Private Equity Spotlight: Impact of corporate criminal liability changes

In this episode of our Private Equity Spotlight series, we explore what the UK Economic Crime and Corporate Transparency Act means for those in the private equity industry. We focus in particular on the “failure to prevent fraud” offense introduced by this Act. Our speakers will talk you through which companies will be liable and explore how they can defend themselves against regulatory action.

Private equity partner Tom Whelan is joined by Reed Smith regulatory and investigations partners Rosanne Kay and Ali Ishaq, as well as former Reed Smith partner Patrick Rappo, to share practical insights and tips in this edition of our series.

Transcript: 

Intro: Hello, and welcome to Dealmaker Insights, a podcast brought to you by Reed Smith's corporate and finance lawyers from around the globe. In this podcast series, we explore the various legal and financial issues impacting your deals. Should you have any questions on any of the content, please contact our speakers.

Tom: Hi, everyone, and welcome back to Dealmaker Insights. I'm Tom Whelan, a partner in Reed Smith's private equity group in London. I'm joined today by Roseanne Kay, Patrick Rappo and Ali Ishaq. Before we dive in, I'll let them briefly introduce themselves. Roseanne.

Rosanne: Hi everyone, I'm Roseanne Kay. I am a partner in Reed Smith's London office, specialising in white-collar crime. I focus on financial services litigation also.

Tom: Patrick.

Patrick: I'm Patrick Rappo, formerly headed up the Bribery and Corruption Divisions at the UK Serious fraud office and advise some members of the House of Lords in relation to the legislation that we're going to be talking about today.

Tom: Excellent. Ali.

Ali: Hi, Tom. I'm a partner in the firm's London office, and my practice focuses on regulatory investigations and enforcement proceedings, profane claims, and also general commercial litigation and arbitration.

Tom: Great. Thank you all. Well, today we'll be discussing what the Economic Crime and Corporate Transparency Act means for the private equity industry, with a special focus on the failure to prevent fraud offence. There's a lot to cover, so let's jump right in. Ali, why are the two new corporate criminal offences relevant to private equity and their portfolio companies? Namely liability for failing to prevent fraud by associated persons and liability for senior managers who commit economic crimes.

Ali: Thanks, Tom. So this is a new UK offence, which is the failure to prevent fraud offence, which is coming into force in September 2025. It was brought into the UK statute books together with a new senior manager offence, which came into force in December 2023, and which I'm going to touch on very briefly and to begin with. Now, both of these new corporate offenses are part of the UK government's plan to make it easier to find corporates criminally liable. Starting very briefly then with the senior manager offense. This new offense makes corporates criminally liable for the actions of their senior managers acting within the actual or apparent scope of their authority who commit economic crimes. It is also going to apply to private equity companies, and like the failure to prevent fraud offense, has a wide extraterritorial effect. Now, a senior manager is defined as someone who plays a significant role in making decisions about how all or a substantial part of the organization's activities are to be managed or organized, or in actually managing or organizing a whole or substantial part of those activities. Now, the applicable economic crimes which a senior manager can commit and therefore make the company liable for are broad in range and include offenses such as cheating the public revenue, false accounting, money laundering, bribery or fraud, and even sanctions violations. So that very briefly was the senior manager offense. Moving on then to the failure to prevent fraud offense. Now, this offense is important to private equity firms and their portfolio companies for two key reasons. The first reason being, in very simple terms, that the failure to prevent fraud offense can hold a private equity company liable for fraudulent actions committed by associated persons if it can be shown that the private equity company or its clients benefited from that fraudulent act. These associated persons whose actions can create liability include employees and most notably both portfolio companies and even the GP. And adding to this concern is the fact that the failure to prevent fraud offenses is broad in nature. It covers a range of fraud offenses from abuse of position and failing to disclose information to fraudulent trading and false accounting. So under this new offense, there are a range of fraudulent acts that can be commissioned by a portfolio company or the GP that results in liability ultimately for the private equity company. Now, the second reason why this offense is of relevance to PE firms is that the offense is a strict liability offense, which means that to be found guilty of this offense, the authorities do not need to establish criminal intent or even show that the entity had knowledge of the offense being committed. So once the offense has been committed, private equity company cannot come out and say that they were not aware of the portfolio company's action to avoid liability. In fact, the only defense would be for the firm to show that it had reasonable procedures in place to prevent the fraud. So to summarize all of that in a few sentences, the failure to prevent fraud offense has meant that PE firms now face increased risk of liability from the daily operations of their portfolio companies, and this risk of liability is quite significant. However, not all entities will fall under the purview of this offense. It's only going to apply to an entity within a PE structure that meets two out of the three qualifying criteria. So firstly, if the entity employs more than 250 employees. Secondly, if the entity has total assets worth more than £18 million pounds and/or the entity has a turnover of 36 million pounds. Now, these criteria apply to the whole organization, including subsidiaries, regardless of where the organization is headquartered or where the subsidiaries are located. So that Tom is a very quick summary as to why these two offenses are something PE firms need to consider very seriously.

Tom: Thank you, Ali. And we go on now to Roseanne. So Roseanne, what sort of conduct is going to create a problem under the failure to prevent fraud offence for private equity and their portfolio companies?

Rosanne: So the way it works, Tom, under this failure to prevent fraud offence is that there are some specific base fraud offences which are referred to in the act that brought this new offence into force or is going to bring it into force, which must have been committed in order for a corporate to then have the criminal liability of failing to prevent that fraud offence. And what I'm going to do is refer to some practical examples. But before that, I just wanted to mention a few points, which are that we're not dealing with new kinds of misconduct. So the sort of practical examples that I will mention will be recognisable types of fraud. But what's new is that that misconduct will now more easily create criminal liability for the corporates under the new offence. The second point to mention is that the fraudulent conduct can be looked at from different perspectives, from the perspectives of the different entities and individuals who might be involved in the typical private equity structure. So although we're focusing on the failure to prevent offence, the same misconduct may give rise to liability for different individuals and different entities under different offences at the same time so for example the specific employee who may have done the the wrong act will be themselves liable personally for a fraud offence there may be liable liability for a corporate under the failure to prevent offence, in addition to liability for entities under this new senior manager offence, which Ali mentioned, if there were senior managers involved in the commission of the offence. So turning now to some of the practical examples, there were sort of four headings that I wanted to mention. The first is fraudulent financial misrepresentation. And here we're talking about some form of misrepresentation, for example, of the fund's performance. For example, if an individual within the general partner provides inflated valuations or misrepresents the performance of portfolio companies to attract investors or false statements to the limited partners or misleading disclosures, those kinds of fraudulent financial misrepresentations are the type of base fraud offence which could then create liability for failing to prevent fraud. Another area, misrepresentation to lenders or regulators. So, for example, some misleading information in a loan application to banks or private credit lenders to secure financing. Similarly, could amount to one of these fraud base offences, which could give rise to a failure to prevent fraud offence on the part of the entity. As I mentioned, these are sort of misconduct that won't be new to you and the listeners of this podcast. Other examples I'll mention briefly would be market manipulation, insider dealing. Obviously, we know that those are offences in any event, but they will now give rise to additional liability under this new offence, as could some fraudulent conduct in the portfolio companies, for example, accounting fraud or some tax evasion or false expense claims, all of which could be appropriate fraud that could give rise to liability.

Tom: Thank you very much, Rosanne, for that level of detail and some of the examples where such fraud is caught by this legislation. So I'm going to turn now to Patrick. From a practical point of view, Patrick, what do private equity managers and their portfolio companies need to do to protect themselves from prosecution under the failure to prevent fraud offence?

Patrick: Thanks, Tom. Important to note that these are fairly seismic changes in UK law. I've been actively involved in the prosecutorial side of UK law enforcement for many years and have been defending and acting with various investigations and with litigation. And this really is a huge change of focus, making companies liable for a much broader range of offences than ever before. Very similar to the US system, where the company is effectively liable for all acts of its employees that benefit the company. Not quite as broad, but it's getting there. So that's the first point. In terms of practical steps, I think the first one is, are you caught within the crosshairs of either of these bits of legislation? In most cases, actually, you don't need to spend a huge amount of time looking into that. Because ultimately, if you've got some kind of UK nexus, some kind of activities taking place in the UK, or senior managers or associated persons who are UK based, you're likely to be caught by it. But that's question number one, you know, are you caught by it? Number two is really, assuming that you are, is looking at your risks and what your risks are underneath both of these bits of legislation. And really, your risks are who are your associated persons and who are your senior managers. So first off, you need to start identifying who those individuals and entities are within the sort of PE group structure and then also within your and also the PE group's organization just to see who could in effect make you liable. Part of that risk assessment will be what are the risks that they could make you liable for, which are the various misrepresentations that Roseanne outlined in some detail there. So looking again at what your risks are in relation to the various products and funds that you are likely to be involved with. Next is really getting your policies and procedures in shape. And by in shape, I mean you have a legal defense, which is a full defense in law, if you're able to show the authorities, should they ever come knocking, that you have reasonable prevention procedures in place. Now, what are reasonable prevention procedures? Well, they will be based on what procedures are needed to counter the risks that you identify within your risk assessment. There's a bit of a wishy-washy legal answer, which ultimately means you need to assess your risks. Then you need to make an analysis of what you should be introducing to counter those risks and having policies which effectively put that into effect. And then on top of that, I think you need to train. You need to train your senior managers. You need to train your associated persons. You need to train, essentially, your employees and those within the group to ensure that everybody is aware of what could make the respective companies liable and the code of conduct, the culture, which is expected in all of the circumstances. Also, it's useful to be monitoring the effectiveness of those policies and procedures, doing biannual or annual audits of your processes and procedures to see if they are, in fact, fit for purpose. The deadline for having policies and procedures in place in relation to the failure to prevent fraud offence is the 1st of September this year. So essentially, there's six months left. Many within the PE space will already have been looking at this for some period of time. They, as Roseanne have mentioned, are likely to have policies and procedures in relation to fraud, money laundering, and other things already in place. So that's a good starting point. On its own, not necessarily enough. And that's why you need to conduct minimum a gap analysis, maximum a full-on risk assessment. But this needs to be ready to roll by 1st of September this year. Next, there are some other issues which are useful to take a look at to make sure that those are in place as well, which is your whistleblowing procedures, because you need to know what is happening within the group, within the entities involved. Before effectively it goes outside to an external regulator. And as recently as a number of days ago, HMRC introduced that there would be a new government scheme set out in the near future, which effectively rewards whistleblowers for coming forward with information that leads to the recovery of unlawfully withheld taxes. As a result, there's going to be a huge incentive out there for whistleblowers to skirt outside of the organisation and go direct to government, you want to make sure that you've got whistleblowing policies and procedures in place as well in order to be able to check if there is a problem long in advance of it ever going to the regulators. So again, that's a sort of whistle-stop tour of the types of things that can be done. That sounds, obviously, as if it's going to take a huge amount of time, cost a huge amount of money. But in the grand scheme of things, many firms out there, such as Reed Smith and others, can offer quick turnaround assessments, gap analysis in relation to these things. But ultimately, it's a matter which can and should be done. And the advantage of it is that it will provide you a full defense. Along with training your employees, it'll put you in the best position to be able to show you are a reasonable company that is looking at all of the risks that it has, is mitigating them as well as they can, and as a result, should not be prosecuted for any of these matters. So back to you, Tom.

Tom: Thank you very much, Patrick. And also thanks, Roseanne and Ali as well for your earlier insights. If I may sum up what we've heard briefly today, the failure to prevent fraud offence is relevant to private equity managers and their portfolio companies who have a UK nexus and the senior managers within them. The failure to prevent fraud offence will impact such private equity managers and their portfolio companies and ultimately their investors and senior managers of such portfolio companies if steps are not taken to prevent fraud and a fraud comes to light, with such impact being primarily felt through reputational damage and the potential for unlimited fines. This clearly reduces returns not just to investors but also to the underlying private equity managers and executive management, both of which may impact the ability then of a private equity manager to raise a new fund. So the failure to prevent fraud offence should encourage such private equity managers and portfolio companies to start taking steps now to protect themselves by identifying affected senior managers and associated persons, risks assessing their geographies, sectors, clients and suppliers in light of the new offence, updating their policies and procedures, providing training, monitoring, and incentives compliance, and extending the use of whistleblowing hotlines to include fraud to the extent they don't cover fraud already. I think that's all we have time for today. If you'd like more information about the offense and practical next steps, please do feel free to reach out to Roseanne, Patrick, or Ali. Thank you for listening and have a great day.

Outro: Dealmaker Insights is a Reed Smith production. Our producer is Ali McCardell. For more information about Reed Smith's corporate and financial industry practices, Please email dealmakerinsights@reedsmith.com. You can find our podcast on Spotify, Apple, Google, Stitcher, reedsmith.com, and on our social media accounts at Reed Smith LLP on LinkedIn, Facebook, and Twitter. 

Disclaimer: This podcast is provided for educational purposes. It does not constitute legal advice and is not intended to establish an attorney-client relationship, nor is it intended to suggest or establish standards of care applicable to particular lawyers in any given situation. Prior results do not guarantee a similar outcome. Any views, opinions, or comments made by any external guest speaker are not to be attributed to Reed Smith LLP or its individual lawyers. 

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