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06/01/2012
The Foreign Corrupt Practices risk: Understanding the investment risk to hedge funds
It is an unpleasant scenario to contemplate: a hedge fund manager makes a significant investment in a start-up biotech company with a promising patent for the next-generation of anti-viral medications. The patent is sound, the principals of the company are industry veterans with proven track records, and the upside to the investment is potentially enormous.
Shortly after the investment is finalized, rumours start to circulate of a government investigation into the company’s medical trials in West Africa, and the company’s next 10-Q acknowledges a Department of Justice inquiry into possible corrupt payments made to local government officials in the Niger Delta associated with local trials of the new medicine.
New rumours arise that one of the principal researchers at the company authorised corrupt payments and may be individually prosecuted. A few months later the SEC is involved in the investigation as well, and states it intends to seek disgorgement of profits related to sales of the new medicine that can be connected back to the trials in Africa.
Suddenly a once sound investment in a promising company is tanking under the haze of this investigation, the associated legal fees, the threatened multi-million dollar criminal penalties and the incarceration of one of the company’s key personnel. How did things go so wrong? And what could the hedge fund manager have done to anticipate and avoid these risks?
The answer is to include screening for risk under the Foreign Corrupt Practices Act, or “FCPA”, in the course of investment due diligence. Broadly speaking, the FCPA prohibits US persons and issuers from corruptly providing (or offering to provide) anything of value to a foreign government official in order to obtain or retain a business advantage.
The law reaches beyond straightforward cash bribes, and includes other “things of value” such as excessive entertainment, travel, or lavish gifts. The tide of FCPA enforcement has been steadily rising over the last several years, and resolutions of criminal actions against corporations routinely involve multi-million dollar criminal penalties, civil fines, and disgorgement of profits, not to mention the associated costs with responding to government investigations.
A properly structured due diligence process will help screen and identify for such FCPA risks. While the particulars will vary from fund to fund (and the type of investment being contemplated (for instance the due diligence of a passive stock investment will necessarily be a different than undertaking a controlling interest in a company) the goals of FCPA due diligence are always the same: to identify corruption red flags and ensure that the investment target has adequate anti-corruption controls in place in ensure it is not violating the FCPA.
Hedge fund managers should ensure they identify all foreign countries within which the company operates, where and how it interacts with foreign government officials, and the identity of any foreign business partners. Moreover, in most cases, screening for FCPA risk can be integrated into existing due diligence processes and procedures.
Any investment carries risk, but hedge fund managers specialise in weighing and evaluating such risks. In the course of this evaluation, there is no reason not to add the additional data and information that comes with conducting some form of FCPA-due diligence.
The author is a member at law firm Miller & Chevalier
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