Is Your Portfolio Exposed to Corruption Risk?

In an increasingly globalized world, companies are taking advantage of business opportunities across borders and in new markets. While multinational corporations enjoy many benefits of their global reach, they also may face risks. One such risk is corruption, which is prohibited under the Foreign Corrupt Practices Act, or FCPA.

The FCPA is a U.S. law that was passed in 1977 and applies to any company, U.S. or foreign, that has securities registered in the United States. Under the Act, it is illegal to pay foreign officials in order to obtain preferential business treatment. The FCPA also requires companies to meet certain accounting standards.

More investigations, bigger fines
In recent years, the U.S. federal government has been enhancing its enforcement of the FCPA. Not only has the number of investigations increased, but the penalties paid by corporations have also risen dramatically.

German engineering company Siemens  (NASDAQOTH: SIEGY  ) paid a record $800 million in fines to the U.S. government in 2008 for bribes made to foreign officials in countries including Argentina, Bangladesh, China, Israel, Russia, Nigeria, Venezuela and Vietnam for telecommunications, construction, medical-device, and infrastructure projects. Shares of Siemens plummeted more than 50% in 2008 and took years to recover. Of course, most stocks took a big hit during the 2008 financial crisis, but shares of Siemens fell much more sharply than those of the company's peers, including 3M and Honeywell.

The company was under investigation for more than two years, which took a toll on its reputation. Seimens is still failing to keep up with the growth of its peers, and it removed its CEO Peter Loescher in 2013.

More recently, in 2013 and 2014, French oil company Total S.A. and U.S. aluminum company Alcoa paid fines of almost $400 million each for FCPA violations. Charges against Total S.A. related to payments the company made, through a third party, to Iranian officials for oil and gas contracts between 1995 and 2004. Alcoa was charged with paying bribes to the royal family of Bahrain for the rights to supply aluminum to a state-run producer.

Even if a company never pays a fine, the costs associated with an investigation can be high. For example, U.S. retail giant Wal-Mart (NYSE: WMT  ) has already reportedly spent more than $439 million in the past two years on its ongoing FCPA investigation. Wal-Mart faces allegations that its Mexico unit Wal-Mart de Mexico paid bribes to Mexican officials to sidestep government regulations in order to speed up the opening of new stores. The company has had to pay huge fees for attorneys and compliance specialists to restructure its compliance programs and defend against derivative shareholder lawsuits.

Are you exposed to high-risk markets or industries?
It is impossible to know for sure whether your investments are exposed to corruption risk, but certain countries and sectors present greater risk than others. The international civil society organization Transparency International produces an annual "Corruption Perceptions Index" that measures perceived levels of public corruption in most countries in the world. For example, according to the index, the perceived corruption in Mexico is much higher than in Chile, and the perceived corruption in Russia is much higher than in Turkey.

While this index is certainly not a perfect indicator, it could be a useful tool for roughly estimating corruption risk. The index is based on surveys and data from worldwide governance institutions about perception of corruption in various countries. While this indicator is certainly subject to bias, the index provides a useful estimation of a factor that's difficult to measure because corruption is intentionally concealed by those who participate in it.

Another imperfect indicator of risk is exposure to countries that have been involved in FCPA investigations in the past -- particularly those that have been involved in multiple investigations, including Argentina, China, Mexico, Nigeria, and Russia. Past enforcement is more tangible than a corruption index, but it doesn't account for corruption that has not yet been brought to light or prosecuted.

Certain industries also carry greater risk. For example, in 2013 the U.S. government brought the greatest number of actions against oil and gas, aviation, energy, and financial-services companies. In the past, pharmaceutical and medical-device companies have also seen a large number of enforcement actions. The U.S. Securities and Exchange Commission website has a list of its FCPA enforcement action since 1978. The U.S. Department of Justice has a list of FCPA cases going back to 1977

The Foolish bottom line
While investors should not necessarily shy away from investing in multinational or foreign corporations, they should make informed investment decisions, taking into account the increasingly high risk presented by international public corruption as FCPA enforcement increases.

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