A reminder about the importance of pre-acquisition and post-completion corruption due diligence
Acquirers should be cautious to ensure that along with the assets of the acquired company, they are not also acquiring liability in the form of penalties and fines for breaches of anti-bribery and corruption laws.
A recent lawsuit commenced by a US company against its former lawyers in this context serves as a reminder of the importance of properly scoped pre-acquisition and post-completion corruption compliance due diligence.
Lawsuit by Watts Water Technologies, Inc
On 6 June 2012, Watts Water Technologies, Inc. (Watts), a publicly listed US company commenced proceedings against its former law firm, Sidley Austin LLP (Sidley Austin), alleging (among other things) professional negligence in relation to the conduct of legal due diligence with respect to the acquisition of a Chinese company (the Proceedings).
Sidley Austin was engaged by Watts in 2004 to perform due diligence on Changsha Valve Works (Changsha), a Chinese target company that Watts was interested in purchasing. During the course of the due diligence, Sidley Austin uncovered a document that indicated that Changsha had a written policy of paying kickbacks to government officials in China to secure government contracts.
The existence of the document was not disclosed to Watts in any of Sidley Austin's due diligence reports or in any other communications between Sidley Austin and Watts. Unaware of the document or its potential implications, Watts paid millions of dollars to purchase Changsha and proceeded to operate the business for several years.
The Sidley Austin partner responsible for the due diligence has subsequently conceded that the document, which violates the US Foreign Corrupt Practices Act (FCPA), was a 'red flag'.
In 2009, Watts implemented anti-corruption and FCPA training for its Chinese subsidiaries, including Changsha. During the course of that training, in-house counsel for Changsha was alerted to the potential FCPA violations and notified Watts' management in the US.
Watts retained outside counsel and forensic accountants to conduct an internal investigation, self-reported the breaches identified to the US Department of Justice (DOJ) and Securities Exchange Commission (SEC) and implemented remedial measures to address the corruption issues identified.
Substantial FCPA penalties imposed
Both the SEC and DOJ investigated the corruption issues reported by Watts. On 13 October 2011, the SEC entered Orders requiring Watts to:
- pay a civil money penalty of US$200,000;
- disgorge profits of US$2,755,815; and
- pay prejudgment interest of US$820,791.
Watts also alleges that it was required to sell Changsha for a substantial loss. By the lawsuit, Watts sought to hold Sidley Austin to account for the loss and damage it alleges it has suffered claiming to be in excess of US$100,000 in damages, plus the costs of the Proceedings and attorneys' fees.
Due diligence best practice
The Watts' lawsuit against Sidley Austin highlights the importance of undertaking thorough pre-acquisition and post-completion corruption compliance due diligence in the M&A context.
The scope of the pre-acquisition due diligence will depend on a variety of factors including the usual considerations such as the amount of available time, the relative bargaining positions of the parties, the amount of money involved and whether or not the buyer has exclusivity.
However, as an exposure to the risk of bribery and corruption penalties has the potential to substantially erode the value of any acquisition, corruption compliance is a critical factor that requires careful consideration. The five essential elements of a corporate compliance program serve as a useful guide in assessing the attention which should be directed to corruption risk:
- Leadership – does the target have a solid foundation of strong ethical values which starts at the top?
- Risk Assessment – does the target have formal processes in place for assessing compliance risks?
- Standards and Controls – does the target have written policies and procedures and are they implemented?
- Training and Communication – does the target have a considered approach to training officers, employees and third parties about anti-corruption measures?
- Monitoring, Auditing and Response – is the target's compliance regime actually implemented, monitored and regularly revised?
If it is not possible to answer all these questions as part of a scoped pre-acquisition due diligence, acquirers should seek advice about the steps that can be taken within the transaction to minimise their potential exposure to corruption risk if they wish to proceed with the acquisition.
Once the transaction has completed, the acquirer should ensure that rigorous and detailed post-transaction due diligence is undertaken in order to:
- promptly undertake any remedial steps required;
- halt any persisting business practices which may present on-going exposure to a breach of anti-bribery and corruption laws;
- maximise its ability to claim under any contractual warranties and indemnities that may have been offered by the vendor as part of the transaction; and
- be in the best position to respond to any inquiries or enforcement steps that may be taken by a regulator.