurisdiction of the DOJ and possibly the SEC, if their conduct violates the FCPA.

2. Private Equity Funds Face Potential Liability for FCPA Violations Committed by a Foreign Company, Even As a Minority Investor

Private equity firms and hedge funds should be aware that the FCPA is a knowledge-based statute, and any knowledge of wrongdoing can lead to potential liability. In other words, just because a private equity firm has a small interest in a foreign entity that violates the FCPA, the small size of the investment may not shield the private equity firm from a large exposure to liability. This is particularly true because the U.S. investor may benefit from the foreign affiliate's bribery of local officials. Even a 1% investment will be deemed to receive a benefit if the foreign company gains special treatment as a result of bribes or gift giving to foreign officials.

A review of recent prosecutions by the SEC and DOJ makes clear that from the government's perspective, a U.S. company that either knows or has reason to believe that a company in which it invests is engaging in illegal conduct under the FCPA risks potential liability regardless of the level of its ownership stake in the foreign company. If pre-investment due diligence uncovers FCPA violations, or potential violations (“red flags”) by the foreign investment target, private equity investors will not be insulated from FCPA liability simply because they have only taken a minority stake or invested only indirectly, through a fund. In other words, where a U.S. company knew of the potential for illegal conduct by its target company, turned a blind eye, and possibly benefited from that conduct, the size of the investment will likely not be an effective defense to FCPA liability.

In addition, private equity firms must be cautious when placing a representative on the board the investment company. U.S. regulators can impute knowledge of any corrupt practices committed by the foreign company (or one of its agents acting on its behalf) to the board members, and ultimately back to the private equity company itself, regardless of overall investment percentage.

3. Recommended Steps for Private Equity Firms to Ensure Compliance with the FCPA

To defend against potential liability stemming from FCPA violations by a portfolio company, two things are critically important: 1) pre-investment due diligence; and 2) post-investment compliance programs. Private equity investors must make a good faith effort to ensure that investment targets are in compliance with the FCPA, both at the time of the acquisition and on an ongoing basis once the investment has been made. If potential problems are found, and the decision to invest is made, then disclosure to the DOJ and SEC ' with its possible ramifications ' must be considered. See FCPA Opinion Procedure Release 2008-02 (June 13, 2008) (Opinion Release 08-02, obtained by Halliburton, illustrates the DOJ's desire that companies disclose potential FCPA issues and avail themselves of the Opinion Release process). Yet making disclosure decisions has become more complicated because of the enactment of foreign anti-corruption laws, such as the UK Bribery Act. It is often difficult to coordinate settlements where there are concurrent foreign and U.S. investigations.

Best practices dictate that continued post-investment monitoring of the foreign entity be implemented to shield the private equity fund from future liability. While the DOJ and SEC have not released official guidance as to what constitutes appropriate post-investment due diligence, the DOJ's Deferred Prosecution Agreements are illustrative of what measures it considers adequate. In September 2010, the DOJ entered into a deferred prosecution agreement with ABB Ltd., requiring its representatives to sign agreements that include provisions designed specifically to prevent FCPA violations. Among the provisions that the DOJ considered appropriately preventative were “[1] [r]ights to conduct audits of the books and records of the ABB representative ' [2] Anti-corruption representations and undertakings relating to compliance with the anti-corruption laws and regulations ' [3] Rights to terminate [the relationship] as a result of any breach of anti-corruption laws and regulations ' ” United States v. ABB Ltd., Deferred Prosecution Agreement, Attachment D, page 33 (Sept. 29, 2010); see also Deferred Prosecution Agreement between Johnson & Johnson, its subsidiaries, and its operating companies and the United States Department of Justice, Criminal Division, Fraud Section, Attachment D, pages 33-37 (Jan. 14, 2011). Though deferred prosecution agreements are generally not meant to apply to circumstances outside the facts of the cases they govern, they provide valuable insight into what the DOJ considers effective measures to help prevent FCPA violations from occurring within an investment target.

How much influence the minority shareholder can wield over the target company will likely depend on the size and/or importance of the investment and its operational control of the company. Nonetheless, there are certain steps that any private equity investor should take to demonstrate a good-faith effort to promote FCPA compliance.

First, as a condition of the investment, a private equity company should require the foreign company to certify, at least on an annual basis, that it has an anti-corruption policy in place and that it is in fact operating in compliance with the FCPA. Second, as a condition of the investment, private equity firms should be granted access to the books and records of the company, with the right to conduct audits at its discretion. It is important that, once this access is secured, the company actually conducts periodic audits to ensure FCPA compliance. The frequency and rigor of the audit should be guided by the FCPA qualitative “risk factors” associated with the foreign company. If, for example, the company in question is a large, high-revenue entity in an emerging market that competes for numerous government contracts, then more regular and thorough auditing would be expected and recommended.

Third, as a condition of its investment, a private equity firm should be granted the right to terminate its involvement with the company and receive a full refund of its investment should it later discover any violations of the anti-corruption laws by the foreign company.

Fourth, as a condition of its investment, a private equity firm should obtain an agreement that the target company will require any agents or representatives that it hires to: 1) make annual certifications that they are operating in compliance with the FCPA; and 2) make their books and records available upon request by the foreign company. In addition, the foreign company will need to agree to terminate any agent or representative who either fails to comply with this second obligation or whose conduct raises red flags about FCPA compliance.

These requirements are the minimum safeguards that a private equity company should insist on putting in place when investing in a foreign entity. A company's refusal to grant these basic rights and privileges should be considered a red flag requiring reconsideration of the investment decision.

Failure to Ensure FCPA Compliance Can Devalue
The Overall Investment

In addition to the question of potential liability, failure to implement adequate post-investment compliance safeguards could greatly devalue a private equity firm's investment or impair its ability to sell its stake in the foreign company in the future. A potential buyer or investor can be expected to conduct pre-acquisition due diligence and, if adequate FCPA safeguards are not found to be in place, the buyer may balk at the transaction or require a dramatic reduction in price to cover the cost of implementing the safeguards themselves. There is also the risk that if the buyer (or even an internal whistleblower) discovers FCPA violations during its due diligence, it might self-report these violations to the SEC or DOJ.

Further, competitors within the industry or other investors in a foreign company may report funds that they believe are investing in corrupt entities. The government's recent sweep into the pharmaceutical industry was allegedly built on information that Pfizer Inc. and Johnson & Johnson provided about their competitors within the industry. See Christopher Matthews, Pfizer Settlement Offers Window Into Pharmaceutical Industry Probe, The Wall Street Journal, Nov. 21, 2011. Typically, a private equity firm or hedge fund investing in a foreign company will be one among several such investors. Should other investors uncover FCPA violations within the foreign investment company, they are highly incentivized to be the first to report such conduct in order to broker better settlements for themselves or potentially avoid liability altogether.

Conclusion

As private equity firms continue to expand into international transactions, the need for FCPA compliance and understanding also grows. While their investment may be small in relation to the overall deal, the exposure will not be limited by the amount of the investment. Accordingly, to protect their investment and investors, well-conceived compliance programs that are not just “paper programs” are vital.

Jonathan Feld, a member of this newsletter's Board of Editors, is a partner at Katten Muchin Rosenman LLP in Chicago. Scott Resnik is a partner in the firm's New York Office and is Co-Chair of the New York Litigation and Dispute Resolution Department; and Elizabeth Langdale is an associate in the New York Office. They focus their practices on civil and criminal enforcement matters and compliance.

The Foreign Corrupt Practices Act of 1977 (FCPA) has been an enforcement “hot topic” for the U.S. Department of Justice (DOJ) and the U.S. Securities and Exchange Commission (“SEC”). The 35-year-old statute, generally speaking, prohibits U.S. corporations from bribing or otherwise corrupting foreign officials in order to obtain or retain business advantages. In the past, private equity firms and hedge funds have not been subject to the rigorous regulatory scrutiny applied to publically traded companies under the FCPA. However, it appears that this trend may be changing.

In recent years, the DOJ and SEC have begun to examine foreign investments made in emerging markets by private equity firms and hedge funds for possible FCPA violations. In November 2010, the SEC began investigating Europe's largest insurer, Allianz SE, for possible bribery committed by a German printing press company that was majority-owned by Allianz's private equity arm. This inquiry marked the SEC's first FCPA investigation into a private equity fund based on allegations of misconduct by a company in its investment portfolio.

Equally significant, the SEC began scrutinizing hedge funds and private equity funds for FCPA violations in conjunction with their dealings with sovereign wealth funds. It has been reported that the SEC sent inquiry letters to several hedge funds and private equity firms requesting information about their dealings with sovereign wealth funds.

These developments appear to signal a new regulatory interest in private equity firms, but it remains unclear how extensively U.S. enforcement authorities will continue to scrutinize the financial services sector. Nevertheless, in light of these developments, private equity firms and hedge funds should consider measures to remain compliant with the FCPA's mandate.

A Few Basics

Private equity firms and hedge funds should understand some basic constructs when it comes to protecting themselves from FCPA liability.

1. A Private Equity Firm Can Face Either Civil or Criminal Liability Under the FCPA

The SEC's jurisdictional reach under the FCPA is typically limited to “issuers” ' any company with securities traded on a U.S. exchange. See 15 U.S.C. ” 78m. However, private equity firms and hedge funds are not immune from FCPA scrutiny simply because they are privately owned or are not traded on public exchanges. The SEC, as well as the DOJ, takes a broad view of agency principles and vicarious liability theories. U.S. enforcement authorities, including the SEC, may have jurisdiction to investigate an American company even though it is not publicly traded. If a privately owned firm invests in a publicly traded company, for example, the SEC may have grounds to initiate an investigation based on violations committed by the investment company. Further, the DOJ's jurisdiction under the FCPA is broader and is not limited to issuers, but includes any business, whether publically traded or not. Thus, any financial organization (even if it is entirely privately owned), and all of its principals or agents, may be within the jurisdiction of the DOJ and possibly the SEC, if their conduct violates the FCPA.

2. Private Equity Funds Face Potential Liability for FCPA Violations Committed by a Foreign Company, Even As a Minority Investor

Private equity firms and hedge funds should be aware that the FCPA is a knowledge-based statute, and any knowledge of wrongdoing can lead to potential liability. In other words, just because a private equity firm has a small interest in a foreign entity that violates the FCPA, the small size of the investment may not shield the private equity firm from a large exposure to liability. This is particularly true because the U.S. investor may benefit from the foreign affiliate's bribery of local officials. Even a 1% investment will be deemed to receive a benefit if the foreign company gains special treatment as a result of bribes or gift giving to foreign officials.

A review of recent prosecutions by the SEC and DOJ makes clear that from the government's perspective, a U.S. company that either knows or has reason to believe that a company in which it invests is engaging in illegal conduct under the FCPA risks potential liability regardless of the level of its ownership stake in the foreign company. If pre-investment due diligence uncovers FCPA violations, or potential violations (“red flags”) by the foreign investment target, private equity investors will not be insulated from FCPA liability simply because they have only taken a minority stake or invested only indirectly, through a fund. In other words, where a U.S. company knew of the potential for illegal conduct by its target company, turned a blind eye, and possibly benefited from that conduct, the size of the investment will likely not be an effective defense to FCPA liability.

In addition, private equity firms must be cautious when placing a representative on the board the investment company. U.S. regulators can impute knowledge of any corrupt practices committed by the foreign company (or one of its agents acting on its behalf) to the board members, and ultimately back to the private equity company itself, regardless of overall investment percentage.

3. Recommended Steps for Private Equity Firms to Ensure Compliance with the FCPA

To defend against potential liability stemming from FCPA violations by a portfolio company, two things are critically important: 1) pre-investment due diligence; and 2) post-investment compliance programs. Private equity investors must make a good faith effort to ensure that investment targets are in compliance with the FCPA, both at the time of the acquisition and on an ongoing basis once the investment has been made. If potential problems are found, and the decision to invest is made, then disclosure to the DOJ and SEC ' with its possible ramifications ' must be considered. See FCPA Opinion Procedure Release 2008-02 (June 13, 2008) (Opinion Release 08-02, obtained by Halliburton, illustrates the DOJ's desire that companies disclose potential FCPA issues and avail themselves of the Opinion Release process). Yet making disclosure decisions has become more complicated because of the enactment of foreign anti-corruption laws, such as the UK Bribery Act. It is often difficult to coordinate settlements where there are concurrent foreign and U.S. investigations.

Best practices dictate that continued post-investment monitoring of the foreign entity be implemented to shield the private equity fund from future liability. While the DOJ and SEC have not released official guidance as to what constitutes appropriate post-investment due diligence, the DOJ's Deferred Prosecution Agreements are illustrative of what measures it considers adequate. In September 2010, the DOJ entered into a deferred prosecution agreement with ABB Ltd., requiring its representatives to sign agreements that include provisions designed specifically to prevent FCPA violations. Among the provisions that the DOJ considered appropriately preventative were “[1] [r]ights to conduct audits of the books and records of the ABB representative ' [2] Anti-corruption representations and undertakings relating to compliance with the anti-corruption laws and regulations ' [3] Rights to terminate [the relationship] as a result of any breach of anti-corruption laws and regulations ' ” United States v. ABB Ltd., Deferred Prosecution Agreement, Attachment D, page 33 (Sept. 29, 2010); see also Deferred Prosecution Agreement between Johnson & Johnson, its subsidiaries, and its operating companies and the United States Department of Justice, Criminal Division, Fraud Section, Attachment D, pages 33-37 (Jan. 14, 2011). Though deferred prosecution agreements are generally not meant to apply to circumstances outside the facts of the cases they govern, they provide valuable insight into what the DOJ considers effective measures to help prevent FCPA violations from occurring within an investment target.

How much influence the minority shareholder can wield over the target company will likely depend on the size and/or importance of the investment and its operational control of the company. Nonetheless, there are certain steps that any private equity investor should take to demonstrate a good-faith effort to promote FCPA compliance.

First, as a condition of the investment, a private equity company should require the foreign company to certify, at least on an annual basis, that it has an anti-corruption policy in place and that it is in fact operating in compliance with the FCPA. Second, as a condition of the investment, private equity firms should be granted access to the books and records of the company, with the right to conduct audits at its discretion. It is important that, once this access is secured, the company actually conducts periodic audits to ensure FCPA compliance. The frequency and rigor of the audit should be guided by the FCPA qualitative “risk factors” associated with the foreign company. If, for example, the company in question is a large, high-revenue entity in an emerging market that competes for numerous government contracts, then more regular and thorough auditing would be expected and recommended.

Third, as a condition of its investment, a private equity firm should be granted the right to terminate its involvement with the company and receive a full refund of its investment should it later discover any violations of the anti-corruption laws by the foreign company.

Fourth, as a condition of its investment, a private equity firm should obtain an agreement that the target company will require any agents or representatives that it hires to: 1) make annual certifications that they are operating in compliance with the FCPA; and 2) make their books and records available upon request by the foreign company. In addition, the foreign company will need to agree to terminate any agent or representative who either fails to comply with this second obligation or whose conduct raises red flags about FCPA compliance.

These requirements are the minimum safeguards that a private equity company should insist on putting in place when investing in a foreign entity. A company's refusal to grant these basic rights and privileges should be considered a red flag requiring reconsideration of the investment decision.

Failure to Ensure FCPA Compliance Can Devalue
The Overall Investment

In addition to the question of potential liability, failure to implement adequate post-investment compliance safeguards could greatly devalue a private equity firm's investment or impair its ability to sell its stake in the foreign company in the future. A potential buyer or investor can be expected to conduct pre-acquisition due diligence and, if adequate FCPA safeguards are not found to be in place, the buyer may balk at the transaction or require a dramatic reduction in price to cover the cost of implementing the safeguards themselves. There is also the risk that if the buyer (or even an internal whistleblower) discovers FCPA violations during its due diligence, it might self-report these violations to the SEC or DOJ.

Further, competitors within the industry or other investors in a foreign company may report funds that they believe are investing in corrupt entities. The government's recent sweep into the pharmaceutical industry was allegedly built on information that Pfizer Inc. and Johnson & Johnson provided about their competitors within the industry. See Christopher Matthews, Pfizer Settlement Offers Window Into Pharmaceutical Industry Probe, The Wall Street Journal, Nov. 21, 2011. Typically, a private equity firm or hedge fund investing in a foreign company will be one among several such investors. Should other investors uncover FCPA violations within the foreign investment company, they are highly incentivized to be the first to report such conduct in order to broker better settlements for themselves or potentially avoid liability altogether.

Conclusion

As private equity firms continue to expand into international transactions, the need for FCPA compliance and understanding also grows. While their investment may be small in relation to the overall deal, the exposure will not be limited by the amount of the investment. Accordingly, to protect their investment and investors, well-conceived compliance programs that are not just “paper programs” are vital.

Jonathan Feld, a member of this newsletter's Board of Editors, is a partner at Katten Muchin Rosenman LLP in Chicago. Scott Resnik is a partner in the firm's New York Office and is Co-Chair of the New York Litigation and Dispute Resolution Department; and Elizabeth Langdale is an associate in the New York Office. They focus their practices on civil and criminal enforcement matters and compliance.