How a Customs Mistake Can Become A Buyer’s Headache: An unwary acquirer could be slapped with stiff penalties for a seller’s customs infractions even if they occurred years before the deal closed.

As U.S. companies strive to remain competitive, many are looking overseas to save costs. More companies are outsourcing the manufacture of some or all of their products to countries with low labor costs and then importing those finished products into the United States. Other U.S. firms import everything they sell in the U.S. market. In short, many U.S. businesses today are involved in global trade activities in one way or another. The reality that large numbers of companies of all sizes engage in importing imposes a responsibility on the thorough acquirer to ensure that its target is squared away on payment of customs duties. Neglecting that often-overlooked aspect of preacquisition due diligence can lead to painful and expensive consequences after the deal has closed. As a result, due diligence should include the time and effort to determine whether the target has properly paid customs duties, is in compliance with customs regulations, or has any pending disputes with the U.S. Customs Service. No matter how experienced an importing company is in dealing with tariff and customs laws, serious customs issues can arise because of ignorance, negligence, or fraud and that can mean hidden customs liabilities that come to light after the deal is done. Buyers that overlook the customs aspect of due diligence and assume that a potential target’s customs payments are in order may be in for some unpleasant surprises. Just as an acquirer can inherit product liability or intellectual property rights claims or other liabilities from a target, it also can end up paying for a target’s infractions concerning proper payment of customs duties and compliance with customs regulations. The Customs Service has a long reach in its ability to recover unpaid duties: It may collect any underpayment of duty, plus a penalty, up to five years from the date of entry of the goods into the U.S. That means that an unwary buyer could pick up the tab for a target’s customs infractions even if they occurred years before the acquisition. Hidden customs liabilities can lurk behind any importer’s financial statements, so it is important for a buyer to do a bit of digging if it wants to be assured that the target has a clean customs record. Under U.S. customs law, an importer deposits “estimated” duties at the time it imports merchandise (called an “entry”) into the customs territory of the United States or Puerto Rico. The estimated duties are “finally assessed,” or “liquidated,” by Customs usually within 314 days after entry, but, with certain exceptions, no more than one year after entry. One exception that creates extended liability is merchandise subject to antidumping or countervailing duties, which generally may be liquidated up to four years after entry. Once an entry is liquidated, all liabilities of the importer for that entry are deemed final unless one of three things occurs: nThe importer files a protest challenging the liquidation within 90 days; nCustoms reliquidates the entry within 90 days; or nCustoms finds that the importer committed negligence, gross negligence, or fraud in connection with the entry and assesses a civil penalty. When such a civil penalty is claimed, Customs may collect any underpayment of duty, and a penalty, up to five years from the date of entry. If Customs claims that fraud was committed, the applicable statute of limitations runs five years from the date of discovery of the fraudulent activity. Statutory penalties are stiff. If a “loss of revenue,” i.e., underpayment of duty, is involved, the maximum penalty for fraud is the domestic value of the merchandise, which is roughly equivalent to the resale value in the U.S. For gross negligence, the penalty is the lesser of the domestic value or four times the duty due. For negligence, the penalty is the lesser of the domestic value or twice the duty owed. In non-loss of revenue cases, the penalties are as follows: For fraud, up to the domestic value; for gross negligence, up to 40% of the dutiable value of the merchandise, or the “landed” cost; and for negligence, up to 20% of the dutiable value. Suppose that the day after a merger closes, Customs discovers fraud involving an unpaid duty by the target. Customs would have five years from that date to bring a collection action against the combined entity for unpaid duties and penalties. Theoretically, such duties and penalties could be claimed on prior entries going back indefinitely. However, because Customs bears the burden of proof in a civil penalty action, it would only be able to go back as far as records exist. By statute, importers must keep import records for only five years from the date of entry. So, if the importer no longer retains any records for entries made more than five years ago, Customs would be limited in its claim to entries made within five years prior to and five years after the date of discovery of the fraud. The maximum statutory civil penalties can be substantially reduced if the importer makes a “prior disclosure” of the violation before Customs has commenced an investigation of the subject activity; in such cases, the importer’s liability is capped at the actual duty owed plus interest or, in the case of fraud, the actual duty plus a penalty equal to 100% of the duty. In simple terms, a “prior disclosure” is a written notification to Customs made prior to the commencement of a formal investigation of the matter that a material misstatement or omission has been made in connection with an entry. Drafting a valid “prior disclosure” is an art form. It requires walking a fine line between meeting the strict requirements of customs regulations while avoiding the issuance of a penalty claim as a result of the disclosure. Unless the deal is a divestiture in which only specified assets of the target are acquired, an acquirer that fails to perform a customs risk assessment as an integral part of its acquisition due diligence assumes unnecessary and possibly substantial risks. Thus, an acquirer may end up inheriting liability for customs duties and penalties applicable to importations that occurred years before the deal was closed but that were discovered by Customs after closing. Consider a case in which a disgruntled employee perhaps someone let go as a result of the merger or acquisition knows of conduct by the target that Customs could view as culpable. That employee would have significant financial incentive to act as an informant: Up to 25% of the amount of the recovery up to $250,000 may be his or her reward by statute. This scenario is not rare. Unless the due diligence team includes one or more professionals versed in customs law, the books and records examined during due diligence will not reveal potential customs liabilities. For example, certain items that should have been included in the declared customs value upon entry of the merchandise may instead have been omitted, e.g., additional payments to a foreign vendor, or to a party related to the vendor, or dutiable “assists” in the form of machinery, tools, dies, or molds sent to a foreign manufacturer for use in the production of the imported merchandise. Items like these will not be readily apparent from an examination of general ledger accounts. In customs due diligence, one must know what to ask in order to ferret out information that is not apparent from merely inspecting documents. In customs practice, what is not apparent is often more significant than what is apparent. An acquirer trying to determine when to ask the target for more information can look for certain “red flags.” There may be hidden customs liabilities if the target: * Purchases imported merchandise from related parties; * Uses “agents” for purchase of imported merchandise; * Pays royalties or license fees; * Double-invoices; or * Pays interest on the purchase of imported merchandise. Although customs liabilities may lurk beneath any importer’s financial statements, some industries are more import-sensitive than others are. For example, the textile and apparel industry is subject to many more import regulations and trade restrictions than other industries. However, no matter how experienced an importer is in dealing with Customs, innocent mistakes arising from the importer’s ignorance of the complexities of customs valuation laws can result in underpayment of duty – and, therefore, potential hidden liability for an acquirer. Even a target’s experienced import managers or customs compliance managers may not be aware of potential problems if, as is typical, the company is decentralized in its foreign purchasing transactions. Significantly, most payments of additional duty to Customs are made not as a result of penalty claims issued by Customs but by voluntary tenders of duty made by the importer because of innocent mistakes. If the voluntary tenders of duty are made after liquidation of the entry, they are generally in the form of “prior disclosures”; if made before liquidation, they may be made by supplemental information letters amending the entry. Such tenders are made to avoid the potential for discovery by Customs long after the entry occurred. Despite the potential risks, many acquirers give short shrift to or completely overlook the customs dimension of due diligence. They may mistakenly believe that customs is only a minor transportation or logistics function of the target company, that customs transactions that occurred before deal closing can be presumed closed, or that the target’s import manager properly handled all prior customs issues. Such assumptions can be costly for an acquirer. Take, for example, the acquisition of a firm that we will call Company B, which is an importer of various products from the Far East, by an acquirer that we will call Company A. Company A assumed that it had nothing to worry about because Company B’s president previously had worked for Customs for many years. Four years after the acquisition – and long after that executive and other personnel responsible for customs matters at the company had left – a Customs Special Agent appeared at Company A’s headquarters and served a subpoena for the records of Company B because Customs was investigating undervaluation by all importers of a specific product that had been sourced from certain Far East vendors. Company A faced a customs claim for additional duty owed for the previous five years plus a penalty for negligence in the amount of the unpaid duty. Had Company A done a competent customs risk assessment prior to the acquisition, this issue likely would have surfaced and a “prior disclosure” could have been made, thereby limiting the negligence penalty solely to interest on the unpaid duty. In another case, a very large apparel company made two acquisitions without conducting customs due diligence. Subsequently, it was advised to perform a customs compliance assessment on the two targets, and it did. As a result, the acquirer voluntarily tendered significant additional duties to Customs as “prior disclosures.” In its next acquisition, the acquirer did not formally include the customs dimension in its due dili- gence, but it made provision for a significant customs duty contingent liability in the acquisition agreement. In its most recent acquisition, however, the company included the customs dimension in its due diligence, and as a result, it negotiated a lower purchase price paid for the target. An acquirer that conducts a perfunctory customs due diligence or skips the inquiry altogether adds to all the other risks and uncertainties of a deal. Similarly, a lender that does not perform a customs risk assessment before extending credit to an importer creates the possibility of later surprise that its debtor may have substantial liability for past and/or ongoing customs transgressions. Investing the time and effort to perform a proper customs due diligence may well avoid expensive post-closing headaches. it pays to prySerious customs issues can arise because of a seller’s negligence or fraud – and that means that hidden customs liabilities could surface after a deal is done. Neglecting the often-overlooked customs aspect of due diligence adds to all the other risks and uncertainties of a deal. Also, customs penalties can be stiff: An acquirer could pay anything from twice the unpaid duty up to an amount equal to the domestic value of the merchandise on which duty is owed, in certain fraud cases. Savvy buyers that take the time to check out the seller’s customs status – and find trouble – are in a good position to make provision for a customs duty contingent liability in the acquisition agreement or even to negotiate a lower purchase price.