Theme Report - 4th in a series

T his Eurosif thematic report has been compiled with research conducted by Vigeo. It emphasises the detrimentalimpacts of corruption on business performance, sustainable development and the various risks faced bycompanies that fail to address this issue. It also describes the most influential legislation, commonly affected

sectors, and best practices to adopt for better corruption prevention.

CORRUPTION OVERVIEW

Over recent years, corruption has become one of the major concernsof large international companies, NGOs, and civil societyorganisations. The topic has become increasingly material forinvestors due to the adverse effects of legal proceedings and othercorruption risks.

Corruption is defined by Transparency International (TI) as “the abuseof entrusted power for private gain.” Among the many corruptpractices that prevail, bribery is the most commonly used term todefine an act of corruption. Forms of corruption within the privatesector include, among others, corporate fraud, account manipulation,embezzlement, facilitation of payments and money laundering.

Conflicts of interest are also considered as corruption in the sensethat they may alter a company’s decisions as well as affect theintegrity of its executives and employees, for private gain.

The Global Competitiveness Report 2009-2010 issued by the WorldEconomic Forum strongly emphasises the impact of corruption oncompanies. The study identifies corruption as one of the top threemost problematic factors (on a list of fifteen) for business practices in51 of the 133 analysed countries (38%). Another study, released in2007, revealed that half of international business managers estimatethat corruption increases project costs by at least 10% (in some casesby more than 25%).2

Corruption

CORRUPTION: IMPACTS ON COMPANIES AND INVESTORS

Companies that practice corruption are focused on short-term returnsand often do not realise the long term risks. In addition to directfinancial costs and lost business opportunities, corruption practicescause substantial damages to branding, staff morale and externalbusiness and government relations. Likewise, the enforcement of anti-bribery rules in some jurisdictions has resulted in stiff prison sentences

and penalties amounting to millions of euros. The various corruption-related risks that are described in this report may significantly impactcompanies’ material and immaterial assets. A Transparency Internationalmap on corruption perceptions index (shown above) ranks 180countries and territories on their perceived level of public-sectorcorruption; higher rankings indicate a lower presence of corruption.

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June 2010

Eurosif wishes to acknowledge the support and direction provided by the Corruption Sector Report Steering Committee:

CM-CIC Asset Management

ECPI

Fundación Ecología y Desarrollo

Henderson Global Investors

This sector report has been compiled by:

1 Bribery is defined by Transparency International as “the offering, promising, giving, accepting or soli-citing of an advantage as an inducement for an action which is illegal, unethical or a breach of trust.Inducements can take the form of gifts, loans, fees, rewards or other advantages (taxes, services, do-

nations, etc.)”. Transparency International & Social Accountability International, “Business Principles forCountering Corruption”, 2004.2 Control Risks and Simmons & Simmons, 2007.

16 The Aspen Institute Business & Society Program, “Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management”, www.aspeninstitute.org

15

Implementing adequate control systemsEmployees have resources at their disposal enabling them todenounce any corrupt behaviour they have witnessed. It isimperative that this information is processed confidentially and thebonafide whistleblowers are protected from any discrimination.Companies should verify how well their policies are followed byregularly carrying out internal audits in order to ensure theirsystems are helping to prevent corruption.

Best practices: ● The Code of Conduct is part of induction training for all new

employees, and experienced employees must test their knowledgeof integrity issues on a regular basis (every three years).

● At-risk employees (consultants, sales agents, procurement staff, etc.) receive specific training on anti-corruption, such as situationaltraining, which places the company’s principles into practice.

● An integrity component is included in the remuneration “scorecard” of managers.

Best practices: ● The whistle blowing system is managed by a third party,

increasing the employees’ confidence in the reportingmechanism.

● The whistle blowing system is open to all third parties including transaction intermediaries, such as consultants, butalso suppliers and business partners.

● The company’s internal controls are regularly subject to evaluation by an external organisation.

Ensuring that employees know how to handle at-risksituations

Awareness-raising and training programmes aim at improving theemployees’ understanding of the company’s principles with regardsto corruption. It helps them avoid any misconduct and promote thecompany’s principles of integrity.

MAJOR ANTI-CORRUPTION CONVENTIONS

1996 Inter-American Convention Against Corruption

1997 OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions

1999 The Council of Europe Criminal and Civil Law Conventions on Corruption

2000 UN Convention Against Transnational Organised Crime

2003African Union Convention on Preventing and Combating Corruption

UN Convention Against Corruption

Foreign Corrupt Practices Act (US):

1998 extension

UK Bribery Bill, passed in April

2010

Partnership against Corruption Initiative

(PACI): launched in 2004

Extractive Industries Transparency Initiative (EITI), launched in 2002 Wolfsberg Group,

founded in 2000

Major National Laws Voluntary Initiatives

Recommendations for investors:• Ask for more transparency and disclosure on the issue of corruption• Push for an international level playing field and effective enforcement• Engage with companies and establish dialogue• Consider companies’ exposure to corruption risks in their investment policies• Use voting power and collaborate with other shareholders• Urge for corrective measures following condemnations

Corruption perceptions index 2009

Best practices: ● The company is transparent on its objectives in terms of

corruption prevention and the reporting of its policies.● The number and nature of incidents indicated through the

company’s whistle blowing system are disclosed. In addition,the company communicates concrete elements on thehandling of these reported incidents (assistance, internalinvestigations, disciplinary measures etc.).

● The company reports on what corrective measures have been implemented following a sentencing.

● The company discloses all payments and taxes paid to host governments on a country-by-country basis.

TransparencyAny company willing to strengthen its anti-corruption culturemust be transparent. Being transparent about the implementationof preventive strategies lies within the set of predominantobligations of Corporate Social Responsibility. Transparencybenefits all stakeholders: from investors to civil society.

Legislative and Voluntary framework

Identifying potential red flags

● Foreign Direct Investments in weak governance zones are amongthe strongest factors that can undermine corporate integrity. All worldregions have recently received record amounts of foreign investment,which in Africa and Latin America were driven mainly by boomingdemand for natural resources and other commodities.3

● Cross-border Mergers & Acquisitions also constitute at-risk situations: By 2007, transnational corporations (TNCs) wereestimated to control some 790,000 foreign affiliates around theworld. In 2006, the 100 largest TNCs from developing countriescontrolled more than €4.3 billion of foreign assets, led mainly byinvestors from China, South Korea, Brazil and Mexico.

● Outsourcing and recourse to overseas intermediaries: Corporateintegrity is also at stake when cross-border business takes the form ofoutsourcing and trade rather than foreign ownership. Producers inmany key industries, including chemicals, pharmaceuticals, electricmachinery and medical components, source more than 30% of theirinputs from outside their countries.4

● Relationships with public officials: Private-to-public corruptionis often categorised as either administrative corruption or politicalcorruption. Administrative corruption may be defined as the abuseof power by public officials during their interactions with citizensor organisations, while political corruption consists of theillegitimate private gain by government officials due to theirabuse of legislative power and distortion of public policies. Insome developing countries, corrupt politicians and governmentofficials receive bribes believed to total around €15 to €30 billionannually. In countries such as Egypt, India, Morocco, Nigeria andPakistan, more than 60% of the business executives polled in a TIsurvey reported having been solicited for bribe payments.

Corporate Risks5

Operational and Financial risk An investigation for corruption can be a major burden for a company,requiring the allocation of substantial resources and means. Thepresence of investigators at the workplace, researching and analysing acompany’s documents, disrupts business. Top managers and boardmembers may step down or be fired if they are found responsible,creating disruptions at the highest levels.

Other operational risks may be linked to a company’s access to marketsand call for tenders. In 2009, the operating license of the French oilgroup Total was suspended for one year by the Italian authorities dueto an investigation related to corruption.6 The case of the German

corporation Siemens is another notorious example of the market riskslinked to court decisions. As a consequence of Siemens’ sentencing, thecompany agreed to a four-year debarment for its Russian subsidiaryand a voluntary two-year shutout from bidding on the World Bank'sprojects for Siemens AG and all of its consolidated subsidiaries andaffiliates.7

Legal risks and feesThis is the most material risk for companies due to its direct associationwith administrative and financial sanctions. In the United States,legislative reinforcements have led to an increase in sanctions inflictedon companies found guilty of corrupt acts. The costs of non-compliance to anti-corruption laws are now reaching higher levels.During the past twelve months, Halliburton and Siemens paid finesamounting to €440 million8 and €1.2 billion9 respectively forcorruption cases. These costs exclude the additional burden of feesrelated to operational disruptions, investigations, and the review ofinternal control systems.

Reputation risk The reputation risk does not necessarily affect the financial health ofall companies because reputation might be damaged very differentlydepending on the industry and business nature (Business to Business orBusiness to Consumer). However, being active in the prevention ofcorruption may reduce reputational risk and preserve a company’slicense to operate, which is vital in many sectors.

Human capital riskWhen employees and managers are accused of corruption, the risk for adeteriorating corporate culture environment increases. If themanagement’s involvement is confirmed by a judicial decision, this couldresult in employees losing their trust in management and losing faith inthe company’s values. In addition, companies facing recurrent allegationsor sentencing may send a negative message to potential job seekers.

What is at stake for investors?

● Impacts on earnings: In light of the magnitude of fines received bySiemens (€1.2 billion) and Halliburton (€440 million), or thecontingency provision set aside by Technip (€279 million) inanticipation of a settlement, investors cannot afford to ignore thisissue.

● Impacts on share prices: Fines represent the ex-ante implications oflegal proceedings but markets may anticipate court decisions andsignificantly influence share prices. This has been shown by casessuch as BAE Systems (the share price slumped nearly 8% after newsthat the US Department of Justice had launched a corruptionprobe)10 German truck maker MAN11 (-3%) or AVON (-8%).12

executives in 26 countries), Transparency Internationalrevealed that the Public Works Contract & Constructionindustry was the most likely to pay bribes to public officials.15

Finance: a black box?As most forms of corruption usually involve a financialtransaction between one person or institution and another, manycorrupt dealings eventually involve banks or other financialintermediaries. Although often unknowingly, financialintermediaries’ remain highly exposed to and potentially directly

Engaging employees and managers to behave honestly

Generally, responsibilities pertaining to the management of acompany’s business principles belong to the Board of Directors andto Senior Management. Some companies are transparent about theorganisational support standing behind their commitment, thuschoosing to communicate the name of the department or of theperson responsible for this role. The involvement of companies withexternal or sector driven initiatives reinforces the legitimacy andsuccess of a company’s commitment to transparency.

The analysis of the relevance of corporate policies is based on threeelements: the visibility of the policy, the content of thecommitment, and the level of corporate support, or ownership (see“Leadership policies” chart).

● Impacts on cost of capital: The cost of capital of a company mayalso be at stake if investors decide to divest their shares. Forexample, the Norwegian Public Pension Fund, which owns shares inSiemens amounting to 6.3 billion Norwegian kroner, decided to

place Siemens under surveillance and to evaluate its efforts in termsof anti-corruption measures before making a final decision on howto handle this investment.13

3 United Nations Conference on Trade and Development (UNCTAD), "World Investment Report 2008:Transnational Corporations and the Infrastructure Challenge” Geneva, 2008.4 World Trade Organisation (WTO), “World Trade Report 2008: Trade in Globalizing World”, 2008.5 Vigeo comments on 4 categories of intangible assets that may be positively or negatively affected de-pending on how companies handle relevant CSR objectives: Reputation, Human Capital, OperationalEfficiency, and Legal Security. Vigeo believes that changes in these immaterial assets may over the me-dium to long term impact positively or negatively a company’s economic and financial performances

6 Reuters, « Italie-La police suspend pour un an une licence de Total », 16 February 2009.7 The World Bank, Press Release n° 2010/001/EXT/FR, 2 July 2009.8 Bloomberg, “KBR, Halliburton Agree to $579 Million Fine for Nigeria Bribes,” 12 February 2009.9 Bloomberg, “Siemens to Pay $1.6 Billion to Settle Bribery cases”, 16 December 2008.10 http://www.guardian.co.uk/business/2007/jun/26/marketforces.baesystemsbusiness.11 http://www.reuters.com/article/idUSLC80616720090512.12 http://www.marketwatch.com/story/avon-shares-drop-amid-internal-ethics-probe-2010-04-13.

13 Norwegian Ministry of Finance, “Siemens under observation in corruption case”, 13 March 2009. 15 http://www.transparency.org/policy_research/surveys_indices/bpi.

2 3 4

14 http://www.ft.com/cms/s/0/8134d35a-126a-11df-8d73-00144feab49a.html, 5 February 2010.

Source: Vigeo, “What measures are listed companies taking in the fight against corruption:A comparative analysis of North-American and European strategies for the prevention ofcorruption between 2007 and 2009”, February 2010. The figures presented in the charts areaverage scores, on a scale of 1 to 100, obtained from 772 European and North Americancompanies listed on the Dow Jones Stoxx Global 1800 Index.

SECTORS: THE MANY FACES OF CORRUPTION

The most vulnerable sectors are considered to be at-risk based on theirlocation, the nature of their operations and the type of their financialtransactions. Despite sector driven initiatives, companies operating inextractive industries (oil, gas, coal, etc.), and more generally, companiesthat have relations with public officials, typically utilities (powergeneration, water), waste and tobacco have the highest exposure toallegations of corruption.

According to a 2010 Vigeo study, 13% of European companies (out of506) were subject to allegations or condemnations between April 2007and August 2009. The most frequent cases of corruption concernedbriberies or payments made to public officials. In Europe, Energy andPharmaceuticals rank among the most controversial sectors.

CONTROVERSIAL SECTORS IN EUROPE

Sectors - EuropeShare of companies subject to

allegations

Energy (oil & gas) 38%

Pharmaceuticals & Biotechnologies

38%

Aerospace & Defence 30%

Source: Vigeo, “What measures are listed companies taking in the fight against corruption: Acomparative analysis of North-American and European strategies for the prevention ofcorruption between 2007 and 2009”, February 2010.

Examples of affected industries

Extractive industries: the “resource curse” paradoxThe “resource curse” is a notion that describes the paradox between thehigh revenues generated by the extraction of oil, gas, and minerals vs.the poverty and lack of basic infrastructure from which the civilsocieties of some natural resource-rich countries suffer. If the taxes,royalties, or production entitlements paid to host governments weredisclosed on a country-by-country basis, it would make hostgovernments accountable towards their citizens. In reality, the argumentof commercial sensitivity is used by most companies to justify theiraccounting opacity. A few countries, such as Norway and Canada,require disclosure by companies of the payments they make to foreigngovernments for oil, gas, and minerals.

In February 2009, the oilfield services company Halliburton andits one-time KBR subsidiary paid a combined €440 million tosettle bribery charges in connection with their dealings withNigerian officials.

Pharmaceuticals and healthcare: corruption to bypass competition?In an environment of fierce competition, characterised by thedecline of new drugs discovery, the near extinction of blockbusterpatents and the increased regulation of sales and marketingchannels, pharmaceutical firms are under pressure to change theirbusiness model. While emerging economies represent new businessopportunities, corporations may be tempted to bypass the rules ofthe market in order to preserve their future margins. Corruption canappear in several forms in this sector, such as: bribes to publicauthorities in order to receive marketing approval, incentives todoctors for prescribing certain treatments, conflicts of interestregarding researchers conducting clinical trials, and pricing schemesto defraud government health systems.

In the USA, on October 19, 2009, AstraZeneca and three otherpharmaceuticals companies paid €93 million to the state ofMissouri to resolve allegations that they had underpaid theirrebate obligations to the Medicaid programme by improperlyclassifying drugs.

Aerospace and defence: classified bribes?The intense competition and considerable amounts of money in theaerospace industry and the frequent interaction with variousgovernments, especially in politically sensitive regions, significantlyexpose aerospace companies to potentially corruptive situations.The increase in military revenues largely depends on nationalgovernments’ decisions to invest in defence. Thus, lobbying isrecognised as a central strategy in the aerospace industry andconflicts of interest may arise.

In February 2010, the highly political BAE case ended with thecompany paying €290 million to the US Department of Justice(DoJ) and €35 million to the British Serious Fraud Office (SFO) tosettle the case.14 The DoJ and the SFO had been investigatingthe case for eight years and their sanctions highlight the gapthat can exist in the implementation of national laws.

Construction: building beyond awareness? Corruption in the construction sector can result in unnecessary,unsuitable, or dangerous projects, which are often subject to severedelays. Construction is highly exposed to corruption for two mainreasons. First, it is a capital intensive industry which requires largeup-front investments to start and run projects. Second, it has strongties with the public sector (e.g. for building permits, delimitation ofliving spaces, bid processes, etc.).

In its 2008 Bribe Payers Index (survey of 2,742 senior business

involved in corruption. Typically, a financial institution could beused as a vehicle for corruption by a corporate customer thatplaces funds in a bank, often in offshore locations, to pay bribes.

On March 2009, the Britain's Serious Fraud Office (SFO) announcedit was investigating an alleged 56 million pound (€65 million) fraudin the corporate banking department of Allied Irish Banks. The SFOsaid Allied Irish Banks (AIB) had provided loans to companiescontrolled by an unnamed individual who was the main suspect inthe probe. The loans were used for the purchase of investmentproperties in the UK by these companies between 2003 and 2007.

PREVENTING CORRUPTION: BEST PRACTICES

Implementing a company’s principles into practiceThe most advanced anti-corruption programmes combineawareness-raising and training programmes, advice services (e.g.helpline), risk analysis tools, adequate internal and external controlprocedures and whistle blowing systems.

By evaluating the tangibility and adequacy of processes and resources(human, financial, organisational etc.) that have been put in place bythe organisation to prevent corruption (see “Implementation” chart),the coherence of these policies may be measured.

Best practices: ● A Code of Conduct, available in local languages, that addresses

and defines the forms of corruption existing in the sector.● A clear commitment from top management against any forms

of corruption.● A decentralised network of compliance officers to ensure the

correct implementation of the Code of Conduct.● Collaboration with external stakeholders and/or initiatives in

the fight against corruption.

Source: Vigeo, “What measures are listed companies taking in the fight against corruption:A comparative analysis of North-American and European strategies for the prevention ofcorruption between 2007 and 2009”, February 2010. The figures presented in the charts areaverage scores, on a scale of 1 to 100, obtained from 772 European and North Americancompanies listed on the Dow Jones Stoxx Global 1800 Index.

Leadership (policies) - Average scores

Implementation - Average scores