Compliance baggage

An oft overlooked aspect of M&A activity is the compliance history the acquiring company inherits    Acquisitions and mergers are much like human relationships—there’s an excitement about the possibilities of two different parties joining together to create a new, stronger entity.
   But without a clear understanding of each other’s pasts, the new partnership could get off to a rocky start with problems that could take years to resolve.
   Seasoned corporate compliance officers know this reality all too well, as they witness their companies pursue acquisitions or become the acquired. Past compliance errors and penalties can haunt the operational union of two companies for years and the responsibility for cleaning up these messes often rests on the shoulders of those compliance officers in charge.
   “We don’t expect compliance to be a showstopper involving large acquisitions, but at least address those issues before the deal is closed so that you know how to deal with them,” said Dennis Farrell, director of global trade compliance at the semiconductor maker Analog Devices.
   Farrell warned that import and export compliance violations are not merely open and shut cases in the eyes of regulatory enforcement agencies. Yet, many companies still make acquisitions with the belief that the compliance baggage disappears with the former outfit, not fully comprehending that the acquiring firm takes on the “successor liability,” he said.
   Often, companies will set up escrow accounts to pay any government fines or penalties associated with the acquired firms, either realized upfront or discovered downstream.
   “I don’t subscribe to this mentality,” Farrell said. “Who cares if you have the money to pay the fines and penalties? You now own these violations, and you can rest assured that the enforcement agencies will be watching you because of them.”
   When preparing to acquire another firm, Analog Devices uses a questionnaire or checklist as part of its compliance due diligence. This questionnaire is facilitated by the company’s vice president in charge of mergers and acquisitions. Upon receiving the answers back from the questionnaire, the vice president’s office sends those related to compliance activities to Farrell’s office for a thorough review and feedback.
   Mitch Fonda, senior manager of global compliance and stewardship at Waters Corp., a laboratory instrument and software company, said it’s important before any discovery process begins to know what type of acquisition it actually is and to be involved as early as possible. Is the company buying an entire business or just a product line? These questions must further drill into the details, such as where are the company’s products manufactured – domestically or internationally – and who are its customers?
   “You first need to have a clear risk picture before you can perform a clear risk evaluation,” Fonda said. “Just providing checkboxes on a sheet of paper to ‘check the boxes’ is not the way to perform a risk evaluation.”
   Fonda works with Waters’ legal department to provide the correct compliance questions based on the type of acquisition. The legal department then presents those questions to its counterpart at the other company, who in turn passes them along to its designated compliance officer. Once the questions are answered, the cycle is reversed and the compliance-based answers are returned to Fonda for his review.

It’s important before any discovery process begins to know what type of acquisition it actually is and to be involved as early as possible. Is the company buying an entire business or just a product line?

   “We are a trusted partner of legal,” he said.
   For Waters, the initial due diligence questions are actually quite basic. Does the company have a dedicated staff for compliance activities? Does it maintain written compliance procedures? Does the company screen its exports against the Commerce and State department entities and denied parties lists?
   “Just because you’re squeaky clean on paper doesn’t mean you’re squeaky clean in practice,” Fonda said. “You have to ask the mining questions.”
   Fonda refers to these as “mining questions” since the answers that come back can be mined for more information to begin to paint the risk picture, leading to the risk evaluation.
   From the initial round of questions and answers, Fonda is able to generate follow-up, deeper, probing questions, which Waters’ attorneys send back to the other company. At the same time, Waters conducts public records searches to find out if the company being acquired has been subject to recent compliance penalties or other violations.
   “Sometimes you find parties that are hesitant to answer a question,” Fonda said. “However, we have found that most people answer honestly,” though he admitted that “theoretically, if a company wants to bury something, they can bury it.”
   During this question-and-answer process, Fonda looks for key indicators of compliance inconsistences or absences of information that would pose risks after the acquisition. The statute of limitations for U.S. compliance violations is five years from the date of the violation occurring.
   “Voluntary self-disclosures (VSDs) made by the target company to the governing regulatory agencies in the recent past may be an indicator that the target company’s compliance program is deficient and out of control,” Fonda said.
   Other “red flags” may include a company being listed on one of the U.S. government’s denied party lists, or if it had itself recently come off one of these lists. Another red flag would be if the company is located overseas and has a significant customer base in Iran or China.
   “As a company, you need to make sure you screen against all of the denied parties lists,” Fonda said. “If you’re not checking them constantly, how do you know if someone that they have hired or shipped to is on a denied party list?
   “The most egregious thing is to hear a company say ‘we don’t do any restricted party lists checks.’ That would point to a potential serious risk.”
   And just because a prospective acquisition involves a small company doesn’t make it any easier for the export compliance officer conducting due diligence.

Just because you’re squeaky clean on paper doesn’t mean you’re squeaky clean in practice.

   “Small companies may be completely clueless with how they handle their exporting,” Farrell said. “A lawyer for a small company may dismissively say to me, ‘we just ship samples,’ or ‘we only deal in intellectual property (IP), we do not ship products.’ Well, these types of shipments can still qualify as technology that’s controlled. Nothing involving exports is ever a small matter.”
   Farrell said it’s not uncommon for many small companies to acknowledge that they place their exports in the hands of express couriers or freight forwarders to manage, not even worrying about the compliance obligations.
   One of the biggest frustrations for any export compliance officer, Farrell said, is not being included in the acquisition process early enough.
   “Most compliance officers get the information later than they would like,” he said. “We would all like to have more time. If we have the time we are able to talk to the compliance staff in the other company to understand them better.”
   There’s an inherent difficulty, however, with obtaining knowledge of past or potential compliance violations during the early phase of an acquisition or merger process.
   “What very often occurs is the acquiring company does not engage its compliance organization – both export and import – to conduct a comprehensive compliance audit prior to completing the merger or acquisition,” said Paul DiVecchio, principal of 35-year-old export compliance consultancy DiVecchio & Associates. “The concern by publically traded companies is to minimize the number of personnel that have access to knowledge of the potential merger or acquisition, and thus the executives exclude the compliance organization from participating in the due diligence review.”
   Freight forwarders and customs brokers run into similar compliance due diligence problems as their exporter and importer customers do when it comes to acquisitions and mergers in their industry.
   “One of the biggest things to ask, is there a culture of compliance and how much does it really exist” in the firm being considered for acquisition, said Michael Ford, chief compliance officer at BDP International.
   “You can start by asking a simple question: do you have an export compliance manual?” Ford continued. “That should be a staple for any company, because it says this is how you should be conducting yourself.”
   When reviewing another forwarder’s export compliance, Ford considers compliance aspects such as how the company manage its powers of attorney, trade embargoes and volumes of so-called “routed shipments.” Routed shipments occur when an overseas agent tells a forwarder that there’s an order ready from their supplier in the United States and that forwarder then handles the required export documentation and filings with the U.S. government.

One of the biggest frustrations for any export compliance officer is not being included in the acquisition process early enough.

   “There is more data available now than ever before, so you can get a lot of data to do your own reviews,” Ford said. “What would worry me most with a potential acquisition is if there are transshipments going to places like Iran . . . That would throw up a red flag for me.”
   Forwarders may also have violations with U.S. Customs and Border Protection as the result of late data filings or mis-filings due to re-routed shipments, for example, which result in penalties.
   Ford said BDP must consider myriad federal agencies, such as the Transportation Department for hazardous materials transport and the Commerce Department’s Bureau of Industry and Security, when considering whether to acquire another forwarders or customs broker.
   However, both Fonda and Ford emphasized that it’s equally important for the acquiring firm to have its own compliance checked before taking on another company’s export and import activities.
   “You have to have your own health in order,” Fonda said. “If you have a bad compliance program yourself and you bring in another, you’ll compound your issues.
   “What we do every day is try to continuously strengthen our own compliance processes and share that information across our company, so that when an acquisition opportunity does come along it’s a heck of a lot easier to manage.”
   At BDP, Ford likes to periodically run reports about the forwarder’s businesses by using an automated intelligence tool to analyze its shipping data. He recently reviewed the volume of hazardous materials shipments handled by BDP for its large chemical shipper base.
   “We used to say we handled ‘a lot’ of hazmat shipments,” he said. “Now we can tell specifically how much, even down to the different classes of hazmat, that we move. It gives a clearer vision of what we’re actually doing and allows me to have the right focus in the right areas, rather than going on a gut call. It either confirms your compliance views or requires you to make specific changes to them.”



Step-by-step approach to M&A compliance due diligence
Conducting due diligence on a company that’s about to be merged or acquired eliminates many potential headaches before the deal is done. Here are some of the key steps a company can take when performing a pre-M&A compliance review:

• Ensure that your key export and import compliance officers are an integral part of the due diligence committee. These trusted individuals should be involved early in the due diligence process, interact with parallel departments, and have full cooperation of the target enterprise.
• The compliance officer needs to be a part of the business process review. This review should include knowledge of any manufacturing that takes place overseas and where those products are shipped; overview of distribution center operations; understanding sales and services for international activities; compliance vetting by subsidiaries and branches; and contractual agreements with distributors and language regarding their compliance to the company’s standards.
• Obtain a clear picture of how the company being merged or acquired has managed its responsibilities to federal agencies with oversight of export and import regulations. In terms of export control regulations, for example, this includes the company’s processes for handling commodity jurisdictions (Commerce Department versus State Department), Commerce classifications, technical data transfers (are there non-U.S. personnel employed in the company, both in the United States and overseas, who have access to controlled technologies), sanctioned countries, restricted party screening (vetting parties to the transaction against the myriad U.S. denied party and entities lists), export clearance process (does the target company prepares its own Automated Export System filings, or does it delegate the work to freight forwarders and carriers), and record keeping.
• Check to see whether the company has any current or previous export or import violations.

“If the acquiring party does not exercise its due diligence compliance review, then the likelihood of failing to detect violation prior and during the acquisition will potentially hold the acquiring company subject to government liabilities,” said DiVecchio.