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An M&A Case Study

The Foreign Corrupt Practices Act is a niche practice area for sure.

At the same time, FCPA issues intersect with other business law issues such that the FCPA is a fundamental skill set for all business lawyers and advisers, including in the mergers and acquisitions context.

The FCPA enforcement and related actions in connection with the 2010 acquisition of Watts Valve Changsha Co. Ltd. by China Valves Technology, Inc. (“China Valves”) has turned into a full-fledged case study on this issue as a result of the September 29th SEC action against China Valves and various of it executives – an action that has generally flown under the radar screen in the FCPA space.

First, some background.

As highlighted in this post, in October 2011 the SEC issued (here) an administrative cease and desist order against Watts Water Technologies, Inc. (“Watts”) and Lessen Chang concerning violations of the FCPA’s books and records and internal control provisions.  The conduct at issue focused on Watts Valve Changsha Co. Ltd. (“CMV”), a wholly-owned Chinese subsidiary operated by Watts and sold in 2010.

Specifically and according to the SEC, “employees of CWV made improper payments to employees of certain [Chinese] design institutes … to influence the design institutes to recommend CWV valve products to [SOEs] and to create design specifications that favored CWV valve products.”   The SEC found that “CWV’s improper payments generated profits for Watts of more than $2.7 million.”

Based on the above conduct, Watts agreed to pay approximately $3.8 million ($2.8 million in disgorgement, $820,000 in prejudgment interest and a $200,000 civil monetary penalty).  Chang (a U.S. citizen and former interim general manager of CWV)  agreed to pay a $25,000 civil monetary penalty.

As indicated above, the FCPA enforcement action against Watts in 2011 was based on the conduct of CMV – an entity Watts had sold prior to the FCPA enforcement action.

The purchaser of CMV was China Valves.  More on that below including the recent enforcement action against China Valves and various executives.

Prior to this recent enforcement action however, and as highlighted in this prior post, Watts filed a civil lawsuit against its U.S.-based law firm for legal malpractice claiming that the law firm’s legal services in connection with Watt’s acquisition of CMV was inadequate based on insufficient due diligence.  As highlighted in this prior post, the U.S. law firm strenuously denied the allegations, yet the action was reportedly settled and little details disclosed.

The take-away point thus far in the story is that one acquired entity caused FCPA scrutiny for the acquiring company and civil scrutiny for the law firm advising the acquirer.  

Fast forward to the recent SEC action against China Valves and certain of its executives (see here for the SEC release and here for the complaint).  According to the SEC complaint, China Valves is a Nevada corporation with operations solely in China which became a U.S. issue in December 2007 through a reverse merger.

China Valves purchased CMV from Watts in January 2010 and according to the SEC did so with “full knowledge” of the FCPA issues facing CMV.  According to the SEC, when China Valves purchased CMV, China Valves paid “$2.2 million [in] outstanding sales commissions to CMV’s sales force – the very same commissions Watts declined to pay because of suspected FCPA violations.”

The above two allegations, along with several others that do not relate to the SEC, serve as the basis for the SEC’s claim that China Valves and various of its executives engaged in fraud.  For instance, the SEC alleged that the Form 8-K China Valves filed with the SEC announcing the acquisition “omitted any mention of the FCPA investigation of CMV, or that the payment of unrecorded liabilities included payment of $2.2 million in sales commissions that were not recorded on CMV’s books and that Watts had determined were not FCPA compliant.”

The SEC’s complaint also contains other similar allegations regarding China Valve’s other SEC filings over a two year period. Specifically , the SEC alleged that these filings contained material false statements and omissions “because a reasonable shareholder would want to know the true nature of the acquisition … about the FCPA Investigation at CMV, and that [China Valves] paid amounts that potentially violated the FCPA.”

In short, the alleged improper conduct at CMV created scrutiny not only for the first acquiring company (Watts) and Watt’s counsel in the form of a malpractice action, but also the second acquiring company (China Valves) and its executives.

This full-fledged M&A case study should put the FCPA on the radar screen for all business lawyers and advisors, including in the merger and acquisitions context.

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