Managing Acquired Risk: Global expansion is perilous, but integration is the biggest risk of all

Thursday, December 29, 2016 - 16:15

Metropolitan Corporate Counsel wrapped up its 2016 series examining global risk with a fourth roundtable dinner – again co-hosted by Clifford Chance – on November 10 at Marea in New York City. The topic for the finale was how to safely manage the risks that companies take on as they expand internationally.

In total, the 12 companies attending this year’s Risk Dinner Series have combined annual revenues of $250 billion. They represent a broad swath of industries, including pharmaceuticals, energy, transportation, manufacturing, heavy equipment, and consumer and retail goods and services. A precondition for their participation was respect for their anonymity as well as the anonymity of their companies

MCC publisher Kristin Calve and her co-hosts for the series – Clifford Chance partners David DiBari and Guy Norman – opened the evening by thanking the participants for being part of this year's inaugural series. They then turned it over to the evening's subject matter experts, Litigation partner Wendy Wysong and Corporate partner Emma Davies.

Wysong leads Clifford Chance's Asia-Pacific Anti-Corruption practice and splits her time between Hong Kong and Washington, D.C., while Davies heads the firm’s China Corporate and Asia-Pacific Healthcare practices.

They both spoke from firsthand experience in discussing the array of challenges multinationals face when expanding globally.

 “Over the last three years, there has been an increase in the layers of complexity that Emma and I have been dealing with,” Wysong said. She noted that business practices revolving around gifts, hospitality and the roles of third-party intermediaries are cultural incongruities that pose well-known risks under Western laws. Companies have become accustomed to dealing with those risks. The issue now, however, is how to deal with new enforcement authorities in Asia that are being encouraged to crack down on corruption with ever-evolving rules and different perceptions as to what can be tolerated and what is unacceptable corruption.

In China, she explained, authorities are cracking down on corruption, but enforcement varies from region to region and office to office. It also varies depending on the host locale – for example, Hong Kong or the People’s Republic of China – and whether the target of the investigation is local or from the U.S. or the UK.

“There’s no lengthy history of enforcement,” Wysong said. “In some locales, they seem to be making it up as they go along.”

There are also misimpressions about particular countries' perceived level of corruption risk. For example, she warned against "believing in Singapore’s reputation for being free of corruption. In fact, while money may not be used as a bribe, there is no shortage of other favors being exchanged for benefits. Given Singapore's role as a trading and financial hub, it might have a low-risk rating, but you have to assume there’s a lot more going on and remain diligent."

DiBari said that today more than ever the issues facing multinationals are not whether to take a risk but which risk to take, and while those decisions are inherently judgment based, they need to be based on the right information.

“Risks have never been higher or more personal," he said. "It's incumbent upon us and all legal advisors in this space to provide clients with practical and concise assessments of the actual risks and mitigating options, so they can make the informed judgments needed to confidently drive the business.”

Growing Role of Compliance

“People are talking more seriously about compliance review as part of due diligence,” said Davies, who advises companies around the world on mergers and acquisitions across Asia. “Our view is that there should be a separate team engaging on compliance risk distinct from the legal and accounting teams.”

During the due-diligence process, she advises her clients to take three actions to address compliance risk: “Engage a forensic accountant, follow the money and ask tough questions.”

Following the money is time-honored advice, of course, but it can be difficult in practice. Many of the general counsel and compliance officers in attendance indicated that it is standard for target companies to have two sets of books: one that minimizes cash flow for tax reporting and one that maximizes owners’ equity for valuation.

Executives at these prospective acquisitions, according to Davies, are “actually really keen to show the second set of books.”

Still, neither chart of accounts is likely to list bribes to police, gifts to visa officials or free plane rides to other bureaucrats, according to Wysong.

“If they freely show you they have two sets of books, there’s a third,” she said.

Regardless of how willing an acquisition target’s management might seem to share information, bidding companies will encounter any number of obfuscation layers. Speaking specifically about the PRC, Wysong said, “Data rooms are very limited, and the State Secrets Law can prevent disclosure of much documentation before an acquisition occurs.”

Valuating Corruption

"Once an acquiring company has determined the presence and intensity of a target’s corrupt practices, the key question is what to do with that knowledge. Can it be remediated without risk of successor liability, and what will be left of the company value upon ending the bribery on which the business model depends," noted Wysong. “Clients ask, ‘If we clean it up and it turns out all contracts are based on bribes, does [the acquisition] really make sense?’”

Given the financial nature of the question, no one at the table had a direct answer, but it was noted that even if general counsel cannot quantify the downside, they can define it: the cost of bringing practices into home-country legal compliance, plus the risk-adjusted cost of paying fines and settlements.

Moreover, as Wysong explained, there can be no illusions about instantaneous compliance as soon as the target company is acquired and a memo from the purchaser’s GC is promulgated. “Zero-tolerance policies on zero day look good on paper,” she said, “but that threshold may not be possible or sustainable.”

She added that generally regulators and prosecutors understand that it takes some time to understand existing practices and to integrate best practice compliance following an international acquisition. Wysong recommends that the management team be honest with the enforcement agency about the known breaches and the measures being taken to correct them at the consummation of the deal. There is a history at the U.S. Justice Department, for example, for giving a company a certain amount of time to "ramp up." As long as a company can demonstrate its remediation efforts, the enforcement agencies will hold off unless and until that trust is violated repeatedly.

Regulators, in her experience, would rather “see a report in three months about how we cleaned this up,” rather than have the company walk away from a compliance challenge – it is to everyone's benefit to have more compliant companies. And when compliance efforts fail, sometimes "disclosure is a preemptive strike [that prompts] the DOJ to give a pass to the disclosing company.”

But this latitude is subject to the enforcing agency’s own agenda. Wysong pointed out that when U.S. agencies bring in fines or settlements, the funds go into the general treasury, which means that, although performance reviews and bragging rights are spoils in and of themselves, the agencies do not depend directly on these cash flows. In the UK, however, the analogous regulators are funded by fines.

Paper Trails

The issue then becomes how much of the known corrupt practices ought to be documented.

One factor in favor of transparency, according to Wysong, is that “there’s no successor liability if the predecessor was not subject to the [Foreign Corrupt Practices Act] at the time the historic conduct occurred.” Another factor is that the bidding companies are answerable not just to their home-country governments but to anyone with a computer and a cause.

“Leaks can come from [nongovernmental organizations] with a mission, disgruntled employees, whistleblowers, counterparties, perhaps competing governments, or a very talented hacker,” DiBari said. “The combination of the internet and the digitalization of company information has increased the risk of third-party leaks and thus has dramatically altered the disclosure risk calculus.”

Some Assembly Required

The agreement, though, is not the entirety of the acquisition. Integration is by all accounts – and on this point the assemblage was exceptionally vocal – the next critical challenge once the deal is done.

“It’s too lightly treated,” one GC said. Integrations are “typically set up for six months but should be longer.”

“Integration takes longer than 18 months,” said another, “sometimes years.”

Norman observed that follow-through from due diligence is often lacking where a fresh integration team takes over from the deal team. “All the experience from the deal team can get dissipated early in the integration process," he said. “And M&A fails when integration fails.”

“Post-acquisition is when the real due diligence starts,” DiBari noted, necessitating a “verification stage – that’s when you find out what’s actually going on.”

Sometimes the source of that intelligence is a whistleblower. The issue with whistleblowers, according to Wysong, is determining what will cause them to suddenly be more forthcoming.

“I’m not sure how many whistleblowers are motivated by reward,” she said. “Some are fed up [with lingering practices], some have an axe to grind, some are fearful they’ll get in trouble and some are motivated by moral discomfort.”

The disparate interests of individuals have, according to broad consensus at the table, made compliance hotlines a valuable resource for verification, but not a completely reliable one and certainly not a standalone solution.

Wysong recommended "dawn raid" drills to ensure that managers on the ground are prepared to mitigate the likelihood and severity of violations.

Lessons Learned

Wysong had some specific pieces of advice for companies looking to expand into China by acquisition:

  • “Be careful of negotiating too good a deal with the local regulators or police as it could be considered a bribe, depending on whose pocket it goes into."
  • “Chinese prosecutors don’t really need your documents. If they are charging you, they already have everything they need.”
  • “Be humble. Attitude is 90 percent of the case against you.”

 

Davies also had recommendations to the would-be player in China:

  • “Chinese law is based on high-level principle legislation. The power of interpretation devolves to regulators [including antitrust and price-collusion enforcers].”
  • “Government officials will bar your lawyers from meetings. We’re considered an affront. ‘You’re telling me – the regulator – how to interpret my law?’ ”
  • “Work with the government [before you need a favor in return]. Advise on improving safety standards. Assist and support during emergencies.”