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Investing in trouble – the risks to hedge funds of international corruption

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To date hedge funds have largely escaped the impact of the increasing scope and aggressive enforcement of the Foreign Corrupt Practices Act by the US Department of Justice and the Securities and Exchange Commission. However, Matthew Reinhard, a member at Washington, DC law firm Miller & Chevalier, argues that hedge fund firms must monitor two large FCPA risk areas: inbound investment into and outbound investment by the fund…

It is hard to ignore the increasing scope and aggressive enforcement of the Foreign Corrupt Practices Act by the US Department of Justice and the Securities and Exchange Commission. While some recent prosecutions of individuals have suffered setbacks (such as the string of hung juries and acquittals in the ‘Shot Show’ bribery cases that led the US government to abandon the cases in mid-February), the drumbeat of high-dollar resolutions against corporations continues and enforcement actions against individuals shows no sign of abatement.

Through this tumult, hedge fund managers appear to have largely escaped FCPA scrutiny. However, this does not mean hedge funds operate without FCPA risk. The US government has shown a proclivity to engage in industry-by-industry FCPA investigations and prosecutions, and the high-value and global nature of many hedge funds’ operations may ultimately prove too tempting a target.

The FCPA’s jurisdiction
Broadly speaking, the FCPA prohibits the corrupt payment or provision of anything of value (such as lavish entertainment, gifts, or non-business travel) to a foreign official (a term that is broadly interpreted by the enforcement agencies to include not only ministerial positions, but also employees of state-owned or run enterprises) in an attempt to obtain or retain business.

The law contains both civil “books and records” accounting provisions as well as criminal prohibitions against corrupt payments. There is no dollar threshold for liability – whether USD10 or USD10,000, any corrupt payment can result in a violation.

The FCPA is enforced by the DOJ and SEC. The SEC generally enforces the accounting provisions of the law, which apply to issuers under SEC regulations. Therefore, most private hedge funds are not within the jurisdiction of the SEC and the accounting provisions of the FCPA do not apply.

However the criminal anti-bribery provisions extend to any US person (a broadly defined term that would include hedge fund managers and employees of the manager) or any act occurring within the US. The DOJ Fraud Section is primarily responsible for enforcing the FCPA’s criminal provisions.

Violations of the criminal provisions can result in fines of up to USD2m for corporate actors and USD100,000 and up to five years in prison for individuals, per count. It is the practice of the DOJ to sever a corrupt scheme into as many counts as possible – for instance, a scheme to pay a USD100,000 bribe in four USD25,000 instalments would be charged as four separate counts.

Therefore, for most hedge funds, it is the criminal provisions of the law that have direct applicability to the fund, its employees and investors. In this regard, hedge fund operations have two large risk areas that must be monitored to prevent corrupt activity and guard against FCPA liability: inbound investment in the fund and outbound investment by the fund.

Inbound investment
“How did he get that money?” That is likely the question DOJ prosecutors are pondering right now regarding Francisco Illarramendi. Having already pleaded guilty to federal wire fraud charges, Illarramendi is now facing a wave of civil suits, which have brought to light allegations that he made significant pay-offs to the former manager of the pension fund of the Venezuelan national oil company PDVSA to attract the pension fund’s investment into Illarramendi’s hedge fund.

If true, such allegations would almost certainly constitute violations of the anti-bribery provisions of the FCPA and, I suspect, federal authorities are monitoring these developments very closely to determine whether further charges are warranted.

The saga of Illarramendi illustrates the FCPA risks associated with attracting investment into hedge funds. Large institutional and pension funds may at first glance appear to be completely private actors, with no government connections.

However, like the PDVSA pension fund, investors closely tied to nationalised industries, or operating in socialized countries such as China, will likely be viewed as “foreign officials” for the purpose of the FCPA, even where they appear to be acting as independent entities. Therefore, a corrupt payment (or unduly lavish entertainment or gift-giving) by hedge fund employees to secure inbound investment from such pension schemes runs afoul of the FCPA.

Similarly, investments by sovereign wealth funds are unquestionably investments made by government actors, meaning that employees or representatives of such funds are also foreign officials under the law.

Outbound investment risk
Though presenting a narrower band of risk, outbound investment by hedge funds also presents potential FCPA pitfalls where the fund is investing abroad. The main danger presented by the FCPA for foreign investment is through the use of third-party agents or intermediaries.

Fast-growing but underdeveloped economies may make attractive investment opportunities, but also often present a thicket of bureaucratic red tape and corrupt officials. To cut through this tangle, many funds may chose to retain local agents or ‘fixers’ who can obtain government approval for investments, licences to operate or other necessary legal documents.

However, under the FCPA the corrupt actions of an agent – even if wholly outside the US – can create liability for the fund that engaged the agent. As a result, special care must be exercised in hiring agents and ensuring they are not acting corruptly on a fund’s behalf.

Even seemingly innocuous small payments by local agents to “speed things up” – such as USD50 or a carton of cigarettes given to a notary to issue a requisite stamp on investment documents – can create FCPA liability for the hedge fund.

Protecting the fund
Once a hedge fund manager reviews and quantifies its potential risks under the FCPA, it must start taking steps to monitor and control these risks through the institution and implementation of an anti-corruption compliance programme.

While there is no such thing as a reliable one-size-fits-all or off-the-shelf FCPA compliance programme, all successful programs will include, at a minimum, a strong “tone at the top” prohibiting corrupt activities; clear written anti-corruption policies applicable to all employees and agents; appropriate third-party due diligence and contracting procedures for potential agents; and training and education of employees regarding corruption risks and the fund’s anti-corruption policies.

Often anti-corruption programmes can be effectively grafted on to existing compliance programmes (such as anti-fraud or anti-money laundering programmes), reducing the impact and disruption to business. Experienced FCPA counsel should be able to assess a hedge fund’s risk effectively and assist in the development of a risk-appropriate compliance programme.

While the hedge fund world has avoided significant scrutiny under the FCPA to date, the industry’s profile and operating procedures present risks funds must recognise and address.

Hedge funds that are proactive in these areas now will be much better positioned to respond to and rebuff government inquiries under the FCPA if and when they should arrive. Indeed, with the recent announcement by federal authorities of more than 100 ongoing insider trading investigations, many involving hedge funds, it is likely that additional allegations of corruption against hedge funds may soon come to light.

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