Current Issues In Internal Corporate Investigations

Originally published January 20, 2005

This article was prepared with the assistance of Henninger Bullock, Michelle Annunziata, Ryan Borho and Mauricio Espana, all of whom are associates at Mayer, Brown, Rowe & Maw LLP. Many thanks for their substantial contributions.

1. Introduction

A. Concern over the liability exposure of directors and officers has never been higher.

2. Sarbanes Oxley has increased the responsibilities of a company's board of directors, and has ensured a level of board independence that has significantly increased the frequency of internal corporate investigations designed to identify and correct misconduct and fend off regulators, including the SEC.

3. In 2004 alone, the SEC brought more than 600 new enforcement actions against issuers, and their directors and officers. That extraordinary number is, of course, in addition to the numerous ongoing SEC formal and informal investigations.

4. There is a great on-going debate as to whether the SEC's relatively new aggressiveness will be beneficial to issuers and their investors in the long-term. What is clear now, however, is that the current SEC enforcement environment, combined with the new Sarbanes obligations of boards, as well as company counsel, has put more emphasis than ever on the internal corporate investigation.

5. This presentation attempts to cover in some detail many facets of the internal investigation, from its commencement, through the preparation of a report to the board, to the use of the report to eliminate or reduce regulatory exposure. This presentation also covers many aspects of the Sarbanes regime, with particular emphasis on the new policing role of company counsel. The presentation concludes with a summary of recent SEC settlements and an in-depth examination of the extent to which those settlements were influenced, one way or another, by the use of the internal investigative report with the SEC.

   II. Initiating an Internal Investigation

   A. Why conduct an investigation at all?

   1. If some material impropriety is suspected, whether internally at the company, or as a result of the commencement of a government investigation or private action, conducting an internal investigation is more often than not the advisable course of action. See Brad D. Brian and Barry F. McNeil, INTERNAL CORPORATE INVESTIGATIONS 6-7 (2d Ed. 2003).

   2. Duty of the board to exercise due care in managing the company.

      a. Members of a corporation's board of directors owe the corporation and its shareholders a duty of care, which refers to "the responsibility of a corporate fiduciary to exercise, in the performance of his tasks, the care that a reasonably prudent person in a similar position would use under similar circumstances". Norlin Corp. v. Rooney, Pace Inc., 744 F.2d 255, 264 (2d Cir. 1984)

      b. It is incumbent on the board of directors, then, to conduct an investigation to ensure that it has full knowledge of all issues affecting the company.

   3. If the company, and its Board or its counsel have discovered or even suspect some material impropriety, they may have an affirmative obligation to conduct an investigation.

      a. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") requires an attorney "appearing and practicing before the Commission" to report "evidence of a material violation by the issuer or by any officer, director, employee or agent of the issuer." SEC Release Nos. 33-8185, 34-47276 (enacting Section 307 of the Sarbanes- Oxley Act). Often in connection with reporting such a violation, counsel advises the company to commence an internal investigation to ensure an "appropriate response" under the statute.

      b. Section 10A of the Securities Exchange Act of 1934 (the "Exchange Act") requires the company to conduct an internal investigation if a "registered public accounting firm detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred . "

   4. Advantages of conducting an internal investigation:

      a. identify the improper conduct;

      b. uncover the identity and role of the persons responsible for that conduct;

      c. permit the company to make an informed assessment of the legality and propriety of that conduct; and

      d. provide the company with the opportunity to make an informed and proactive decision regarding whether and how to take corrective action, including whether to self-report to the SEC, or other regulatory agency. Edwards, Calloway and Edwards, What To Do When the Whistle Blows: Do's and Don'ts of Internal Investigations, 22 No. 5 ACCDKT 41, 42 (May 2004).

   5. Risks of conducting an internal investigation:

      a. inadvertent waiver of privileges

      b. creation of an inaccurate or misleading record of events that portrays the company in an unnecessarily negative light or that calls into question the company's motive in undertaking the investigation

      c. a public leak of negative information

      d. inability to limit the investigation's scope

      e. very expensive

2. Different types of internal investigations for different purposes.

   1. Self-directed --i.e., commenced at the direction of the Board of the company's Chief Legal Officer.

   2. Investigations conducted in an attempt to cooperate with government regulators (e.g., SEC or DOJ) or self regulating organizations (e.g., NYSE or NASD).

   3. Investigations commenced at the insistence of the company's auditors pursuant to Section 10A of the Exchange Act.

3. Who should direct the investigation?

   1. The Audit Committee?

   2. A special committee of independent directors?

   3. A "Qualified Legal Compliance Committee" under Sarbanes-Oxley?1

   4. Outside counsel retained specifically to conduct the investigation (i.e., not the company's regular counsel)?

   1 As discussed in greater detail below, a Qualified Legal Compliance Committee ("QLCC") is a committee that an issuer may form to consider and investigate allegations of a material violation of the federal securities laws.

4. The scope of the investigation.

   1. Existence or non-existence of a government investigation or private lawsuit is key in deciding whether to conduct an investigation as well as the scope of the investigation. Brian & McNeil at 6.

   2. Who should have input into the scope?

      a. Counsel conducting the investigation and management should decide on the scope of the investigation and should strictly adhere to the agreed-upon parameters. Brian & McNeil at 6-7.

      (i) If internal investigation is in response to the commencement of a government investigation, the scope of the internal investigation should mirror that of the government investigation. Id. at 6.

      (ii) If internal investigation occurs where allegations of misconduct arise within the company and where no government investigation exists, counsel and management should agree on scope based on purpose of or reason for the investigation. Id. at 6-7.

      b. If the investigation is being conducted pursuant to Section 10A of the Exchange Act, the company's auditor will want to have input into the scope.

      c. Care should be taken to ensure that scope is not broader than necessary. It is appropriate to push back on both the SEC and the company's auditors to limit scope.

   3. Counsel conducting the investigation should confirm in writing, in the form of an engagement letter, the scope of the investigation. The engagement letter should state:

      a. that counsel has been asked to investigate certain allegations;

      b. that the investigation is being conducted to enable counsel to advise the company regarding its legal rights, obligations and potential liabilities; and

      c. that all communications with counsel are protected by the attorneyclient privilege and intended to remain confidential. Id. at 7.

5. Document retention.

   1. The attorney's role.

      a. The obligation to preserve evidence runs first to counsel. Counsel then has a duty to advise and explain to the client its obligations to retain pertinent documents that may be relevant to the litigation. See Telecom Int'l. Am., Ltd. v. AT&T Corp., 189 F.R.D. 76, 81 (S.D.N.Y. 1999)

      b. Counsel to the company also has recurring obligation to monitor the company and its representatives with respect to their continuing obligations with respect to the document retention. See, e.g., Zubak v. UBS Warburg LLC, No. 02 Civ. 1243 (SAS), 2004 WL 1620866 (S.D.N.Y. July 20, 2004).

   2. Document retention doctrines:

      a. Retention of documents is necessary under the new provisions of Sarbanes-Oxley, as well as pre-Sarbanes-Oxley statutes and case law that had already established it a crime to destroy evidence for the purpose of interfering with government proceedings and investigations.

      b. Also, there is a parallel body of state statutes that punishes interference with state investigations and proceedings.

      c. Every state and federal jurisdiction recognizes spoliation - the destruction or alteration of evidence relevant to pending or future litigation as wrongful conduct.

      d. Spoliation entitles private litigants to various possible sanctions and evidentiary penalties.

   3. Document retention policy advice for companies:

      a. Establish and implement written retention policies for paper and electronic documents.

      b. If subject to federal or state regulatory inspection, consider informing regulators of pertinent portions of current policies and seek approval.

      c. Implement procedures to suspend document destruction and preserve documents when documents may be relevant to pending or anticipated claims.

      d. Designate a point person as decision maker to be notified when even potentially relevant documents are slated for destruction.

6. Reporting lines.

   1. Promptly establishing reporting lines through the company and from the company to counsel to ensure a thorough investigation.

7. Experts.

   1. Forensic IT; and

   2. Forensic Accountants.

      a. Auditors must be given the assurances necessary to allow them to rely on the results of the investigation when preparing the company's financial...