Investing in India: How addressing corruption and fraud risks creates higher value

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By Mini vandePol, Asia Pacific Head of the Compliance and Investigations Practice, Anna Lamut, Registered Foreign Lawyer (New York, USA), and Claire Chen, Associate, Baker McKenzie – India is forecast to be the fastest growing economy among the G20 countries in 2020 despite the Covid-19 pandemic. Foreign companies and private equity funds, particularly those that hold a long-term view, will still find ample opportunities when this pandemic recedes, particularly in sectors such as health care, FMCG and financial services that are likely to withstand economic and social uncertainties over the long term. 

However, India, like many emerging economies, presents a risk landscape that is difficult to navigate. In order to structure and price transactions appropriately and avoid unpleasant surprises, companies must proactively assess and address inherent risks underlying their transactions. This article explores key compliance risks that foreign businesses investing in India need to mitigate in order to avoid threats and delays to completion, successor liability for ongoing illegal activities, reduced revenue, profits and ultimately, resale value.

India, with all its opportunities, poses significant fraud and corruption risks to foreign investors. In a 2017 Transparency International survey, nearly 7 in 10 individuals in India admitted to paying a bribe in order to access public services. This is the highest bribery rate in Asia-Pacific, and shows the extent to which corruption plagues virtually every form of government interaction, be it clearing customs, obtaining permits and licenses, or soliciting support from state-owned institutional investors and sovereign wealth funds. While Prime Minister Narendra Modi has significantly reduced corruption at the Federal level, many Indian States and local governments remain high-risk. 

In the current global economy, General Partners are more likely to seek attractive private investment in public equity transactions. Under increasing financial pressure brought on by Covid-19, some businesses may cut corners or falsify their financials to appear more viable. This makes an even stronger case for conducting pre- and post-transaction compliance risk assessments to safeguard the acquirer's business interest. 

It comes as no surprise that many foreign businesses have fallen prey to corrupt practices in India, some of which have caught the attention of global anti-corruption authorities. Moreover, Indian enforcement agencies now have sharper tools to investigate and prosecute bribery offences. The 2018 amendments to Indian anti-corruption laws added bribe-giving as an offence, allowed companies to be held strictly liable for the actions of employees, and allowed managers to be held liable for the actions of lower-level employees. Recent investigations signal that Indian authorities are stepping up enforcement, including against foreign companies.   

Drawing from global cases and our experience of conducting investigations, transactional due diligence and post-acquisition integration on the ground, we set out below the key compliance risks that foreign investors may likely face when investing in India, and some practical tips on how to mitigate those risks. 

Despite Federal efforts such as the creation of a Special Investigation Team to probe corruption cases, State and local government officials retain often-unchecked discretionary powers and operate in an opaque bureaucracy.

Several US Foreign Corrupt Practices Act (FCPA) enforcement cases in India have exposed bribes paid to officials to place products in prominent positions in government-owned retail stores, increase product sales in government-run retail channels, ensure timely inspections at factories, and expedite licensing and label registration processes. In one instance, the label registration process stalled for months because the excise official refused to approve its registration without a 1 million INR bribe. 

These cases involved elaborate, coordinated bribery schemes implicating all levels of government – from junior officials whose role was to ensure routine administrative processes, to senior officials who routinely abused their power and discretion. At a deeper level, they reveal the systemic corruption which has trapped companies by making it easier for them to give in to corrupt demands, rather than fight the system.  

In the majority of FCPA enforcement cases in India, companies paid bribes through third-party sales promoters, agents and distributors. These companies lacked crucial third party controls, such as conducting background checks or monitoring third parties' activities and expenses leading them to approve fabricated or inflated invoices and falsely record the third-party payments as legitimate costs in their books. 

Internal fraud via third parties is also a major concern, with employees using third parties to circumvent the company’s controls and leech money from the business.  

Aside from legal liability, failing to conduct compliance risk due diligence puts companies at risk of buying bribe-tainted contracts and licenses which are crucial to business continuity.  The impact is often immediately felt when the cessation of improper interactions with officials post-closing adversely affects the value of the deal and future structure of the business – a consequence that takes on extra weight in the Covid-19 era where supply chains are already under stress.

1 Conduct pre-acquisition due diligence appropriately tailored to the target's risk profile. 

Many companies conduct “desktop” due diligence or use questionnaires – but this is inadequate. It is important to conduct background checks on the sponsors, physically inspect the operations, conduct financial transaction testing and undertake interviews to understand the target’s business model and how it applies policies in practice. With the current travel restrictions, collaborating with trusted local partners is key. 

Furthermore, robust due diligence can deter enforcement, even if the company proceeds with the acquisition after discovering misconduct. This is in line with the US Department of Justice’s 2019 guidance that assured acquirers that if they uncover misconduct and then voluntarily disclose and remediate, the regulator might refrain from enforcement.  

2 Incorporate specific representations, indemnities and warranties in transactional documents.

General protection clauses in the sale and purchase agreement may not cover existing risks due to limited scope, time and financial caps. For more effective protection, these clauses must target the specific risks identified during due diligence. 

3 Immediately upon closing, remediate risks identified during diligence and implement a robust compliance program which is effective but not an undue burden on the business. 

The sooner companies take steps to remediate, the lower their risk of accepting liability for the target's violations. Companies can use diligence findings to diagnose high-risk areas for focused attention and redundant or ineffective initiatives to eliminate. An effective integration timeline includes taking over financial and operational control, conducting training in local language, rolling out localised policies, obtaining key executives' commitment in writing, conducting forensic financial transactions testing and implementing monitoring, auditing and response mechanisms.

The cost-benefit of investing in the management and mitigation of transactional compliance risks in India cannot be understated. At an immediate level it will preserve the value of the asset by deterring future misconduct and reducing legal liability. More importantly, it will instil a positive and ethical culture in the business, build stakeholder trust, win customer and employee loyalty, and ultimately lead to significantly higher returns.

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