THE ORIGINS OF THE FCPA: LESSONS FOR EFFECTIVE COMPLIANCE AND ENFORCEMENT: PART TWO

This is the second part of an occasional series. The first part is available here.

The entire paper will be published by Securities Regulation Law Journal early next year.

The illicit or foreign payments cases

The preliminary inquiry was followed by formal SEC investigations early in 1974. The resulting cases would become known as the “illicit or foreign payments” cases. The focus of the investigations was on corporate accountability and governance, not the propriety of making the payments. Report of the S.E.C. on Questionable and Illegal Corporate Payments and Practices, submitted to the Committee on Banking, House and Urban Affairs, U.S. Senate (May 1976) (“SEC Report”).If shareholder funds entrusted to corporate officials were being used to make political contributions, pay bribes and take other, similar actions, there should be disclosure. Shareholders are entitled to know how their money is being used, the manner in which their company is operating and the type of stewards who work for them. As Director Sporkin stated: ”Our concept was to get the information to the shareholders and let the shareholders make decisions on what they wanted to do.” Transcript at 14. That theme was echoed in the SEC Report to Congress on its enforcement efforts in 1976: “Disclosure of these matters reflects the deeply held belief that the managers of corporations are stewards acting on behalf of the shareholders, who are entitled to honest use of, and accounting for, the funds entrusted to the corporation and to procedures necessary to assure accountability and disclosure of the manner in which management performs its stewardship.” SEC Report at 20.

The investigations focused on several prominent corporations. A variety of conduct was uncovered.

· In a number of instances facilitation payments were found, that is, those made to obtain the performance by foreign officials of their duties;

· In others, excess sales commissions and kickbacks were uncovered;

· Off the book transactions were discovered;

· Falsified corporate records were discovered along with secret slush funds used for a variety of purposes;

· The corporate records did not reflect accurately how shareholder funds were used – they concealed the transactions, the source of the funds and the fact that their application was for illegal purposes.

See, e.g., Statement of SEC Chairman Roderick M. Hills Before the Subcommittee on Consumer Protection and Finance, House Committee on Interstate and Foreign Commerce at 2 (Sept. 21, 1976);Mike Koehler, The Story of the Foreign Corrupt Practices Act, 73 Ohio St. L. J. 929, 935 (2012) (“Koehler”).

Collectively, these practices “cast doubt on the integrity and reliability of the corporate books and records which are the very foundation of the disclosure system established by the federal securities laws.” SEC Report at 3.

In January 1974 the SEC considered the issuance of what would become Securities Act Release No. 5466 (March 8, 1974) and a recommendation from Director Sporkin and the Division of Enforcement to file the first enforcement action stemming from the illicit payment investigations. The Commission carefully deliberated a series of issues before authorizing the Release and the enforcement action. SEC Commissioner John Evans recounted those deliberations: “Before making the decision to file the complaint [in SEC v. American Shipbuilding], and before voting to accept the settlement, various members of the Commission expressed concern, and there was considerable discussion that this application of the securities laws and enforcement approach would lead to undesirable results. Although there was some speculation at the time, we could not have known, of course, that our program would result in the disclosure of illegal or questionable payments by many corporations to recipients throughout the world. We could not have known that investigations by independent company committees would bring about the replacement of top management officials of some major corporations. We could not have known that some corporations had made payments which, if disclosed, would result in political crises in foreign countries.” SEC Commissioner John Evans, Remarks at Northwest State-Federal-Provincial Securities Conference at 5 (May 13, 1076), (“Evans”), available at http://www.sec.gov/news/speech/1976/051376evans.pdf. Director Sporkin and the Commission did not think that additional legislative authority was necessary to support the proposed enforcement action. The securities laws provided a firm foundation in their view. Sporkin at 274.

Materiality was a key question carefully evaluated by the five Commissioners and the Enforcement Division. That concept was generally defined at the time in objective terms, considering, information which a reasonable investor might find useful. See e.g., Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970). Two years later the Supreme Court further developed that standard in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). A key point in the materiality discussions, as Commissioner Evans recounted, was the fact that most of the illegal or questionable payment cases involved false and fictitious entries on the corporate books and records and the filing of false and misleading reports with the Commission. These two points “were weighed heavily in our decisions [to bring the actions] . . . Any diversion of funds outside the corporate system, or any deception with respect to corporate books and records, cannot be permitted without undermining the purposes of the securities laws,” the Commissioner noted. Evans at 9.

Later in its Report to Congress the Commission reiterated its view on materiality: “[Q]uestionable or illegal payments that are significant in amount or that, although not significant in amount, relate to a significant amount of business, are material and required to be disclosed . . . [if the payments are] unknown to the board of directors, [it] could be grounds for disclosure regardless of the size of the payment itself or its impact on dependent business because the fact that corporate officials have been willing to make repeated illegal payments without board knowledge and without proper accounting raises questions regarding improper exercise of corporate authority and may also be a circumstance relevant to the ‘quality of management’ that should be disclosed to the shareholders. . . [in addition] a questionable or illegal payment could cause repercussions of an unknown nature which might extend far beyond the question of the significance either of the payment itself or the business directly dependent upon it. For example, public knowledge that a company is making such illegal payments, even of a minor nature, in one foreign country could cause not only expropriation of assets in that country but also similar a similar reaction or a discontinuation of material amounts of business in other counties as well.” SEC Report at 15.

One major oil company that made such payments, for example, had that fact asserted as the basis for an expropriation by a Latin American Republic. Id. Another point considered was the fact that substantial criminal penalties could be imposed on the organization – something shareholders should be told, according to Director Sporkin. Sporkin at 275. Likewise, concealing the fact that the company is securing business through the payment of bribes could also shroud underlying difficulties with the business. If, without the payment of the bribes, the company cannot compete effectively, there may be difficulties with the business model, its products or the manner in which it is competing in the international market place. Shareholders would have a right to such information. See, e.g., Edward Herlihy and Theodore Levine, Corporate Crisis: The Overseas Payment Problem, 8 Law & Policy In International Business 547, 575-576 (1976) (“Herlihy & Levine”). And, all of these factors reflected on the stewards of the corporation, the management entrusted with the funds of the shareholders: “This factor is important because investors have a right to be informed regarding the integrity of management in connection with the administration of corporate affairs and assets,” Commissioner Evans noted in recounting the SEC’s discussions on the point. Evans at 10.

The SEC authorized the issuance of the Release and the filing of its first enforcement action from the illicit payment investigations at the January meeting. Evans at 2. The enforcement action was against American Ship Building Company and its CEO. The complaint centered on the payment of about $120,000 in political contributions and other payments falsely booked as payments to employees in the corporate records. SEC v. American Shipbuilding Co., Civil Action No. 74-588 (D.D.C. Filed October 4, 1974). It alleged violations of the proxy and periodic reporting requirements by failing to disclose that corporate funds had been used to make political contributions. The complaint also alleged that the books and records of the company had been falsified to conceal these facts from the shareholders. This would become the first of the illicit or questionable payments cases. Id. In the Commission’s view the filing of this enforcement action should have indicated that “the standard for disclosure in such a case was not traditional economic materiality, but that such payments reflected on the integrity of management.” Evans at 4.

The Release focused on disclosure obligations when there was a conviction, a guilty plea, or pending indictment alleging that the federal election laws had been violated. It also noted that in other instances management was in the best position to assess the issuer’s disclosure obligations. The Release was issued as Securities Act Release No. 5466 (March 8, 1974).

The American Shipbuilding enforcement action was settled at the time of filing with a consent decree. It would become a predicate for other similar cases. The focus of the settlement was an injunction effectuated by Court-ordered undertakings which included:

· A requirement to establish a review committee which included a chairman not affiliated with the company;

· A directive that the committee examine all the books and records of the company beginning with September 1970;

· A directive that the examination focus on expenses or payments entered on the books and records of the company for purposes other than those indicated;

· The Committee was required under the order to prepare a report and submit its findings to the court, the Commission and the board of directors; and

· A requirement that the board reviews the report and take the appropriate action to implement its recommendations.

Next: Key foreign payments cases and the remedies utilized.