Hedge Funds and FCPA

Should Hedge Funds be Concerned with Government Enforcement of FCPA in 2014?

Three years ago, law firms and consulting firms predicted an apocalyptic future for hedge funds and private equity firms during the investigation of Allianz SE which resulted in a DOJ declination and an SEC enforcement action against Allianz. That enforcement action was premised on  improper payments to foreign officials made by Utama, a majority owned subsidiary of Allianz in Indonesia, to obtain government insurance contracts, and the recording of those payments as legitimate transaction costs in violation of the FCPA accounting provisions, Section 13(b) of the Exchange Act.

This year, however, the government has provided some guidance and has taken some steps that strongly suggest that they are sincerely committed to tackling corruption and prosecuting potential violations of the Foreign Corrupt Practices Act (FCPA) involving hedge funds and private equity firms, especially in connection with sovereign wealth funds.

Hedge Funds

 1.      GAIM Ops Cayman

 In April, government agencies warned hedge funds at GAIM Ops Cayman that enforcement of the Foreign Corrupt Practices Act (FCPA) will be a priority for 2014. To this end, Sarah Coyne, chief of the Business and Securities Fraud Section at the U.S. Attorney’s Office for the Eastern District of New York and one of the chief prosecutors responsible for the investigation and global FCPA settlement with Ralph Lauren, underscored:

Hedge funds are likely to fall into two buckets. The first would be if they are soliciting investments from a foreign official or a sovereign wealth fund or pension fund controlled by the state and we will be scrutinising any gifts, entertainment or travel afforded to those individuals to ensure they do not break the rules. The other area where hedge funds may fall foul is when they invest in a market where corruption is a way of life.

Ms. Coyne further emphasized that:

The use of a third party in a jurisdiction where corruption is widespread or the use of a consultant who has awareness about the local culture and who may be dealing with a sovereign wealth fund is an area where hedge funds are most likely to get into trouble under the FCPA.

Id.

2.      Och-Ziff Capital Management Group, LLC Hedge Fund

Ms. Coyne’s above-described statements coincided with the public disclosure made by Och-Ziff to shareholders that they are conducting an internal investigation related to allegations that the Company: (1) violated relevant anti-bribery laws by accepting an investment from the Libyan Investment Authority; (2) loaned $234 million to help finance two ventures in the Democratic Republic of Congo, in violation of the Foreign Corrupt Practices Act; and (3) failed to disclose that, beginning in 2011, Och-Ziff received subpoenas from the Securities and Exchange Commission and the United States Department of Justice in connection with these transactions.

Investigations and Litigation Involving Libyan Independent Authority (LIA)

The Department of Justice initiated a Foreign Corrupt Practices Act investigation into private-equity and hedge fund dealings with LIA, a sovereign wealth fund, including Goldman Sachs, Credit Suisse, Societe Generale SA, and JP Morgan Chase. The investigation is focused on a group of “fixers,” or placement agents, operating in the Middle East, London, and elsewhere after the collapse of the Libyan government. After revolutionaries toppled the old Gadhafi regime, economic sanctions were lifted and Western firms jumped at the opportunity to invest in Libya. The placement agents may have acted as conduits to government leaders, providing direct access to members of the Libyan government.

The Libyan Investment Authority, which is a sovereign wealth fund (SWF) with an estimated value of 50-75 billion dollars sued Goldman Sachs in London’s High Court of Justice, Chancery Division in connection with losses it incurred by investing money with Goldman. The LIA claims that Goldman and its asset managers abused their relationship of trust by advising them to make investments that were too complex to understand.

Questions

Put simply, in FCPA land, this raises several questions about the extent to which the FCPA applies to investment firms (including hedge funds) when they engage placement agents, on an independent contractor basis, to develop relationships with officers, managers, or employees of sovereign wealth funds.

First, what is a sovereign wealth fund (SWF)?

A SWF is a state-owned investment fund composed of financial assets such as stock, bonds, real estate, or other financial instruments funded by foreign exchange assets. SWF’s are essential for a country’s economic growth, however, such funds can be risky depending on how capital from those funds is invested. Generally, central banks reserves, which accumulate due to budget and trade surpluses, or revenue generated from exports such as natural resources, fund the SWF.

Two other common sovereign investment vehicles are public pension schemes, for example, Japan’s government pension fund used to finance pensions for public sector employees, and state owned enterprises, which are legal entities created by the Government to seek investments on their behalf, for example, Freddie Mac or Fannie Mae. A state owned enterprise is either wholly or partially owned by a government and is typically earmarked to participate in commercial activities. Just like SWF’s the amount of money held in these vehicles is substantial.

Second, what is the purpose of engaging a placement agent, third party consultant, client relationship manager, or “fixer” in the context of attracting foreign investment from SWF’s?  Investment firms should be capable of answering this question and should, where applicable, answer the following questions:

  • Who or what department is responsible for engaging a placement agent and/or cultivating relationships with the placement agents?
  • What is the primary purpose of engaging a placement agent?
  • Is the placement agent a registered representative governed by FINRA, or a similar, foreign regulatory body?
  • What was discussed during any preliminary conversations between the firm and placement agents?
  • After the discussion(s), what was the placement agent’s understanding of (1) what her role might be in obtaining access to investment opportunities in SWF and (2) how she might obtain access to investment opportunities in SWF?
  • Who, if anyone, is responsible for monitoring or supervising the placement agent? Is the relationship completely “hands off” once the relationship commences?
  • Who or what department is responsible for monitoring any ongoing relationships with placement agents aimed at obtaining access to managers, officers, or employees of an SWF?

Third, how are the agents compensated and how is that compensation recorded?

This issue was recently addressed in In SEC v. Tomas Alberto Clarke Bethancourt, et al, No. 13-CV-3074 (S.D.N.Y. June 13, 2013). In that case, the SEC alleged that the emerging markets arm, located in Miami, of a New York broker-dealer, was funneling bribes to officials of a state-owned bank in Venezuela in return for transaction fees – in the form of markups and markdowns – on riskless principal trade executions in Venezuelan sovereign state bonds. Part of the scheme involved the use of a “foreign finder” located in Panama to identify investment opportunities in Venezuela.

Further, in the parallel criminal case, the Department of Justice indicted several individuals (some of whom later pled guilty), including the manager of the Miami branch, for violations of the anti-bribery provisions of the FCPA.

Against this backdrop, firms might ask some of the following questions:

  • How are placement agents’ compensated, flat fee or commission?
  • Is an independent consultant retained to assess the fair market value of any fee? Do they conduct a fair market valuation to determine the reasonableness of the fee?
  • Is payment properly recorded in the firm’s books and records?
  • If so, how is any agent compensation recorded in the investment firm’s books and records? Is it recorded as a consulting fee?
  • How is payment made to the placement age, check, cash, wire transfer, etc?
  • Is payment made directly to the placement agent individually or to a company or entity designated by the placement agent to receive payment?
  • If so, how is that payment recorded in the firm’s books and records?

Finder’s Fee?

  • Is the placement agent awarded a “finder’s fee?”
  • If so, how is the finder’s fee calculated?
  • If so, does the firm confirm that the foreign finder is not required to register in the U.S. as a broker/dealer nor is subject to disqualification?
  • If so, does the firm confirm that the finder is a foreign national or entity domiciled abroad?
  • If so, does the firm confirm that the customers referred by the finder are foreign nationals or entities?
  • Does the firm disclose what compensation is to be paid to the finder to the customers/investors?
  • Does the firm provide investors/customers with a written acknowledgement of the compensation arrangement and, if so, does the firm currently maintain a copy of such acknowledgement?
  • Does the firm maintain records reflecting finder compensation?

Fourth, what is the placement agent’s role, if any, in providing the firm with access to employees, managers, or officers of the SWF?  

Additional questions the firm might ask in this context are as follows:

  • How does the firm regulate or supervise the degree of influence its placement agents may exercise in seeking to obtain pledges to invest in the fund?
  • How does the firm define “anything of value” in its Code of Conduct and/ FCPA/Anti-Corruption Compliance Policy?
  • Does the Policy narrowly circumscribe the permissible conduct of agents in this context?
  • Does the Policy narrowly circumscribe the permissible categories of “anything of value” in this context?
  • How would the firm record “anything of value,” offered to any employee, officer, or manager of an SWF in its books and records, including entertainment, travel, gifts, or equipment?

Fifth, are employee, managers, or officers, with whom the placement agents interact, officers or employees of a foreign government, or any department, agency or instrumentality thereof?

At first blush, answering this question may appear simple, but there is a significant appeal pending before the Eleventh Circuit in United States v. Esquenazi, et. al which addresses this precise issue. Indeed, during oral arguments before the Eleventh Circuit Court of Appeals, one of the main questions on appeal is whether the convictions of defendants, telecommunications executives, should be reversed based on the district court’s refusal to grant defendants’ instruction regarding the definition of “foreign official,” specifically the definition of what constitutes an “instrumentality” of a foreign government.

The appellate attorney representing the Department of Justice underscored that an instrumentality is an entity through which government exercises its function and has dominion and control.

Further, the U.S. District Court for the Central District of California in United States v. Aguilar, 783 F. Supp. 2d 1108 (C.D. Cal. 2011)emphasized that there are several factors court should consider in deciding whether an entity is an instrumentality of a foreign government:

  • The entity provides a service to the citizens — indeed, in many cases to all the inhabitants — of the jurisdiction.
  • The key officers and directors of the entity are, or are appointed by, government officials.
  • The entity is financed, at least in large measure, through governmental appropriations or through revenues obtained as a result of government-mandated taxes, licenses, fees or royalties, such as entrance fees to a national park.
  • The entity is vested with and exercises exclusive or controlling power to administer its designated functions.
  • The entity is widely perceived and understood to be performing official (i.e., governmental) functions.

Thus, under current FCPA jurisprudence, an officer or employee of a SWF may very likely constitute an “instrumentality” of a foreign government. So, unless the Eleventh Circuit significantly narrows the definition of “instrumentality” in Esquenazi, that is the position that the DOJ is likely to maintain in future enforcement actions, investigations, and prosecutions related to the FCPA.

Conclusion

Given the current enforcement landscape and the government’s current investigations involving placement agents and SWF’s, hedge funds and private equity firms would be well-advised to review their internal policies and procedures addressing SWF’s and placement agents.

Keep in mind, this Note does not address the other anti-corruption laws that may apply in this context and firms seeking to attract foreign investment through the implementation of third party consultants in high risk countries should review and enhance compliance with the applicable anti-corruption laws.