Divergent diligence? Uncovering M&A anti-corruption risks in Asia Pacific

Mergermarket’s global and regional M&A report indicates that, in respect of the Asia-Pacific region (excluding Japan), there were a total of 1,591 deals worth US$307.4 billion announced during the first half of 2016. A large number of these deals were driven by attractive valuations, industry consolidation and interest in specific sectors (such as semiconductors).

In each of these cases, acquirers would have performed due diligence on targets to assess the risks of the acquisition, plan around these risks and, if appropriate, adjust their valuations.

It is, however, our experience that whilst acquirers in the Asia-Pacific region are familiar with traditional legal, financial and tax due diligence, not all are equally familiar with performing robust anti-bribery and corruption (ABC) due diligence.

Parties to corporate transactions (for example joint ventures, strategic alliances and acquisitions) often perform some level of ABC due diligence on their counterparties. This is for good reason: bribery and corruption extract value from investments, and have the potential to expose parties to regulatory risks, sometimes outside the jurisdiction in which the transaction occurs. Evidently, the siphoning off of significant profits for illicit purposes and the imposition of billion dollar fines fundamentally change the business case for an acquisition and result in reputational damage – in some instances, a party might have been better off aborting the transaction.

The need thus arises to ascertain if counterparties and acquisition targets are in compliance with applicable ABC laws and that there are sufficiently robust internal processes to prevent or, at a minimum, detect and respond to the occurrence of such illicit value-extracting activities. This, in essence, is ABC due diligence.

But what exactly does ABC due diligence entail? And just how much time ought to be spent on this? The answer, as is often the case, is “it depends”. The extent of the ABC due diligence often diverges depending on the risk profile of the transaction and its parties, as well as applicable laws and other compliance requirements.

In our experience, a significant number of parties do not adopt a risk-sensitive approach to ABC due diligence. This is relatively common in deals done in emerging market jurisdictions, including those in the Asia-Pacific region.

Sometimes, ABC due diligence is ticked off the pre-completion checklist simply by asking management to complete an ABC due diligence questionnaire, which is subsequently not thoughtfully considered so as to identify latent risks and implement necessary follow up actions.

This is sometimes supplemented with online internet and media searches. Such searches are useful in retrieving publicly known information about the target and its officers. However, these searches may not be sufficient to identify other latent deficiencies which have yet to come to light, such as poor internal controls and weak oversight. Alternatively, acquirers may rely on a business intelligence report produced by a third party due diligence service provider, focusing on watchlists and sanctions databases. Whilst this is likely to be more useful, depending on the particular risks and facts at hand, a more involved process is often necessary.

In certain instances, there may even be no clear allocation of responsibility for ABC due diligence, and hence this critical compliance issue could remain unattended to despite parties being aware of its importance.

We strongly recommend that parties specifically discuss the following points with their lawyers in relation to ABC due diligence.

Similar to other aspects of diligence, such as financial and legal due diligence, it is important that members of the deal team be specifically tasked with responsibility for ABC due diligence, who would usually be the compliance officer as supported by external specialist counsel.

A clear division of responsibility, while obvious, is not always prioritized when transactions progress at an accelerated pace. We are aware of instances in which ABC due diligence is left out altogether, or carried out far too late in the transaction, neither of which is ideal.

The scope of ABC due diligence would depend on the overall risk profile of the transaction, as well as applicable laws.

The following factors are often considered in calibrating the scope of the ABC due diligence:

• identity and compliance track record of the parties and their respective ownership structures;
• jurisdictions involved;
• nature of business and industries involved;
• degree of government sales and interaction, participation in public tenders and political involvement (if any);
• use of third party intermediaries;
• other results of due diligence (whether legal, financial or otherwise); and
• revenue of target and value of transaction.

Depending on the circumstances, a desktop review may suffice for low-risk transactions, perhaps with more detailed analysis performed post-closing. In other instances, face-to-face interviews with senior management and customer-facing employees may be required, together with a rigorous review of financial records and internal controls.

Where there is sufficient nexus to the US or UK, the extraterritorial application of ABC laws in these jurisdictions such as the Foreign Corrupt Practices Act and the UK Bribery Act ought to be considered as well.

Where parties have internal ABC due diligence guidelines, these ought to be customized and implemented with the purposes of the transaction in mind.

In short, the scope of ABC due diligence ought not to be a one-size-fits-all questionnaire; instead, it should always be thoughtfully tailored with the needs and risks of a party and transaction in mind.

ABC due diligence is traditionally thought of as fulfilling a compliance requirement. However, such diligence can also be used to preserve existing value and potentially create value as well.

For example, a targeted diligence exercise can identify weaknesses in a target’s internal processes. Remedial action may then be taken to prevent ABC risks from materializing, and thereby extracting value from the investment. This preserves value. The cost of the remedial action can be factored into the purchase price. If the weaknesses cannot be remedied, the purchase price can be reduced correspondingly so as to reflect the additional risk that the acquirer will be taking on.

In cases where the acquirer has significantly more bargaining power, the purchase price or part thereof may be paid into an escrow account (instead of being immediately paid to the vendor on the completion date). Post-completion, if lapses or weaknesses in internal controls are identified, such amounts may be deducted from the escrow account and returned to the acquirer.

Less apparent is the advantage that the target’s internal processes may be brought in line with exacting international best practices (and not just domestic standards) using the findings of ABC due diligence. This, in turn, has a positive positioning effect in relation to potential co-investors, private equity investors, sovereign wealth funds and other parties which may be subject to more rigorous ABC compliance requirements (e.g. those imposed by US and UK legislation). To elaborate, such other parties may view the target as a more favourable:

• joint venture partner;
• investment;
• supplier / distributor / other contractual counterparty; and
• acquisition target (if an exit is eventually desired).

This, in turn, creates value by improving the target’s revenue generation potential. In the event an exit is desired, the pool of potential acquirers is also expanded beyond those comfortable with domestic standards (which may lag behind international best practices), and this accordingly means that a higher price may potentially be negotiated for and obtained.

By approaching ABC due diligence thoughtfully, and by asking the right questions, parties can obtain positive outcomes in a manner that preserves and creates commercial value. The above questions, while fairly obvious to most, often remain unasked and hence unanswered, with unintended long-term repercussions. We hope that the above will serve as a useful starting point for parties as they progress ABC due diligence alongside general diligence in their corporate transactions.