Can You Bank on Good Faith Efforts?

Hedge fund managers and anti-bribery and corruption compliance

MIKE BRODSKY and KEVIN CORBETT, DELOITTE FAS LLP
3

Hedge fund managers should recognise that compliance with the US Foreign Corrupt Practices Act’s (FCPA) prohibition against bribing foreign government officials and the UK Bribery Act of 2010 (UKBA) prohibition against commercial bribery is an integral part of an effective compliance programme. Recent actions by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) strongly reflect the necessity for hedge fund managers to have strong anti-bribery and corruption programmes.

As hedge funds are increasingly looking to emerging markets to attract investors and grow assets under management, such opportunity could expose these firms to the risks of violating the FCPA and the UKBA. Additionally, in both 2011 and 2012, the types of businesses facing FCPA enforcement actions by the SEC included financial services firms. While implementing anti-bribery and corruption compliance programmes does not guarantee that a firm will avoid violating such statutes, recent SEC and DOJ actions signal that in levying penalties regulators may reward a firm’s good faith efforts to implement and maintain effective compliance processes.

This article explores the anti-bribery and corruption exposure that hedge fund managers may face and suggests some leading practices that firms may want to incorporate in their existing compliance programmes. Implementing such a compliance programme may decrease the risk of both criminal and monetary penalties, as well as potential reputation damage.

Hedge fund managers in the hot seat
In part, the risk that a hedge fund manager may encounter anti-bribery and corruption risks stems from the very nature of the asset management industry. Asset managers (including hedge funds) are regularly involved in capital-raising activities around the globe, in some cases in conjunction with foreign governments or state-owned enterprises (SOEs).

Such situations can create an exposure for hedge funds whose employees/agents/representatives may be tempted to make gifts, or provide some other type of value to government officials to influence investment or procurement decisions. In addition, extensive regulation and oversight can increase government touch points and the potential for government officials to become attractive targets of illegal activity.

FCPA actions undertaken by the SEC reached a record level in 2011 – a year that was also the second most prolific in terms of combined SEC and DOJ actions.1 The dramatic rise in overall FCPA enforcement in recent years is likely a sign of potential greater exposure for asset managers. The increase follows a significant 2010 reorganisation of the SEC’s Enforcement Division, which, among other changes, established a specialised unit to focus on investigations involving investment advisers, investment companies, hedge funds, and private equity funds.2  

Furthermore, under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, certain advisers must now report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risks to the US financial system. Another rule, adopted by the SEC in late 2011 implementing Sections 404 and 406 of Dodd-Frank, requires SEC-registered investment advisers with at least $150 million in private fund assets under management to periodically file a reporting Form PF to the SEC.3

In early 2011, the SEC sent letters of inquiry to approximately 10 financial services firms requesting information on their dealings with sovereign wealth funds, an act which demonstrated the significance of the US government’s pursuit of these regulations to the financial sector.4 The SEC inquired whether these firms may have violated any FCPA provisions in attracting investments from such funds, since employees of these enterprises may now meet the expansive definition of “foreign government officials”. As hedge funds look overseas for funds, the likelihood they will interact with a sovereign wealth fund increases greatly.

Potential rewards for FCPA preparedness
A 2012 FCPA case involving a global financial services firm may offer an enlightening example of how, in assessing penalties for FCPA violations, the SEC is recognising compliance programmes with anti-corruption controls. In short, the firm’s development of, and commitment to, its FCPA compliance programme positioned it to directly respond to the situation.

In this case, the SEC charged a former executive of the firm with violating the anti-bribery, books and records, and internal control provisions of the FCPA by secretly acquiring real estate investments for himself and an influential foreign official, who in turn steered business to the firm.5  

The firm, however, was able to demonstrate that it had taken FCPA compliance seriously for years. According to the SEC, the firm’s compliance officer specifically informed the executive that employees of the state-owned entity led by the foreign official were government officials for purposes of the FCPA. The executive received at least 35 FCPA compliance reminders, but nonetheless orchestrated a scheme to illegally win business and funnel funds to himself and the official.6

Eventually, the executive agreed to a settlement in which he was permanently barred from the securities industry and ordered to pay disgorgement and relinquish real estate interests.

The firm, on the other hand, was “not charged in the matter,cooperated with the SEC’s inquiry and conducted a thorough internal investigation to determine the scope of the improper payments and other misconduct involved.”7 Its preparedness helped it to avoid fines and penalties, as well as reduce negative publicity.

Crafting an effective anti-bribery and corruption compliance programme
Adopting the following practices in anti-bribery and corruption compliance may help hedge funds lay the groundwork for potential future investigations:

Risk assessment. As noted earlier, hedge funds may not have sufficiently broad compliance programmes because they have not been a prime target of regulation or regulatory enforcement. However, the risks are real, and it is important for fund management to understand them, especially those associated with its business model. A thorough risk assessment can help make developing and carrying out anti-bribery and corruption compliance activities more manageable. For example, using third parties or agents to win new clients or gain business with sovereign wealth funds may be considered an anti-bribery and corruption risk. The risk assessment – possibly involving legal counsel, the compliance department, business development, fund managers, and the audit team – could include analysing firm operations to understand the internal controls environment, identifying government touch points, and uncovering possible schemes and scenarios. The results of the risk assessment can help prioritise remediation of residual corruption risks.

Gap analysis. Once risks are identified, a gap analysis can help a hedge fund determine what types of compliance improvements or mitigation strategies should be adopted. While anti-corruption compliance programmes should be tailored to funds’ particular risks, there can be significant value in benchmarking compliance procedures against industry standard practices to help identify deficiencies and development areas.

Organisational tone. The case of the financial services firm noted above stresses the notion that a strong tone at the top and zero tolerance for deviations may significantly help a company strengthen anti-corruption preparedness, as well as execute appropriate mitigation should issues arise. Delivering clear signals that a firm will not tolerate corrupt behaviour is crucial, even if it means losing business. Furthermore, the anti-corruption provisions of Dodd-Frank and other measures that provide whistleblower bounties can foster a “lottery effect” within the organisation. Having the right tone at the top, along with appropriate messaging from senior leadership, can help employees feel confident that their concerns will be handled appropriately within the organisation, without retribution, rather than going to government officials. Additionally, training employees in the nature and importance of anti-corruption compliance is imperative. Regular communications from firm leaders through emails, speeches, intranet messages, and other contacts can help reinforce that employees who come forward will be supported.

Due diligence. Relationships with third parties may present a substantial risk of bribery and corruption violations for hedge fund managers. In fact, the majority of DOJ enforcement actions in 2011 included violations that involved third parties.8 Conducting due diligence on the organisations and individuals doing business on the firm’s behalf, including background and integrity checks, is a key component of an effective compliance programme.

Monitoring. Hedge funds can enhance their compliance programmes through ongoing and consistent monitoring to identify suspicious relationships and transactions and other red flags in the control environment. Along with maintaining accurate books and records, effective monitoring involves making sure that those records reflect the underlying business transaction.

Increasingly, firms are relying on data analytics to understand the nature and extent of corrupt transactions. Keyword searches and other data analytics tools that monitor third-party payments can help flag suspicious activities. Taking a risk-based approach to compliance can help determine the nature and frequency of analysis required.

An ounce of prevention
The complexities, nuances, and potential regulatory pitfalls of conducting business across national boundaries are growing concerns for hedge funds as they expand into new markets. As recent developments have shown, firms that institute sound anti-bribery and corruption measures, and fully commit to them, can both increase their potential to capitalise on global opportunities, as well as help gain the trust and consideration of regulators should issues arise.

Mike Brodsky is a director and Kevin Corbett is a partner for Deloitte Financial Advisory Services LLP. Both Brodsky and Corbett serve clients throughout the financial services industry, particularly those in hedge fund, mutual fund and private equity sectors.

Footnotes

  1. Shearman & Sterling LLP. “Cases and Review Releases Relating to Bribes to Foreign Officials under the Foreign Corrupt Practices Act of 1977.” FCPA Digest (January 2012).
  2. www.sec.gov/news/press/2010/2010-5.htm
  3. www.sec.gov/news/press/2011/2011-226.htm
  4. Searcey, Dionne, and Randall Smith. “SEC Probes Banks, Buyout Shops Over Dealings With Sovereign Wealth Funds.” Wall Street Journal  14 Jan. 2011.
  5. www.sec.gov/news/press/2012/2012-78.htm
  6. Ibid.
  7. www.sec.gov/news/press/2012/2012-78.htm
  8. www.gibsondunn.com/publications/pages/2011Mid-YearFCPAUpdate.aspx