FCPA: Smith & Nephew DPA: Lessons Learned in Using Distributors

A distributor can be generally defined as a company or individual who purchases a product from an original equipment manufacturer (OEM) and then independently sells that product to an end user. A distributor takes title, physical possession and owns the products. The distributor then sells the product again to an end-using purchaser. The distributor usually receives the product at some discount from the OEM and then is free to set the resell price at any amount above what was originally paid for the product. A distributor is often used by the US manufacturing industry to act as a sales force outside of the US.

The landscape of the Foreign Corrupt Practices Act (FCPA) is littered with cases involving both agents and resellers, who are most clearly acting as representatives of the companies whose goods or services they sell for in foreign countries. However, many US businesses believe that the legal differences between agents/resellers and distributors insulate them from FCPA liability should the conduct of the distributor violate the Act. They believe that as the distributor takes title and physical possession of the product, the legal risk of ownership has shifted to the distributor. If the goods are damaged or destroyed, the loss will be the distributor’s not the US business which manufactured the product. Under this same analysis, many US companies believe that the FCPA risk has also shifted from the US company to the foreign distributor. However, such belief is sorely miss-placed.

As reported by the FCPA Professor and FCPA Blog, on February 1, 2012, the Department of Justice (DOJ) announced that it entered into a Deferred Prosecution Agreement (DPA) with Smith & Nephew, Inc., a medical equipment manufacturer, for violations of the FCPA.  Smith & Nephew paid a monetary penalty of $16.8MM to the DOJ and $5.4MM to the Securities and Exchange Commission (SEC) as a civil penalty, all for a total of $22.2MM in fines and penalties. The violations revolved around a Greek distributor of Smith & Nephew who paid bribes to Greek doctors so that they would purchase and use Smith & Nephew products. According to the FCPA Professor, in a post entitled “Next Up – Smith & Nephew”, Smith and Nephew and its German subsidiary, would sell products to the entities “at a discount to the ‘list’ price and the Greek Distributor would re-sell to Greek HCPs and government hospitals at a profit.”

Further, as noted by the Professor, the purpose in setting up these entities “was to secure lucrative business with hospitals in the Greek public health care system by making and promising to make corrupt payments of money and things of value to publicly-employed Greek HCPs.”  According to the information, “S&N, certain of its executives, employees, and affiliates agreed to sell to [the] Greek Distributor at full list price, then pay the amount of the distributor discount – between 25 and 40 percent of the sales made by [the] Greek Distributor – to an off-shore shell company controlled by [the] Greek Distributor, in order to provide off-the-books funds for [the] Greek Distributor to pay cash incentives and other things of value to publicly-employed Greek HCPs to induce the purchase of S&N products, while concealing the payments.”  According to the information, S&N “falsely recorded or otherwise accounted for the payments to the shell companies on its books and records as ‘marketing services’ in order to conceal the true nature of the payments in the consolidated books and records of S&N and GmbH.”

In honor of the commencement of Spring Training next week, I put together a handy Box Score of the entities which Smith & Nephew set up for this FCPA conspiracy.

Entity Designation Domicile of Entity Commission Rate Services Provided Actual Services
Shell Company A UK 40% of sales of Greek distributor Marketing Did not perform any services
Shell Company B UK 26% of sales of Greek distributor Marketing None listed
Shell Company C UK 35% of sales of Greek distributor Marketing Did not perform any true services

Indicia of Bribery and Corruption

What are some of the factors that demonstrate the distributors used by Smith & Nephew were fraudulent and did not have a legitimate business purpose? Initially I would note that the distributor was domiciled in a location separate, the UK, and apart from the sole location it was designed to deliver products or services into, Greece. This clearly demonstrated that the entities were used for a purpose that the company wished to hide from Greek authorities. While it is true that a distributor might sell products into a country different than its domicile, if the products are going into a single country, this should raise a Red Flag.

However, the biggest indicium of corruption was the amount of the commission paid. The traditional sales model for a distributor has been to purchase a product, take the title, and therefore the risk, and then resell it to an end user. Based upon this sales model, there has been a commission structure more generous than those usually accorded a reseller or sales agent, who is usually only a negotiator between the OEM and the end user. This difference in taking title, and risk of loss, have led to a cost structure which has provided a deeper discount of pricing for distributors than commission rates paid to resellers or sales agents. The sales structure used by Smith & Nephew had pricing discounts of between 26-40% off the list price. Further, this money was used precisely to pay bribes to Greek doctors to use Smith & Nephew products. If your company uses a distributor model, I would suggest that you review and reassess your pricing structure in light of this enforcement action.

Monitorship

A very interesting feature of the Smith & Nephew DPA is that the company agreed to an external Monitor. This is not something we saw in most DPAs from 2011. The Monitor’s primary purpose is to “assess and monitor Smith & Nephews compliance with the terms of this Agreement so as to specifically address and reduce the risk of any recurrence of Smith & Nephew’s conduct.” The Monitor is to be retained by Smith & Nephew “for a period of not less than eighteen (18) months.” The DPA specifies that the Monitor is to perform at a minimum two reviews and corresponding reports. The Monitor shall provide to Smith & Nephew a written work plan no less than 60 days before commencing either review. The Monitor is to formulate conclusions based upon “among other things (a) inspection of relevant documents, including Smith & Nephew’s current anti-corruption policies and procedures; (b) onsite observation of selected systems and procedures of Smith & Nephew at sample sites, including internal controls and record-keeping and internal audit procedures; (c) meetings with, and interviews of, relevant employees officers, directors and other persons at mutually convenient times and places; and (d) analyses, studies and testing of Smith & Nephew’s compliance program with respect to the anticorruption laws.”

The Smith & Nephew DPA provides the compliance practitioner with specific guidance regarding how not to use a distributor. While this post did not focus on the conduct of Smith & Nephew during the pendency of the investigation, suffice to say that its conduct after self-disclosure led to a fine which was 20% below the minimum suggested by the Sentencing Guidelines. This fact clearly points to the value of self-disclosure and cooperation with the DOJ, as a key, if not THE key component during any enforcement action.

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