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Safely navigating the surge of M&A activity: pre-acquisition corruption due diligence - International Law Office

International Law Office

White Collar Crime - USA

Safely navigating the surge of M&A activity: pre-acquisition corruption due diligence

January 24 2011

Introduction
Case study

Suggested due diligence strategy


Introduction

With renewed confidence in the economy and stock prices on the rise, 2011 is likely to usher in a host of mergers and acquisitions. Forbes.com recently proclaimed 2011 as "the year of M&A", projecting a 36% increase in M&A activity from that of 2010.(1)

For companies, the predicted frenzy of M&A activity promises not only growth, but also legal risk. Without appropriate pre-acquisition due diligence, a company looking to acquire a strategic advantage may find that it has also acquired liability under the Foreign Corrupt Practices Act or other anti-corruption laws. Last year was a headline year in Foreign Corrupt Practices Act enforcement and the Department of Justice (DOJ) and Securities and Exchange Commission have promised that 2011 will be no different.(2)

Case study

All too often, Foreign Corrupt Practices Act enforcement actions follow on the heels of M&A transactions. The In re RAE Systems Inc settlement in December 2010 presents a cautionary tale of failed pre-acquisition due diligence.

Between 2004 and 2006, RAE Systems acquired stakes in and formed joint ventures with two Chinese entities whose primary customers were state-owned entities. Before acquiring its interest in the first joint venture, RAE Systems conducted due diligence and learned that the Chinese company's sales force often made improper payments to customers, including government officials.(3) However, one RAE Systems employee noted that to implement a compliance programme and "kill the sales model that has worked for them all these years [was] to kill the JV deal value or hurt sales momentum".(4)

RAE Systems therefore went forward with the acquisition, taking a series of half-measures to stop the bribery, but the bribery continued.(5) RAE Systems did not conduct Foreign Corrupt Practices Act due diligence before acquiring its interest in the second joint venture. The DOJ noted:

"Given RAE Systems's experience with [the first joint venture], the high-risk nature of the location, and the existence of numerous government customers, pre-acquisition corruption-focused due diligence was merited."(6)

Indeed, the joint venture target made improper payments both before and after the acquisition. To resolve the enforcement actions, RAE Systems agreed to pay a $1.7 million criminal penalty, disgorge approximately $1.2 million and enhance its compliance programme.(7)

Suggested due diligence strategy

As the RAE Systems settlement illustrates, pre-acquisition Foreign Corrupt Practices Act due diligence is critical. Companies cannot escape liability under the act by deciding not to conduct diligence in the first instance; nor can they turn a blind eye to unpleasant diligence findings. Moreover, corruption-based due diligence affects the true value of the deal and the scope of compliance-related steps that must be implemented after the deal has been closed.

However, the practical question remains: how should companies conduct pre-acquisition Foreign Corrupt Practices Act due diligence? While there is no 'one size fits all' or box-checking approach to pre-acquisition due diligence, the steps below outline the measures that companies should take as part of the diligence process.

Target risk areas and develop the diligence strategy
Before launching the diligence, companies should consider the particular risks related to the target - by evaluating the climate for corruption in the countries and industries in which the target conducts business - and assess the target's experience and reputation in the region. Next, companies should evaluate the target's existing compliance policies and internal controls. Understanding the proportion of the target's business that could be implicated under the Foreign Corrupt Practices Act is key to crafting a focused and effective due diligence strategy. Companies should then reassess the strategy as new information or red flags emerge.

Gather facts about the business and those involved with it
Fact finding should begin with the identification of key entities and people (eg, subsidiaries and affiliates, management personnel, officers and directors) related to the target. Asking the target to complete a questionnaire is a useful way to capture this information. Next, companies should search publicly available information for indications of connections to government entities and officials or allegations of impropriety, and assess the information and identify topics for discussion or clarification with the target's management.

When interviewing, it is important to select members of the management who can shed light on the target's business model and sales strategy, including:

  • the type, amount and nature of business that the target conducts in foreign countries;
  • any foreign government contacts;
  • the type and volume of third parties used (eg, sales agents, distributors, consultants); and
  • the target's current and past accounting structure.

Interviewing members of the target's management team is extremely useful and gives immediate insight into the issues likely to arise through the due diligence effort. Finally, companies should conduct a detailed review of the target's internal compliance policies and controls. The rigour of internal anti-corruption controls can often set the tone for the level of review needed.

Review red flags and determine whether additional diligence steps are necessary
After completing the initial fact-finding steps, companies should assess whether any potential red flags exist and, if so, determine what additional steps must be taken to resolve them. Appropriate follow-up steps will vary with different circumstances, but may include a second round of interviews, a detailed forensic accounting review or even a targeted review of company emails.

Determine the fate of the deal
Once fact finding has been concluded, the risks associated with the deal should be evaluated. If some of the risks are high, it is important to weigh the potential costs of legal liability with the benefits that the target would bring to the company's business. The risks are not limited to inheriting liability - companies should consider whether it would be possible to terminate improper payments if the deal went forward. In some cases the risks may be high enough to warrant walking away from the deal, where in others a renegotiation of the terms in light of the risks may be more appropriate.

When moving forward with a merger or acquisition despite implications under the Foreign Corrupt Practices Act or corruption risks, companies should alert the government to potential violations, allowing the target to take responsibility. Finally, once the deal closes, companies should take steps to implement an appropriate and comprehensive anti-corruption programme.

For further information on this topic please contact Guy Singer, John Kelly, Anne Elkins Murray or Tracy DeMarco at Fulbright & Jaworski LLP by telephone (+1 202 662 0200), fax (+1 202 662 4643) or email (gsinger@fulbright.com, jkelly@fulbright.com, amurray@fulbright.com or tdemarco@fulbright.com).

Endnotes

(1) Hilary Kramer, "2011 Will Be the Year of M&A", December 28 2010, www.forbes.com/2010/12/22/mergers-acquisitions-business-trend-2011-kramer-intelligent-investing.html.

(2) See, for example, Lanny A Breuer, assistant attorney general, DOJ, 24th National Conference on the Foreign Corrupt Practices Act (November 16 2010), "[W]e are in a new era of FCPA enforcement; and we are here to stay", available at www.justice.gov/criminal/pr/speeches/2010/crm-speech-101116.html.

(3) In re RAE Systems Inc, Non-Prosecution Agreement (December 10 2010), at Appendix A ¶¶ 7-11, available at www.justice.gov/criminal/fraud/fcpa/cases/docs/12-10-10rae-systems.pdf.

(4) Id at Appendix A ¶ 10.

(5) Id at Appendix A ¶ 13.

(6) Id at Appendix A ¶ 14.

(7) See "SEC Files Settled FCPA Case Against RAE Systems Inc", SEC Litig Release 21770, December 10 2010, available at www.sec.gov/litigation/litreleases/2010/lr21770.htm; In re RAE Systems Inc, Non-Prosecution Agreement (December 10 2010) at 2.


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