What you don t know can hurt you: Successor Liability Resulting from Inadequate FCPA Due Diligence in M&A Transactions

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1 Litigation March 2009 What you don t know can hurt you: Successor Liability Resulting from Inadequate FCPA Due Diligence in M&A Transactions Last month, Halliburton paid a combined criminal and civil penalty of $579 million, on behalf of itself and its former subsidiary, KBR, to resolve the long-running FCPA investigation into KBR s activities both before and after its acquisition by Halliburton in As reflected in the government pleadings, Halliburton s due diligence at the time of the acquisition missed or ignored several significant red flags relating to KBR s use of overseas agents and the government viewed Halliburton s efforts to implement appropriate controls at its new subsidiary to be inadequate at best. On the other hand, a recent DOJ FCPA Opinion Release issued to Halliburton demonstrates that careful attention to M&A due diligence and post-acquisition implementation of an effective compliance program can help shield a company from successor liability for the acts of a newly acquired business unit and even, in some circumstances, provide a limited grace period for post-acquisition wrongful conduct. Background Unusually for an FCPA matter, the Halliburton/KBR matter had its origins in a corruption investigation overseas. In 2003, the French press reported that a French investigating magistrate had opened an investigation into the activities of a TSKJ, a joint venture originally formed by KBR s predecessor, M.W. Kellogg Co., and several foreign companies. Soon after, Halliburton, then the corporate parent of KBR, disclosed that it was cooperating with U.S. authorities who had opened a similar investigation. As set out in the government s pleadings, the joint venture successfully won four contracts between 1994 and 2004 with an aggregate value of $6 billion to construct liquid natural gas trains for the Bonny Island LNG project in Nigeria. These projects, however, were obtained only after the joint venture met with a succession of senior Nigerian executives and agreed to pay bribes to both senior and mid-level Nigerian officials through two agents one located in the U.K. and the other in Japan. Between 1995 and 2004, the joint venture wired a combined total of $182 million from the joint venture s accounts in the Netherlands to the agents accounts in Japan, Switzerland, and Monaco to pay bribes to Nigerian officials. Halliburton acquired Dressor Industries, and with it M.W. Kellogg Co., in 1998, after the bribery scheme was already in progress, and merged M.W. Kellogg Co. with its existing subsidiary, Brown & Root, to form Kellogg Brown & Root. Eight years later, in 2006, in the midst of the bribery investigations, it spun off KBR through an Initial Public Offering, but agreed to indemnify the new KBR for any FCPA penalties resulting from the investigation to enhance KBR s financial stability and solvency.

2 2 Halliburton s acquisition and subsequent sale of KBR explains the structure of the final disposition, in which the U.S. authorities brought criminal charges against the new KBR and civil charges against both the new KBR and Halliburton itself. The DOJ charged the new KBR, as the successor to the old KBR, with conspiracy and substantive FCPA bribery counts, to which the company pleaded guilty, agreed to pay a $402 million fine (for which Halliburton was liable under the indemnity), and agreed to retain a monitor for a period of three years. The SEC, in turn, charged Halliburton, the issuer between 1998 and 2004, with violating the books and records and internal controls provisions of the FCPA and further charged the new KBR Inc., as the successor of the Halliburton subsidiary, with violation of the FCPA s anti-bribery provisions and with aiding & abetting Halliburton s violations of the accounting provisions of the FCPA. In addition, the SEC required Halliburton to disgorge $177 million in ill-gotten gains. Acquisition Due Diligence The bribery scheme was well underway by the time Halliburton acquired M.W. Kellogg, and the SEC s pleadings clearly state that neither at the time of the acquisition nor later did KBR s officers inform the new owners of the scheme. Nevertheless, the SEC s pleadings detail what it clearly viewed as a pattern of inadequate due diligence and failure to implement adequate internal controls, and it was therefore not inclined to let Halliburton off the hook for acts by its new subsidiary of which it had no apparent knowledge. To begin with, the SEC noted that Halliburton exercised control and supervision over the newly constituted KBR subsidiary, appointed KBR s board of directors, hired and replaced KBR s senior officials, determined salaries, and set performance goals, consolidated KBR s financial statements into its own, and reported KBR s profits to its investors as its own. The SEC noted that Halliburton learned, at the time of the acquisition or soon after, that the joint venture was using an agent in the UK with respect to the Bonny Island contracts and, in fact, Halliburton s attorneys conducted post-acquisition due diligence on the agent. However, although the attorneys learned that the agent s fees were paid to a Gibraltar shell company owned by nominees, they did not learn the identity of the beneficial owners and did not seek to determine how the UK Agent would or could carry out his duties under the consulting contract. Further, they did not check all of the agent s references, some of which, the SEC noted, were false. Finally, the attorneys due diligence findings were, in turn, reviewed by a senior legal officer at Halliburton who knew that the due diligence investigation had failed to learn significant information. Nevertheless, in the face of these substantial red flags, Halliburton approved the continued use of the UK agent by KBR and the joint venture. As a legal proposition, Halliburton had clear books and records liability and internal controls responsibility over KBR, including those business lines that had previously been part of M.W. Kellogg Co. Had it conducted more rigorous due diligence, however, and been more sensitive to the red flags its due diligence lawyers noted but did not pursue, it might have avoided the appearance that it was complicit in M.W. Kellogg s (and later KBR s) wrongdoing and mitigated its eventual liability. Due Diligence on Third Parties The SEC was also critical of Halliburton s existing policies concerning due diligence on agencies, both on paper and in practice. It noted that Halliburton s policies in 1998 required a reasonable under the circumstances due diligence investigation that examined, among other things, the reasonableness of an agent s fees and the culture in which he would be operating. The SEC, however, appeared critical of the fact that Halliburton s policies at the time did not require... any specific description of the agent s duties, or that the agent agree to any accounting or audit of fees received, nor did the policies specify what steps needed to be taken in conducting the investigation. These problems became manifest when KBR sought approval for the joint venture to enter into new

3 3 contracts with the agent with respect to bids for additional projects at Bonny Island. The SEC noted that Halliburton did not even follow its existing policies but instead conducted minimal follow-up due diligence before approving the new contracts. For example, the SEC noted that KBR executives prepared a due diligence document that contained false information concerning the agent s qualifications, yet Halliburton executives approved the new contract without undertaking any independent review or asking any questions. The SEC also noted that Halliburton had no mechanism to test the characterization of contracts entered into by its subsidiaries or joint ventures. Thus, it conducted no due diligence on the Japanese agent because KBR executives effectively hid the true nature of the relationship by identifying the relationship as a services contract rather than an agency. Liability Sticks This matter demonstrates that the government will not allow corporate reorganizations or M&A activity to dilute or extinguish liability. The DOJ brought a criminal action against the new KBR, even though it had been spun off as a new company long after the bribery scheme had ended, had completely new owners who had not profited from the unlawful conduct, and new management which had no apparent involvement in the unlawful conduct. The SEC s decision to charge Halliburton with books and records and internal controls violations is consistent with its approach in previous cases of holding the parent issuer liable for its current or former subsidiary s false books and records and to hold it accountable for not having imposed adequate internal controls at the subsidiary. Although the SEC could have forborne from charging the new KBR, now an issuer in its own right, for its predecessor s role in causing Halliburton s books and records to be inaccurate and in evading Halliburton s internal controls, its decision to bring the civil charges against the new company most likely reflects the seriousness of the allegations in the complaint that KBR executives regularly concealed information from Halliburton and submitted false information that was incorporated into Halliburton s records. Although the company s senior management and ownership may have changed, lower level employees remained and by bringing charges and imposing a monitor (in both the SEC and DOJ settlements), the authorities ensured that the new KBR s compliance program continued to receive sufficient resources and attention. More surprising is the SEC s decision to charge the new KBR with violations of the anti-bribery provisions. Although the DOJ had jurisdiction over KBR as a U.S. company under the FCPA s domestic concern provisions, the SEC s jurisdiction is limited to issuers and their agents. Thus, although KBR is today an issuer, at the time of the bribery scheme it was merely a subsidiary of an issuer, and the SEC was therefore forced to charge it as an agent of Halliburton, a U.S. issuer, acting on Halliburton s behalf. This allegation appears starkly inconsistent with the SEC s own pleading alleging that KBR s executives had not informed Halliburton that the agents had been retained to pay bribes to Nigerian officials. One can only speculate that, by doing so, the SEC felt it was strengthening its claim for disgorgement of the profits from the Bonny Island projects. What Can Be Done? As a legal matter, when one corporation acquires another, it assumes any existing liabilities of that corporation, including liability for unlawful payments, regardless of whether it knows of them. That does not mean, however, that the DOJ or the SEC must take enforcement action against the successor corporation, and it is within their power to reward corporations who perform appropriately rigorous acquisition due diligence. Careful and searching due diligence in the pre-acquisition phase will allow the parties to manage the risk of prosecution if the problems arise and, particularly important to the acquirer, take steps to isolate the problem. For example, when GE discovered a FCPA problem in preacquisition due diligence of InVision, it insisted that the

4 4 company resolve its FCPA problems prior to agreeing to close the transaction. Alternatively, a company may choose to go forward with the transaction but maintain the acquired company as a free-standing corporate entity at least as long as necessary to resolve the FCPA issues, as Johnson Controls did with York International. When all else fails, the acquirer may choose to walk away rather than face uncertainty of future prosecution, as Lockheed did when it terminated its planned acquisition of Titan. Finally, there are probably other cases, not publicized, in which the acquirer discovered problems, quietly dealt with them, and wound up not having to enter into any formal resolution with the government. The government has provided some guidance through a series of FCPA opinions, culminating in a recent opinion issued, as it happens, to Halliburton. In these opinions, the Department has established a pattern (albeit not a binding position) that an acquiring company will not be held liable for pre-acquisition conduct provided it promptly implements a compliance program to prevent post-acquisition conduct, discloses any pre-acquisition conduct it discovers, and cooperates in the government s investigation. Moreover, the DOJ s FCPA opinions suggest that there may be a grace period during which the acquiring company will not be prosecuted for postacquisition conduct provided it is in the process of cleaning house. On the other hand, a new owner that turns a blind eye or fails to expend the necessary time, energy, and money to implement adequate controls will be held liable for such ongoing activity, even activity that takes place very shortly after the transaction closes. In FCPA Opinion Procedure Releases and 03-01, the Department essentially stated that an acquirer (or joint venture partner) that did reasonable due diligence, investigated any problematic transactions, disclosed its concerns to the DOJ and what remedial steps it had or would take, and promised to implement a rigorous compliance program would not be charged for disclosed pre-acquisition conduct. In 2004, in Release 04-02, issued to the new owners of the Vetco Gray companies, the Department provided assurance that it would not prosecute the Vetco Gray companies for disclosed preacquisition conduct in light of the extensive preacquisition joint global compliance review conducted by counsel for the new owners and the prior owners, the guilty pleas of two of the Vetco Gray subsidiaries, and the new owners undertaking to institute a rigorous compliance program, whose scope and elements were described in detail in the Opinion. * In FCPA Opinion Procedure Release 08-02, Halliburton sought an opinion providing it with protection against liability for pre-acquisition conduct and a grace period for post-acquisition conduct in the context of an auction sale where it had no opportunity to conduct any preacquisition due diligence beyond the limited data the seller was willing to post in a data room. The government agreed to grant such protection, but at a high price. In exchange for the safe harbor provided by the FCPA Opinion, Halliburton agreed, assuming it won the auction (which it did not), to provide the Department with a detailed post-acquisition due diligence workplan within 10 days of the closing, retain external counsel and forensic accountants to undertake a comprehensive compliance review of high, medium, and low-risk areas of the new business, report on its findings at set period, and to institute a rigorous compliance program. In exchange, the Department agreed not to bring an enforcement action against the company for disclosed post-acquisition conduct that took place within the first six months after the closing. It is questionable whether the standard set by reflects what is necessary in all cases to invoke a grace period or what was necessary to obtain DOJ s agreement in advance. Halliburton, on the eve of resolving the KBR FCPA investigation, was clearly eager to ensure it was protected from having to endure yet another investigation, and DOJ set a high price on affording it the protection provided by a written Opinion. In most cases, it seems likely that a company that is able to and does conduct reasonable risk-based due diligence in advance of * Unfortunately, however, the Vetco Gray companies failed to honor these commitments and two years later, the companies were prosecuted for wrongful payments made soon after the acquisition.

5 5 the acquisition (something Halliburton was not able to do in the auction described in 08-02), ensures that reasonably rigorous compliance procedures and controls are in place soon after the acquisition, and takes appropriate remedial action immediately upon learning of any issue is likely to be afforded lenient treatment regardless of whether it conducts a forensic compliance review of the sort described in One cautionary note is appropriate, however. All of these transactions involved an acquisition either in whole or in part of another company in which, as a result of the transaction, the company that had engaged in the improper conduct was now owned by new clean owners. In such a circumstance, the government may well be persuaded that it is not fair to the new owners to hold them responsible for acts over which they have no control. In a merger, on the other hand, the old company may be viewed as part-owner of the new company, and the argument of clean hands may not prevail. Conclusion issues. The ultimate resolution of the matter insofar as it concerns Halliburton and KBR, however, demonstrates the critical importance of conducting rigorous due diligence both in the pre-acquisition and post-acquisition period, of adopting rigorous anticorruption internal controls and implementing them in a serious, consistent fashion, and of obtaining not only financial control but effective compliance control over newly acquired subsidiaries. This did not happen in the Halliburton/KBR transaction, and both companies ultimately paid the price. On the other hand, adequate due diligence accompanied by an appropriate sensitivity to corruption red flags may help to shield a company from successor liability for the pre-acquisition acts, and in some circumstances even for some postacquisition acts, of its new possession. Thus, by applying sufficient resources in advance, a company may save itself the considerable expense, distraction, and pain of future investigations and prosecutions. Halliburton s acquisition of KBR was a troubled transaction from its start, and Halliburton s decision to spin it off was probably largely unrelated to the FCPA This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. We would be pleased to provide additional details or advice about specific situations if desired. If you wish to receive more information on the topics covered in this memorandum, you may contact your regular Shearman & Sterling contact person or any of the following: Philip Urofsky Washington, DC purofsky@shearman.com Danforth Newcomb New York dnewcomb@shearman.com Stephen Fishbein New York sfishbein@shearman.com Patrick D. Robbins San Francisco probbins@shearman.com Richard H. Kreindler Frankfurt rkreindler@shearman.com Markus S. Rieder Munich markus.rieder@shearman.com Josanne Rickard London jrickard@shearman.com Robert Treuhold Paris rtreuhold@shearman.com John Savage Singapore / jsavage@shearman.com Andrew Béla Jánszky São Paulo ajanszky@shearman.com 599 LEXINGTON AVENUE NEW YORK NY Shearman & Sterling LLP. As used herein, Shearman & Sterling refers to Shearman & Sterling LLP, a limited liability partnership organized under the laws of the State of Delaware.