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Foreign Sales Mean Increased Risk for Directors

Executive Counsel

With the United States facing recession, companies are looking toward foreign markets to bolster their bottom line.  Greater foreign activity and sales buoyed stock prices in 2007, but they also significantly increased the legal exposure facing directors of U.S. companies.

As some directors are learning the hard way, when their company’s economic footprint expands, so do their fiduciary obligations.  In particular, the obligation to manage the increased risk associated with foreign operations and to ensure that these activities comply with all local, regional and E.U. laws, becomes crucial.

For more than ten years—predating the passage of the Sarbanes-Oxley Act of 2002—directors in the United States have been required to maintain reasonable information and reporting systems that alert them to wrongdoing or activity that could expose the company to harm.  In 1996 and again in 2006, the Delaware Supreme Court issued landmark decisions detailing the scope of a director’s oversight responsibilities.  These decisions tell us that directors cannot be held liable if they demonstrate a “good faith” effort to oversee management’s actions.

The key to meeting this burden is a compliance program that provides timely, accurate information sufficient to allow management and the board to reach informed judgments concerning the corporation’s financial controls, compliance with laws and its business performance.

Although not all companies will have sufficient non-U.S. revenue to warrant a foreign compliance program, as foreign sales increase, more oversight of the process that generated those sales is required.  As fiduciaries, directors must consider the need for a foreign compliance program.  If circumstances demand, they must adopt one that is as vigorous as the domestic counterpart.

This is no small task.  The potentially improper activity often occurs half a world away, and it may violate laws or regulations neither the company nor its directors know exist.

Some directors may believe their company’s foreign operations are simply not significant enough to warrant special attention.  To avoid personal liability this thinking must change.

Even businesses that are viewed as inherently domestic, such as the television industry, are looking overseas to sustain growth.

NBC Universal recently announced it expects to double revenues from its television channels over the next three years by exploring opportunities in Latin America, Portugal, CzechRepublic, Hungary, Poland and Russia.

General Electric has long been viewed as a global enterprise, but even its old industrial northeast locomotive manufacturing operation has been supported by foreign sales.  This 100-year-old $4 billion operation located in the industrial relic of Erie, Pennsylvania, is expected to export over a third of its $4 million locomotives to countries such as China, Brazil and Kazakhstan.

All told, the foreign sales for S&P 500 companies is running at about 48.5 percent of total revenue, a number that is sure to grow.

In many cases the increased importance of foreign sales is not part of a concerted business strategy.  Instead, many companies find themselves players in the global marketplace by serendipity.  A major impetus has been the weaker dollar, which boosts foreign earnings.  Profits earned in Germany, France and other European nations increase dramatically when converted from Euros to dollar equivalents.

Domestic truck maker Paccar, based in Bellevue, Washington, reported first quarter revenue of $3.9 billion, of which $129 million was derived through favorable currency exchange rates.  Likewise, currency translations favored Amazon.com by $84 million and McDonald’s by $224 million.

Even for companies whose foreign sales remain flat, current exchange rates are causing non- domestic revenues to become a larger percentage of total revenue.

Fortune 100 Companies Snared Last Year

Notwithstanding the significance of foreign sales, some directors may question the need to revise their current compliance programs to reflect foreign activity.  After all, isn’t that what auditors are for?

Not quite.  That annual compliance report prepared by the auditors relates solely to internal controls concerning the reliability of financial reporting.  It does not relate to the effectiveness or efficiency of a company’s operations, or compliance with applicable laws and regulations, and that is where trouble may be brewing.

Many U.S. companies have gotten into trouble due to their foreign operations.  For example, not long ago, police in China detained 22 people in a bribery investigation that snared McDonald’s, Whirlpool and McKinsey & Company.  In another case, Monsanto agreed to pay $1.5 million in penalties to the U.S. government over a bribe paid in Indonesia to bypass controls on the screening of genetically modified cotton crops.

The year 2007 was a watershed year for Foreign Corrupt Practices Act enforcement, with over 50 public companies disclosing pending government investigations.  In one instance, Baker Hughes agreed to pay $44 million in criminal and civil penalties for its FCPA violations.  The directors of Baker Hughes are now defendants in a shareholder derivative action in which they are accused of breaching their fiduciary duties by failing to implement adequate controls and compliance procedures.

Illegal conduct aside, many leading companies have seen their reputations diminished by reliance on irresponsible foreign operations or suppliers.  Last year there was a cascade of massive recalls due to product safety issues, starting with Chinese manufactured toothpaste that contained the poisonous chemical, diethylene glycol.  Within months, there were recalls of over 100 pet food products, after the FDA announced that a wheat gluten additive from China was found to be a danger to animals.

These recalls tarnished the reputation of such companies as Colgate, Menu Foods, Hill’s Pet Nutrition, P&G Pet Care, Nestle Purina PetCare, Del Monte Pet Products and Sunshine Mills.

Although companies may be able to quantify the short term costs associated with product recalls, it is nearly impossible to calculate the impact of a tarnished reputation.  The most visible example of reputation damage can be seen by Mattel’s recalling of more than 11 million Chinese-made toys, including popular Barbie, Polly Pocket and “Cars” movie items, because of lead paint and tiny magnets that could be swallowed.  This recall was preceded by Mattel’s recall of over 1.5 million Fisher-Price brand toys due to lead paint.

While the Fisher-Price brand and Mattel will spend millions of dollars trying to earn back consumer confidence, rest assured that Mattel’s directors are implementing a compliance program targeting foreign manufacturing standards, and grilling management over why a program capable of avoiding the massive recalls had not been adopted years ago.

Personal Liability

The failure to establish an effective reporting system can result in directors being held personally responsible for what has become known as “oversight liability,” which in essence holds directors financially responsible for the improper conduct of others.

Oversight liability is considered a violation of a director’s duty of loyalty, not the duty of care.  This is significant.  While many companies have adopted charter provisions shielding directors from liability for breaches of the duty of care, directors cannot be relieved of personal liability for failing to exercise their oversight responsibilities.  Directors found to have violated this duty are unable to avail themselves of by-law provisions requiring that they be reimbursed for the legal fees incurred in defending a shareholder lawsuit.

While most boards have adopted compliance programs, many of those once deemed robust may now be grossly inadequate due to rapid globalization.  Most were established when an overwhelming majority of revenues were generated through domestic sales and operations and, as a result, were likely designed to identify only potential violations of U.S. laws and regulations.  They would not be equipped to address the patchwork of differing laws and regulations found overseas, let alone the many cultural variations in the overseas locales.

Compliance programs should not ignore strategic and operational risks.  As noted by the courts, compliance programs are intended to address not only blatantly illegal conduct, but also behavior that threatens the economic health of the enterprise, including activity that poses a significant threat to the company’s reputation.

While often overlooked, such scandals can be just as devastating as findings of criminal wrongdoing because they erode confidence in a company and its products.

With the importance of non-domestic operations established and the risks posed by those same operations representing a clear and present danger, what are directors to do?

First of all, stay informed.  Although management has a primary role in assessing risks and developing controls, the board must make its own independent assessment to determine that compliance programs are effective, especially with regard to foreign operations.

This includes making sure the compliance program specifically addresses the laws in countries in which the company has significant operations or revenues, Directors should question management frequently, to gauge their understanding of risks and whether the compliance program is designed to address them.

One preferred practice is a presentation at board meetings about all high-risk foreign operations, including a discussion of how the compliance program attempts to mitigate those risks.

Most importantly, directors should document all oversight and compliance efforts.

To assist the board in fulfilling its responsibility, directors should retain outside advisors to independently assess their compliance programs.  These independent third parties should understand the director’s fiduciary duties, leading industry standards and relevant law, both foreign and domestic.

Once the assessment is performed, the board must require detailed action plans by management to address any deficiencies. The board should then monitor management’s progress and require regular updates regarding implementation of corrective action.  Failure to follow through may create personal oversight liability for directors.

Stockholders look to the directors to ensure that sound risk management. processes are functioning and that they are effective with regard to foreign operations, Directors who fail to recognize this fiduciary responsibility risk being named as a defendant in a shareholder derivative action.

Originally published in the May/June 2008 issue of Executive Counsel (vol. 5, no. 3).  © 2008. Reprinted with permission.