Merger and acquisition activity in the defense sector is robust. Any merger or acquisition requires serious due diligence, to give buyers, sellers, and merger partners a clear picture of their prospective partners, examine specific issues and to test the viability of their business strategy in a particular case. Many companies employ due diligence checklists to review myriad organizational, financial, tax, employment and legal issues. In addition to standard legal compliance issues, that checklist should always include close examination of ethics, corporate culture, organizational conflicts of interest and viability of compliance programs. These issues are especially complex in the defense industry as a result of statutes and regulations relating to contracting and government ethics.
Corporate culture is the aggregate of attitudes, experiences, beliefs and values of an organization. A candid assessment of cultural differences between companies, reflected in ethics codes, compliance programs and related policies and procedures, records of enforcement, and tone from the top invariably will pay large dividends.
A close review of past voluntary disclosures, enforcement actions and penalties is particularly revealing. If a voluntary disclosure was made, analyzing resolution of that disclosure, and the impact on the target company's current government business is obviously crucial. A company's culture is the cornerstone of its ethics program, and, in turn, compliance programs implement a company's ethics policies.
When acquiring or merging with any government contractor, reviewing ethics policies, compliance programs, and all recent voluntary disclosures will provide a wealth of invaluable information. Government contractor ethics programs govern the conduct of employees and agents. Ideally, the ethics program permeates everything from day-to-day interaction with government officials to organizational conflicts of interest, improper gifts and gratuities, bribery, the Anti-Kickback Act, contingency fees, the Procurement Integrity Act, revolving door rules, the Truth in Negotiations Act, false statements and false claims, penalties for violations, and what to do if an employee is aware of a violation. Even attitudes toward tax compliance can provide insight.
An effective compliance program lends structure to an ethics policy, empowers compliance officers, emphasizes training, and enforces and corrects infractions. In short, in a merger or acquisition, ethics and compliance programs should be current and effective, and capable of being quickly aligned.
Quality of ethics programs range from detailed, pro-active ethics programs that are promoted from the top of the organization, to companies that literally have no ethics program. To be effective, every employee must generally know and take seriously the company's ethics program. Employees should be trained to understand the legal constraints on federal contractors and their employees. Employees are expected to spot potential ethics issues and contact the company's compliance officer when issues arise. The absence of a pro-active ethics program will often call into question the quality of other data that the target produces during the due diligence process.
Organizational conflicts of interest arise when, for example, a contractor performs work on one or more contracts that would possibly impair its judgment were it to perform work on another contract. Examples include performing testing and evaluation services on one contract and supplying the types of equipment being tested on a related contract, or assisting with source selection on one contract and attempting to bid on the same or related procurements. Companies either do or do not have effective mechanisms in place to prevent, or at least identify such conflicts that arise organically. These potential issues of conflicts obviously can significantly impair deal value. Recently reported acquisitions saw selling enterprises carving off large divisions in order to avoid a conflict of interest, or otherwise to allow an acquisition to close.
There are short-term ways to mitigate the impact of respective ethics programs that are not compatible. For example, an acquired company may be kept structurally separate with the new ethics program implemented incrementally. Ultimately, however, the ethics programs of two merged entities ultimately must also be merged. Compatibility may not always be the problem; rather, the issue could be resolution of lingering violations. In recent high-profile attempted mergers, upon discovery of unresolved ethics issues, companies have either terminated the deal, thereby diminishing the enterprise value of the target, or have postponed deal closure until a voluntary disclosure has been made and conclusively responded to by the government, with or without penalties.
When contemplating a merger or acquisition, the sooner a due diligence review of ethics issues occurs, the better. Ideally, and pragmatically, this should occur in conjunction with initial considerations of deal value and deal structure. This affords the combining enterprises an opportunity to identify issues that inevitably affect valuation and purchase price, negotiation of risk-shifting clauses in the purchase agreement, and successfully closing the deal. The goal of the due diligence process is, inter alia, to assess the extent to which a deal is value-additive. This obviously includes a sober assessment (and quantification) as to whether problems will exceed benefits, whether any issues affect deal value, and whether combining with another enterprise will jeopardize the existing business. Key to achieving these goals is a reliable understanding of the quality of a company's ethics culture, programs, and leadership, and, historically, how quickly and honestly it has handled violations when they occur.
Manik K. Rath (mrath@lmi.org) is vice president, general counsel and corporate secretary of LMI, a government consulting firm in McLean, Virginia. Lawyers at the law firm of Greenberg Traurig (www.gtlaw.com) provided editorial support for this article. The opinions expressed here are solely those of the author and are not intended to provide legal advice or represent the view of NDIA or the NDIA Ethics Committee. The authors welcome comments to their article.
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