IBM Caught Bribing Chinese Officials: A Teachable Moment

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When I say “teachable moment” I don’t mean that there are lessons here that everyone should know. I actually mean that I will literally be using this IBM situation as a case study in my FDI Law class. Why? It’s rather classic stuff, it’s an easy case, and it illustrates both how US anti-bribery laws work and common mistakes foreign investors make in China.

Some background:

The International Business Machines Corporation, the computer services provider, agreed on Friday to pay $10 million to settle claims that it gave cash and gifts to Chinese and South Korean officials in connection with about $54 million in government contracts.

The applicable anti-corruption law in the United States is the Foreign Corrupt Practices Act, which makes certain kinds of bribery and related activities done overseas illegal. The FCPA covers a lot of territory, but it’s basically focused on improper accounting practices and bribery.

Why is accounting involved? Well, companies do two different things. First, they bribe government officials. Second, they cover it up, or attempt to do so. Enforcement of the FCPA would be a lot more difficult if it just made bribery illegal without going after the creative ways companies have used to hide these practices.

Moreover, enforcement has to deal with the usual excuse of “we (HQ) did not authorize that bribe, it was the employee acting on his own” — that excuse can work to separate the company from the act of bribery (sometimes), but if the company has an affirmative duty to keep adequate books and records that can be used to ferret out illegal activities, then the government can use that obligation as a secondary enforcement target.

Does that make sense?

In this case, the complaint against IBM was made by the Securities and Exchange Commission (SEC), which has authority to impose fines under the FCPA. The Department of Justice handles criminal matters — IBM’s activities did not rise to that level here.

“Deficient internal controls allowed employees of I.B.M.’s subsidiaries and joint venture to use local business partners and travel agencies as conduits for bribes or other improper payments to South Korean and Chinese government officials over long periods of time,” the S.E.C. said in the complaint.

“Internal controls” refers to that FCPA focus on accounting practices. In other words, the SEC is slapping IBM on the wrist, saying that they failed to adequately supervise their people, and not that IBM (as a single entity) knowingly permitted these illegal activities.

What were they doing over here in China?

[T]he SEC alleges that officials created a “slush fund” to pay for travel and entertainment expenses in order to help IBM win deals between 2004 and 2009. The SEC contends that the trips and entertainment expenses covered by the slush fund had little or nothing to do with business meetings or training.

Again, classic stuff. Officials from MIIT or MOFCOM want to go to Vegas for a few days? Their friends at some big IT companies can help. (Back in the day, also law firms, accounting agencies, and other service providers, but you didn’t hear that from me.)

This all makes me a bit nostalgic. The case relates to activities that took place between 1998 and 2009, so we’re talking about almost my entire time in China (so far). All that travel-related bribery was rampant at that time and only recently has been curtailed, with respect to American companies, due to stepped-up FCPA enforcement and, more importantly, a crackdown by Beijing on official travel.

So the SEC is saying that IBM’s internal controls were not adequate, which allowed these activities to persist for so long without, apparently, HQ catching on. No red flags went up because the IBM system was not designed to manage this kind of thing. No surprise here — what company in China doesn’t have a huge line item on its books designated “Entertainment Expenses”? The entire freakin’ tax system practically mandates that kind of structure.

The accounting provisions in the FCPA make more sense when you look at a case like this. If the FCPA was strictly an anti-bribery statute, then the choice is between a strict liability system (i.e. IBM is liable for all actions of its employees — no excuses) or one that includes a knowledge requirement (i.e. IBM only liable for acts it knew about).

With the accounting rules, the government can operate in that middle ground, penalizing firms for activities it allowed to happen, even if the government cannot prove actual knowledge.1

You can see how this case is a nice illustration of the FCPA and the relationship between bribery and accounting practices. It also contains a good example of what used to be a very common type of bribery. Sounds like classroom gold to me.

One last comment. The SEC filed this case in US federal court and IBM immediately settled. Here are the numbers:

Before the ink was even dry on the lawsuit filed by the SEC today, IBM did an 8K filing with the stock regulator, saying it had settled the matter. (That must be some sort of land speed record.)

“As part of the settlement, IBM has consented to the entry of a judgment relating to the books and records and internal control provisions of the securities laws,” the company said in the short filing. IBM has also agreed to pay a total of $10m. That figure includes $5.3m for the profits the company gained from all of the deals in South Korea and China where bribes were given, $2.7m in prejudgment interest on that $5.3m, and $2m to cover the civil penalty for breaking the FCPA.

So of the ten million bucks they will pay, eight million covers disgorgement (profits gained from the deals they won through bribery in South Korea) and related interest, while two million would correspond to a fine.

I don’t know about you, but bribery that took place in two different countries over the course of many years, including the delivery of bags of cash to South Korean officials, and all they have to do is pay two million bucks? By the way, under the terms of the settlement, IBM is not even admitting any wrongdoing.

Seems like IBM is getting a really good deal here — agreed?

  1. FYI, FCPA litigation over the years has focused, among other matters, on this issue of knowledge. But that’s for another post. []

8 responses on “IBM Caught Bribing Chinese Officials: A Teachable Moment

  1. Adam Minter

    A very good deal – in fact, the kind of deal that would make a company like IBM start to think that FCPA is just an irritating cost of doing business. The thing that caught my eye was this: $5.3 million of the $10 million fine is to cover the profits made as a result of the bribery. No wonder they were so quick to settle! I have to think that, by this point, they’ve made many times that sum just off the relationships formed due to the bribery.

    If the SEC was really serious about stopping this kind of thing, they’d publicize the names of the officials who received all of those junkets. A few releases along those lines and they could shut down enforcement for a couple of years.

    1. Stan Post author

      Totally. Also keep in mind that the disgorgement covers S. Korea only, I assume because they couldn’t tie in the China bribes to specific deals. So IBM got away with years and years of China bribery with a pittance.

      It does seem a bit schizo, since the US government has been charging ahead very aggressively with FCPA in the past two or three years. The overall climate has been really good recently with respect to scaring the crap out of companies, but this kind of slap on the wrist — I agree with you, it’s not exactly going to scare anyone.

      1. deldallas

        My impression has been that the big fines are usually reserved for foreign companies or particularly embarassing U.S. citizens while fines for U.S. companies are usually just ‘public spankings’ to encourage faith in the U.S. government’s ethical beliefs.

  2. Fredrik

    I also find it very hard to believe IBM did not make a good deal more than $5.3 million from the bribes. Honestly if that’s all they made they’ve made probably the worst risk-benefit calculations in the history of the practice.

    I’m interested in the law itself though, not being American, what is needed to prosecute a company here? Does it have to be registered in the US (or will a US listing do), and what about holding companies?

    1. Stan Post author

      Remember that the government has to prove its claims, so that 5.3 million figure represents only what the SEC thought it could prove in court.

      On the scope of the FCPA, it is quite expansive, and was actually widened in 1998. It covers:

      (a) any U.S. corporation or any officer, director, employee, agent or stockholder acting on behalf of such corporation,
      (b) U.S. citizens, nationals, or residents, or
      (c) any foreign corporation or individual acting within the territory of the United States

      A US listing brings a foreign company within the scope of the FCPA. Indeed, a lot of folks have been anticipating cases involving Chinese firms listed on NASDAQ and NYSE. As far as a holding company is concerned, I’m not sure. Subsidiaries are obvious, but if a foreign multinational had a US sub but the violation concerned someone way up in a holding entity — good question . . .

      1. Fredrik

        Yes, I’ve been going through financial statements of all the US-listed VIE companies from China, so I’ve seen many a reference to this act, but I was never certain quite how far its jurisdiction went.

        The fact that it covers all US citizens is fairly interesting as well I think, especially with some of the businesses in China being run by formerly Chinese Americans, I wouldn’t be surprised if we see some cases in this category ones some of these companies start to grow a bit…

        Thank you for your answer, it was most enlightening!

  3. Curious about things

    “Back in the day, also law firms, accounting agencies, and other service providers, but you didn’t hear that from me”

    Let’s talk about that for a minute. Law firms and accounting firms were particularly active in this area in the 1990s, and maybe even to today. Foreign companies that needed to get things done in China would often work through these firms because they had relationships with the officials. The firms developed those relationships through many of these “educational” trips that would involve an hour lecture in their New York office, days of touring and the mandatory stop in Las Vegas. The firms would pay all the expenses, and even provide daily pocket money. In Vegas a popular ploy was to enter into gambling partnerships – where the accounting firm partner would put up the money for gambling with the agreement that they would split any profits, but the partner would absorb all of the losses. By the end of the 1990s many tax officials had been to so many countries on these tours they had grown tired of the travel!

    Because the accounting firms are not U.S. owned they presumably do not fall under the FCPA and cannot be pursued by the SEC. Law firms have more of a problem, since many are U.S. owned. But the client rarely knew how the sausage was made and only benefited from the relationships the firm had.

    1. Stan Post author

      Has a law firm ever been subject to such an FCPA investigation? I have no idea but would like to know. Also remember that most of these “gifts” had nothing to do with specific deals — they were all about relationship maintenance, sort of like what IBM was doing here.