Private Self-Regulation in Cross-Border M&As’ Sanction Compliance

• In Event: Economic Sanctions and Global Business

Abstract

Regulating multinational corporations (MNCs) is key to the success of economic sanctions. One under-appreciated development is the increasing importance of private governance in the enforcement of economic sanctions—MNCs are responsible for policing the compliance of their business operations. While critics think private self-regulation is merely “ceremonial” if not embolden violations, such an arrangement can be effective if it is self-enforcing. What motivates firms to commit to costly private self-regulation such that business decisions are altered to align with sanction enforcement goals of the government? This article investigates MNCs’ decision on one important element in corporate sanction compliance—due diligence—in the context of cross-border mergers and acquisitions (M&As).

I conceptualize due diligence as a costly endeavor that generates specific information on sanction-related risks about the target. As the acquiring firm faces potential punishment if the counterpart has been involved in deals with sanctioned entities, there is a strategic tradeoff: whether the acquirer should conduct sanction-related due diligence to gather specific information on the target’s sanction risk or rely on the macro risk indicator of whether the target’s home state has been sanctioned. The latter choice is a free but imprecise proxy of the target’s sanction risks—not all firms in the sanctioned states are sanctioned entities, and not all firms in non-sanctioned states are free of risks. The acquirer only commits to costly due diligence if the improved information precision alleviates concerns of a potentially problematic deal.

I build a formal model to reveal conditions under which due diligence as a strategic information-purchasing mechanism effectively changes firms’ operations in line with regulatory objectives: (1) high ex-ante risk perception of the acquirer, (2) moderately high non-compliance penalty, and (3) low due diligence cost. One testable implication coming out of the model is that as the cost of due diligence drops, high-risk deals—that is, those involving the target whose home state has been sanctioned—are more likely to succeed because firms are willing to conduct costly due diligence that generates more accurate information about the risks involved.

To empirically test this hypothesis, I leverage the publication of “A Framework for OFAC Compliance Commitments” in May 2019 as a reduction in transaction cost of sanction-related due diligence and analyze the success of 9314 cross-border M&A deals in 2018-23 from the Orbis database using Cox proportional hazard analysis. The Framework clarified regulatory expectations for MNCs’ efforts to be compliant with US sanction programs and specifically emphasized the importance of due diligence in cross-border M&As. Consistent with my theoretical expectation, I find that while deals involving target firms from US-sanctioned states have lower success rates, this negative relationship is positively moderated after the Framework’s publication.

I also provide qualitative interviews with M&A professionals to establish the mechanisms that are not malleable to statistical testing, that is (1) the OFAC Framework indeed reduced regulatory uncertainty and transaction cost for sanction-related due diligence, and (2) this cost reduction motivated firms to commit to sanction-related due diligence, especially for potentially risky deals.

This study highlights the importance of regulatory politics in bringing together the scholarships of international political economy (IPE) and economic coercion. Transnational business operations shape how states exercise political power in a globalized world. And MNCs become important agents in international politics. While sanction scholars call for “firm-level theories” of sanction enforcement, few have taken the political economy of regulation seriously. To the best of my knowledge, this article is the first to examine private self-regulation in economic sanction enforcement. This brings the firm-level studies of economic sanction closer to the established literature in IPE that studies the regulation of global firms in environmental protection, labor rights, financial transparency, corporate social responsibility, etc.

Author

• Zhizhen Lu, University of Texas at Austin