Attempting to capture marketplace opportunities through business alliances and joint ventures could result in serious problems.
Companies that leap into strategic alliances and joint ventures without prudent due diligence and appropriate controls may find themselves entangled and implicated should things go awry – even if they’re not principally at fault.
When two or more companies strike an accord to do business together – whether it’s a handshake agreement, a formal alliance or the creation of a separate entity like a joint venture – they could expose themselves to serious risks beyond the potential failure of a business deal. Companies and their directors and officers could find themselves dragged into regulatory investigations and subjected to stiff fines, shareholder lawsuits and even criminal prosecution. If one of their allies commits fraud or engages in illegal activities, guilt by or through association with the other party could be a concern.
‘As people know from watching recent criminal trials, the so-called ostrich defense – I didn’t really know or It wasn’t something I paid attention to – isn’t good enough under the law,’ says Andrew Weissmann, former director of the US Department of Justice’s Enron task force. ‘It is not a defense that you can deliberately close your eyes to the information because you don’t want to know. Under the law, that doesn’t fly.
‘There has been increased attention in the wake of Enron, not just on what companies are doing themselves, but whether there are any other companies that are facilitating the first company’s fraud,’ adds Weissmann, who is currently a partner at the law firm of Jenner & Block. ‘You can’t hide behind the fact that it might not be your balance sheet.
‘Concomitantly, companies are becoming more responsible and conducting a lot more due diligence before they enter into agreements,’ continues Weissmann. ‘They want to know what’s going on, what’s the purpose and exactly whom they’re doing business with.’ For example, companies should concern themselves with any problems that the other parties may have had in the past, including regulatory, compliance and antitrust issues.
Increased due diligence on potential partners and liability concerns may offer insight into why strategic alliances and joint ventures have not rebounded from a dip in 2001 (see table, page 16, ‘Trends in strategic alliances and joint ventures’). Although these tactics provide a speedy way for businesses to develop products, enter new markets, broaden their distribution and achieve a host of other objectives, companies are learning to look more closely before they leap. Moreover, the scope of their due diligence is expanding.
Warren Neel, executive director of the University of Tennessee’s Corporate Governance Center, believes companies should approach strategic combinations with as much deliberation as acquisitions, considering both corporate culture and marketplace factors. ‘Cultural due diligence is just as powerful as financial due diligence,’ says Neel. ‘If you’ve got an inappropriate mix of cultures, then in all likelihood you’re going to fall prey to some dysfunctional set of circumstances going forward.’
Most strategic relationships are based on commercial needs, not on whether the strategic partner has a similar ethical environment, according to Jeffrey Sone, partner and co-chairman of the special investigations group at Jackson Walker LLP. Sone believes it’s incumbent upon boards to query management about a potential partner’s ‘tone at the top.’
‘To the extent that you have a close relationship with another entity, you’re effectively endorsing their tone at the top,’ says Sone. ‘You run the risk of undermining or changing your own ethical environment because you have endorsed this other entity.’
For example, employees from a public company teaming up with a non-public company may find a very different modus operandi in place, while staffers from straight-laced, rules-oriented cultures might find interactions with individuals from more freewheeling cultures extremely challenging.
One way to mitigate problems associated with dissimilar cultures is to institute stronger controls. If you have particular concerns about preventing wrongdoing, boundary systems and diagnostic controls might be appropriate.
Sone believes boards should also consider the overall impact of an alliance on a company’s internal controls. ‘The audit committee in particular needs to ask, How will the strategic relationship affect the company’s internal controls? Has management given consideration to whether [the alliance] creates an opportunity to evade, intentionally or otherwise, the company’s internal financial controls?’ he says.
The more a strategic arrangement impacts a company’s financial statements, the more it warrants control and oversight, according to Trent Gazzaway, managing partner at Grant Thornton. ‘The first thing I would look for is an assessment by management of the significance of the function that was outsourced,’ he says. ‘If the potential impact is high, then I’m going to expect management to do more work. I would, at minimum, expect [management] to get an SAS 70 report from that service provider. If the service provider does not provide an SAS 70, then I would expect the management team to go in and do their own audit.’
If the arrangement has minimal impact on a company’s information and financial reporting systems, an audited financial statement or a ‘right to audit’ clause in the contractual agreement might suffice, according to Gazzaway. ‘It would not be acceptable in an outsourced arrangement for a company to just trust that the service provider was doing everything right,’ he states. ‘Management doesn’t abdicate responsibility just because they’ve outsourced it.’
Increased use of SAS 70 reports – the standard an auditor uses to issue an opinion on a company’s controls – in strategic combinations is cited in a recent report entitled ‘Managing strategic alliance risk: survey evidence of control practices in collaborative inter-organizational settings’. The Institute of Internal Auditors Research Foundation sponsored this survey, which was conducted by Shannon Anderson, associate professor of management at Rice University’s Jesse H. Jones Graduate School of Management, Karen Sedatole, associate professor of accounting at Michigan State University, and Margaret Christ, a doctoral student in accounting at the University of Texas’ McCombs School of Business.
A good question for an audit committee to ask is ‘How are we accounting for something compared to how are they accounting for something?’ Weissmann says. ‘When Enron entered a transaction with Blockbuster, the way Enron accounted for it and the way Blockbuster accounted for it were completely different. Sometimes that [difference] is legitimate and other times it raises a lot of red flags.’
‘When you set up the joint venture arrangement, you want to make sure, regardless of whether it’s dealing with revenue, inventory, marketing dollars or whatever the case, that it provides for proper accounting in accordance with Gaap,’ adds Gazzaway. ‘If it doesn’t, then you’re going to have problems down the road when it comes time to prepare your financial statements.’
In revenue-sharing agreements, Gazzaway says it’s important that both parties calculate revenue consistently and in accordance with Gaap. While there is room in ‘limited cases’ within accounting standards for differences in how you account for revenue, he notes that it’s important to understand what the differences are, if the differences truly are legitimate, and then disclose those differences appropriately in the financial statements.
Besides implementing strict financial and other controls, companies can structure alliances and joint ventures in ways that define their responsibilities and limit their legal exposure. However, they should be aware that the public perceives them as conjoined.
‘At some level, all of these joint ventures are, in effect, a partnership,’ comments Steven Browne, co-chairman of the corporate mergers and acquisitions and securities group at Bingham McCutchen. ‘You’re presenting yourself to the world as doing something together. While you can take certain steps to minimize that exposure, fundamentally to the outside world you are working together, and it will view your liability as joint.
‘No matter what you do on the legal side to protect yourself, you’re still going to bear the reputational harm if something goes wrong because you are putting yourself out as a partner with the other party,’ adds Browne. ‘If something wrong happens, even if you are ultimately entitled to collect [monetary] damages because you set it up the right way, you have to bear the reputational risk.’
‘Be careful whom you partner with because if they get sued, you might get sued,’ warns Steve Shappell, managing director at Aon Corporation. ‘Insurance helps you protect and defend yourself, and D&O [coverage] responds when directors and officers are named.’ Shappell urges boards to seek ‘bulletproof’ policies with ‘every bell and whistle’ to protect their assets. ‘Boards should make sure that their policy has state-of-the-art severability protection in it so that the behavior – the criminal fraudulent behavior of other individuals – is not and cannot be imputed to them and cause them to lose their insurance coverage,’ he cautions.
Sandy Smith, senior partner at Morris, Manning & Martin, says that while boards typically receive notification after the fact about non-material alliances, they are expected to do considerable probing and questioning of management about prospective material alliances. ‘The level of scrutiny that boards are expected to make – and it’s not just Sarbanes-Oxley, but case law – has increased,’ comments Smith. ‘The real issue is, are there procedures and protocols set up for boards to evaluate joint ventures ahead of time so they can do it correctly?’
One surprising and disconcerting finding of the research conducted by Anderson and colleagues is that most companies, even large corporations with hundreds of alliances, don’t have an overarching strategy for assessing a prospective strategic combination to determine whether it fits into a master plan.
‘We didn’t see anybody taking that next step to think about the correlations among risks and coming up with some notion of formalized enterprise risk management as a valuation proposition,’ comments Anderson. ‘Internal auditors can do a very good job of assessing risk and ensuring appropriate controls for individual alliances. However, boards of directors have that strategic insight. They should be able to look across the alliances along with the strategy group to say, How is this portfolio of alliances working for us? What potential conflicts can arise across alliances?’
Another unexpected finding of Anderson’s research is that, with the exception of financial risks, most companies are still at the early stages of identifying risks, thinking about how to control them and coming up with checklists of things they want to consider. Smith speculates that someday companies may even retain outside consultants to assess public relations or product liability risks prior to forming strategic combinations.
Don’t think it won’t happen to you. As any seasoned market observer will tell you, stock performance is as much about perception as underlying financials. Companies need to be far more careful when forming alliances, and ultimately it comes down to the board to ensure that all risk factors are being considered.
After reaching a high point of 10,495 a year in 2000, joint ventures and strategic alliances dropped 33 percent in 2001. Since 2002, these collaborations have hovered between 4,000 and 5,000. However, with only 2,238 joint ventures and strategic alliances reported through June 23, 2006, Richard Peterson, senior research analyst at Thomson Financial, does not expect these collaborations to reach 5,000 by year’s end.
‘The pinnacle was in 2000 when over 10,000 of these transactions occurred,’ observes Peterson. ‘That, in part, coincides with the last peak in worldwide merger activity. But while merger activity has accelerated since 2003, we have not seen the ramp-up in joint ventures and strategic alliances.’
Peterson suggests that corporate governance concerns following the enactment of Sarbanes-Oxley may have caused companies to shy away from these deals in an effort to ‘avoid liability or the appearance of liability.’ Since 1988, the formation of strategic alliances continues to outpace that of the more structured joint ventures.
‘As people know from watching recent criminal trials, the so-called ostrich defense – I didn’t really know or It wasn’t something I paid attention to – isn’t good enough under the law,’ says Andrew Weissmann, former director of the US Department of Justice’s Enron task force. ‘It is not a defense that you can deliberately close your eyes to the information because you don’t want to know. Under the law, that doesn’t fly.
‘There has been increased attention in the wake of Enron, not just on what companies are doing themselves, but whether there are any other companies that are facilitating the first company’s fraud,’ adds Weissmann, who is currently a partner at the law firm of Jenner & Block. ‘You can’t hide behind the fact that it might not be your balance sheet.
‘Concomitantly, companies are becoming more responsible and conducting a lot more due diligence before they enter into agreements,’ continues Weissmann. ‘They want to know what’s going on, what’s the purpose and exactly whom they’re doing business with.’ For example, companies should concern themselves with any problems that the other parties may have had in the past, including regulatory, compliance and antitrust issues.
Increased due diligence on potential partners and liability concerns may offer insight into why strategic alliances and joint ventures have not rebounded from a dip in 2001 (see table, page 16, ‘Trends in strategic alliances and joint ventures’). Although these tactics provide a speedy way for businesses to develop products, enter new markets, broaden their distribution and achieve a host of other objectives, companies are learning to look more closely before they leap. Moreover, the scope of their due diligence is expanding.
Warren Neel, executive director of the University of Tennessee’s Corporate Governance Center, believes companies should approach strategic combinations with as much deliberation as acquisitions, considering both corporate culture and marketplace factors. ‘Cultural due diligence is just as powerful as financial due diligence,’ says Neel. ‘If you’ve got an inappropriate mix of cultures, then in all likelihood you’re going to fall prey to some dysfunctional set of circumstances going forward.’
Most strategic relationships are based on commercial needs, not on whether the strategic partner has a similar ethical environment, according to Jeffrey Sone, partner and co-chairman of the special investigations group at Jackson Walker LLP. Sone believes it’s incumbent upon boards to query management about a potential partner’s ‘tone at the top.’
‘To the extent that you have a close relationship with another entity, you’re effectively endorsing their tone at the top,’ says Sone. ‘You run the risk of undermining or changing your own ethical environment because you have endorsed this other entity.’
For example, employees from a public company teaming up with a non-public company may find a very different modus operandi in place, while staffers from straight-laced, rules-oriented cultures might find interactions with individuals from more freewheeling cultures extremely challenging.
One way to mitigate problems associated with dissimilar cultures is to institute stronger controls. If you have particular concerns about preventing wrongdoing, boundary systems and diagnostic controls might be appropriate.
Sone believes boards should also consider the overall impact of an alliance on a company’s internal controls. ‘The audit committee in particular needs to ask, How will the strategic relationship affect the company’s internal controls? Has management given consideration to whether [the alliance] creates an opportunity to evade, intentionally or otherwise, the company’s internal financial controls?’ he says.
The more a strategic arrangement impacts a company’s financial statements, the more it warrants control and oversight, according to Trent Gazzaway, managing partner at Grant Thornton. ‘The first thing I would look for is an assessment by management of the significance of the function that was outsourced,’ he says. ‘If the potential impact is high, then I’m going to expect management to do more work. I would, at minimum, expect [management] to get an SAS 70 report from that service provider. If the service provider does not provide an SAS 70, then I would expect the management team to go in and do their own audit.’
If the arrangement has minimal impact on a company’s information and financial reporting systems, an audited financial statement or a ‘right to audit’ clause in the contractual agreement might suffice, according to Gazzaway. ‘It would not be acceptable in an outsourced arrangement for a company to just trust that the service provider was doing everything right,’ he states. ‘Management doesn’t abdicate responsibility just because they’ve outsourced it.’
Increased use of SAS 70 reports – the standard an auditor uses to issue an opinion on a company’s controls – in strategic combinations is cited in a recent report entitled ‘Managing strategic alliance risk: survey evidence of control practices in collaborative inter-organizational settings’. The Institute of Internal Auditors Research Foundation sponsored this survey, which was conducted by Shannon Anderson, associate professor of management at Rice University’s Jesse H. Jones Graduate School of Management, Karen Sedatole, associate professor of accounting at Michigan State University, and Margaret Christ, a doctoral student in accounting at the University of Texas’ McCombs School of Business.
A good question for an audit committee to ask is ‘How are we accounting for something compared to how are they accounting for something?’ Weissmann says. ‘When Enron entered a transaction with Blockbuster, the way Enron accounted for it and the way Blockbuster accounted for it were completely different. Sometimes that [difference] is legitimate and other times it raises a lot of red flags.’
‘When you set up the joint venture arrangement, you want to make sure, regardless of whether it’s dealing with revenue, inventory, marketing dollars or whatever the case, that it provides for proper accounting in accordance with Gaap,’ adds Gazzaway. ‘If it doesn’t, then you’re going to have problems down the road when it comes time to prepare your financial statements.’
In revenue-sharing agreements, Gazzaway says it’s important that both parties calculate revenue consistently and in accordance with Gaap. While there is room in ‘limited cases’ within accounting standards for differences in how you account for revenue, he notes that it’s important to understand what the differences are, if the differences truly are legitimate, and then disclose those differences appropriately in the financial statements.
Besides implementing strict financial and other controls, companies can structure alliances and joint ventures in ways that define their responsibilities and limit their legal exposure. However, they should be aware that the public perceives them as conjoined.
‘At some level, all of these joint ventures are, in effect, a partnership,’ comments Steven Browne, co-chairman of the corporate mergers and acquisitions and securities group at Bingham McCutchen. ‘You’re presenting yourself to the world as doing something together. While you can take certain steps to minimize that exposure, fundamentally to the outside world you are working together, and it will view your liability as joint.
‘No matter what you do on the legal side to protect yourself, you’re still going to bear the reputational harm if something goes wrong because you are putting yourself out as a partner with the other party,’ adds Browne. ‘If something wrong happens, even if you are ultimately entitled to collect [monetary] damages because you set it up the right way, you have to bear the reputational risk.’
‘Be careful whom you partner with because if they get sued, you might get sued,’ warns Steve Shappell, managing director at Aon Corporation. ‘Insurance helps you protect and defend yourself, and D&O [coverage] responds when directors and officers are named.’ Shappell urges boards to seek ‘bulletproof’ policies with ‘every bell and whistle’ to protect their assets. ‘Boards should make sure that their policy has state-of-the-art severability protection in it so that the behavior – the criminal fraudulent behavior of other individuals – is not and cannot be imputed to them and cause them to lose their insurance coverage,’ he cautions.
Sandy Smith, senior partner at Morris, Manning & Martin, says that while boards typically receive notification after the fact about non-material alliances, they are expected to do considerable probing and questioning of management about prospective material alliances. ‘The level of scrutiny that boards are expected to make – and it’s not just Sarbanes-Oxley, but case law – has increased,’ comments Smith. ‘The real issue is, are there procedures and protocols set up for boards to evaluate joint ventures ahead of time so they can do it correctly?’
One surprising and disconcerting finding of the research conducted by Anderson and colleagues is that most companies, even large corporations with hundreds of alliances, don’t have an overarching strategy for assessing a prospective strategic combination to determine whether it fits into a master plan.
‘We didn’t see anybody taking that next step to think about the correlations among risks and coming up with some notion of formalized enterprise risk management as a valuation proposition,’ comments Anderson. ‘Internal auditors can do a very good job of assessing risk and ensuring appropriate controls for individual alliances. However, boards of directors have that strategic insight. They should be able to look across the alliances along with the strategy group to say, How is this portfolio of alliances working for us? What potential conflicts can arise across alliances?’
Another unexpected finding of Anderson’s research is that, with the exception of financial risks, most companies are still at the early stages of identifying risks, thinking about how to control them and coming up with checklists of things they want to consider. Smith speculates that someday companies may even retain outside consultants to assess public relations or product liability risks prior to forming strategic combinations.
Don’t think it won’t happen to you. As any seasoned market observer will tell you, stock performance is as much about perception as underlying financials. Companies need to be far more careful when forming alliances, and ultimately it comes down to the board to ensure that all risk factors are being considered.
After reaching a high point of 10,495 a year in 2000, joint ventures and strategic alliances dropped 33 percent in 2001. Since 2002, these collaborations have hovered between 4,000 and 5,000. However, with only 2,238 joint ventures and strategic alliances reported through June 23, 2006, Richard Peterson, senior research analyst at Thomson Financial, does not expect these collaborations to reach 5,000 by year’s end.
‘The pinnacle was in 2000 when over 10,000 of these transactions occurred,’ observes Peterson. ‘That, in part, coincides with the last peak in worldwide merger activity. But while merger activity has accelerated since 2003, we have not seen the ramp-up in joint ventures and strategic alliances.’
Peterson suggests that corporate governance concerns following the enactment of Sarbanes-Oxley may have caused companies to shy away from these deals in an effort to ‘avoid liability or the appearance of liability.’ Since 1988, the formation of strategic alliances continues to outpace that of the more structured joint ventures.
