Assessing Corruption Risk In M&A Transactions

Mini vandePol, Georgie Farrant, Simon De Young and Ryan Hennessey of Baker & McKenzie

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 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).

The law firm 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, the law firm allegedly 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 allegedly not disclosed to Watts in any of the law firm's due diligence reports or in any other communications between Watts and its lawyers. Unaware of the document or its potential implications, Watts alleges that it paid millions of dollars to purchase Changsha and proceeded to operate the business for several years.

The partner of the law firm 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 allegedly 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 has sought to hold its lawyers 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.

The Proceedings are at an early stage and so it is presently unclear to what extent Watts will ultimately succeed with its action against its lawyers.

However what is clear from the Watts' lawsuit is the significance of undertaking thorough pre-acquisition and post-completion corruption compliance due diligence in the M&A context. While it may seem as just another addition to the transaction costs, the failure to make this investment may ultimately result in the erosion of part or the entire value of the deal.

Due diligence best practice

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.

Mini vandePol, Partner,

Mini vandePol is a partner in Baker & McKenzie's Melbourne office and is the head of the Asia Pacific Regional Dispute Resolution Group. Mini is a member of the Firm's Global Compliance Group and has been a partner since 2000.

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Georgie Farrant, Partner,

Georgie Farrant is a partner in Baker & McKenzie's Sydney office and a member of the Australian Dispute Resolution, Compliance, Financial Services and Insolvency practice groups. She also serves as a member of the Firm's Global Anti-Money Laundering and Counter Terrorism Financing Group.

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Simon De Young, Partner,

Simon De Young, a partner in Baker & McKenzie's Melbourne office, has extensive experience in private equity, public and private treaty M&A and equity capital markets transactions. He is a member of the Firm's Global Health, Pharmaceutical & Biotechnology team, and has practiced in Australia and the United Kingdom.

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Ryan Hennessey, Associate,

Ryan Hennessey is a senior associate in the Dispute Resolution and Litigation team at Baker & McKenzie, Melbourne. Ryan has advised both local and international clients in relation to commercial disputes concerning a broad range of issues, insolvency and anti-bribery, and anti-corruption related issues. He also acts on a pro bono basis on behalf of clients of the Homeless Persons' Legal Clinic and patients of the Peter Mac Cancer Centre. Prior to joining the Firm in 2004, Ryan worked at a top-tier accountancy firm focused on insolvency, restructuring and corporate finance. He is a member of a number of professional organizations including the Law Institute of Victoria and the Law Council of Australia.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Baker & McKenzie. This work reflects the law at the time of writing.