Yesterday, the SEC issued (here) an administrative cease and desist order as to Watts Water Technologies, Inc. (“Watts”) and Lessen Chang concerning violations of the FCPA’s books and records and internal control provisions.  Watts designs, manufactures, and sells water valves and related products and Chang, a U.S. citizen, was the former interim general manager of Watts Valve Changsha Co. Ltd. (“CWV”), a wholly-owned Chinese subsidiary operated by Watts and sold in 2010. According to the SEC, Watts consolidated CMV’s books and records into its financial statements and CWV’s revenues accounted for approximately 1% of Watts’ gross revenues.

According to the SEC, “CWV produced and supplied large valve products for infrastructure projects in China” – projects “mostly developed, constructed, and owned by state-owned entities” that routinely retained “state-0wned design institutes to assist in the design and construction” of projects.   According to the SEC, “employees of CWV made improper payments to employees of certain design institutes … to influence the design institutes to recommend CWV valve products to [SOEs] and to create design specifications that favored CWV valve products.”  According to the SEC, “the payments were disguised as sales commissions in CWV’s books and records, thereby causing Watts’ books and records to be inaccurate,” and that “Watts failed to devise and maintain a system of internal accounting controls sufficient to prevent and detect the payments.”  According to the SEC, Chang “approved many of the payments to the design institutes and knew or should have known that the payments were improperly recorded on Watts’ books as commissions.”  The SEC found that “CWV’s improper payments generated profits for Watts of more than $2.7 million.”

The Watts enforcement action is yet another example of an FCPA enforcement action focused on Chinese Design Institutes.  Previous enforcement actions include Rockwell Automation (here), ITT (here), and Avery Dennison (here).

In the order, the SEC found that “Watts failed to implement adequate internal controls to address the potential FCPA problems posed by its ownership of CWV – a subsidiary that sold its products almost exclusively to SOEs.”  The SEC noted that “although Watts implemented an FCPA policy in October 2006, Watts failed to conduct adequate FCPA training for its employees in China until July 2009.”  As to Chang’s role, the SEC stated that “Chang approved commission payments to CWV sales personnel that he knew included payments to design institutes.”  According to the SEC, “Chang also knew that Watts’ management in the U.S. was unaware of the CWV [sales policy that generated the commission payments] that facilitated the improper payments and he resisted at least one attempt by several of his colleagues at Watts China to have the policy translated and submitted to Watts’ senior management for approval.”  The SEC stated that “Chang’s resistance to efforts to have the Sales Policy translated and submitted to Watts’ management in the U.S. was a cause of Watts’ internal control violations, since it prevented the parent company from discovering the improper payments.”

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 agreed to pay a $25,000 civil monetary penalty.

How did Watts’ general counsel learn that Chinese Design Institutes could present FCPA risk?  According to the SEC, by reading its prior enforcement action against ITT.  The SEC states as follows.  “In March 2009, Watts’ General Counsel learned of a Commission enforcement action against another company that involved unlawful payments to employees of Chinese design institutes. Because Watts’ senior management in the U.S. knew that CWV’s customers included [SOEs], Watts implemented anti-corruption and FCPA training for its Chinese subsidiaries. This training took place starting in the Spring of 2009. In July 2009, following FCPA training sessions for certain management of Watts China, Watts China’s in-house corporate counsel became aware of potential FCPA violations at CWV through conversations with CWV sales personnel who were participating in the training. Shortly thereafter, the in-house lawyer notified Watts’ management in the U.S. of the potential violations.  On July 21, 2009, Watts retained outside counsel to conduct an internal investigation of CWV’s sales practices. Watts’ outside counsel subsequently retained forensic accountants to assist with the investigation.  On August 6, 2009, Watts self-reported its internal investigation to the staff. As the internal investigation progressed, Watts shared the results of the investigation with its outside auditors and the staff through periodic reports, and undertook” remedial measures.

Under the heading “Watts’ Remedial Measures” the SEC stated as follows.  “Since July 2009 when the conduct was discovered, Watts has taken the following remedial steps. At the start of its internal investigation, Watts directed all of its sales and finance employees at CWV and Watts China to stop all payments of any kind to SOEs. While the internal investigation was ongoing, Watts eliminated commission-based compensation at CWV to ensure that no further improper payments were made by CWV sales personnel and disclosed the internal investigation in its August 7, 2009 Form 10-Q. In addition, Watts retained additional outside counsel to draft and implement enhanced anti-corruption policies and procedures, including an enhanced Anti-Bribery Policy, a Business Courtesy Policy designed to ensure that any payments made to customers comply with the FCPA, an enhanced Travel and Entertainment Expense Reimbursement Policy for its Chinese subsidiaries, and enhanced intermediary due diligence procedures.  In conjunction with its internal investigation, Watts conducted a worldwide anti-corruption audit. As part of its anti-corruption audit, Watts conducted additional FCPA and anti-corruption training for Watts China and the company’s locations in Europe, conducted a risk assessment and anti-corruption compliance review of Watts’ international operations in Europe, China, and any U.S. location with international sales, and conducted anti-corruption testing at seven international Watts sites, including each of the manufacturing and sales locations in China. In an effort to ensure FCPA compliance and training going forward, Watts contracted with an online global training organization to provide regular anti-corruption training and hired a Director of Legal Compliance, a new position that reports to Watts’ General Counsel regarding issues under the Code of Conduct and Anti-Bribery Policy.”

Question of the day – should payments made without U.S. management knowledge at a Chinese subsidiary constituting less than 1% of overall revenue  result in a company conducting a worldwide review of its operations?