Avoiding the “Al Capone” version of an FCPA enforcement action—Are your internal controls in order?

Notorious gangster Al Capone likely was guilty of numerous crimes, including bootlegging, maintaining a house of prostitution, bribery, racketeering and multiple counts of murder.  Yet he was never convicted of those crimes.  He ultimately was convicted of tax evasion and contempt of court in 1930.  Although federal prosecutors were unable to obtain the evidence necessary to convict him for his more well-known crimes, by addressing his failure to maintain accurate books and records (in this case, his tax filings) they were able to send him to jail for 11 years, including a lengthy stint at the notorious Alcatraz Federal Penitentiary.

The United States Government, through the Securities Exchange Commission (“SEC”) or the Department of Justice (“DOJ”), sometimes employs a similar tactic when prosecuting persons engaged in foreign bribery as well as in other violations of federal law.  The most well-known section of the Foreign Corrupt Practices Act (“FCPA”) is the bribery provisions, the primary U.S. law used to prosecute the bribery of foreign government officials.  15 U.S.C. § 78dd-1 et seq.  The bribery provisions prohibit offering to give anything of value to a foreign official with the corrupt intent of gaining an improper business advantage.  Lesser known is the FCPA’s requirement that issuers keep accurate books and records and maintain and devise a system of internal accounting controls.  15 U.S.C. § 78m(b)(2).  These requirements are known as the “accounting provisions” and never mention the word “bribery.”  The accounting provisions only apply to “issuers,” which are generally thought of as those companies listed on U.S. stock exchanges (including their non-U.S. operations and majority-owned subsidiaries).  Because foreign entities sometimes issue their shares on U.S. exchanges, the accounting provisions also can apply to these foreign companies.

Similar to Capone’s tax evasion prosecution, using the FCPA’s accounting provisions allows the Government to prosecute companies even though it may not have the evidence to prove actual bribery of a foreign official.  Similarly, while the anti-bribery provisions outlaw only bribery of foreign government officials, the government can use the accounting provisions to enforce commercial bribery if those bribes are not recorded accurately (and who would record a bribe as a “bribe” in the ledger?).  Perhaps most interesting, however, is that the accounting provisions allow the government to pursue enforcement against companies completely unrelated to bribery.

How does the SEC use the Accounting Provisions?

Charges brought under the FCPA’s accounting provisions are often easier to prove than anti-bribery violations
Prosecutions under the FCPA’s accounting provisions generally focus on instances where companies have concealed bribes in the company’s books by labelling them as “processing fees,” “administrative fees” or even “chocolates” in one case (see below).  Because the bribes are not recorded as what they truly are, the government can allege a books and records violation or an internal controls violation under the accounting provisions.  To prove a books and records violation, the Government merely must show that a company did not keep its books accurately, while to prove an internal controls violation, the Government must show only that a company did not put reasonable accounting controls in place to ensure the company keeps accurate books.  Because the Government is not required to prove materiality, quid pro quo (the corrupt intent of gaining an improper business advantage), or even intent, it is easier for the Government to prove a violation of the accounting provisions than if the same behavior were charged under the FCPA’s anti-bribery provisions.

Such was the case in SEC v. Nature’s Sunshine, where the SEC obtained $600,000 in penalties against a company relating to violations of the FCPA’s accounting provisions.  The SEC alleged Nature’s Sunshine made cash payments to Brazilian customs agents that it recorded in its accounting records as “importation advances,” but which were actually improper payments to allow the import of unregistered products.  Although it cited the bribery as part of the offending behavior, the SEC did not bring charges under the FCPA’s anti-bribery provisions but instead relied upon a books and records violation under the accounting provisions.  By using the accounting provisions, the SEC avoided a potentially difficult prosecution under the anti-bribery provisions that may have required the testimony of foreign nationals as well as proof of intent or materiality.

No Quid Pro Quo
Likewise, the SEC has used the accounting provisions to prosecute cases where it cannot show the company expected to receive anything in return for its payments to government officials.  BHP Billiton paid $25 million to settle the SEC’s allegations the company improperly paid for 60 government officials and employees of government-owned companies and their spouses to attend the 2008 Summer Olympics.  The SEC could not show any quid pro quo in return for the company’s payment of the hospitality costs.  However, it alleged BHP recognized that inviting the officials to the Olympics created a heightened risk of violating anti-corruption laws, yet failed to implement sufficient internal controls to ensure that bribery would not happen.

Potential for Bribery
Along the same lines, the SEC investigated Oracle India Private Limited when Oracle India instructed its distributor to hold back millions of dollars in funds related to certain deals with India’s Ministry of Information Technology and Communications.  Oracle held back $1.7 million from revenue and later authorized invoices for payments to purported third-party vendors, none of which provided any services or were included on Oracle’s approved vendor list.  Although no actual bribery was alleged, the SEC’s complaint alleged that Oracle violated the books and records and internal controls provisions by failing to accurately record the side funds it maintained with its distributors and by failing to maintain sufficient internal controls to prevent the improper use of company funds.  Specifically, the SEC alleged that parking these funds created a risk that the funds would be used for bribery or embezzlement.

Bribery of a Foreign Government
The Government also can use the accounting provisions to pursue companies that bribe foreign governments, rather than foreign officials.  (Remember that the anti-bribery provisions only prohibit paying bribes to a foreign official, not to foreign governments.)  In SEC v. General Electric Company et al, the SEC’s complaint alleged the company paid kickbacks to certain Iraqi government ministries that it characterized as “after sales service fees” on sales of products to Iraq under the Oil for Food Program.  The kickbacks were prohibited by the Oil for Food Program and U.S. trade sanctions on Iraq.  Because the kickbacks were paid to the government, rather than any government official, the kickbacks themselves did not run afoul of the anti-bribery provisions of the FCPA.  However, recording those kickbacks as “after sales service fees” misrepresented what the payments were and, therefore, violated the books and records provisions.  The SEC further claimed that GE’s internal controls failed to provide reasonable assurances that the payments were made with authorization and recorded as necessary to maintain accountability for the company’s assets, thereby violating the internal controls provision.  General Electric agreed to pay $23.4 million to settle the charges.

Non-Bribery Enforcement
What is perhaps even scarier for companies, however, is that the Government has used the FCPA to penalize companies for behavior that has nothing to do with bribery.  After all, the accounting provisions do not mention bribery.  They merely require that companies keep accurate books and maintain sufficient internal controls.

Stein Mart, a large retailer of discount designer clothing, failed to record correctly its pretax income related to inventory.  Stein Mart claimed tax deductions for the discounts it eventually applied to its clothing prior to actually offering the discounts to its customers.  As a result, the SEC charged Stein Mart with violations of the books and records and internal controls provisions.  Stein Mart agreed to pay an $800,000 penalty to resolve the issue.  As is typical, the Government did not disclose any reasons as to why it chose to use the FCPA’s accounting provisions rather than prosecuting the company for misstatements on its SEC filings or even for tax violations.  However, because intent is not required under the accounting provisions, a violation is easier to prove than securities fraud, which requires evidence of intent.

Similarly, the SEC charged MusclePharm Corporation with violations of the accounting provisions related to its failure to accurately record in its books (and disclose in its securities filings) expensive perks paid to its CEO, including $244,000 worth of cars, clothing, meals, golf, and personal services, in addition to its failure to disclose other items, such as private jet use, vehicles and golf membership for its executives.  MusclePharm agreed to pay $700,000 in civil penalties to settle the issue.  Proving that payment of these expenses was fraudulent (which would have required evidence of fraudulent intent) likely would have been much more difficult than simply proving that the payments were not recorded accurately in the company’s books.

A Word about Facilitation Payments

One more word of advice: structure your internal controls to prohibit “facilitating payments.”

Unlike most foreign anti-corruption laws, the FCPA contains an exception for “facilitating (aka facilitation or expediting) payments,” or small bribes to secure the performance of routine government action that does not implicate the discretion of the government official (like a $25 “tip” to get your items through customs faster).  Many companies, on their own, have established a policy against paying facilitating payments for several very valid reasons:

  • Facilitating payments are bribes.  They are always illegal in the country where your employees pay them.  They are also illegal under other foreign bribery laws to which your company may be liable, such as the UK Bribery Act.
  • The definition of a facilitating payment under the FCPA is very narrow and technical, and it is sometimes difficult to determine whether a payment is a permissible (under U.S. law) facilitating payment or an illegal bribe. You do not want to put your employees on the ground in the position of making this difficult legal decision that can have important consequences for your company and potentially your employee.
  • Facilitating payments are financial transactions.  Like any other expense, they have to be recorded accurately in a public company’s books and records to comply with the accounting provisions.  Because the anti-bribery laws of many countries do not recognize an exemption for facilitating payments, accurate recordation of the payment in the company’s books and records, such as a “facilitating payment of $25 to Minister of Interior of Foreign Country to expedite government permit,” will create a record that can be used to prove your company intentionally violated the law of the country where you made the payment (as well as the UK Bribery Act, if that act applies to your company).
  • Allowing facilitating payments can sometimes encourage a culture of corruption—which then can lead employees to make improper payments that would not qualify as facilitating payments.  After Orthofix’s Mexican subsidiary bribed officials at a government-owned health care and social services institution and recorded the bribes (cash, laptops, TVs and appliances) as “chocolates,” Kara Brockmeyer, SEC Enforcement Chief of the FCPA Unit, aptly noted, “once bribery has been likened to a box of chocolates, you know a corruptive culture has permeated your business.”

What about Individuals?

Notably, under the accounting provisions, the SEC also will hold officers, directors and other individuals personally liable for causing the misstatement of the company’s books and records.  These individuals can be found indirectly liable for “causing” the corporations violations, “knowingly” implementing the fraudulent procedures, or “controlling the corporation in a manner that results in an FCPA violation.”  Such was the case in Nature’s Sunshine where the SEC also obtained $25,000 penalties from each of the CEO and CFO for not implementing sufficient internal controls and for allowing the false books and records to be maintained.

In light of the recent Yates memo from the DOJ (see this Featured Article) indicating the DOJ’s intent to hold individuals liable for corporate missteps (both civilly and criminally), individuals in charge of the books and records, as well as those who supervise them, should be especially vigilant in ensuring the company’s internal controls are such that the books are kept accurately.  The DOJ will not hesitate to hold an executive liable for “knowingly” failing to implement a system of internal accounting controls through a “willful blindness” or “conscious disregard” theory.  In addition, because, unlike the anti-bribery provisions the accounting provisions have no “scienter” requirement, even without a “corrupt intent” executives and accounting mangers may be subject to liability under the accounting provisions.

While no compliance procedure is fool-proof, implementing effective internal controls can help ensure your company, your executives, and you do not become the next example of the SEC’s Capone-style enforcement under the accounting provisions.

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