Special Report: Emerging markets

With well over half the world’s population deemed to be living in the “developing world”, it is little wonder that western corporations want to tap into emerging markets to grow their business and increase their profits. But while the rewards can be huge, the risks can also be great. Many countries in Asia, Africa and South America, for instance, do not have the physical infrastructure, such as airports, roads, telephone and electricity networks, to accommodate the needs of foreign companies, while they also fall short on regulatory and legal frameworks and transparency.

Government intervention, in particular, can be a problem. In February this year, Brazil signalled that it wants to collect a much bigger chunk of the profits from the oil that it produces. The country, which produces about 2.4 million barrels of oil a day, currently requires oil companies that do business on its soil to pay around 50% of their profits to the government in either royalties or corporate taxes, which is in line with the rates paid in other “low-tax” countries like the United States and Canada. But a major new discovery off the country’s coast, estimated to contain as much as 50 billion barrels of oil and natural gas, could change all that. With this new resource in mind, Brazilian lawmakers are considering a bill that would push the effective tax rate for outside oil companies north of 80%, terms similar to countries like Iraq or Norway.

The legislation would require that international energy outfits get the majority of the materials used to extract oil from Brazilian suppliers, and would give the government final say over which projects get developed. The new law would also require any oil firm operating in the country to partner with Brazil’s state oil company Petrobras, which would be solely responsible for laying the infrastructure required to extract oil and ultimately overseeing all the production – despite not having the resources or manpower to actually carry out such a role, according to analysts. International oil firms would be relegated to providing funding and technical know-how in exchange for a share in the profits.

Nigeria is also considering hiking its royalty rate and requiring much of the material used in construction projects to be locally made. It also wants its state oil firm to have a bigger role in projects. The major difference is that Nigeria, unlike Brazil, lacks both a technically advanced state oil company and a major industrial base to make home-grown equipment for the industry. The proposed law has prompted one major oil firm operating in the country to call it “a cumbersome document that lacks insight into the very basics of our industry”, adding that the royalty provisions are some of the “harshest in the world”.

Forcing foreign companies to work with – or for – state-owned companies in exchange for licensing agreements is not new and many companies now accept that in some locations it is a necessary adjunct to doing business there. David Skinner, partner in the technology transactions group at international law firm Morrison & Foerster, says that in China, for example, it is increasingly common for western companies to set up a joint venture with a local firm so that they can get a foot in the door. “Without partnering with a local firm, it can be very difficult and time-consuming trying to get a licence to operate,” says Skinner.

In other Asian countries, such as Laos, having the government as a partner also seems to be the accepted way of moderating discretionary government actions. The level of fairness of the regulatory system appears to largely depend on whether an investor is willing to allow the government to take an option or an initial equity stake in the project of between 10%-20%. Unsurprisingly, Laos has a poor record for protecting investors (ranked 180th out of 181 countries) and has an only slightly better record for enforcing contracts (ranked 111th out of 181 countries), according to the World Bank’s recent Doing Business Report. Transparency in business transactions is also alarmingly low, according to anti-corruption campaign group Transparency International, which ranks the country 158th out of 180 countries in its Corruption Perceptions Index 2009 – the lowest rating in Asia after Burma.

John Collins, partner for South Asia at McKinney Rogers, a global business performance consultancy, says that while there is corruption in business in Asia, western companies should not make the mistake of always believing that paying bribes or facilitation payments is the way to close or speed up a deal, not least since the practice is illegal. He says that westerners often perceive that a reluctance by Asians to seal agreements quickly means that they are angling for envelopes stuffed with cash.

“In Asia, business relationships are built up over time,” says Collins. “It can take up to a year in some cases for a deal to be finalised and agreed after an initial introduction – they do not want to be rushed. And this causes problems. Western businessmen, or the agents acting on their behalf, believe that a bribe or ‘facilitation payment’ may speed up the process, and this is often the stage where things get messy and corrupt practices start. It’s a mistake. In the majority of cases, the Asian partner wants to do the deal – but the terms will be concluded at their pace.”

Collins says that there a number of other issues that prevent companies successfully operating in Asia. For example, he says, local labour laws tend to favour employees rather than employers, so it can be difficult to dismiss people. One way around this, however, is to extend an employee’s probationary period so that it gives employers greater flexibility if they decide that a worker is not suitable.

Other barriers to success are more personal. “Asian businessmen and officials are great at promising the world but are often slow in delivering the goods. Operating licences, permits, memorandums of understanding and so on can take months to materialise, which means that you can have your staff twiddling their thumbs before you can do any work. Also, accommodation and local facilities, such as schools, hospitals, shops and restaurants, can be very poor, which means that western executives do not want to stay to oversee the practice for very long. These issues tend to have a greater, immediate impact than corruption and can be very expensive,” he adds.

However, bribery and corruption risk is likely to stay high on the board’s agenda for quite some time as prosecutors in the US and UK – rather than the legislators in the emerging markets where these companies are doing business – clamp down on corrupt practices. The US Foreign and Corrupt Practices Act (FCPA) allows prosecutors to take action against such companies for corrupt practices, even though the corruption may be taking place in another country. Those firms that conduct business in the US are subject to scrutiny, along with those that use the services of firms and individuals based there.

Experts agree that sanctions under the FCPA are potentially the toughest in the world. Under criminal prosecution, corporations and other business entities are subject to a fine of up to US$2m while officers, directors, stockholders, employees, and agents are subject to a fine of up to US$100,000 and imprisonment for up to five years. Moreover, under the Alternative Fines Act, these fines may be up to twice the benefit that the defendant sought to obtain by making the corrupt payment.

The UK’s outmoded bribery laws – some of which date as far back as 1889 – are set to be replaced by new bribery legislation which will make it a criminal offence to give or offer a bribe in the UK or abroad and will increase the maximum prison term from seven to ten years. The bill also introduces a corporate offence of negligent failure to prevent bribery on behalf of a business, resulting in an unlimited fine.

Tony Lewis, partner in the fraud and corruption team at Field Fisher Waterhouse, says that “the impact on companies and businesses is that the combination of the extra-territorial effect and the introduction of a new corporate offence may make it easier for bribery prosecutions to be brought against UK companies”.

He also says that while the new bill does not define what would constitute “adequate procedures”, he warns that “in light of the proposed new legislation, companies should be reviewing their bribery law compliance programmes to ensure that it has responsible and effective risk management systems in place.”

Both pieces of legislation specifically tackle the role that third parties can play in corrupt practices as several companies that have been investigated often claim that it was the local agent acting on their behalf that made the illicit payments – and always without the parent company’s knowledge or consent. However, both the UK and US legislation make it clear that the company and its directors are entirely responsible for the conduct of any third party or individual acting on their behalf, which means that companies need to carry out more careful due diligence on their local contractors.

Charles Hecker, director of Russia and the CIS at Control Risks, warns of the risk to foreign companies trading in Russia from so-called “grey practices” used by local businesses, agents and third parties which can include tax evasion schemes, one-day companies, and offshore ownership structures designed to generate “black” cash – unreported income then used to grease the palms of unscrupulous regulators. Hecker says that these operators “represent a significant but often overlooked source of reputational, operational and regulatory risk to foreign companies doing business in Russia”.

“These practices may not at first sight appear clearly and explicitly illegal, but they can very quickly turn from grey to black,” says Hecker. “For example, the money these schemes generate and the structures themselves can form part of deliberate and concerted efforts to defraud, facilitate money laundering, pay bribes and conceal conflicts of interest.”

“Grey practices are not necessarily part of corruption, but like corruption, they still expose foreign companies to criminal prosecution. Tighter regulation, in the form of the FCPA, the UK Bribery Bill and the OECD Anti-Bribery Convention, and more proactive enforcement is only increasing this exposure.”

Neil Ysart, senior manager in the forensic services practice at professional services firm PricewaterhouseCoopers, says that effective, on-site due diligence is essential to maintain integrity in the services that are being provided on a company’s behalf. “A lot of companies feel that they outsource risk as well as service provision when they engage a third party supplier to act on their behalf. Unfortunately, this is not the case.”

Ysart adds that any notion that internal control, due diligence and independent assurance follow UK practice can often be very wide of the mark. “It is in the interests of the third-party supplier to hide bad news and inflate performance figures to retain the contract. Only by actually carrying out on-site visits and audits can a company really get an accurate picture of how well the third-party supplier is providing its services, and whether it is acting ethically and legally in accordance with local, UK and international law,” he says.