U.S. Cracking Down on Defense Industry Corruption Overseas

By Glen Kopp and Kedar Bhatia
Defense spending across the Middle East and North Africa is on the rise and U.S. companies are pursuing business opportunities there. From small-cap to large-cap, defense firms are looking to capitalize on the big appetite of foreign governments for defense imports. 

The race for international sales during the past few years has been followed by a wave of government investigations into defense companies for both major and relatively minor violations of the Foreign Corrupt Practices Act. By some measures, 2014 was a banner year for the government’s FCPA enforcement regime, with it collecting more than $1.5 billion in fines, penalties and disgorgement — one of the highest totals the government has ever collected in FCPA cases in a single year.

The FCPA gives authorities the right to investigate alleged bribery all over the world and in any cases involving a domestic company or one that trades on a U.S. stock exchange. But prosecution trends reveal a pattern of investigations that focus on certain industries, at certain times and in certain countries.

Existing players and new entrants are faced with the need to weigh the challenge of capturing new business in a competitive market with assurances from locals that “this is how business is done here.” Despite year-over-year reports of FCPA prosecutions, neither the assurance nor the balancing ever gets old. 

Government investigators consider defense contractors to be among the companies most at risk of violating the act.

This view arises from the idiosyncratic business model required for direct commercial sales to foreign governments. Potential government decision makers are “foreign officials” within the meaning of the FCPA, to whom U.S. companies may not give “anything of value” to obtain or retain business, so foreign defense sales often draw close scrutiny by the U.S. Department of Justice and Securities and Exchange Commission.

Second, foreign procurement contracts are typically subject to significant offset requirements, which may call for the use of local subcontractors that present a minefield of corruption.

Recent government investigations bear out the close scrutiny that companies in the defense sector face. In late 2014, the SEC announced sanctions and a monetary settlement against two employees in the Dubai offices of FLIR Systems Inc., an Oregon-based defense contractor operating around the world.  The case involved Stephen Timms and Yasser Ramahi, two sales employees with FLIR who were responsible for a $12.9 million contract the company secured to provide thermal binoculars to the Kingdom of Saudi Arabia. Timms and Ramahi were accused of bribing Saudi officials with “expensive luxury watches,” a form of bribery nearly as old as watchmaking itself, and arranging for some of the same Saudi officials to take a 20-night “world tour” through Casablanca, Paris, Dubai, Beirut and New York City before arriving in Boston for a tour of FLIR facilities. 

Although the trip to Boston was itself a legitimate business expense, Timms and Ramahi had gone through FCPA training that correctly highlighted side trips as a form of bribery prohibited by U.S. law.

Further complicating their situation, Timms and Ramahi provided FLIR’s finance department with fabricated invoices for the watches after an unrelated review flagged the purchases. The fraudulent invoices listed the cost of the watches in Saudi Riyal rather than the true currency of the exchange, U.S. dollars, which made them appear much less valuable than the actual price. Timms and Ramahi ultimately agreed to pay financial penalties of $50,000 and $20,000, respectively. In April 2015, based on the allegations against Timms and Ramahi, FLIR paid $9.5 million in disgorgement and penalties to settle claims by the SEC that the company failed to maintain adequate internal controls and keep proper books and records.

In June 2015, defense contractor IAP Worldwide settled FCPA claims with the Department of Justice over $1.7 million in bribes paid to Kuwaiti government officials to ensure that IAP was retained to complete a significant surveillance installation contract. According to the Justice Department, after the company won a small phase one contract, it funneled nearly half of its phase one earnings into kickbacks that were designed to help it secure the more lucrative phase two contract.  The company eventually settled FCPA charges for $7.1 million, more than four times the amount it paid in kickbacks.

The government has also shown a willingness to go after well-known companies for relatively small-dollar incidents. When the SEC announced a settlement with Smith & Wesson Corp. for $2 million, commentators noted that even though the fine was relatively small, the alleged crime was even smaller — a $10,000 bribe that helped to secure a Pakistani contract worth less than $110,000. In its press release, the SEC said the public settlement was meant to be a “wake-up call for small and medium-size businesses that want to enter into high-risk markets and expand their international sales.” 

Aside from cases settled in 2014, there are several ongoing investigations. For example, Embraer, the Brazilian aircraft manufacturer that trades on the New York Stock Exchange, is under investigation by U.S. and Brazilian authorities for alleged bribes made in the Dominican Republic. In September 2014, Brazilian authorities filed one of the country’s first lawsuits alleging corrupt behavior abroad. The Wall Street Journal reported that the U.S. Department of Justice and the SEC played a role in the prosecution by assisting the Brazilian government. 

Defense companies can often avoid these overt violations by monitoring the integrity and operations of their business development and contracting teams. However, when it comes to other, harder to detect corruption risks, even executives with the best intentions and judgment can become unwary victims. 

In particular, offset requirements in defense contracts pose a significant corruption risk and raise problems for companies and their counsel. Fundamentally, offset requirements are intended to accomplish a greater good by requiring foreign contractors to reinvest a portion of the contract value into the local economy and infrastructure. Depending on the region, certain offset regimes mandate that foreign contractors use local subcontractors for a percentage of the work on a prime contract or support local initiatives, including employee training, infrastructure support or charitable causes.   

One of the most common scenarios involving FCPA scrutiny of offset agreements occurs when a company does not conduct adequate due diligence into a local subcontractor who later turns out to make corrupt payments. An Organization for Economic Cooperation and Development report on foreign bribery published in December reported that three out of four foreign bribery cases around the world involved intermediaries, such as agents, distributors, brokers, subsidiaries or local consultants. 

Further, the diligence protocols of anti-bribery and corruption policies of many U.S. companies do not adjust for the reality that regions such as the Middle East do not have the same level of public transparency that is taken for granted in the United States. The types of corruption risks that defense companies are exposed to because of the lack of transparency can take many forms. As another example, in satisfying an offset requirement, it is not uncommon for companies to donate to local charities. It is possible, however, that unbeknownst to management, the local charity is run by a government official or his close family member, thereby exposing the defense company to potential FCPA liability. 

Companies doing business in the Middle East and North Africa regions or expanding their footprint there must be careful of the real and perceived corruption associated with that part of the globe. Actual corruption increases the challenges of operating in these environments as it often leads even well intentioned employees astray. Perceived corruption risks are also significant because the government is waiting and watching to make an example of companies that are toeing the line in high-risk countries.

Government investigators may also view a company’s lax oversight of projects as an example of “willful blindness” — effectively, the government’s ability to extend its reach on the basis that operating within high corruption risk regions alone should put compliance officers on notice.

For example, in a SEC cease-and-desist order against Alcoa Inc., in January 2014, the government claimed that company employees “either knew or were willfully blind to the high probability” that commissions to certain consultants would be used for bribes. The government based its conclusion, in part, on a 1996 memorandum by an Alcoa sales employee stating that the “methodology of business in the Middle East is a complex web of interactions that are necessarily difficult to understand to disguise the payment of commissions.”  Alcoa ultimately settled these FCPA charges with both the DoJ and the SEC for a total penalty of $384 million. 

In late 2013, the Justice Department and SEC settled an investigation with Weatherford International and its subsidiaries that included conduct in the Middle East. The government claimed that one of Weatherford’s subsidiaries, Weatherford Oil Tools Middle East Ltd., paid “volume discounts” to distributors that the subsidiary believed would free up funds the distributor would use to pay bribes to officials at the national oil company. Between 2005 and 2011, the company paid approximately $15 million in unauthorized volume discounts that ranged between 5 percent and 10 percent of the contract price. The company’s conduct contributed to the overall $252 million that Weatherford was forced to pay in civil penalties, criminal fines and disgorgement.

While it is unrealistic to expect companies to foreclose international market channels, it would be shortsighted to cut corners or relax enforcement of so-called FCPA best practices. 

Those practices include: conducting regular internal corruption risk assessments; demonstrating leadership from the top on anti-bribery initiatives; developing a clear and straightforward code of conduct; erecting a robust and effective compliance program; regularly updating each of the items above in response to changing business focuses, enforcement trends, and evolving technology; and monitoring and enforcing company compliance policies and procedures on agents, distributors and local partners.

Building a robust anti-corruption plan helps to prevent corruption in the first instance and also helps a company defend itself against rogue employees.

For example, in the SEC’s investigation against Timms and Ramahi, the government found evidence that FLIR’s anti-corruption program was working rather well. The employees accused of wrongdoing previously received proper training from the company and compliance reviews flagged their illegal expenditures on more than one occasion. When the SEC accused FLIR of failing to maintain proper internal controls, the company was able to settle the case with a relatively modest penalty, as measured by the value of the company’s ill-gained profits and multipliers typically used to calculate a corresponding penalty.

The unusually small penalty may have been due in part to the company’s robust anti-compliance program and, later, its proactive steps in self-reporting and cooperating with the government’s investigation.

Glen Kopp, former assistant U.S. attorney in the Southern District of New York, is a partner in Bracewell & Giuliani’s white collar, internal investigations and regulatory enforcement practice. Kedar Bhatia is an associate in Bracewell & Giuliani’s New York office. 

Andrew J. Schoulder, a partner in Bracewell & Giuliani’s New York office, is chair of the firm’s aerospace and defense group; and Chris Williams, managing partner of Bracewell & Giuliani’s Dubai office contributed to this report.

Topics: Business Trends, International

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