The Omega Investors hedge fund likely thought it was going to recognize an enormous return on an investment in a consortium seeking to privatize the Azerbaijan National Oil Company (”SOCAR”). Unbeknownst to Omega Investors (but apparently known by one of its partners who later pleaded guilty to federal criminal charges) the privatization scheme, which ultimately unraveled, hinged on significant cash bribes to Azeri officials allegedly made by the leader of the investment consortium. Francisco Illarramendi, on the other hand, chose to invest for foreign national oil companies, not in them. His hedge fund, MK Capital Management (now revealed to have been a Ponzi scheme), was funded in part through large-scale investments by the pension funds of the Venezuelan National Oil Company (”PDVSA”). It is now alleged, however, that those investments were obtained by making significant bribes to the pension fund manager. The experiences of Omega and Illarremendi highlight the risks of foreign corruption for hedge funds operating in an international financial marketplace and why hedge funds must be aware of the scope and jurisdiction of the U.S. Foreign Corrupt Practices Act (”FCPA”)

Understanding the FCPA

Broadly speaking, the FCPA prohibits corrupt payments to a foreign official (or their family members) for the purpose of obtaining or retaining business. Within this seemingly simple concept, however, are a number of potential pitfalls for the unwary. For example, the law is not limited to cash bribes but extends to any “thing of value” provided to a foreign official with a corrupt intent – from lavish entertainment or gifts to non-business related travel. Additionally, the definition of what constitutes a “foreign official” under the law remains unsettled, with enforcement officials advocating a broad reading of the provision to include not only “traditional” government employees, but also employees of state-owned or controlled entities who, at first glance, may appear to be engaged in private commerce. Finally, the law has an enormous jurisdictional reach. It applies not only to actions taken within the United States, but also to all U.S. “persons” (a broadly defined term that would include nearly all U.S.-based hedge funds) regardless of their physical location, as well as to all U.S. “issuers” – companies who have securities traded on U.S. exchanges.

The FCPA contains civil “books and records” provisions (traditionally enforced by the SEC) and criminal anti-bribery provisions (traditionally enforced by the DOJ), but for many hedge funds their registration status will exempt them from the civil “books and records” provisions of the law. The criminal provisions, however, apply regardless of a fund’s registration status and it is precisely these criminal provisions that present significant risk for hedge fund managers operating in international financial markets. Under the FCPA, each violation of the law may be punished with a $2 million criminal fine for corporate actors, and $100,000 fine and up to five years in prison for individual actors. Multiple corrupt payments made under a single scheme will almost always result in multiple charged counts. For example, a $10,000 bribe paid in five $2,000 increments would be charged as five counts, subjecting an individual to up to a 25 year prison sentence.

Recognizing and Addressing FCPA Risks

As the experiences of Omega and Illarramendi illustrate, there are two main FCPA risk areas for hedge funds – outbound foreign investment and inbound investment from foreign institutional investors. With regards to outbound investments, hedge fund managers must be especially cautious when using local agents or “fixers” to gain access to markets. Under the FCPA, third party agents acting on behalf of a principal can create FCPA liability for the principal, even if the agent is not otherwise subject to the law. Therefore, a corrupt payment by a local agent to, for example, a regulatory official to gain necessary trading or investment licenses could create FCPA liability for the fund manager employing the agent.

Additionally, hedge fund managers accepting inbound investment from foreign institutional investors must understand who (or what) ultimately controls such investors and insure that inbound investment was not obtained through corrupt activity. In some instances it may be obvious where inbound investment is controlled by foreign officials – such as investments made by sovereign wealth funds. Other potential inbound investment, such as from foreign pension funds, may require closer attention to determine whether the investors are state actors and, therefore, whether the investor representatives constitute “foreign officials.”

Despite these risks, the FCPA should not be viewed as a prohibition or impediment to investments and investors in foreign markets. It does, however, counsel in favor of analyzing the risks of foreign corruption and taking appropriate steps to prevent and mitigate liability. Unfortunately, there is no “one size fits all” solution to controlling such risks but, by completing a thorough risk assessment and implementing adequate compliance controls, hedge fund managers can make large strides to ensure they do not run afoul of the law.

The necessary first step is to assess and understand the risk given a fund’s current investment strategies, goals, and processes with regards to both inbound and outbound investment. For example, purely domestic hedge funds, or funds that make only passive foreign investments through well-established foreign exchanges present lower risk profiles than funds engaging in non-exchange traded foreign investments. Likewise, funds that actively recruit investments from foreign sovereign wealth funds face different risks than those focusing on generating investment from high-net worth individuals.

Once a fund’s anti-corruption risk is better understood, tailored anti-corruption compliance and control mechanisms should be put in place. In many cases, such processes need not be created from whole cloth, but can be effectively grafted on to an existing business ethics, anti-fraud, or anti-money laundering program. Such processes will vary but should, at a minimum, include the following general elements:

- A strong “tone at the top” prohibiting corrupt activities;
- Clear written anti-corruption policies applicable to all employees and agents; and
- Training and education of employees regarding corruption risks and anti-corruption policies.

Beyond these general elements, fund managers may also institute specific anti-corruption safeguards for inbound and outbound investments, including:

- Contracting and due diligence guidelines regarding the retention of third party agents, including anti-corruption language for all contracts and, in some cases, training the agent as to the fund’s anti-corruption policies;
- Implementing “know your investor” processes to detect investment directed by foreign officials, regardless of the apparent origin of the investment; and
- Instituting (and enforcing) clear guidelines regarding the type, limit and frequency of entertainment of foreign officials.

Federal enforcement authorities have shown a propensity to undertake industry-wide FCPA “sweeps.” As investigations into insider-trading in hedge funds grows, along with other financial industry investigations, the chance of foreign corruption being uncovered and an industry-wide review of the foreign investment practices of hedge funds increases. Managers that take steps now to understand their FCPA risks and implement strong and comprehensive anti-corruption policies will be much better situated to respond to, and possibly avoid, costly government investigations and intrusions should they occur.

Matthew T. Reinhard is a member at law firm Miller & Chevalier, Chartered

This entry was posted on Thursday, April 19th, 2012 at 12:00 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.