JVs: making a case for active due diligence and continuous monitoring

With the economic environment supporting nearly $3.5 trillion in M&A activity last year, some corporations may now be considering joint ventures (JVs) as a way to expand their business in what continues to be a sluggish world economy. Entering into a JV requires companies to conduct effective due diligence in order to screen for the right JV partner, mitigate reputational risk and expose any legal liabilities, while also establishing compliance monitoring programs that will prevent potential violations of the FCPA, the UK Bribery Act and other regulations.

As with any financial transaction, the quality of a company’s due diligence will determine whether it has a successful venture with a shot at profitability or whether it will enter into a partnership that exposes it to internal investigations, lawsuits and increased regulatory scrutiny.

‘It is extremely important to focus on due diligence, particularly in an environment like this, where valuations are getting higher,’ says Rob Townsend, co-chair of Morrison & Foerster’s global M&A practice group. ‘Due diligence is the best way to ensure that you as a buyer or party to a JV are getting what you are paying for.’

Experts suggest that companies carefully plan how they intend to conduct due diligence on potential JV partners, as each JV has a unique size, scope and complexity. While it is easy to point to the financial and reputational aspects of due diligence, Kroll managing director David Holley says companies should first determine whether a potential partner has the capabilities to deliver the product or service that is needed for the success of the JV, because the venture is doomed if it cannot.

If the JV partner claims to produce a high-quality product or service, ‘we recommend independently verifying that the product or service is indeed of high quality, that the partner can deliver it consistently, that the product meets required specs, and that the company has a track record of fulfilling orders on time and at cost,’ says Holley.

Know your partner

Determining that your partner can actually deliver on its claims is just the first step in getting to know it well. In fact, Robert Winner, partner at Seyfarth Shaw, says ‘knowing your partner’ is now the primary concern for firms considering entering into a JV. Companies should be sure to carefully examine the business relationship they expect to establish with their JV partners. ‘The capital, personnel and resources committed to the JV, the corporate culture, and the business plans all have to be aligned before going forward with your JV partner,’ he says.

Knowing your JV partner also involves determining the level of exposure to reputational risk that might be brought to the enterprise. To identify reputational risks, experts advise that companies contract outside firms to conduct a public records search and ‘human source inquiries’ that can uncover damaging information about potential JV partners and their executives. Michael Pace, co-leader of FTI Consulting’s global risk and investigations practice and senior managing director of its forensic litigation consulting unit, says searches and inqui- ries should be scaled to the size and complexity of the JV partner and should be targeted to the markets in which the new JV will operate.

As reliable information may be hard to come by in emerging markets where many JVs are established, human source inquiries are used to identify and interview people who can help determine whether any corruption can be tied back to a particular company and its executives. ‘A careful human source inquiry might identify former business partners, government officials and people on the other side of a business dispute,’ says Pace.

Combing through media reports and public records can uncover judgments, published reports of criminal or regulatory proceedings and other documents that may identify connections to government officials or state-owned enterprises that could signal corrupt activity. The searches can also determine how extensive the JV partner’s interactions with the government are and identify ‘politically exposed people the US-based partner should be interested in,’ Pace explains.

The FCPA and other concerns

Conducting reputational due diligence will help companies avoid entering into JVs with partners that have engaged in corruption in the past. Going into business with a JV partner that has committed corruption could expose US companies to successor liability, making them responsible for any fines, penalties or other liabilities resulting from misconduct that occurred prior to forming the JV.

Avoiding successor liability is particularly important as regulators across the globe ramp up their anti-corruption efforts. In addition to concerns about the FCPA and the UK Bribery Act, new anti-corruption efforts in Brazil, China, India and several Eastern European and African nations have increased the risk for multinational companies. Penalties can include significant investigation costs, substantial fines and even jail time, both in the US and elsewhere.

Violations of the FCPA and other anti-corruption laws can cover a number of activities. The manner in which unique or rare materials are obtained by the JV partner could place companies at risk, particularly if local government contacts, illegal payments or bribes are used. The US also has sanctions against trading with certain nations (such as Iran and Syria) that carry severe penalties.

Efforts to combat fraud and money laundering also involve the FCPA. Holley warns companies to avoid violations of the FCPA books-and-records mandate, adding that ‘if the US-based entity is publicly traded there could also be SEC issues related to the maintenance of accurate books and records.’

The US Department of Justice and SEC have been more aggressive about taking action against companies that do not make good-faith efforts to identify corrupt practices through sensible due diligence prior to closing M&A deals, and those actions will be extended to JVs. Companies immediately implementing corrective measures to bring JV partners into compliance may avoid some liability.

Steven Goldberg, a corporate governance deal lawyer with BakerHostetler, says companies should ensure their JV partners have an FCPA policy in place prior to any deal. Companies without FCPA policies may be more likely to have a culture of misconduct. He also advises that a separate FCPA policy should be created once the new JV is established. ‘In conducting due diligence on the JV counterparty, special attention should be paid to any previous FCPA violations and the JV agreement should contain representations and warranties regarding FCPA compliance,’ he says.

Another area of important due diligence is intellectual property, which will play a large role in most new JVs. Townsend warns companies to make sure their due diligence covers the JV partner’s ownership of relevant intellectual property that is either being contributed to the JV or licensed to the JV, and that the partner is not retaining any intellectual property that could later be used against the JV.

‘You need to agree on rules for the allocation of any new intellectual property created by the JV in the future,’ says Townsend. ‘And you need to ensure, to the extent possible in the early stages, that the products to be created by the JV can be offered to the market without infringement of any existing third-party patents.’

If you find a third party owns patents or intellectual property critical to your JV operations after you’ve created a new product, you’ll be at risk of lawsuits seeking financial compensation and damages or barring your firm from continuing to sell the product.

Financial diligence and compliance

Conducting financial due diligence to ensure your JV partner is financially stable is critically important. Getting an independent financial picture of the JV partner, including verifying the company’s earnings, should be done before establishing any deal.

‘If the US client is entering into a JV that might require the partner to infuse a certain amount of cash into the business, make improvements to a facility or expand a manufacturing capability, it’s important to verify that the company is credit-worthy and has the ability to secure a loan,’ says Holley.

Unfortunately, many firms neglect to conduct due diligence on their JV partner’s anti-corruption policies and procedures or their partner company’s code of conduct. Getting an understanding of these areas will shed light on how a company has been operating over the long term and determine whether corruption is part of the corporate culture.

Understanding the level of anti-corruption policies and procedures that are in place will give you information that can help you search for potential corrupt and illegal activity at your JV partner and its third-party suppliers. Regulators will be expecting there to be robust anti-corruption measures in place once you are up and running, so identifying problems and eliminating them is essential.

‘You want to make sure your JV partner acts as ethically as you do, and can prove it does,’ says Holley. Among the things companies must determine are: does the JV partner conduct any due diligence on its vendors? Does it know everything about who it is doing business with? Does it know who it has acting as an agent on its behalf in other parts of the world where oversight might be difficult?

Holley also says companies must be careful to ensure the JV partner follows the code of conduct of the US-based company or the majority owner. A compliance and monitoring system must be put in place to adequately train employees on the company code of conduct and FCPA compliance regulations if fines and penalties are to be avoided.

Winner suggests companies create a compliance team at the JV level that will establish proper policies and procedures and arrange for regular audits of all financials. If the JV is based in a different country, he recommends ‘engaging local counsel to monitor and understand customs and how business is run locally, as well as how the regulatory schemes operate’.

Monitoring progress

Pace recommends performing some level of transaction testing – a forensic accounting exercise that examines the books and records of a potential JV partner to identify whether there are indications of bribery, improper payments or other corruption.

Lastly, Townsend says companies should have representation on the board of the JV ‘to monitor the JV management team and make sure it is executing on its business plan, that it is properly identifying and managing risk, and that it is avoiding any entanglements that might create reputational issues for the parent company.’

Monitoring should include internal reports on the performance of the JV that should be made periodi- cally to the parent firm. Capital obligations and com- mitments with the parent company should be periodically reviewed and the performance of any agreements and commercial contractual relationships with the parent company should also be monitored, just as any contracts with third-party vendors would be monitored to ensure all obligations are honored.

There is no doubt that performing JV due diligence and establishing monitoring programs once the venture is operating is a complex process, but it must be done if a company wants to avoid future regulatory fines and legal liability.

‘JV due diligence is a lot less expensive than some of the fraud investigations, sanctions, trade investigations and loss of intellectual property investigations that stem from failing to do adequate due diligence,’ says Winner.