Analyzing Bribery and Corruption

For Professional Investors Only

Introduction

While there is no one-size-fits-all approach to assessing and financializing bribery/corruption risks, we lay out some of what we have learned when approaching this issue in our investment process. Analyzing this issue requires deep fundamental research, coupled with a focus on active ownership and engagement. Since there is no one governance model that will ensure the elimination of these issues, our assessment of these issues and ongoing engagement with management is always case-by-case and company-specific. That said, there are certain risk factors and company-specific flags that can be helpful in the research process to identify companies with higher risk of exposure to bribery/corruption.

Financializing the risk of bribery/corruption or a known allegation is also fraught with difficulty (e.g. inherent imprecision of fine estimates; limits to what management can know, disclose and control) but nevertheless important when assessing the range of outcomes for a given investment. We lay out some of the tools at our disposal to help financialize this risk.?

Active and ongoing engagement with management can help us get ahead of these issues and is also essential in the wake of a scandal to hold management accountable for failures. We detail some of the lines of enquiry we have found most helpful when discussing this issue with management teams.

We conclude with an example of how we have approached bribery/corruption for companies under coverage to bring to life our ESG integrated investment process.

Dimensions of Bribery/Corruption Risk

General Risk Factors

1. Geography

• % of revenue or profits coming from countries at higher risk of bribery/corruption
• Transparency International Corruptions Perception Index

2. Government involvement

• Flows of money to government or pseudo-government entities?
• Reliant on government for approvals/license to operate

3. Size of contracts at stake

4. 3rd?party involvement

• Use of subcontractors
• Reliance on agents and/or lobbyists
• Active JVs and participation in consortiums

While the issue is technically sector agnostic, some industries have particular exposure to these risk factors and so have developed a reputation for ongoing issues.?

Company-Specific Flags

1. Undue success in one or more specific regions (i.e. is the company always winning contracts)?

2. Unusual flows of money

• Significant charitable donations in one or several regions
• Significant entertainment expenses

3. Staff movements/resignations?

Incorporation into Fundamental Research

Financialization

Direct?- Fines:?

• If fines are already known/disclosed then these can be incorporated directly into the model?
• If fines are unknown, then they can be estimated using past precedent. This is particularly true when falling under domestic anti-corruption statues e.g. Foreign Corrupt Practices Act?FCPA?and UK Bribery Act (UKBA)

Direct?- Position-Sizing:?

• Since the range of fines will vary, position sizing should account for inherent riskiness of these fines and any uncovered issues
• We can mitigate portfolio risk by maintaining a smaller position size for companies impacted by this risk factor

Indirect - Regulatory Penalties:

• Companies may be subject to consent decrees or other government-imposed penalties e.g. a bank may be held to higher capital requirements or a company may be prevented from paying bonuses which could lead to talent attrition

Indirect - Reputational Damage:?

• Widens the range of outcomes for an investment e.g. risk of public backlash; diminished employee morale leading to talent attrition; reduced market access; and loss of customers
• In extreme cases it can increase a company’s cost of capital and/or close off certain markets

Engagement Topics

Engagement on this topic can serve two purposes:?

1.?To try and get ahead of any risk of a bribery/corruption incident by better understanding the risk profile of an investment

2. Once an incident of bribery/corruption has occurred, it is important to continually engage to hold management accountable and understand the range of remediation activities and the inherent associated tradeoffs.

Some lines of enquiry that can help when probing management on this issue include:?

Company governance:

• Tone from the top on these issues
• Board effectiveness (independence, experience, independent effectiveness review etc.)
• Agenda of audit committee
• How different levels of the organization are incentivized

Anti-bribery/corruption policies and controls:?

• How they are implemented and monitored
• How effectiveness is determined/assessed

Use of agents/lobbyists:

• Sourcing process
• Operating practices and oversight capabilities

Remediation:

• Sense of ownership for remediation e.g. full cooperation with authorities vs. denial
• How and why these issues will never happen again
• Reasons for executive resignations (as appropriate)?

Case Study

Andritz: Engineering & Construction?

ESG/Investment controversy: engineering & construction is a high-risk industry for bribery and corruption issues

Research Insight:?Analyzed and engaged on the following to get comfortable that Andritz was a responsible operator:

• History of company financials, including balance sheet strength, margins etc.?
• Company process to determine whether to reject or bid for a project?
• Operating policies and procedures, including project management risk assessments that include environmental and social issues
• Allegations made by one third party ESG data provider of lax operating standards in one prior project were dated and unrelated to projects operated by Andritz

Research challenges: strong policies, procedures and operating practices are not a guarantee that there will be never be any future issues

Ongoing engagement objective: continually probe on the issues above to make sure there is no change in our assessment of the risk profile of the investment?

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Further Information:

These materials are intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management, LLC (“PIM”) as of the date hereof and are subject to change.?PIM is a registered investment adviser registered with the United States Securities and Exchange Commission.?PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized.??Past performance is not indicative of future results. All investments involve risk, including risk of total loss.

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