The Impact of Anti-Bribery Enforcement Actions on Target Firms Jonathan M. Karpoff WAMU Chair in Innovation Foster School of Business University of Washington D. Scott Lee Lincy Professor of Finance Lee School of Business Univ. of Nevada, Las Vegas Gerald S. Martin Assoc. Professor of Finance Kogod School of Business American University

Impacts of anti-bribery enforcement 2 U.K. Bribery Act of 2010 (implemented July 1, 2011) “[T]he world's most draconian anti-corruption legislation…” The American Lawyer, July 1, 2011 “FSA warns firms over anti-corruption rules” “… The Financial Services Authority (FSA) has announced that although it does not enforce the Bribery Act, it can still take regulatory action against firms who fail to adequately address corruption risk.” Financial Times, September 12, 2011 July 2011: The FSA fines Willis Ltd. £7m for inadequate anti- bribery and corruption controls failings

Anti-bribery efforts worldwide From Trace International’s Global Enforcement Report 2011 Impacts of anti-bribery enforcement 3

4 U.S. anti-bribery enforcement actions on the rise (1978 through June 2011) Total = 109 (excludes 44 actions not involving publicly traded firms) Total = 109 (excludes 44 actions not involving publicly traded firms)

“Even a single incident [of an FCPA bribery charge] can lead to irreparable economic hardship and reputational damage that may adversely affect the overall stability and competitiveness of any business.” – Pricewaterhouse Coopers “…the puny size of the penalties [for bribery] could provide an incentive for managers to stretch the rules.” – Fortune magazine 5 Impacts of anti-bribery enforcement What happens to these firms?

Impacts of anti-bribery enforcement 6 Our questions How costly is it to be targeted for bribery enforcement? What is the nature of the cost? Fines and penalties? Investigation expenses? Foregone bribery-dependent revenues? A general loss in reputation?

For firms, an optimization issue: How much should a firm spend on anti-bribery compliance and control? For regulators, an enforcement puzzle: Are reputational costs small or large? If reputational loss is small, then deterrence depends on legal and regulatory actions. 7 Impacts of anti-bribery enforcement Why is this important?

Impacts of anti-bribery enforcement 8 … Financial misrepresentation and consumer fraud? Occasionally significant legal penalties Large reputational impacts on the firm’s operations … Or environmental violations? Occasionally significant legal penalties Small impact on ongoing operations Is bribery more like: When it comes to reputation…

What do I mean by REPUTATION? Reputational capital is the present value of favorable business terms received from those who trust you to not act opportunistically to their detriment. customers suppliers employees investors Impacts of anti-bribery enforcement 9

Reputational capital is: An asset, just like the firm’s physical plant and people. Created by investment, just like a building is created by investment. Affected by random events, good and bad luck, and things outside the firm’s control (like a building’s value). A damaged reputation can be repaired by investment. Sometimes it warrants the investment (Tylenol) Sometimes it does not (Arthur Andersen) Impacts of anti-bribery enforcement 10

Even more on “reputation” Examples: Does Walmart have a lot of reputational capital? How about McDonalds? Does a used car dealer of luxury cars necessarily have a lot of reputational capital? Impacts of anti-bribery enforcement 11

Impacts of anti-bribery enforcement 12 Our sample All 109 enforcement actions for bribery since the FCPA was passed, 1978 – June 2011 All SEC and DOJ releases Factiva, Lexis-Nexis news searches Double-check with DOJ employees

What constitutes an enforcement action? 13 Impacts of anti-bribery enforcement

14 United States v. Faro Technologies Inc. (2008) Sells computerized measurement devices and software In 2005, Faro’s subsidiary paid $533,163 to managers of China state-controlled firms to obtain sales contracts worth $4.9 million. In June 2008, Faro agreed with DOJ and SEC to: $1.1 million criminal penalty $1.4 million disgorgement Prejudgment interest of $439,637 Retain an independent compliance monitor

Impacts of anti-bribery enforcement 15 Other DOJ and SEC bribery actions… BAE Systems PLC (2010) Paid £135,000,000 to Saudi officials for defense contracts Kellogg Brown & Root LLC (2009) Paid $180 million to Nigerian officials for business worth $6 billion Westinghouse Air Brake Technologies Corp. (2008) Paid $170,542 to officials of the Indian Railway Board Chevron Corp. (2007) Paid $20 million in kickbacks during the Iraq food-for-oil program

Who gets charged? 16 Impacts of anti-bribery enforcement Large manufacturing firms

Why do firms pay bribes? 17 Impacts of anti-bribery enforcement

How large are the bribes? What are the expected benefits to bribe payers? 18 Impacts of anti-bribery enforcement Fuzzy concept, frequently not the NPV

Where are the bribes paid? Impacts of anti-bribery enforcement 19 Nigeria (n=30) Iraq (n=26) China (n=24)

Market value losses 20 Impacts of anti-bribery enforcement What accounts for these losses? 1.Confounding news/associated charges 2.Fines and penalties 3.Investigation costs 4.Lost bribe- related business 5.Reputational losses

1. Effect of simultaneous fraud charges The largest hits involve financial fraud 21 Impacts of anti-bribery enforcement

2. Fines & penalties imposed in bribery enforcements Impacts of anti-bribery enforcement 22

3. Investigation and legal expenses Impacts of anti-bribery enforcement 23

5. Is there much of a reputation loss? Impacts of anti-bribery enforcement 24

W hat determines cross-sectional differences in market value losses? 25 Impacts of anti-bribery enforcement

Summary 1. Bribery charges are associated with a relatively small but significant loss in market value 2. Why? 1. Confounding news/associated charges - Yes 2. Fines and penalties - Yes 3. Investigation costs – Yes 4. Foregone bribe-related business - Yes 5. Reputational losses – No Impacts of anti-bribery enforcement 26 Direct costs matter, and more than explain the market value losses Indirect costs do not matter, on avg.

What does this mean? The costs of bribery enforcement actions on the target firm: Typically modest fines and penalties Occasionally criminal penalties Reasonable investigation expenses But does not affect the firm’s ongoing operations or costs of capital (reputational capital remains intact). That is, bribery enforcement costs are smaller than the costs of being caught defrauding consumers or investors. Impacts of anti-bribery enforcement 27