International business transactions can be subject to intense scrutiny due to the broad scope of the U.S. Foreign Corrupt Practices Act (FCPA) and the UK Bribery Act, in addition to other similar anti-corruption measures around the world. The risks for private equity investors that can result from corrupt activities of a target company may be significant, especially if the target operates in a high-risk jurisdiction or business sector. These risks can include loss of value of the investment, as well as being held liable for previously unknown wrongful acts committed by the target, its local shareholders or others acting on their behalf. Given the significant penalties that can result from violations of these laws, private equity investors can no longer afford to overlook the risks deriving from potential compliance violations attributable to a target or its shareholders before completing a deal. Further, while this article focuses on violations of anti-corruption provisions, similar considerations generally apply to international trade sanctions regulations.
Private equity investors therefore should consider:
- Thoroughly assessing compliance risks through due diligence;
- Protecting their investment by drafting contractual “shields” for relevant purchase agreements; and
Including post-closing protections in any shareholders’ agreement or other document related to the post-investment operations of the target (collectively, shareholders’ agreements).
Due Diligence and Compliance
In considering the feasibility and opportunity of a private equity deal, it is important to first conduct thorough due diligence to assess anti-corruption compliance risks regarding both the target and its shareholders, in order to:
- Clearly identify and assess the risk exposure of the target and, indirectly, the potential investor;
- Consider the potential financial impact of the due diligence findings on the final transaction, and assess whether such findings may deter the investor from completing the transaction; and
Determine the structuring of the investment and the implementation of contractual measures that may be appropriate to reduce such risks.
In practice, such due diligence should involve assessing the target’s:
- Main shareholders and key managers;
- Contracts with major clients and suppliers;
- Contracts involving public authorities or state-owned enterprises; and
Other activities involving public authorities (such as obtaining permits and regulatory licenses).
Indeed, there is a high risk for the target – and potentially, the investor – to be exposed to prosecution by multiple authorities in different jurisdictions for the violation of anti-corruption laws, especially under the theory of successor liability in which an investor may assume liability for a target’s pre-existing violations of anti-corruption laws. In practice, this means that, in addition to potential liability for corrupt activities conducted by the target post-close, a private equity investor taking control of a target also could be held liable for corrupt activities engaged in by the target prior to the investment if such activities were in violation of the FCPA or other anti-corruption laws at the time they occurred.
It is important to note that the FCPA applies not only to entities incorporated or listed in the United States (and their subsidiaries), but also to any other entity that acts, or causes others to act, in furtherance of prohibited bribery while in the United States or through the use of U.S. interstate commerce. The U.S. Government interprets broadly the interstate commerce requirement in order to assert FCPA jurisdiction over activities conducted by non-U.S. persons outside of the United States, which may have only limited connections to the United States (such as making phone calls or sending emails from the United States in furtherance of a bribery scheme otherwise occurring entirely outside of the United States).
An investor also might be held liable even if:
- The activities were not initially subject to the FCPA, but they continued subsequent to investment by an investor whose activities are subject to the FCPA; or
The corrupt activities ceased prior to investment, but resulted in future or ongoing returns on the investment for the investor post-close.
In principle, successor liability should not create liability under the FCPA – meaning that, if an investor subject to the FCPA acquires a target that was not previously subject to the FCPA, then the mere acquisition does not retroactively create FCPA liability for the investor. However, post-completion of its investment, the investor must take measures to halt any ongoing corruption and implement a compliance program to prevent future potential improper activities.
An investor that fails to investigate or remediate the conduct of a target (including by failing to take measures to implement a compliance program at the target) can be subject to prosecution resulting from the prohibited conduct engaged in by the target. Such liability depends primarily on two related factors:
- The extent to which the investor has control over the operations of the target company or companies engaged in prohibited conduct, and
The level of the investor’s knowledge regarding corrupt activities engaged in by the target before and/or after investment.
Other risks associated with a non-compliant target may include:
- Reputational consequences;
- Erosion of shareholder value due to public enforcement proceedings;
- Shareholder derivative litigation; and
Financial losses relating to a decrease of the target’s value (such as by losing contracts that had been obtained through corrupt means).
Investors must also satisfy any enhanced compliance standards required by their own investors or service providers, in order to mitigate any additional potential liability.
Contractual Safeguards Applicable to the Pre-Closing Period
It can be difficult for an investor to detect potential wrongdoings by the entities or individuals involved in a target’s business. Furthermore, even if acts occurred in the past, they may still be ongoing. Therefore, when drafting contractual safeguards in a purchase agreement, regardless of the level of due diligence conducted, investors should take into account the possibility of corrupt acts in order to reduce exposure to such risks. To do so, investors have a resourceful set of tools to potentially shield themselves against both identified and non-identified risks:
First, representations and warranties offer two distinct functions:
- Furnishing information; and
Providing compensation in the event the information or warranties furnished proves to be wrong.
The scope of the representations and warranties should be broad to protect investors against any wrongdoing committed by or on behalf of the target or its existing shareholders prior to, or in furtherance of, the transaction (such as bribes paid to obtain ongoing contracts with government customers or regulatory approvals necessary for the completion of the investment). To the extent specific risks are identified in due diligence, representations and warranties can be drafted to more precisely cover such issues.
Second, investors can seek protection from identified risks by implementing specific indemnification mechanisms. These indemnities would be activated in case such risks materialize into losses following completion of the investment.
Third, clauses pertaining to material adverse changes and conditions precedent can enable investors to abandon a contemplated investment if corrupt activities are identified before the investment has been completed, while covenants can provide protection with respect to the conduct of business of the target during the interim period between signing and closing.
Contractual Safeguards Applicable to the Post-Closing Period
Investors also may wish to include contractual rights in their shareholders’ agreements to mitigate post-closing compliance risks. These tools should enable investors to have a clear overview of the management, key personnel and compliance program – if corrupt activities occur or are suspected, the investors could be provided with the ability to pull out from their investment or to carve out the affected portion of the business. This could be accomplished by negotiating a call or a put option to be triggered by certain events which may include, but need not be limited to: post-investment discovery of bribery or other prohibited conduct (or credible allegations of same) by the target, or the target’s shareholders and/or managers.
The Management and Compliance Program
Specific contractual protections in the shareholders’ agreements should be designed to enable investors to adequately supervise the management of the target from a compliance standpoint. Investors can also request to have approval of, or input into, the appointment of key managers and compliance/legal personnel at the target level. In practice, the shareholders’ agreements must determine the competent body for the appointment and control of such personnel and clearly list their mission and powers. In addition, investors can seek the ability to easily trigger compliance audits of the target, either on a routine periodic basis or in response to the discovery of potentially-improper behavior. Furthermore, the shareholders’ agreements can require the target to implement (or enhance) a compliance program in a form satisfactory to the investors. These precautions should provide investors with a greater ability to identify and correct potential compliance issues.
A put option may enable the investor to exit the deal upon the post-closing discovery of corrupt activities. Applicable anti-bribery regulations typically would not prohibit investors from receiving the fair market value for their ownership interest in the target. This is the case even where the payment of the sale price is made by one or more persons or entities (including shareholders or managers) that engaged in improper activities.
Concerns could arise in the context of determining “fair market value” for an investor’s stake because the entity’s value might be based, at least in part, on proceeds arising from corrupt activities. This would need to be addressed on a case-by-case basis involving fact-specific analysis. In theory, it should be possible to carve out any proceeds arising from corrupt activities so that a valuation is calculated based solely on the activities of the target that are not under suspicion.
With a call option, an investor could seek to buy out from the target any non-compliant shareholders. There may be a concern that exercising a call would result in an investor paying money to a shareholder that has acted in a manner that violates applicable laws, and that these funds might be used by the recipients to further their corrupt activities. To address this concern, the call may be structured to require the recipient to certify in advance that the proceeds to be received would not be used to conduct additional prohibited acts. While such contractual rights might not be enforceable, they may reduce an investor’s potential liability by demonstrating the investor’s seriousness of purpose and commitment to compliance both to the target’s shareholders and to any enforcement authorities who might review the matter thereafter.
Negotiating put and call options would only be practical if the enforceability of these contractual provisions is available in the target’s jurisdiction. If not, investors may wish to consider investing in a holding company above the target, which could be incorporated in a friendlier jurisdiction for the enforceability of put and call options.
In addition to put and call provisions, investors could also negotiate for the blocking of voting rights, as well as the payment of dividends into an escrow account, as alternatives or interim measures pending the exit of a non-compliant party.
Right to Information regarding Other Shareholders
Finally, an investor should be afforded the right to know the identity of all other shareholders of the target, to assist in a determination of whether the investor might be dealing indirectly with non-compliant or otherwise problematic parties. For that purpose, the shareholders’ agreements should contain provisions enabling the investor to be informed of any change in the shareholdings of its co-investors. This could enable the investor to trigger a put or call option (as described above).
Ultimately, the measures taken to mitigate compliance risks should be tailored to address the specific risks raised by the target at issue. Conducting comprehensive due diligence prior to an investment – particularly for targets operating in high-risk jurisdictions or business sectors – will help inform appropriate contractual protections to include in purchase and shareholders’ agreements.