Lawyer: Hedge Funds Must Heed Foreign Corrupt Practices Act

Feb 6 2012 | 10:04am ET

What is the Foreign Corrupt Practices act and why should you be concerned about it?  Matthew Reinhard of the Washington, D.C.-based law firm Miller & Chevalier, says FCPA penalties have increased “exponentially” over the past decade and could pose a significant economic risk to investment managers. Reinhard would know—he focuses his practice on white collar crime, internal investigations and complex civil litigation and has conducted internal investigations into allegations of FCPA violations. He spoke to FINalternatives’ recently about the implications of the FCPA for private equity and hedge fund managers.

Why do hedge fund and private equity managers need to think about the FCPA?
There are several reasons why managers need to consider FCPA issues. First, FCPA liability can present a significant economic risk from an investment perspective. The size of FCPA penalties has increased exponentially over the last decade, with resolutions in the tens, or hundreds, of millions of dollars not uncommon. Often, these penalties include disgorgement of profits attributable to the corrupt transaction. Furthermore, there are tremendous costs and expenses in responding to an FCPA investigation. Thus, from an investment risk standpoint, like any other potential liability, managers should consider whether a potential investment presents FCPA risks that, if prosecuted, could significantly diminish the value of the investment.
Second, the FCPA provides for successor liability. Particularly for private equity investors, the purchase of a controlling interest in a company with FCPA liabilities could cause the new owners to become liable for past violations.
Third, the actions of affiliated agents and business partners can create FCPA liability directly for managers. For instance, if a hedge fund manager or private equity group uses foreign agents to help secure an investment in a foreign country, and that agent paid a bribe to a local government official to gain an advantage, the managers may be liable under the FCPA. 
Who enforces the FCPA?
The criminal anti-bribery provisions of the FCPA are enforced by the Department of Justice Fraud Section, based in Washington D.C. In some cases local U.S. Attorneys’ offices may bring FCPA cases, but generally this is done in conjunction, or at least in consultation, with the Fraud Section.
The FCPA also contains certain accounting and books and records provisions that apply to “issuers” (as that term is defined under the securities laws). These provisions are enforced by the Securities and Exchange Commission’s enforcement division.
Generally, hedge funds and private equity funds are not considered “issuers” for purposes of the FCPA (though publicly traded equity groups would be) and are therefore generally not subject to SEC enforcement actions. However, all “U.S. persons” whether or not they are an issuer, are subject to the FCPA’s criminal anti-bribery provisions.
What kind of steps should managers take to reduce their risk under the FCPA?
As with any type of investment, knowledge is power. For passive investments, screening for potential FCPA risk should be integrated into existing due diligence procedures prior to making an investment. Just as an investor would not want to invest in a tech company whose patent may not be valid, investing in a company with lax FCPA controls operating in a high-risk environment could be very risky and ultimately result in a significant diminution—or total loss of—investment.
With more active investments, where the managerial firm is taking a controlling stake in the company, pre-acquisition FCPA due diligence is a must. Such due diligence should include, among other things, a review of the target’s FCPA and compliance controls, interviews with “key” compliance and decision making personnel, and location specific reviews of operations in high-risk environments The discovery of potential FCPA issues during such due diligence need not scupper the deal, but it is important that the potential investor be fully appraised of the risks and have the opportunity to take remedial steps and put in place protections to guard against successor liability.
Finally, hedge and private equity fund managers operating or investing abroad must know their agents and business partners. Potential new foreign partners or agents should be carefully vetted through use of due diligence questionnaires, live interviews, comparison against current government “black lists”, and aggressive checking of references. Moreover, new agents and partners should be trained regarding the FCPA, and certify that they will follow the FCPA (and the manager’s other compliance policies).
What business areas may present especially high risk under the FCPA?
It is not so much the business that creates the risk, but the location of the business. Operations in countries with reputations for corruption—areas such as West Africa, Central and South America, Eastern Europe, Central Asia and Asia-Pacific—must be carefully monitored for FCPA risk. Businesses in such countries that are heavily regulated—where employees and agents will have multiple opportunities to interact with government officials (and where bribes may be solicited or offered)—raise additional red flags. This would include, for instance, companies in the oil and gas, pharmaceutical and medical device, infrastructure and telecommunications industries.
This is not to say that only highly regulated businesses raise risks. In many developing nations where corruption is prevalent even the most mundane processes involve government interactions. It is common to hear stories about having to pay bribes to get electricity turned on, mail delivered or a simple shipment of office supplies cleared into the country. We recommend that managers be familiar with Transparency International’s annual Corruption Perceptions Index, which ranks countries based on the perceived level of corruption. All operations or investments in countries faring poorly on this index should be carefully monitored for FCPA risks.
What if I suspect a bribe has been paid, but I don't know for sure? Can I still be prosecuted?
Yes. The FCPA provides that criminal prosecutions can be brought where there is “actual knowledge” of the corrupt activity. However, the law provides that “knowledge” can be “established if a person is aware that there is a high probability of the existence of” corrupt activity. Thus, one cannot “consciously avoid” learning of a corrupt payment and escape liability under the FCPA.
Indeed, investor and co-founder of the “Dooney & Bourke” handbag line, Frederic Bourke, Jr. was convicted of conspiring to violate the FCPA on precisely such a theory. The Court of Appeals affirmed his conviction finding, among other things, that Bourke’s i) knowledge of the corrupt environment in which he was investing (Azerbaijan); ii) knowledge of the corrupt reputation of the leader of the investment scheme; iii) attempts to insulate his business from FCPA violations by setting up shell companies; and iv) recorded statements musing about whether the investment scheme might be paying bribes, all constituted sufficient evidence that Bourke, while perhaps not having actual knowledge of the bribery scheme, consciously disregarded the high probability that the bribes were being paid to Azeri officials. Bourke has been sentenced to one year and a day in a federal penitentiary and fined $1 million.
Have there been any cases involving hedge funds falling afoul of the FCPA regulations?
former investment advisor for the Omega Advisors hedge fund pled guilty to FCPA-related charges arising from the same scheme Frederic Bourke was involved in. That advisor is cooperating with the prosecutors and awaits sentencing. 
There may be other investigations of funds that are not public. Hedge and private equity funds usually do not have the reporting requirements of public companies, which disclose such investigations in regulatory filings.  Moreover, to protect the integrity of its investigation, the Department of Justice almost never discusses or discloses ongoing investigations. Put another way, we don’t know what we don’t know.
Regardless, the risks associated with investing or acquiring companies with potential FCPA liabilities are very real, and several companies over the last few years have been found liable for earlier corrupt payments made by acquired companies. For instance, this spring Johnson & Johnson paid a $21.4 million criminal FCPA penalty arising from payments made by an acquired subsidiary of Johnson & Johnson in Greece.

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