FCPA legal malpractice case shows new liability risks, hazards of overseas acquisitions

Watts Water Technologies learned the hard way that buying a company in a corruption-ridden country often means buying into violations of the US Foreign Corrupt Practices Act. The North Andover, Massachusetts company hired the large law firm Sidley Austin to handle some of the legal work in its purchase of Changsa Valve, a company in China.

Things did not go as planned and Watts is now suing Sidley over the alleged failure of the firm to disclose FCPA violations it had uncovered during its due diligence work prior to the acquisition. It is believed to be one of the first malpractice case involving the FCPA.
Watts says the megafirm failed to turn over evidence of “kickbacks” that Sidley unearthed at Changsa Valve, which Watts bought in 2005. The unlawful payments were uncovered by Watts four years later. The US Securities and Exchange Commission imposed a $3.8 million civil penalty on the company in 2011.

Watts sued Sidley on June 6 in Washington, DC, Superior Court on grounds of professional negligence, breach of contract, and negligent misrepresentation. It alleges that the firm’s “erroneous due diligence” was responsible for the FCPA penalty. It seeks to hold the firm responsible for millions of dollars the company lost in penalties, audits and professional fees during the two-year investigation.

Sidley has not yet filed a response. A call requesting comment by ACFCS.org from the Chicago-based firm was not returned.

Case could set precedent putting third parties at risk in foreign acquisitions

The case could create a precedent that exposes third parties who conduct due diligence on foreign acquisitions, including auditors, accountants and business brokers, to liability for detected FCPA violations.

“It’s really unusual for a corporation to sue for malpractice,” says Thomas Fox, a Houston attorney who specializes in FCPA cases. “I can only think of a handful of cases I’ve ever seen that happen, and I have to speculate that in this case it’s all about the money.”

Watts, which manufactures valves and other water equipment, already owned several subsidiaries China in when it went shopping for a company to expand into the booming Chinese infrastructure construction market in 2005. Watts had its eye on Changsa Valve Works and paid Sidley Austin $200,000 to “conduct legal due diligence [including] analyzing potential FCPA violations… to ensure that Watts would not be exposed to potential FCPA liability,” the malpractice complaint alleges.

Sidley accused of staying silent on evidence of corruption

During their review, Sidley attorneys allegedly found that Changsa had a “written policy that provided for its sales associates to pay ‘kickbacks’ to… Chinese government officials… to secure the award of contracts to Changsa Valve.”

This kickback written policy was never revealed, the Watts complaint says, and did not appear in Sidley’s final report of July 2005. When the review by Sidley came back with no evidence of corruption, Watts proceeded with the $9 million acquisition of Changsa in October 2005.

Watts discovered and disclosed FCPA violation years after acquisition

Four years later, sales managers at Changsa tipped off Watts to the kickback policy after attending a training session on FCPA compliance. Watts hired the law firm of Paul Hastings to conduct an audit, which found the undisclosed kickback policy document in Sidley’s files.

The Watts complaint alleges that Zhengyu Tang, the partner in Sidley’s Shanghai office who led the review of Changsa, apparently acknowledged that the kickback policy was a “red flag” that should have been disclosed to Watts as possible FCPA violation.

Based on the Paul Hastings investigation, Watts disclosed the kickback policy to the SEC and Justice Department in late 2009. The SEC settled the case with the $3.8 million civil penalty, which was accompanied by a cease-and-desist order. The Justice Department announced that it had declined criminal prosecution. The Watts violation came under the FCPA’s “books and records” provision and not for actual bribery of a foreign official.

Watts case underscores peril of ‘successor liability’

The Watts case highlights the hazards of “successor liability” in overseas corporate acquisitions, especially in countries awash in corruption, such as China. FCPA violations may lurk in foreign subsidiaries or in smaller companies owned by subsidiaries, causing the unforeseen inheritance by parent companies of FCPA violations.

“China is one of the highest-risk jurisdictions for mergers and acquisitions in terms of FCPA violations” says Matt Ellis, principal of Matteson Ellis Law, of Washington, DC, who focuses on FCPA issues. “In essence, bribery is about payments to foreign officials, and in China, everyone is a foreign official.”

Watts is not the only multinational company to run afoul of the FCPA over kickbacks at foreign subsidiaries. In 2010, General Electric paid $23.4 million to settle an SEC civil case after two companies it acquired were discovered to have bribed Iraqi officials for government contracts. Last year, Johnson & Johnson paid a $48.6 million SEC penalty to settle charges its subsidiaries bribed state-employed doctors in several European countries and paid kickbacks to obtain contracts in Iraq.

Justice Department guidance on due diligence in foreign acquisitions slowly emerges

A recent FCPA case against Data Systems & Solutions provides companies a partial roadmap on how to handle FCPA compliance when purchasing an overseas company. The Justice Department entered into a Deferred Prosecution Agreement with Data Systems on June 18, fining the company $8.82 million for bribing employees of a state-owned power plant in Lithuania.

That Agreement for the first time included guidance on a company’s due diligence requirements in acquisitions, says Ellis. “What the Department of Justice has been doing is including what are essentially 13 best practices in their DPAs,” he states, referring to a section titled Corporate Compliance Program. “In this case, they’ve included two new items on due diligence in mergers and acquisitions.”

The new items found in the DPA direct companies purchasing a foreign subsidiary to conduct an FCPA audit, implement an FCPA compliance program, and conduct FCPA training for employees “as quickly as practicable.” This provides more leeway than past Justice Department DPAs and “Opinion Releases” that companies previously relied on for guidance, say Fox and Ellis. In the 2011 DPA involving Johnson & Johnson, the Justice Department directed the company to conduct audits and construct compliance programs at foreign companies 12 to 18 months of acquiring them.

“With the Data Systems & Solutions DPA, the Department of Justice has created a way for corporations to more practically investigate companies they acquire,” says Fox.

That guidance comes too late for Watts, but it may help companies in the future — and the law firms they employ – to avoid costly legal struggles like the malpractice suit now pending in Washington Superior Court.

View the Watts Water Technologies Complaint Here

View the DS&S Deferred Prosecution Agreement Here