In recent years, the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have aggressively investigated and enforced both the anti-bribery and accounting provisions of the Foreign Corrupt Practices Act (FCPA). Many of these matters have been the result of “industry sweeps,” which have included the oil and gas, pharmaceutical and medical device, and telecommunication industries.
DOJ and the SEC have also made clear that the banking and finance industry is a high priority for FCPA enforcement. In January 2011, the SEC initiated investigations into bank and private equity firm transactions involving sovereign wealth funds, national pension funds, joint ventures and a private equity firm’s portfolio companies. Although it is unclear whether those investigations remain active, there has yet to be an announcement that the matters have been closed. Moreover, in November 2012, DOJ and the SEC released a lengthy compendium called “A Resource Guide to the U.S. Foreign Corrupt Practices Act,” in which the banking and finance sector was identified as one of the industries that the agencies would focus their investigative efforts.
Not only have enforcement agencies set their priorities on investigating FCPA violations in the banking and finance industry, they have been given the tools to do so. The SEC, for example, has promulgated rules pursuant to the Dodd- Frank Act that facilitate the investigation of potential FCPA violations, both by affording additional protections for whistleblowers and by imposing greater registration and disclosure requirements that make it easier for regulators to learn about the financial details of hedge funds and private equity firms.
Hedge funds and private equity firms should therefore understand and assess the FCPA risks associated with overseas investments and consider taking proactive steps to mitigate such risks. Failure to do so could potentially lead to unwanted consequences, including the hassle of responding to a government investigation, reputational damage, hefty monetary penalties or even jail time for individuals. This advisory discusses some of the pitfalls that hedge fund and private equity managers may confront and provides guidance on how those risks can be minimized.
Brief Synopsis of the FCPA
The FCPA prohibits individuals and companies subject to U.S. jurisdiction from bribing, offering a bribe or promising a bribe to a foreign official for the purpose of influencing an official act in order to obtain or retain business. The FCPA has two components: (1) the anti-bribery provision, which applies to all companies that are traded on a U.S. exchange (“issuers”), or which have U.S. offices (“domestic concerns”), as well as their officers, directors, employees and agents; and (2) the accounting provision, which imposes record-keeping and internal control requirements on issuers and prohibits individuals from falsifying an issuer’s books and records or circumventing a system of internal controls.
Companies and individuals can be held criminally or civilly liable under either component of the FCPA. Penalties can be severe. For each violation, companies can be fined up to $25 million and individuals can be incarcerated for up to 20 years and fined up to $5 million. Other potential penalties include disgorgement of profits and debarment or suspension from doing business with the federal government.
Hedge funds and private equity firms are generally not publicly traded companies and will therefore not be subject to the FCPA’s accounting provision, which applies to issuers. However, there may still be risks under the accounting provision for a hedge fund or private equity arm of an issuer or for investments in portfolio companies that are issuers.
FCPA Risks for Hedge Funds and Private Equity Firms
The primary areas of FCPA risk for hedge funds and private equity firms are: (1) direct liability for violations of the anti-bribery provision; (2) derivative liability for the acts of third-party agents or intermediaries; and (3) liability for the conduct of portfolio companies or joint ventures.
I. Direct Liability for Violation of the Anti-Bribery Provisions
The risk that hedge funds or private equity firms may directly violate the FCPA’s anti-bribery provision has the greatest potential for arising in the context of soliciting foreign investments or in attempting to make investments in foreign companies.
Funds and firms should be aware of the risks involved when currying favor to solicit investments from foreign investors, such as pension funds, large institutional investors and sovereign wealth funds. These large investors may be owned or controlled by foreign governments, departments, agencies or instrumentalities, and DOJ and the SEC may consider employees of these investors to be “foreign officials” for purposes of the FCPA. Gifts, travel, entertainment expenses and commissions made to such employees for the purpose of soliciting new investments or retaining existing investments could therefore constitute a corrupt payment in violation of the FCPA.
For example, former Connecticut hedge fund manager Francisco Illarramendi has been accused in civil complaints that he paid more than $35 million in bribes to the pension fund manager of a Venezuelan state-owned oil company Petróleos de Venezuela, S.A. (PDVSA) in order to induce PDVSA to engage in bond-swap transactions that gave Illarramendi the necessary liquidity to operate a sustained Ponzi scheme. Illarramendi has already pled guilty to federal fraud charges in connection with the Ponzi scheme. It remains to be seen whether the government will also pursue Illarramendi for making corrupt payments to a foreign official under the FCPA. While the Illarramendi case is an extreme example, it highlights the risks that hedge funds may face when soliciting foreign investments. Hedge funds and private equity firms should also be aware of possible FCPA risks when making foreign investments.
It is well known that in countries with higher rates of public corruption—e.g., China, Russia and Brazil—it can be challenging for companies to gain access to business and investment opportunities without working through foreign government officials. Those challenges may be particularly acute in emerging markets, where efforts to curb public corruption are minimal and local government officials may solicit bribes. Faced with these barriers to entry, a hedge fund or private equity firm manager or employee may be tempted to provide a large gift—such as travel, lavish meals, or expensive entertainment—in order to facilitate an investment opportunity.
Although the Resource Guide confirms that items of nominal value, such as cab fare, cups of coffee or reasonable meals are unlikely to ever manifest the level of corrupt intent required to constitute an FCPA violation, larger gifts (e.g., sports cars, fur coats, and other luxury items) or widespread gifts of smaller value could potentially lead to an enforcement action. Hedge funds and private equity firms should be cognizant of these issues when seeking to make investments in high-risk countries and should consider taking steps to ensure that their managers and employees understand and comply with the FCPA anti-bribery provisions.
II. Liability for Acts of Third-Party Agents or Intermediaries
While direct liability for violations of the anti-bribery provision are certainly possible, FCPA risks may be even more likely to arise when a hedge fund or private equity firm hires third-party agents or intermediaries to act on its behalf in foreign countries. In a common scenario, a hedge fund or private equity firm may choose to hire a third-party consultant in a foreign country who has familiarity with the local culture and ties to local government or business leaders necessary to solicit investment from a sovereign wealth fund. While third-party agents can certainly provide legitimate services and access to key decision-makers, hedge funds and private equity funds must be mindful of the potential that such agents may corruptly offer improper gifts, commissions or other items of value to government officials for the purpose of obtaining or retaining business.
Notably, any arrangement involving a third-party agent who receives unusually high commissions or has an ill-defined role as an intermediary should be closely scrutinized for possible FCPA concerns. A hedge fund or private equity firm that enters into an agreement with a third party who eventually makes prohibited payments may be held liable for the conduct of the agent, even if the firm did not have actual knowledge of the corrupt payment. Under the FCPA, “knowledge” of a corrupt payment can exist if a hedge fund or private equity firm employee is found to have been aware of facts suggesting that there was a high probability that an improper payment would be made, offered, or promised by a third-party agent working on behalf of the firm. The Resource Guide has made clear that this broad interpretation of “knowledge” is meant to eliminate the so-called “head-inthe- sand” problem that could otherwise insulate a company or individual from avoiding FCPA liability simply by turning a blind eye or recklessly disregarding red flags. Consequently, hedge funds and private equity firms—as well as their managers and employees—that deliberately ignore red flags involving third-party agents may be liable under the FCPA’s anti-bribery provision just the same as if they had made, offered, or promised the corrupt payment themselves.
III. Liability for Actions of Portfolio Companies or Joint Ventures
Hedge funds and private equity firms could also face liability for the actions of portfolio companies and joint ventures and may inherit liabilities as a successor after acquiring a company. As such, funds and firms must be aware of FCPA risks not only based on their own actions, but also based on the actions of other companies in which they have an interest.
The Resource Guide discusses that traditional agency principles may lead to FCPA liability. Namely, if a company exercises sufficient control over another company, the latter company’s violation of the FCPA could be imputed to the former. A hedge fund or private equity firm that owns more than 50 percent of a portfolio company may thus be liable for the FCPA violations of the portfolio company under traditional agency principles. Even in the absence of a majority ownership interest, if a hedge fund or private equity firm has the practical ability to control a portfolio company — for example, through control of the company’s board of directors — the fund or firm could still be held liable for the actions of the portfolio company. The fund or firm may further be liable for actions of the portfolio company’s employees under the principle of respondeat superior.
Joint ventures pose similar risks for hedge funds and private equity firms. As a practical matter, DOJ and the SEC consider the activities of a joint venture to be imputed to each member irrespective of the members’ ownership stake, as long as the member is found to have had sufficient “knowledge” of the activity (including actual knowledge or reckless disregard). For example, one recent case involved a joint venture of four multinational companies that allegedly bribed Nigerian government officials in order to win a series of liquefied natural gas construction projects. The joint venture partners and their agents were ultimately the subject of FCPA enforcement actions resulting in the imposition of $1.7 billion in civil and criminal sanctions, a criminal plea by one of the joint venture partner’s subsidiaries and criminal pleas by several individuals. Thus, any hedge fund or private equity firm entering into a joint venture should be cognizant of the risk that actions of the joint venture may create potential liability for all members.
Hedge funds and private equity firms may also face FCPA liability when acquiring a new entity under the principle of successor liability. Generally, an acquiring company inherits the legal liabilities of its acquisition. A hedge fund or private equity firm acquiring a company that violated the FCPA prior to acquisition could potentially expose the fund or firm to civil and criminal FCPA liability. Fortunately, hedge funds and private equity firms can take steps to mitigate successor liability, which include conducting pre-acquisition due diligence, implementing a robust FCPA compliance program after the acquisition, conducting a post-acquisition audit and timely alerting the government to any FCPA issues that are uncovered either before or after the acquisition.
Managing FCPA Risks
Given the FCPA risks discussed above and the government’s continued commitment to aggressive enforcement, hedge funds and private equity firms should consider taking proactive steps to minimize their potential liability, particularly when investing overseas. As an initial matter, hedge funds and private equity firms should consider implementing, reviewing, and assessing their own internal FCPA compliance programs. While there is no one-size-fits-all approach, robust FCPA compliance programs may involve some or all of the following components:
- written FCPA compliance policies, standards, and procedures available to all managers and employees of the hedge fund or private equity firm;
- periodic FCPA training for managers and employees of the fund or firm, as well as for portfolio company employees, third-party agents, and business partners;
- a designated and independent chief compliance officer;
- written requirements that require reporting of all actual or suspected FCPA violations;
- an effective reporting structure for misconduct, including a method by which managers and employees (including employees of portfolio companies) can submit anonymous tips;
- a written system of discipline that provides for consequences, up to and including termination, for conduct that violates the FCPA;
- periodic compliance certifications from appropriate managers, employees, third-party agents, and business partners;
- contractual representations and warranties with third-party agents and business partners requiring compliance with all U.S. laws, including the FCPA;
- contracts that allow oversight and audit of the activities of third-party agents and business partners; and
- a compliance monitoring program.
In addition to implementing these measures at the hedge fund or private equity firm itself, FCPA risk assessment and compliance auditing of portfolio companies and joint ventures may also be helpful in managing potential liability. Among the questions to consider in conducting such assessments and audits are:
- Does the company operate in a high-risk industry such as aerospace and defense manufacturing, banking and finance, health care and life sciences, energy, telecommunications or transportation?
- Does the company operate in high-risk countries?
- Does the company have connections with foreign officials?
- Has due diligence been performed on the company and its business partners, agents, and other third parties?
- Does the company require annual certifications from business partners, agents, and other third parties?
- Are there any red flags in the company’s business dealings, such as requests for large commissions, use of unusual off-shore accounts, employment of third-party intermediaries with ill-defined roles, etc.?
- Does the company have past or present FCPA issues?
- Does the company have an effective FCPA compliance program that includes some or all of the elements referenced above?
It is also important to note that FCPA compliance monitoring, both internal and with respect to portfolio companies and joint ventures, must be an ongoing process. As businesses grow and change, new risks may arise, and additional compliance efforts to address those risks may be necessary.
If a hedge fund or private equity firm identifies a possible FCPA violation, whether by one of its own managers, employees or agents or by a portfolio company or joint venture, the fund or firm should consult with counsel. By promptly investigating any potential violations, managers can determine the proper strategic course — which may include consideration of a voluntary self-disclosure — and attempt to minimize, or eliminate altogether, any potential FCPA liability.