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Penalties Don’t Have To Bankrupt

October 31, 2023

As featured in Corporate Compliance Insights

The volatility of the global economy is something that is hard to ignore in day-to-day life. Whether it is the price at the pump, cost of groceries or interest rate considerations when buying a home or a vehicle – we have all been impacted in one way or another. These impacts are not only felt by individuals or households, but companies too have been put under increased strain with the rising cost of debt and liquidity constraints.

Hightened economic concerns have been lingering for years as we navigated a global pandemic. As some continue to predict an economic recession, companies are forced to continue to make tough decisions to steady the ship. Now, with the rising tides of geopolitical tensions, these decisions are not expected to get any easier.

With the rising cost of debt and reduced access to liquidity, surprises such as regulatory fines, litigation or other penalties can derail a company’s financial health and put it at grave risk of bankruptcy. This is where a company’s ability to pay analysis comes into play and may be used as a mechanism to significantly reduce penalty and fine amounts – in some cases by 4/5ths or more.

If your company has ever been under investigation and/or undergone the process of navigating settlement negotiations, you have likely seen some very large and disconcerting potential settlement figures. Companies will typically perform internal projections during the investigation stage to get a ballpark idea of where the final settlement could land. However, these internal projections rarely capture the extent of the future potential settlement. This begs the question, why are fines so high?

Why are fines so high?

There are a multitude of factors which can lead to penalties being disproportionate to a company’s balance sheet and cashflow forecast. It is important to consider the punitive nature of the sentencing guidelines – which involve penalties and fines beyond simply the disgorgement of ill-gotten profits.

Penalty and fine amounts can quickly stack up depending on the treatment of certain elements. For example, if revenue rather than profits drives the calculation the potential penalty could skyrocket, and even sometimes when the calculation is profit-driven, many relevant costs may be excluded or disallowed, such as debt service (I.e., interest payments), tax and overhead. Regulators may also disallow losses incurred during the relevant period (e.g. on a specific contract, within an accounting period etc.), i.e., the losses cannot be offset against the profits earned elsewhere. If the maximum multiplier is applied, this could quadruple the fine amount. Additionally, if violations are treated on a per instance basis rather than as one overarching scheme, and if the number of instances is voluminous, then the fines can soon become unaffordable.

The length of time from investigation to settlement also impacts the final figure - as time passes, fine amounts can continue to pile on as factors such as pre-judgement interest and/or inflation come into play. After the regulatory settlement, companies still may not be in the clear – additional penalties and fines can continue to pile up as regulatory fines are often followed by civil litigation. Therefore, it is critical to consider an ability to pay analysis early in the process.

What exactly is an ability-to-pay analysis?

Ability-to-Pay analyses, or “ATPs”, involve assessing the impact that a penalty would have on the ongoing operations of a company, typically forecasting the flow-on effects for up to three to five years. The analysis also allows regulators and the company to assess the maximum penalty that a company can pay as well as the timing of penalties – for example if deferrals or instalment payments are permitted and of course warranted.

As stipulated in the US guidelines, an ATP calculates an alternative to, “an otherwise appropriate amount to resolve an alleged claim or violation of law because it lacks sufficient assets required to pay the government and meets its ordinary and necessary business and/or living expenses”[1]. Provided, that the reduction…shall not be more than necessary to avoid substantially jeopardizing the continued viability of the organization”[2].

Naturally, the best-case scenario is that the regulators accept the ATP analysis and factor it into the final settlement figure; however, this analysis is one with minimal downside. Even if the regulators do not accept the ATP analysis in the aggregate, the analysis at least contextualizes the severity of the fine and can be used as a negotiation point as discussions progress.

Given the significant impact that an ATP analysis can have on the final settlement amount, these analyses must be empirical and underpinned by sound objective judgement around key assumptions. Regulators typically do not disclose details around the methodology for calculating the final penalty amount, which leaves much to be desired for companies interested in crafting an ATP analysis. Though many of the details are not shared publicly, we know from our experience working on several of these types of matters where ATP comes under consideration – Petrofac for example - that regulators are becoming increasingly conscious of company’s financial position, and potential impacts that a large penalty would have on the broader market.

[1] DOJ Memo, “Assessing an Entity’s Assertion of an Inabilityto Pay”.

[2] US Sentencing Guidelines, Chapter 8C3.3.

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