FCPA enforcement has historically focused on industries such as energy, telecommunications, and defense, where large government contracts, natural resource availability, or other possible business advantages are at stake. Hedge funds’ capital raising and investment activities would appear to be quite different from these businesses, which tend to require direct interaction with government officials in bidding for, negotiating and executing large project or product-based contracts involving, for example, power plant development, hydrocarbon exploration, or the purchasing of planes or military equipment.
However, recent and ongoing developments signal intensifying enforcement, as well as the emergence of new and specific risks for hedge funds as financial activity continues to globalise. Funds that understand these exposures and establish sound anti-corruption programmes may be better equipped to avoid the serious penalties and potential reputational damage resulting from violations of the FCPA and other anti-corruption laws, including the recently enacted UK BriberyAct (UKBA).
The growing fight against corruption
The FCPA contains two primary elements. Its anti-bribery provision makes it illegal to bribe foreign officials to retain or obtain business or otherwise gain a business advantage. The definition of foreign official is broad, and includes officers and employees of non-US governments, political parties, and public international organizations such as the World Bank and the International Monetary Fund. The FCPA specifically prohibits payments to third parties, such as consultants and representatives, “while knowing” that all or part of the payment will be given to a foreign official for an impermissible purpose. Direct knowledge is not necessarily required; disregarding the likelihood that all or part of a payment will be used to influence a foreign official may suffice.
The FCPA’s second provision requires companies to maintain accurate books and records that fairly reflect the underlying transactions. It further requires companies to maintain a system of controls. The UKBA, which became effective in July 2011, has similar and more expansive provisions than the FCPA, including a prohibition on commercial bribery, and imposes potentially unlimited criminal fines and penalties.
Enforcement of the FCPA has increased dramatically in the last decade, both in the number of cases and the severity of penalties. Combined, the US Department of Justice (DOJ) and Securities and Exchange Commission (SEC) initiated six enforcement actions in 2004. In 2010 there were 47, with at least 15 more initiated in 2011.
The trend in penalties for FCPA violations also reflects the government’s seriousness. The largest ever FCPA-related settlement was $800 million in 2008. Eight of the 10 largest settlements occurred in 2010, ranging from $56 million to $400 million.
The threat draws near
The FCPA applies to publicly held US companies registered with the SEC and “domestic concerns.” A domestic concern is any US citizen, resident, or national, as well as any company or subsidiary incorporated in the United States or that has its principal place of business there. The FCPA covers any officer, director, employee, agent, or stockholder of a domestic concern. Accordingly, the FCPA covers virtually all companies and firms doing business in the US, domestic and foreign.
Several factors suggest that hedge funds may be facing greater anti-bribery regulatory scrutiny, including:
Increased focus on financial services
In the past two years, agencies including the SEC, the Financial Industry Regulatory Authority (FINRA) and the New York State Insurance Department have undertaken initiatives to promote compliance with anti-bribery laws.
Looming SEC registration
Beginning in the first quarter of 2012, private fund advisers, including hedge funds, with assets of at least $150 million will be required to register with the SEC under the Dodd-Frank Act. Advisers will have to provide data about their investors, the assets they manage, and potential conflicts of interest.
Globalisation of capital
The universe of investors is expanding as countries around the world industrialise and pursue economic growth. With the financial crisis continuing to constrain investment in developed countries, private fund firms are looking across borders for investors.
Rise of sovereign funds
State-owned or sovereign wealth funds and foreign pension funds have proliferated in the last decade. The linkages between government officials, these funds, and the funds’ investments increase potential exposure to allegations of improper influence in seeking allocations of sovereign wealth funds.
Recent news accounts reinforce the view that authorities are focusing on the financial and investment sectors. In early 2011, the SEC sent letters of inquiry to banks, private equity firms and hedge funds to gather information about their sovereign wealth fund relationships and controls in place to manage and monitor SWF capital solicitations and investments. In a high-profile case in 2010, the SEC investigated whether a joint venture involving a European insurer and a company owned by the insurer paid bribes. As a result, the company is expected to pay between $7 million and $10 million in fines to settle the matter with the SEC.
FCPA and UKBA impact on hedge funds
Why should hedge fund managers be concerned about these developments? Unlike private equity firms, hedge funds don’t usually take significant stakes in companies they invest in or assume management roles; their passive roles would likely reduce their potential liability exposure should one of those companies violate the FCPA or the UKBA.
However, capital raising and relationship management activities may present significant corruption risks. Capital can come from any number of sources, including foreign countries, some of which present a higher risk of government and commercial corruption. Funds’ efforts to secure investments from state-owned or controlled funds, or foreign government pension assets, could be subject to regulatory review if, for example, benefits are provided to foreign officials in the form of lavish entertainment, travel, promises of employment (to friends or relatives) or through other means.
In our experience, hedge funds typically have not focused their compliance efforts on bribery and corruption, thereby potentially compounding their risk in the current regulatory environment. As described below, better understanding where the risk of corrupt payments resides within a firm, and how to most effectively and efficiently monitor such risks, are key considerations in overall compliance programme design and implementation. Currently, anti-corruption programmes maintained under the general compliance umbrella may not address a fund’s specific risks and struggle for appropriate attention.
Knowing the risks
How can hedge funds mitigate potential FCPA and UKBA problems as they engage with foreign investors? A key first step is to recognize signs of potential problems. One obvious red flag is a country that ranks high for corruption on Transparency International’s Corruption Perceptions Index.
Other questions to consider include:
• Has due diligence been performed on foreign business partners to identify potential government connections?
• Has corruption due diligence been performed on the assets and operations the fund is about to acquire?
• Who may be a government official in my dealings?
• What do I know about my agents, consultants, or other third parties?
• Who is the recipient of any monies I am paying in connection with the investment?
Red flags that can indicate potential trouble include:
• Refusal of third parties to provide certifications of compliance with anti-bribery laws;
• Adverse media references or due diligence results;
• Requests for cash payments, unusually high payments or payments sought prior to the execution of the agreed services;
• Payments inconsistent with agent contract terms or requests for payments to someone other than contracting parties (i.e., introduction of third parties to a transaction);
• Payments to offshore accounts;
• Agent relationships with government officials;
• Incomplete/inadequate transaction documentation;
• Lavish gifts and/or entertainment.
One note of special caution: the payment of a bribe is generally an obvious violation. Less clear is whether gifts, entertainment and travel provided to officials and agents may, under the circumstances in which they’re provided, potentially violate the FCPA or UKBA.
Adopting anti-corruption compliance
Hedge funds can adopt a number of practices to help them avoid violations of the FCPA and UKBA, including:
• Establishing clearly articulated compliance policies, standards, and procedures applicable to directors, officers, employees;
• Appointing a compliance chief or equivalent who reports to senior management or the general partner;
• Performing a thorough corruption risk assessment throughout all operations;
• Conducting periodic anti-corruption training and requiring annual compliance certifications from relevant fund personnel and third parties;
• Institute a compliance reporting system and disciplinary processes;
• Maintain a system of internal controls to identify potential corruption schemes and perform audits to ensure that accurate books and records are maintained;
• Monitor compliance with policies and procedures;
• Articulate standards regarding business relationships with reputable partners;
• Conduct pre-retention due diligence and post-retention oversight of agents and business partners;
• Insist on signed contracts with representations, certifications, and independent internal audit rights of agents and business partners.
Don’t be blindsided
A hedge fund lives or dies by its reputation and the returns it produces. It’s not hard to imagine a bribery scandal causing a run on the fund, and ultimately its demise. Hedge funds that understand the requirements of the FCPA and the UKBA, recognize the risk of violations, and implement policies and procedures to maintain a strong culture of compliance can better position themselves to avoid problems and capture opportunities to attract, invest, and realize returns on foreign-invested capital.
Michael E. Brodsky and Kevin Corbett are Senior Managers with Deloitte Financial Advisory Services LLP.
1. United States Department of Justice “Lay-Persons Guide to the FCPA,” http://www.justice.gov/criminal/fraud/fcpa/docs/lay-persons-guide.pdf
2. “Bribery Act 2010” http://www.fco.gov.uk/en/global-issues/conflict-minerals/legally-binding-process/uk-bribery-act
3. “Recent Trends and Patterns in the Enforcement of the Foreign Corrupt Practices Act,” Shearman & Sterling LLP, July 2011.