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Cognizant Technology Solutions – An Interesting, Albeit Early, FCPA Case Study

As highlighted in this prior post, on September 30th Cognizant Technology Solutions disclosed that it voluntarily disclosed to the DOJ and SEC “certain payments relating to facilities in India [that] were made improperly and in possible violation of the FCPA and other applicable laws.”

Even though Cognizant’s FCPA scrutiny is a mere six weeks old, it presents an interesting FCPA case study as to the FCPA’s many “ripples.” (See here for the article “FCPA Ripples [1]“). As stated in the article: “because of the many ripples of FCPA enforcement, it is important that FCPA enforcement be subjected to meaningful judicial scrutiny and that enforcement actions represent legitimate instances of provable FCPA violations, not merely settlements entered into for reasons of risk aversion.”

On this issue, it is interesting to note that Cognizant’s FCPA scrutiny relates to permits in connection with certain facilities in India and you can read all about actual legal authority concerning this type of FCPA enforcement theory in this article. [2]

On September 30th when Cognizant disclosed its FCPA scrutiny, it shares plunged over 13% to 47.71.

Investors were likely spooked not just by the company’s FCPA disclosure but also the same day Cognizant disclosed that on September 27th Gordon Coburn resigned from his position as President of Cognizant.

The question was obviously asked whether the two disclosures were linked.

Earlier this week, Cognizant updated its FCPA disclosure as follows [3].

“On September 30, 2016, we disclosed that we are conducting an internal investigation into whether certain payments relating to Company-owned facilities in India were made improperly and in possible violation of the U.S. Foreign Corrupt Practices Act, or FCPA, and other applicable laws. In September 2016, we voluntarily notified the U.S. Department of Justice, or DOJ, and Securities and Exchange Commission, or SEC, and are cooperating fully with both agencies. The investigation is being conducted under the oversight of the Audit Committee, with the assistance of outside counsel. To date, the investigation has identified a total of approximately $5.0 million in payments that may have been improper. During the three months ended September 30, 2016, we recorded an out-of-period correction related to $3.1 million of such payments that were previously capitalized that should have been expensed. The remaining $1.9 million of such payments remains under investigation. The recorded correction resulted in an increase of selling, general and administrative expenses of $3.1 million, a reduction in depreciation and amortization expense of $0.4 million, and a reduction in property and equipment, net of $2.7 million. These prior period corrections and the $1.9 million in payments under investigation were not material to any previously issued annual or any interim financial statements and are not expected to be material to the financial results for the year ending December 31, 2016.

During the closing process for the third quarter of 2016, based on the results of the internal investigation to date, we concluded that as of December 31, 2015 and in subsequent interim periods, we did not maintain an effective control environment. Specifically, we did not maintain an effective tone at the top as certain members of senior management may have participated in or failed to take action to prevent the making of potentially improper payments by either overriding or failing to enforce the controls established by the Company relating to real estate and procurement principally in connection with permits for certain facilities in India. Such actions would be inconsistent with the standards and tone at the top to which our Board of Directors and senior management are committed and would be in violation of the Company’s written code of conduct and procedures established in part to detect and prevent improper payments. Based on the results of the investigation to date, the members of senior management who may have participated in or failed to take action to prevent the making of the identified potentially improper payments are no longer with the Company or in a senior management position.

As a result of the foregoing, we have determined that a material weakness existed as of December 31, 2015, and continues to exist in subsequent interim periods, in our internal control over financial reporting. Accordingly, we have updated the previous conclusion included in Item 9A of our Form 10-K filed with the Securities and Exchange Commission on February 25, 2016 with respect to our disclosure controls and procedures and internal controls over financial reporting to conclude that our disclosure controls and procedures and internal controls over financial reporting as of December 31, 2015 were ineffective. Also, we have updated the previous conclusions included in Item 4 of our Forms 10-Q filed with the Securities and Exchange Commission on May 6, 2016 and August 5, 2016 with respect to our disclosure controls and procedures to conclude that our disclosure controls and procedures as of March 31, 2016 and June 30, 2016, respectively, were ineffective.

We have concluded that we have a material weakness as of September 30, 2016. However, based on the results of the investigation to date, no material adjustments, restatements or other revisions to our previously issued financial statements are required.”

Cognizant’s statement that “we did not maintain an effective tone at the top as certain members of senior management may have participated in or failed to take action to prevent the making of potentially improper payments by either overriding or failing to enforce the controls established by the Company relating to real estate and procurement principally in connection with permits for certain facilities in India” would seem to make it more likely than not that the above-referenced executive resignation was linked to the company’s FCPA scrutiny.

Given the drop in Cognizant’s stock price immediately after the September 30th disclosures, it was as predictable as the sun rising in the east that shareholder lawyers would start to circulate. Indeed, Cognizant’s disclosure earlier this week states:

“In October 2016, two purported securities class action complaints were filed, naming us and certain of our officers as defendants and alleging violations of the Securities Exchange Act of 1934, as amended, based on allegedly false or misleading statements related to potential violations of the FCPA, our business, prospects, and operations and the effectiveness of our internal control over financial reporting and our disclosure controls and procedures. On October 31, 2016, a lawsuit was filed in the Bergen County Superior Court – Law Division, New Jersey, naming us, all of our directors and certain of our current and former executive officers as defendants. The Company has not yet been served with the complaint.”

Such FCPA-related civil lawsuits represent an additional cost to company’s under FCPA as separate and distinct counsel are often hired to defend the civil lawsuits.

Very few of these FCPA-related lawsuits have merit (in the sense of getting past the motion to dismiss stage) and on this score it is interesting to note that Cognizant’s stock price closed yesterday at $54.89 – in other words it has regained, in a short amount of time, nearly all of the value from its FCPA-induced dip.

Another of the FCPA’s many ripples, in addition to pre-enforcement action professional fees and expenses associated with FCPA scrutiny (which Cognizant did not disclose specifics about in this week’s filing) and FCPA-related civil actions, are other financial ramifications.

On this score, Cognizant’s disclosure states:

“On November 5, 2016, or the First Amendment Effective Date, we entered into Amendment No. 1 and Limited Waiver No. 1 to the Credit Agreement, or the First Amendment. The First Amendment modifies the representation and warranty in the Credit Agreement relating to compliance with anti-corruption laws to add an exception for actions, proceedings and other matters relating to our internal investigation into whether certain payments relating to our owned facilities in India were made improperly and in possible violation of the FCPA and other applicable laws, or the Disclosed Matters. Pursuant to the First Amendment, the required lenders waive certain defaults or events of default that may have existed prior to the First Amendment Effective Date due to such representation and warranty proving to have been materially incorrect solely as a result of the Disclosed Matters and due to our failure to provide notice thereof to the administrative agent.”

On-going FCPA risk and uncertainly also impacts the “risk factors” that companies are required to disclose to investors. On this score, Cognizant’s recent disclosure states (duplicating certain of the information discussed above):

“Risks associated with our ongoing internal investigation into possible violations of the Foreign Corrupt Practices Act and similar laws, including sanctions, fines or remedial measures that may be imposed by the DOJ or SEC, additional expenses related to remedial measures, the costs of defending and possible judgments against us that may result from associated lawsuits against us and any possible impact on our ability to timely file the required reports with the SEC;

[…]

On September 30, 2016, we disclosed that we are conducting an internal investigation into whether certain payments relating to Company-owned facilities in India were made improperly and in possible violation of the U.S. Foreign Corrupt Practices Act, or FCPA, and other applicable laws. In September 2016, we voluntarily notified the U.S. Department of Justice, or DOJ, and Securities and Exchange Commission, or SEC, and are cooperating fully with both agencies. The investigation is being conducted under the oversight of the Audit Committee, with the assistance of outside counsel. To date, the investigation has identified a total of approximately $5.0 million in payments that may have been improper. Based on the results of the investigation to date, no material adjustments, restatements or other revisions to our previously issued financial statements are required.

On October 5, 2016 and October 27, 2016, two purported securities class action complaints were filed in the United States District Court for the District of New Jersey, naming us and certain of our officers as defendants and alleging violations of the Securities Exchange Act of 1934, as amended, based on allegedly false or misleading statements related to potential violations of the FCPA, our business, prospects, and operations and the effectiveness of our internal control over financial reporting and our disclosure controls and procedures. The plaintiffs seek compensatory damages and an award of the costs and attorneys’ and experts’ fees of the plaintiff and a purported class of stockholders who purchased our common stock during the period between February 25, 2016 and September 30, 2016. On October 31, 2016, a lawsuit was filed in the Bergen County Superior Court – Law Division, New Jersey, naming us, all of our directors and certain of our current and former executive officers as defendants. The Company has not yet been served with the complaint.

We are presently unable to predict the duration, scope or result of the Audit Committee’s investigation, of any investigations by the DOJ or the SEC or the purported class action lawsuits or other lawsuits. The DOJ and the SEC have a broad range of civil and criminal sanctions under the FCPA and other laws and regulations including, but not limited to, injunctive relief, disgorgement, fines, penalties, modifications to business practices including the termination or modification of existing business relationships and the imposition of compliance programs and the retention of a monitor to oversee compliance with the FCPA. We could incur additional expenses related to fines or to remedial measures. The imposition of any of these sanctions or remedial measures could have a material adverse effect on our business, annual and interim results of operations, cash flows and financial condition. Furthermore, while the Company intends to defend the lawsuits vigorously, these lawsuits and any other related lawsuits are subject to inherent uncertainties, the actual cost of such litigation will depend upon many unknown factors and the outcome of the litigation is necessarily uncertain.

[…]

The outcome of the internal investigation being conducted under the oversight of our Audit Committee of possible violations of the Foreign Corrupt Practices Act and similar laws and related litigation could have a material adverse effect on our business, annual and interim results of operations, cash flows and financial condition.

On September 30, 2016, we disclosed that we are conducting an internal investigation into whether certain payments relating to Company-owned facilities in India were made improperly and in possible violation of the FCPA, and other applicable laws. In September 2016, we voluntarily notified the DOJ, and the SEC, and are cooperating fully with both agencies. The investigation is being conducted under the oversight of the Audit Committee, with the assistance of outside counsel.

On October 5 and 27, 2016, two purported securities class action lawsuits were filed in the United States District Court for the District of New Jersey, naming us and certain of our officers as defendants and alleging violations of the Securities Exchange Act of 1934, as amended. The complaints alleged false or misleading statements related to potential violations of the FCPA, our business and operations and the effectiveness of our internal control over financial reporting and our disclosure controls and procedures. On October 31, 2016, a lawsuit was filed in the Bergen County Superior Court – Law Division, New Jersey, naming us, all of our directors and certain of our current and former executive officers as defendants. The Company has not yet been served with the complaint.

We are presently unable to predict the duration, scope or result of the internal investigation, the related purported class actions or any other related lawsuit, and any investigations by the DOJ or the SEC, including whether either agency will commence any legal action.

The DOJ and the SEC have a broad range of civil and criminal sanctions under the FCPA and other laws and regulations including, but not limited to, injunctive relief, disgorgement, fines, penalties, the imposition of revised compliance programs and the retention of a monitor to oversee compliance with the FCPA. The imposition of any of these sanctions, fines or remedial measures could have a material adverse effect on our business, annual and interim results of operations, cash flows and financial condition. We could also incur additional expenses related to remedial measures, including those that we are implementing in response to our conclusion that our internal control over financial reporting and our disclosure controls and procedures are not effective.

The outcome of the purported class action litigation, or any other litigation, is necessarily uncertain. We could be forced to expend significant resources in the defense of these lawsuits or future ones, and we may not prevail. The imposition of any sanctions, remedial measures or judgments against us could have a material adverse effect on our business, results of operations and financial condition.”

Speaking of investors, Cognizant’s investor call earlier this week provides some interesting information.

For starters, CEO Francisco D’Souza stated:

“I’d like to take a moment to update you on the internal investigation we announced at the end of September. The investigation is focused on payments relating to permits for certain company-owned facilities in India and whether such payments were made improperly and a possible violation of the U.S. Foreign Corrupt Practices Act and other applicable laws.

First, I think it’s important to note that we do not anticipate any impact on our ability to continue to provide the quality services our clients expect from us. Second, as disclosed in the Form 10-Q we filed this morning, we’ve identified approximately $5 million in potentially improper payments to-date. We’ve evaluated the effect of such payments and concluded that they are not material and do not require a restatement of our historical financial statements. […]

Third, and also disclosed this morning, we discovered in the course of the investigation that certain members of senior management may have been aware of or participated in the matters under investigation. Any such conduct would be inconsistent with our core values. Based on the results of the investigation to-date, those who may have been involved are no longer with the company or in the senior management position.

Finally, I would like to reaffirm our strong commitment to compliance with all applicable laws and regulations. We voluntarily disclose the matters under investigation to the U.S. Department of Justice and the Securities and Exchange Commission in September, and we’ve been fully cooperating with both agencies. Based on the results of the investigation to-date, we have already started and will continue to enhance our internal controls and compliance programs.”

During the call, an investor asked:

“Thanks for the FCPA update and the materiality stuff there. So, has the FCPA issue had any impact on the client side and on the investigation itself, what needs to happen from here for the issue to be resolved? Could there be any additional costs to remedy the internal controls, for example?”

D’Souza responded:

“Look, I would say, it’s business as usual in terms of serving clients at this point. As I said, we expect no impact on our ability to provide high-quality services to clients, and in fact, haven’t seen any. The fundamentals are we’ve got great associates doing good work every day on behalf of our clients, and I think our clients recognize that. The investigation is ongoing. I don’t want to speculate on how long it’s going to take or the costs that may be associated with it going forward, but our commitment is to conduct a thorough investigation and we’re committed to doing that.”

Another investor asked:

“[A]as it relates to the FCPA investigation, are we confident at this point that it’s been fully scoped at that kind of $5 million or so range? And I guess, I was surprised at how quickly you’ve sort of gotten clarity on this.”

CFO Karen McLoughlin responded:

“So, it is early days in the investigation. I think, as we’ve said both in the Q and on the script today, we are continuing to pursue the investigation. We’ve obviously been working very, very hard to get our arms around this as quickly as we could. And as we said, we’ve identified to-date $5 million of potential improper payments. We were able to get to a place where we thought it was appropriate to record the $3.1 million of the $5 million as an out-of-period adjustment in Q3, but we will continue the investigation until we’re confident that we’ve tracked it all down.”

Cognizant’s FCPA scrutiny has been in the public domain for a mere six weeks, but already it is presenting an interesting FCPA case study.