Distributors under the FCPA

If there was ever a question that distributors were covered under the Foreign Corrupt Practices Act (FCPA), in 2012, the Department of Justice (DOJ) and Securities and Exchange Commission (SEC) made it emphatically clear that this class of entities in a company’s sales chain would be treated that same as any other sales agent, reseller or any other entity which sells a US company’s products outside the United States. While the terms agent, reseller and distributor have distinct definitions in the legal world, they no longer do for FCPA purposes.

The three enforcement actions which made clear that there were no distinctions between agents and distributors in 2012 were the Smith & Nephew, Inc., (S&N) Deferred Prosecution Agreement (DPA) for criminal FCPA violations, the Oracle SEC Complaint for books and records violations and the Eli Lilly and Company (Lilly) SEC Compliant for books and records violations. Each of these enforcement actions had different FCPA violations and they each revealed separate steps which a company should take to both prevent and detect FCPA violations in their company.

Smith & Nephew

On February 1, 2012, the DOJ announced that it entered into a DPA with Smith & Nephew, Inc., a medical equipment manufacturer, for violations of the FCPA. The violations revolved around Greek distributors of S&N who paid bribes to Greek doctors so that they would purchase and use S&N products. According to the Criminal Information, “S&N, certain of its executives, employees, and affiliates agreed to sell to [the] Greek Distributor at full list price, then pay the amount of the distributor discount – between 25 and 40 percent of the sales made by [the] Greek Distributor – to an off-shore shell company controlled by [the] Greek Distributor, in order to provide off-the-books funds for [the] Greek Distributor to pay cash incentives and other things of value to publicly-employed Greek HCPs to induce the purchase of S&N products, while concealing the payments.” Additionally, S&N “falsely recorded or otherwise accounted for the payments to the shell companies on its books and records as ‘marketing services’ in order to conceal the true nature of the payments in the consolidated books and records of S&N and GmbH.”

Oracle

Oracle got into FCPA hot water because its Indian subsidiary directed its distributor to set up a separate slush fund of monies which could be, and were, used to pay monies to persons unknown. As specified in the SEC Compliant, “certain Oracle India employees created extra margins between the end user and distributor price and directed the distributors to hold the extra margin in side funds. Oracle India’s employees made these margins large enough to ensure a side fund existed to pay third parties. “At the direction of the Oracle India employees, the distributor then made payments out of the side funds to third parties, purportedly for marketing and development expenses.” The SEC Compliant noted that “about $2.2 million in funds were improperly “parked” with the Company’s distributors.” To compound this problem, employees of Oracle India concealed the existence of this side fund from Oracle in the US and hence there was an incorrect accounting in Oracle’s books and records.

Lilly

In Brazil, Lilly used the distributor model to market its drugs through third-party distributors who then resold these products to public and private entities. As noted by Matt Ellis, in his post entitled “Eli Lilly’s Distributor in Brazil: The Non-Obvious FCPA Risk”, the discounts that distributors typically receive from manufacturers such as Lilly can be problematic under the FCPA because “enforcement officials can see these discounts as potential “loose money” that can be used for bribe payments. This is especially the case when the distributor is engaging in other activities on behalf of the producer, like marketing, licensing, and customs clearance.”

This was the situation that Lilly found itself in in Brazil, where Lilly sold drugs to distributors who then resold the products to both public and private entities. It was the classic distributor model where Lilly sold the drugs to the distributors at a discount and then the distributors would resell the products “at a higher price and then took their discount as compensation.” There was a fairly standard discount given to the distributors which generally ranged “between 6.5% and 15%, with the majority of distributors in Brazil receiving a 10% discount.”

However, in early 2007, at the request of a Lilly sales manager, the company awarded an unusually high discount of between 17% and 19% to a distributor for the sale of a Lilly drug to the government of one of the states of Brazil. The distributor used approximately 6% of this additional discount to create a fund to pay Brazilian government representatives to purchase the Lilly drugs from him. Further, the Lilly sales manager who requested this unusual discount was aware of the bribery scheme. Moreover, this increase in the discount was approved by the company with no further inquiry as to the reason for the request or to substantiate the basis for such an unusually high discount. If there were any internal controls they were not followed.

Prevention and Detection

These three separate bribery schemes call for three different but overlapping responses. In the case with Lilly, the SEC Complaint noted the following “Lilly-Brazil’s pricing committee approved the discounts without further inquiry. The policies and procedures in place to flag unusual distributor discounts were deficient.” Lastly, as stated by Ellis, “It noted that the company relied on representations of the sales and marketing manager without adequate verification and analysis of the surrounding circumstances of the transactions.”

The Lilly enforcement action also makes clear the need for internal audit to follow up with ongoing monitoring and auditing. Internal audit can be used to help determine the reasonableness of a commission rate outside the accepted corporate norm. As noted by Jon Rydberg, of Orchid Advisors, in an article entitled “Eli Lilly’s Remedial Efforts for FCPA Compliance – After the Fact”, the company should be “implementing compliance monitoring and corporate auditing specifically tailored to anti-corruption” for the distributor sales model.

The Oracle enforcement action demonstrates that Oracle needed to institute the proper controls to prevent its employees at Oracle India from creating and misusing the parked funds in the distributor’s account. The Company needed to audit and compare the distributor’s margin against the end user price to ensure excess margins were not being built into the pricing structure. Oracle should have sought to either (1) seek transparency in its dealing with the distributor or (2) audit third party payments made by the distributors on Oracle’s behalf, both of which would have enabled the Company to check that payments were made to appropriate recipients.

What are some of the factors that demonstrate the distributors used by S&N were fraudulent and did not have a legitimate business purpose? It was clear that S&N did not perform sufficient due diligence on these distributors nor did they document any. I would note that the distributor was domiciled in a location separate and apart, the UK, from the sole location it was designed to deliver products or services into, Greece. This clearly demonstrated that the entities were used for a purpose that the company wished to hide from Greek authorities. While it is true that a distributor might sell products into a country different than its domicile, if the products are going into a single country, this should have raised several Red Flags.

However, the biggest indicium of corruption was the amount of the commission paid. The traditional sales model for a distributor has been to purchase a product, take the title, and therefore the risk, and then sell it to an end user. Based upon this sales model, there has been a commission structure more generous than those usually accorded a reseller or sales agent, who is usually only a negotiator between the Original Equipment Manufacturer (OEM) and the end user. This difference in taking title, and risk of loss, have led to a cost structure which has provided a deeper discount of pricing for distributors than commission rates paid to resellers or sales agents. The sales structure used by S&N had pricing discounts of between 26-40% off the list price. Further, this money was used precisely to pay bribes to Greek Doctors to use S&N products.

These three enforcement actions make clear that distributors will be treated like any other representative in the sales chain. This means that distributors need to go through the same rigorous due diligence and review, contracts and management going forward as agents or resellers.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2013

The Lilly FCPA Enforcement Action (Part III) Lessons Learned from Russia

This Part III is the final installment of my review of the Eli Lilly and Company (Lilly) FCPA enforcement action brought by the Securities and Exchange Commission (SEC). In this Part III, I will review the FCPA issues that Lilly found itself involved with in Russia and use those issues in the context of Paul McNulty’s Three Maxims regarding the effectiveness of a FCPA compliance program. First, what did you do to prevent it? Second, what did you do to detect it? Third, what did you do to remedy it?

I.                   Russia

Lilly used a distributor sales model in Russia. However, there was a further twist which got Lilly into FCPA hot water. Lilly would enter into an agreement with a third party other than the distributor who was selected by the government official making decisions on the purchase of Lilly products. Lilly did little to no due diligence on these third parties which would have identified the beneficial owners of these entities. Further, these other third parties were usually not domiciled in Russia, nor did they have bank accounts in Russia. In other words, they were Offshore Agents who were paid a flat fee or percentage of the total sales with no discernible work or services performed.

The SEC Complaint noted that Lilly itself provided contracts to these third parties which described their services as “immediate customs clearance” or “immediate delivery” of the products or in assisting Lilly in “obtaining payment for the sales transaction” and such other oldie but goodies as “the promotion of the products” and “marketing research.” The SEC Complaint also noted that the services described were actually provided by other entities including Lilly itself.

There also charitable donations made by Lilly in Russia but here Lilly simply made proposals to government decision makers regarding how the company “could donate or other support various initiatives there were affiliated with public or private institutions headed by the government officials or otherwise were important to the government officials.” In addition to the problems with the charitable donations policy in Russia, there were two reports provided to Lilly’s corporate headquarters identifying some of the compliance issues that the company was having in Russia but there was follow up from the corporate office. You have to put “boots on the ground” to make a proper inquiry, assessment or review for a high risk country. Antonia Chion, Associate Director in the SEC Enforcement Division put it another way when he was quoted in the SEC Press Release announcing the Complaint. He said, “When a parent company learns tell-tale signs of a bribery scheme involving a subsidiary, it must take immediate action to assure that the FCPA is not being violated. We strongly caution company officials from averting their eyes from what they do not wish to see.”

a.      Prevent

From the prevent prong there are several things that the compliance practitioner can put in place. There should be an adequate system of internal accounting sufficient to provide reasonable assurance that a company maintains accountability for its assets. Such a system would also provide a procedure that would ensure transactions were executed in accordance with management’s authority. Regarding third parties, a company cannot simply rely on the paperwork submitted by third parties but must verify its accuracy through independent due diligence. A company should also have procedures in place to safeguard that it is not offering anything of value to government officials to assist in retaining or obtaining business. Lastly, when the corporate office receives a report from a high risk country or area in which to do business, there must be follow up on the report.

 b.      Detect

Regarding detect, a company’s internal audit must have procedures in place designed to assess FCPA compliance or other anti-bribery law risk for sales of products and purchases of goods. If there are red flags or other indicia of high risk noted, there must be additional monitoring, review and auditing. As noted in Part I of these posts on the Lilly enforcement action, several Russian distributors were domiciled outside the company, in both Cyprus and the British Virgin Islands. None of these red flags were investigated or followed up. Audit must do more than simply assure itself of the soundness of the paperwork which is submitted to it or it reviews. If the circumstances surrounding the existence of a party or transaction suggest the possibility of a FCPA violation or corruption it must be followed up and reviewed.

II.                Remedy

I have laid out the facts as reported in the SEC Complaint in some detail for several reasons. One of which is to emphasize how wide ranging Lilly’s conduct was regarding FCPA violations. I think that it is incumbent to note that even with this wide ranging and apparently pervasive conduct, Lilly did not sustain a Deferred Prosecution Agreement or even a Non-Prosecution Agreement for criminal violations of the FCPA by the Department of Justice. There was only a civil Complaint filed by the SEC. As to the financial penalty, Lilly agreed to pay disgorgement of $13,955,196, prejudgment interest of $6,743,538, and a penalty of $8.7 million for a total payment of $29,398,734. Lilly also agreed the retention of an independent consultant to review and make recommendations about its foreign corruption policies and procedures but it does not have a monitor.

Lilly also engaged in the third prong of McNulty’s Maxims by remedying the FCPA violations during the pendency of the investigation. These remedies were listed in the SEC Complaint. In China, where the FCPA violation were engaged in by Lilly employees, the company “terminated or otherwise disciplined” those involved. Lilly also agreed to certain structural changes in its compliance program. These changes included:

• enhancing anti-corruption due diligence requirements for relationships with third parties;
• implementing compliance monitoring and corporate auditing specifically tailored to anti-corruption;
• enhancing financial controls and governance; and,
• expanding anti-corruption training throughout the organization.

 III.             Conclusion

The Lilly FCPA enforcement action, as laid out in the SEC Complaint, provides the compliance practitioner with solid information which can be used in a variety of ways to strengthen an anti-corruption/anti-bribery compliance program. First and foremost is the detailed discussion the different types of bribery schemes that were engaged in throughout the company. If your sales model is an employee based sales force, a distributor model with discounts off your list price or commission based third party agents, the Lilly FCPA enforcement action provides you with questions that you can ask to see if you company has FCPA issues to investigate. The SEC Complaint also details the internal controls failures which Lilly sustained and led to the enforcement action. There is also significant and detailed information on what you might look at or do in your compliance program to answer Paul McNulty’s three questions if you are in the position to deal with the SEC or DOJ on a FCPA issue.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2013