The Red Flag Group®

Market development funds (MDFs) are a good way to promote and market one’s business interests through indirect channel partners. However, if not properly checked may lead to integrity, reputational and compliance risks.

A more ominous risk of providing MDFs to a third party, however, is that the third party could make use of the funds to pay bribes in an effort to gain a business advantage without the vendor’s knowledge. What starts as a good faith attempt by a vendor to help its third parties promote its products or services could turn into a situation where the third parties have unregulated control of the vendor’s resources and are use those resources to make bribes and implicate the vendor under the FCPA and other anti-corruption measures. This dangerous possibility raises the need for companies to consider the ramifications of providing third parties with MDFs and design internal controls to ensure that provided funds are monitored closely and used properly by third parties and internal stakeholders. This article will introduce you to the practice of providing MDFs, the benefits and risks associated with their distribution, and how companies must develop prudent policies and measures within their internal compliance programmes to minimise business and corruption risks and ensure that the funds are used effectively, and, most importantly, legally.

What are the risks associated with MDFs?

MDFs are monetary funds provided by a vendor to its third parties to help the third parties sell the vendor’s products or promote its brand. MDFs are commonly used for advertising, such as billboards, web promotions, local trade shows and media placement. The benefits of providing MDFs are numerous, and include improved awareness of the vendor’s brand, better customer relationships with third parties and increased third-party productivity. A well-executed MDF programme fosters a situation where both the vendor and its third parties are driven to work together and succeed in the relevant market.

Provision of MDFs is not without risks. Drawbacks include costs to the vendor and administrative difficulties such as gaining buy-in from third parties and instructing them on the process for application, receipt and proper and legal use of the funds. Companies should take three broad steps when providing MDFs to their third parties to avoid such risks and ensure compliance with all relevant laws: first, they must institute prudent business policies to govern the distribution of the MDFs; second, they must integrate policies within their legal compliance programme to carefully account for and monitor how the funds are used; and third, they should require participating third parties to possess a satisfactory compliance programme that includes accurate accounting and reporting processes to show how they are using the MDFs.

Step 1: Implementing an effective partnership-management system

Companies can guard against imprudent and possibly illegal use of MDFs by their third parties through implementation of sound business policies. These policies should include:

  • an effective partnership-management system that facilitates open discussion between the vendor and third parties
  • specific rules regarding MDF use such as:
    • MDFs should never be used as bribes
    • third parties should not receive payment for their services until after an MDF-sponsored activity has been completed
    • vendors will not pay more than 50 percent of any campaign or activity that the third party is assisting them in.

By implementing an effective partnership-management system the vendor and third parties can engage in open discussion that clearly lays out the vendor’s policies regarding the use of MDFs while also allowing input from the third parties. An effective partnership-management system should be available through a cloud platform which allows for multiple communications, such as routine emails to third parties notifying them of the application process, rules and updates regarding MDF distribution and use. The system could also contain blogs or forums allowing third parties to deliver their input and ask questions about the MDF programme. This two-way communication system will facilitate buy-in for the programme from both parties and result in a more sensible and effective use of the funds.

In addition to, or as part of, the partnership-management system, specific rules of MDF provision and use should be established through a vendor’s business policies. These could be as simple as instructions stating that the funds should never be used in any manner that could even be perceived as a bribe, to more complex rules which notify third parties that payment for services rendered will not be provided until a MDF-sponsored activity has been completed and that vendors will not pay more than a certain sum for an MDF campaign. Such rules will immediately make the third party aware of the importance of responsible use of the MDFs and will help them train their employees to abide by the regulations.

Step 2: Controlling and monitoring

The second broad step is for vendors to implement controls for how the MDFs are used by third parties and internal parties, effectively “closing the loop” in terms of monitoring the use and allocation of funds. Companies that are issuers, or publicly-traded companies, are required under the FCPA to maintain accurate books and records that reflect the company’s transactions and dispositions of company assets, and to devise a system of internal controls to assure management’s control and authority over firm assets. These accounting controls must be extended to cover the distribution and use of MDFs by third parties, especially since the use of MDFs as bribes to foreign officials can implicate companies under the FCPA; companies as a necessity should seek proof of the third party’s use of funds through receipts or other documentation. Companies that are domestic concerns or that are incorporated or possessing a principal place of business in the United States are not normally subject to the FCPA’s accounting provisions. Domestic concerns should nevertheless also implement sufficient internal accounting controls when distributing MDFs to track how those MDFs are used by third parties, as they can be liable under the FCPA’s bribery provisions if third parties improperly use the funds.

Internal accounting controls are not complete unless they can prevent MDFs from becoming a potential source of funding for bribery or corruption by internal parties. Recent incidents involving the misuse of MDFs by internal parties are illustrative of this point. A computer-technology company used distributors to sell software licences to the Indian government. Surplus gained from these transactions was kept in a separate fund labelled as “market development funds”; however, internal parties within the computer technology company channelled these funds to third parties. The SEC alleged that the computer-technology company’s directing of funds in this way made the funds a potential source of bribery, and these actions violated the internal controls provisions of the FCPA. Another computer-technology firm was alleged to have violated competition laws for making payments to a computer manufacturer to ensure that the computer manufacturer exclusively used their microchips over competitors’ microchips. The payments were masked as MDFs but were wrongly used to induce a customer to avoid purchasing competitors’ products. These examples illustrate the need for companies to ensure strict internal controls to safeguard company assets designated as MDFs from being used for other, illegal, purposes.

Step 3: Integrating a MDF programme into your third party compliance programme

Companies providing MDFs should not think that having internal controls in place is sufficient on its own to ensure that the funds will always be used efficiently and legally. Such thinking is akin to having security at the front door of a house without having any at the back door or other entrances to the home. Accordingly, the third broad step companies should take to ensure proper use of MDFs by third parties is to require the third parties to maintain adequate compliance training, policies and procedures. This process should begin with an initial review of a third party’s existing compliance programme and internal controls. Based on this initial review, companies should consider whether the third party possesses personnel and procedures that are sufficiently trained and designed to ensure that business can be conducted without misuse of MDFs. Even if a third party maintains an adequate compliance programme with corresponding training, companies should think of what processes they can integrate into the third party’s programme to make it as robust as their own.

For example, since 2011, a leading global technology provider has required all channel partners participating in its MDF programme to log into its cloud management system, enter claims for each fund request and upload their proof of spending to receive the MDF they have requested. By requiring spending records upfront, this company can see exactly how third parties are using expenses in relation to the MDF programme and reimburse them accordingly. The company’s old system based MDF payments to third parties on business results recorded on a spreadsheet, which placed less responsibility on third parties to keep accurate records on expenses made in connection with MDF-sponsored campaigns. Other processes that companies can utilise to ensure that a third party maintains a sufficient compliance programme and controls include periodic review of the compliance programme and the right to be present at third-party training programmes aimed at educating employees on how to legally and effectively make use of MDFs.

MDFs can be a dynamic way to improve third-party activity related to the sale and promotion of a vendor’s goods; however, it is imperative that the use of MDFs are supplemented by the appropriate reviews and controls. A company should be able to track the use of such funds by a third party, thereby “closing the loop” in terms of monitoring the funds going out and accurately documenting their use as a means of ensuring the risk of funds being used for illicit purposes is minimised.