Asset managers, foreign investors and the FCPA

With assets totaling trillions of dollars, non-U.S. asset owners, including foreign pension plans and sovereign wealth funds, are fertile ground for investment managers to increase their assets under management. But they could also create unexpected and unwanted exposure to regulatory scrutiny.

In 2011, whistle-blower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act were enacted, creating the incentive for employees to report possible violations of the Foreign Corrupt Practices Act and other instances of fraud and corruption. The act provides for awards of 10% to 30% for reporting violations that result in a fine or penalty exceeding $1 million.

In this environment, it is critical that firms holding or considering investments by foreign investors evaluate these relationships and perform appropriate due diligence on any investments by foreign governments, as well as relationships with those governments' agents.

Over the nearly 35 years the FCPA has been in effect, it has had minimal direct impact on money managers. Instead, FCPA enforcement historically has focused on industries such as energy, telecommunications and defense, where large government contracts, natural resource availability or other possible advantages involving significant sums of money are at stake.

However, with recent changes in the regulatory environment, money managers should take a closer look at the FCPA and other anti-corruption laws such as the U.K. Bribery Act. Recent and ongoing developments signal intensifying enforcement, as well as the emergence of new, specific risks for firms as financial activity continues to globalize.

Direct enforcement is expanding. Both the number of cases and the severity of penalties associated with FCPA enforcement actions across all industries have grown in the past decade. Combined, the Department of Justice and the Securities and Exchange Commission initiated six enforcement actions in 2004. In 2010, there were 47. While new actions abated somewhat in 2011, partly attributable perhaps to the government's focus on several existing cases, there still were 16 new cases brought against corporations and 18 against individual defendants. 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.

Internal vigilance is being encouraged. Historically, the government relied on and rewarded self-reporting of FCPA violations by firms. However, the Dodd-Frank whistle-blower provisions add a strong incentive for employees to report suspected violations, creating a new incentive for companies conducting business overseas, including money management firms, to increase their awareness and fraud prevention efforts. This new environment of scrutiny could result in more proactive investigations leading to a dramatic increase in FCPA enforcement.

Several additional factors suggest that money managers might be a greater focus of FCPA scrutiny:

The rise of state-owned investment funds. Sovereign wealth funds and foreign pension funds have proliferated in the last decade. Their investment resources continue to swell, rising from aggregate assets of $3.98 trillion in 2011 to $4.62 trillion midway through 2012. The inherent linkages between government officials, these funds and the funds' investments might increase the potential for corruption issues to arise.

Increased focus on financial services. In the past two years, agencies including the SEC, the Financial Industry Regulatory Authority and the New York State Department of Financial Services have undertaken initiatives to promote compliance with anti-bribery laws.

Looming SEC registration requirements. Beginning in the first quarter of 2012, private fund managers with assets of at least $150 million were required to register with the SEC under the Dodd-Frank Act. Advisers must provide data about their investors, the assets they manage and potential conflicts of interest. The increased registration requirements for private-fund managers could open the door to increased scrutiny of their dealings with all foreign investors.

FCPA provisions that extend to related entities. An asset management firm's investments in other organizations, such as a controlling interest in a portfolio company that conducts business with a foreign government, could create additional exposure. The controlling firm might be held accountable for the actions of management and staff in those companies.

Why should asset managers be concerned about these developments? Simply put, the very nature of the business makes it an obvious target for anti-corruption investigations. Capital invested with managers can come from a number of sources, including foreign countries, some of which are high-risk venues for illegal activity.

How can investment managers mitigate potential FCPA and UKBA problems as they engage with foreign investors? An important 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 red flags might not be so obvious and might include:

npayments of “finder's fees” to third-party agents;

nrequests for cash payments, unusually high payments or payments sought prior to the execution of the agreed services;

npayments to government officials;

npayments inconsistent with agent contract terms or requests for payments to someone other than contracting parties (i.e., introduction of third parties to a transaction);

nagent relationships with government officials; and

nlavish gifts and/or entertainment.

Firms that understand their exposure, watch more carefully for red-flag situations, and establish sound anti-corruption programs might be better equipped to avoid FCPA and UKBA violations and penalties.

In our experience, money managers typically have not focused a significant amount of their compliance efforts on bribery and corruption, which compounds the risk in the current regulatory environment. Because of this, anti-bribery and anti-corruption programs conducted under the compliance umbrella can struggle for a money manager's attention.

Investment management firms rely heavily on their reputation. Firms that understand the requirements of the FCPA and the UKBA, recognize the risks of violating those requirements, and implement policies and procedures to maintain compliance can better position themselves to avoid problems and capture opportunities to attract, invest and realize returns on foreign government invested capital.

Michael Brodsky is a director in the Boston forensic practice and Rachel Berk is a senior manager in the New York forensic practice of Deloitte Financial Advisory Services LLP.