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Deceived By Its Indirect Chinese Subsidiary, Johnson Controls Agrees To Pay $14.4 Million To Resolve SEC FCPA Enforcement Action, DOJ Markets Another “Declination”

According to the SEC, “several members” of Johnson Controls indirect Chinese subsidiary “colluded with each other and circumvented and manipulated JCI’s internal and financial controls …”.

The end result was this SEC administrative order [1] released yesterday in which the SEC found that Johnson Controls (JCI) violated the books and records and internal controls provisions of the Foreign Corrupt Practices Act. Without admitting or denying the SEC’s findings, JCI agreed to pay approximately $14.4 million.

Also yesterday, the DOJ released this June 21st letter [2] to JCI’s counsel stating that it has closed its inquiry “concerning possible violation of the FCPA … despite the bribery by employees of JCI’s subsidiary in China.” The DOJ’s letter is the focus of a separate post today.

Yesterday’s enforcement action against JCI has an interesting background in that it focused on China Marine, an entity described as follows.

“China Marine is part of JCI’s Global Marine business within the company’s Building Efficiency (“BE”) business, which engages in the design and sale of marine HVAC and refrigeration systems as well as aftermarket services and sales. China Marine is comprised of two legal entities: York Refrigeration Marine (China) Ltd. (“YRMC”) and JCI Marine (Shanghai) Trading Company Ltd. The China Marine entities operate as indirect, wholly-owned subsidiaries of JCI and are consolidated into JCI’s financials.”

As noted elsewhere in the SEC’s Order:

“In 2005, JCI acquired York International, a global provider of heating, ventilating, air-conditioning and refrigeration equipment and services, while York was subject to an FCPA investigation. In October 2007, the Commission brought a settled civil action against York, pursuant to which York consented to an order enjoining it from future violations of [the FCPA’s anti-bribery, books and records, and internal controls provisions], disgorgement of $8,949,132, pre-judgment interest of $1,083,748, and a civil penalty of $2,000,000, and the retention of an independent compliance monitor. The monitor provided the Commission and Johnson Controls, as York’s parent, periodic reports that reviewed and analyzed the effectiveness of the controls within the legacy York operations. The monitorship ended in 2010.”

Under the heading “Background,” the SEC’s Order states:

“The Commission’s 2007 action against York alleged that, from 2004 to 2006, YRMC, a subsidiary that sold air conditioning and refrigeration equipment to shipbuilders and shipyards, some of which were owned by the Chinese government, made improper payments to agents and others, including Chinese government personnel at the shipyards, to obtain business. The payments were described in YRMC’s books and records as commissions, sales and marketing expenditures, or gifts and entertainment. YRMC became part of China Marine, a business within BE.

After acquiring York, JCI devoted additional resources to its compliance program, including hiring compliance personnel, conducting trainings, and implementing risk-based procedures and controls. With respect to China Marine, JCI terminated the individuals involved in the YRMC conduct and hired a new managing director of China Marine to oversee the business. The managing director, a Chinese national and resident, reported to the Marine business management in JCI’s Denmark subsidiary, which oversaw the Global Marine business in multiple countries. Because the misconduct identified in the prior civil action involved the improper use of agents, JCI limited the use of agents in its China Marine business model and required that all sales go through its internal sales team based in China. China Marine employees, however, devised another avenue to continue the payments. JCI conducted multiple compliance trainings for the China Marine employees, including trainings on the FCPA. JCI also conducted audits of China Marine, which detected some missing paperwork but failed to detect that the improper payments continued.”

With that background, the Order states in summary fashion:

“This matter concerns violations of the books and records and internal controls provisions of the FCPA by Johnson Controls, Inc. through its managers and employees at its wholly-owned Chinese subsidiary referred to herein as “China Marine.” From 2007 to 2013, the managing director and approximately eighteen employees of China Marine made payments to sham vendors, some of which were then used to make improper payments of approximately $4.9 million to employees of Chinese government owned shipyards, and ship-owners and others, to obtain and retain business, as well as to personally enrich China Marine employees. The improper vendor payments were improperly recorded on JCI’s books and records, and JCI failed to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances to detect and prevent such payments.”

Under the heading “Background,” the Order states:

“The Commission’s 2007 action against York alleged that, from 2004 to 2006, YRMC, a subsidiary that sold air conditioning and refrigeration equipment to shipbuilders and shipyards, some of which were owned by the Chinese government, made improper payments to agents and others, including Chinese government personnel at the shipyards, to obtain business. The payments were described in YRMC’s books and records as commissions, sales and marketing expenditures, or gifts and entertainment. YRMC became part of China Marine, a business within BE.

After acquiring York, JCI devoted additional resources to its compliance program, including hiring compliance personnel, conducting trainings, and implementing risk-based procedures and controls. With respect to China Marine, JCI terminated the individuals involved in the YRMC conduct and hired a new managing director of China Marine to oversee the business. The managing director, a Chinese national and resident, reported to the Marine business management in JCI’s Denmark subsidiary, which oversaw the Global Marine business in multiple countries. Because the misconduct identified in the prior civil action involved the improper use of agents, JCI limited the use of agents in its China Marine business model and required that all sales go through its internal sales team based in China. China Marine employees, however, devised another avenue to continue the payments. JCI conducted multiple compliance trainings for the China Marine employees, including trainings on the FCPA. JCI also conducted audits of China Marine, which detected some missing paperwork but failed to detect that the improper payments continued.”

Under the heading “Improper Payment Scheme,” the Order states:

“Despite the efforts taken by JCI, the bribery and embezzlement schemes at China Marine continued. From 2007 to 2013, the managing director of China Marine, with the aid of approximately eighteen China Marine employees in three China Marine offices, continued the bribery and theft that began under his predecessor by using vendors instead of agents to facilitate the improper payments. The improper payments were made to employees of government-owned shipyards as well as ship-owners and unknown persons, and for the personal enrichment of the China Marine employees.

The scheme was a multi-stepped arrangement that required the complicity of nearly the entire China Marine office from the managing director, to the sales managers, the procurement managers and finally to the finance manager. The managing director aided or at times approved requests for the addition of certain vendors to the vendor master file without disclosing that certain sales managers had ownership or beneficial interest in the vendors. After the managing director’s approval, sales managers added bogus costs for parts and services to sales reports, which inflated the overall cost of the project, and generated purchase orders for the bogus parts and services. The procurement manager knowingly approved the purchase orders. The vendors, at the direction of China Marine sales managers, created fake order confirmations for the unnecessary parts and services and submitted invoices for payment. The finance manager authorized payments even when supporting documentation was missing or erroneous. Once the sham vendors were paid, the money was returned to China Marine employees’ personal bank accounts, where it was then used in part for foreign and commercial bribery and personal enrichment.

The employees knew that JCI limited the use of agents, and thus they used the vendor scheme to create slush funds. The employees fashioned the improper scheme using certain vendors specifically because those vendor transactions were considered low risk by JCI due to the low dollar value of the transactions. Vendors were also considered low risk because they did not interface with government officials. JCI’s internal controls over these vendor payments were less rigorous and, as a result, China Marine employees were able to continue generating money to bribe officials and enrich themselves by using vendors instead of agents.

China Marine operated with very little oversight by JCI’s Denmark office, which oversaw the Global Marine business. JCI gave the newly hired managing director a lot of autonomy and put significant reliance on his ability to self-police his business operations. Because of the Delegation of Authority thresholds in place, and the average low-dollar value of the transactions in China Marine, few business transactions in China Marine required approval by managers in the Denmark office that oversaw China Marine. The average vendor payment was approximately $3,400. The China Marine employees fashioned the vendor scheme to stay below certain thresholds that would not trigger review by Denmark. Even in the instances where managers in Denmark did a review, they did not understand some of the highly customized transactions at China Marine or the projects involving the sham vendors. The managing director masterminded the scheme to make improper payments to government officials and others to obtain shipbuilding projects and to enrich him and other China Marine employees. Further, the managing director instructed China Marine employees to be cautious about their discussions regarding vendor payments to JCI lawyers, accountants, and auditors, as well as to avoid or delete documentation about vendor payments.

From 2007 to 2013, JCI obtained a benefit of $11.8 million as a result of over $4.9 million in improper payments made to or through approximately eleven problematic vendors for the purpose of foreign and commercial bribery, and embezzlement.

JCI did not learn of the conduct until December 2012, when JCI received the first of two anonymous hotline reports alleging that certain employees in China Marine were making payments to sham vendors that did not provide goods or services in order to personally profit and/or bribe Chinese officials. The reports arrived shortly after China Marine’s managing director left the company. JCI self-reported the conduct and began an internal investigation.”

Under the heading “Failure to Maintain Accurate Books and Records,” the Order states:

“JCI failed to make and keep books, records, and accounts that accurately and fairly reflected JCI’s transactions and the disposition of its assets. Numerous vendor payments were incorrectly recorded as legitimate vendor transactions or design fees when in fact they were payments for goods never received or payments intended for foreign or commercial bribery or embezzlement.”

Under the heading “Failure to Maintain Adequate Internal Accounting Controls,” the Order states:

“JCI failed to devise and maintain an adequate system of internal accounting controls. JCI knew that the China Marine subsidiary had a history of FCPA problems and that the China Marine business was high risk. Despite taking steps to address the monitor’s recommendation that the company integrate the Marine business more closely into JCI’s compliance culture, JCI put almost all of its reliance for oversight of China Marine on a newly hired managing director to self-police his high risk business. On paper, the China Marine business was formally overseen by JCI Denmark. However, no one in Denmark reviewed vendor transactions or reviewed sales reports or projects that were below two million dollars in value or had profit margins above 10%. The average China Marine project was valued between $3,000 and $100,000 and therefore was rarely, if ever, scrutinized by the Denmark office. Further, despite conducting some audits of the China Marine business, JCI failed to ensure that its audit and testing procedures would adequately review payments that were routinely below their testing threshold.

Denmark managers stated that even if they had performed additional review, they did not have sufficient knowledge and understanding of China Marine’s projects to recognize when certain vendor payments were unnecessary, whether goods ordered had actually been delivered, or whether design fees were necessary given JCI had an in-house design service.

Because the China Marine employees operated so independently, a culture of impunity existed, and several members of the China Marine staff, including the managing director, colluded with each other and circumvented and manipulated JCI’s internal and financial controls for over six years. JCI failed to detect the improper vendor scheme, which did not come to light until an anonymous report came in after the managing director departed the company.

As a result of the undetected conduct, over $4.9 million in vendor payments were paid for goods and services that were either never delivered or were purchased at inflated rates, and JCI obtained $11.8 million in profits on transactions involving the problematic vendor payments.”

Based on the above, the SEC’s Order finds that JCI violated the FCPA’s books and records and internal controls provisions. Without admitting or denying the SEC’s findings, JCI agreed to pay approximately $14.4 million (disgorgement of $11.8 million, prejudgment interest of $1,382,561 and a $1.18 million civil penalty). The SEC’s Order states that JCI “acknowledges that the Commission is not imposing a civil penalty in excess of $1.18 million based upon its cooperation in a Commission investigation and related enforcement action.”

As a condition of settlement, JCI agreed to report to the SEC “periodically, at not less than six months intervals during a one-year term from the date of the entry of this Order, the status of its FCPA and anti-corruption related remediation and implementation of compliance measures.”

Under the heading “JCI’s Cooperation and Remedial Actions,” the Order states:

“In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff. JCI self-reported the potential FCPA violations to the SEC staff and DOJ in June 2013, after it retained outside counsel to conduct an internal investigation and approximately one month after it received the second anonymous complaint. The company provided thorough, complete, and timely cooperation throughout the investigation. JCI promptly and routinely provided the staff with the results of its investigation as it progressed, and provided all supporting documentation requested. It also provided factual chronologies, hot document binders, and interview summaries, as well as English translations of numerous documents and emails. JCI made employees available for interviews. JCI provided “real time” downloads of employee interviews and made other foreign employees available for interview. When the company caught a Chinese employee shredding documents, it quickly secured the office to preserve evidence. JCI’s cooperation assisted the staff’s investigation. JCI’s timely self-report as well as the thorough productions allowed the staff to initiate and complete its investigation quickly.

JCI has undertaken remedial efforts. JCI terminated or separated sixteen employees implicated in or associated with the illegal scheme and placed all suspect vendors on a do-not-use/do-not-pay list. The managing director resigned from the company before JCI was alerted to the wrongdoing. JCI has closed down its China Marine offices and moved all remaining China Marine employees, none of whom performs a sales or procurement function, into existing BE offices. In addition, JCI enhanced its integrity testing and internal audits to reevaluate vendor onboarding for all JCI business worldwide. JCI implemented random site audits to ensure the delivery of goods on purchase orders. The random testing of delivery of goods would have tested the transactions at issue here and potentially detected the improper payments.”

JCI issued this release [3]

“After discovering evidence of potential improper behavior on the part of employees in its marine business in China, the company voluntarily reported the circumstances to the U.S. government, conducted a thorough investigation and fully cooperated with the U.S. authorities.

[…]

The Department of Justice (DOJ) also made public a letter of declination citing among other things the company’s voluntary disclosure, thorough investigation, full cooperation, remediation and additional enhancements to the company’s internal accounting controls and compliance program. Johnson Controls is neither admitting nor denying the SEC’s findings, which include a total payment of $14.4 million and a one year reporting period.”

In the release, JCI CEO Alex Molinaroli stated:

“At Johnson Controls, integrity is at the center of everything we do. The ability to identify and address issues when they do occur, reflects the company’s commitment to ethics, responsible management practices and the good governance systems that uphold them.  Our continuous improvement culture also involves continuing to make those systems even stronger.”

JCI was represented by Jay Holtmeier [4] and Erin Sloane [5] of WilmerHale.

Yesterday, JCI’s stock price closed up .09%.