Industry May 2014

Compliance-related risks in M&A deals

Co-authored by Catherine E. Palmer.

  • Penalties may be levied if proper analysis is not done
  • UK Bribery Act has broad applications across borders
  • Particular threat for firms that operate in high-risk countries

When considering a transaction involving mergers and acquisitions (M&As), analysing compliance-related risks is often the last thing the parties involved in the deal want to do. Most targets are not keen to air their dirty laundry, nor are most acquirers keen to dig up all of the target’s affairs.

If preliminary due diligence uncovers potentially significant risks, further investigation could be time-consuming, expensive and disruptive.

However, successors and investors could then end up taking on the liabilities of the acquired firm, including its past illegal conduct, which can result in massive fines and criminal penalties. Burying one’s head in the sand is never the right solution, and can make the potential exposure much worse.

Generally, under US law, a successor can end up “buying” the liabilities of the acquired entity, regardless of how the transaction is structured, if (1) there is an explicit or implicit agreement to assume liability; (2) the transaction is a de facto merger; (3) the transaction is a mere continuation of the predecessor’s business; or (4) the transaction is a sham designed to evade liability.

In addition, the European Commission has fined parent companies, including private equity owners, for their subsidiaries’ anti-competitive behaviour, based on the doctrine of parental liability. Thus, at the due diligence stage, it is crucial to conduct a detailed review of a target’s business to adequately understand these risk areas.

These risks may be especially significant if the target does not deal directly with countries that have strict compliance rules.

If the target’s business is primarily in countries where the enforcement of such laws is lax or selective, acquiring such an entity may pose significant risks for an acquirer with substantial ties to countries like the US or the UK.

Even in sophisticated Japanese firms, internal controls and governance structures that would be expected in Anglo-American firms are often lacking, especially if they do not have significant operations outside Asia.

If major issues are discovered during due diligence, or even after the initial closing but before the final price has been set, it may be possible to address the risk through the deal structure or other means.

However, compliance issues are sometimes uncovered only after the deal is concluded and the business has been transferred.

Accordingly, after the transaction is complete, it is often good practice to conduct an overall risk assessment as part of the new operation’s compliance programme, in order to identify and deal with risks quickly.

Major compliance-related risks include the following:

Antitrust/Competition: Violations of antitrust and competition laws, such as fixing prices or allocating markets, or (in some jurisdictions) certain types of information exchanges among competitors, have resulted in massive fines levied by government authorities around the world.

In many jurisdictions, including the UK, the US and Japan, such conduct can also result in criminal prosecutions of individuals.

Bribery/Corruption: Bribery of public officials is a significant risk area, particularly if there is a possibility that conduct may run afoul of the US Foreign Corrupt Practices Act or the UK Bribery Act.

The US government has been particularly aggressive in pursuing non-US (including British and Japanese) firms involved in bribery of foreign public officials, resulting in hundreds of millions of dollars in fines.

The UK Bribery Act also has broad applicability. In addition, accounting irregularities may be red flags for improper payments.

Embargo/Export control: The US government imposes strict restrictions on commercial activities involving countries such as Iran, Cuba and now Russia, which can also apply to non-US firms. Violations of such restrictions can result in substantial penalties, including fines and debarment from government contracts.