United States: Current Issues In Internal Corporate Investigations (Continued)

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3. Unless counsel has received an appropriate response from the company’s CLO, he or she must then report the evidence of the material violation to:

a. The audit committee;

b. Another committee that consists solely of independent directors; or

c. The Board of Directors as a whole if there is no committee consisting solely of independent directors.

4. If counsel believes it would be futile to report the alleged evidence of a material violation to the company’s CLO and CFO, he or she may proceed directly to the committee level of reporting.

5. Once counsel has received what he or she believes is an appropriate response, he or she has no further reporting obligation.

a. If counsel has not received what he or she believes to be an appropriate response, he or she must explain the reasons supporting his or her belief to the CLO and the directors to whom the alleged violation was reported.

b. Counsel may, but is not obligated to, reveal evidence of the material violation to the SEC if counsel believes it reasonably necessary to:

(i) Prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors;

(ii) Prevent the issuer, in a Commission investigation or administrative proceeding, from committing perjury, proscribed in 18 U.S.C. § 1621; suborning perjury, proscribed in 18 U.S.C. § 1622; or committing any act proscribed in 18 U.S.C. § 1001 that is likely to perpetrate a fraud upon the Commission; or

(iii) Rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney’s services were used.

6. Note that these reporting obligations may not apply to:

a. lawyers retained to investigate evidence of a material violation;

b. lawyers retained to assert a colorable defense on behalf of the company in any investigation or judicial or administrative proceeding regarding the alleged material violation.

C. What is an appropriate response?

1. The SEC defines an appropriate response as a response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes:

a. That no material violation, as defined in paragraph (i) of this section, has occurred, is ongoing, or is about to occur;

b. That the issuer has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or

c. That the issuer, with the consent of the issuer’s board of directors, a committee thereof to whom a report could be made pursuant to § 205.3(b)(3), or a qualified legal compliance committee, has retained or directed an attorney to review the reported evidence of a material violation and either:

(i) Has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or

(ii) Has been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation.

2. In reality, what does this mean?

a. It is hard to say given that we know of only one case involving a noisy withdrawal.

b. In TV Azteca, for example, the Issuer has responded to allegations concerning a material violation of securities laws and the results obtained from an internal investigation by adopting a number of corporate governance reforms.

IX. Current Issues in Criminal Law After Sarbanes

A. Sarbanes-Oxley’s criminal provisions.

1. Improper influence on conduct of audits.

a. Section 303 of the Act makes it unlawful for officers and directors of an issuer to "take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of that issuer for the purpose of rendering such financial statements materially misleading."

b. The SEC has exclusive authority to enforce this section.

2. Retaliation against whistleblowers.

a. Broad Protections for Whistleblowers provided by the Act. These protections may encourage employees to come forward, as well as have a chilling effect on employer/employee relations.

b. Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud. Sections 806 and 1107.

(i) Section 806 creates a civil remedy for whistleblowers who suffer retaliation.

(a) Provides a civil cause of action.

(b) Protects employees who are discharged or suffer other discrimination due to any whistleblowing activities.

(c) Applies to all reporting companies.

(d) Limited to whistleblowing regarding federal securities law violations.

(ii) Section 1107 creates criminal sanctions against those who "knowingly, with the intent to retaliate" act against whistleblowers.

(a) Includes both fines and up to ten years of imprisonment. (b) Applies to all reporting companies.

3. Document destruction.

a. 18 U.S.C. § 1512(c), as amended by Section 1102 of Sarbanes- Oxley, provides that whoever corruptly alters, destroys, mutilates, or conceals a record, document, or other object, or attempts to do so, with the intent to impair the object’s integrity or availability for use in an official proceeding shall be fined under this title or imprisoned for up to 20 years or both.

(i) As used in 18 U.S.C. § 1512(c), "corruptly" is likely to require that the defendant possess a "specific intent" to obstruct justice that can be shown by knowingly engaging in acts which have the natural and probable (that is foreseeable) result of obstructing justice. See e.g., 18 U.S.C. § 1503 (courts have held that a conviction under section 1503 (which prohibits "corruptly tampering with a witness in a civil or criminal proceeding") requires the "specific intent" to impede the administration of justice.)

b. 18 U.S.C. § 1519 provides criminal liability of a fine and/or maximum imprisonment of 20 years for whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence any federal investigation.

(i) Congress intended that 18 U.S.C. § 1519 be applied broadly to any act to destroy or fabricate physical evidence so long as the act is done with the intent to obstruct, impede or influence the investigation or proper administration of any federal matter. CONG. REC. S7419 (daily ed. July 26, 2002).

(ii) This provision was so broadly drafted "that it arguably could be applied to a company’s destruction of documents years before even a civil inquiry by an agency begins as long as that company’s activities were ‘administered’ by that agency and the company’s intent was to cover its wrongdoing or hamper a then-only potential future investigation." Abbe David Lowell & Kathryn C. Arnold, Corporate Crime after 2000: A New Law Enforcement Challenge or Déjà vu?, 40 AM. CRIM. L. REV. 219, 225 (2003).

(iii) 18 U.S.C. § 1519 differs significantly from 18 U.S.C. § 1505, its predecessor. Unlike 18 U.S.C. § 1505, 18 U.S.C. § 1519 does not require a willful or corrupt state of mind, which allows the government to prosecute individuals who carry out these acts without knowledge of a law or legal duty. Id. Moreover, 18 U.S.C. § 1519 does not require an actual investigation to be ongoing because it includes unsuccessful attempts at violating this prohibition. Id.

4. New securities fraud statutes and penalties. a. Section 807 of Sarbanes-Oxley, 18 U.S.C. § 1348, creates a new federal felony for securities fraud subject to fines and/or imprisonment of up to 25 years for those who knowingly execute or attempt to execute a scheme or artifice to: (1) defraud any person in connection with securities of an issuer or (2) obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of securities of an issuer.

(i) To date, no federal court has been asked to construe or apply this provision.

(ii) The net effect of 18 U.S.C. § 1348, however, is to make prosecution of securities fraud cases much easier for federal prosecutors because it:

(a) omits the requirement of willfulness found in the criminal provisions of the Securities Act and the Exchange Act, and substitutes for it only a knowing intent to defraud, which deprives an accused of the argument that no matter how improper his conduct may have been, he did not intentionally violate a known legal duty;

(b) eliminates the mailing and interstate wire requirement found in 18 U.S.C. §§ 1341 and 1343; and

(c) omits the requirement that the fraud occur "in connection with the purchase or sale" of a security - it merely requires that the scheme occurred in connection with a security.

b. 18 U.S.C. § 1349 provides for the prosecution of those individuals who attempt or conspire to commit securities fraud.

(i) 18 U.S.C. § 1349 is important in three respects:

(a) First, it does not contain an overt act requirement. Thus, there is one fewer element of proof than required by a conspiracy charge under 18 U.S.C. § 371.

(b) Second, conspiracies charged under 18 U.S.C. § 1349 carry the maximum penalty for the underlying substantive offense, rather than the fiveyear maximum contained in 18 U.S.C. § 371. Thus, conspiracies charged under 18 U.S.C. § 1349 now carry a twenty-five year maximum sentence if they are based on securities fraud violations under 18 U.S.C. § 1348.

(c) Third, 18 U.S.C. § 1349 does not displace 18 U.S.C. § 371.

B. The Decision to Prosecute.

1. The Holder and Thompson Memoranda.

a. In January 2003, the Justice Department released a memorandum by Deputy Attorney General Larry D. Thompson, entitled "Principle of Federal Prosecution of Business Organizations" ("Thompson Memorandum").

b. The Thompson Memorandum updates an earlier memorandum on the same subject issued by former Deputy Attorney General Eric H. Holder Jr., dated June 16, 1999. ("Holder Memorandum").

c. The Thompson Memorandum stresses that any actions taken by a corporation that result in wrongdoing not being uncovered fully, completely and quickly will weigh in favor of prosecution.

d. In general, the Thompson Memorandum outlines the nine principles that federal prosecutors are expected to consider in determining whether to bring charges against a corporation.

(i) Nature and Seriousness of Offense

i. This principle is cited as a primary concern.

ii. Independent of the other factors, the seriousness of a crime alone may warrant prosecution.

iii. However, it is also noted that even if the crime is very severe, it may not warrant prosecution if committed by one rogue employee.

iv. Prosecutors are told to look to other divisions within the Justice Department, such as the Environmental, Tax, Antitrust and Criminal divisions, to see if they have policies that point toward or away from prosecution for certain industries or practices.

(ii) Pervasiveness of Wrongdoing Within Corporation

(a) Prosecutors are advised to look toward the pervasiveness of a violation to decide whether to prosecute. Thus, even if a violation is relatively minor, if it is perpetuated by several employees, officers and/or directors of a corporation, the principles would support prosecution.

(b) The memorandum particularly emphasizes acts of wrongdoing that are condoned by a company’s upper management.

(c) The guidelines tie the first two principles closely together and make them interdependent to a greater extent than the other principles. Thus, if a crime is only moderately serious but very pervasive, the first two principles would support a prosecution.

(d) The involvement of management in wrongdoing is the most important issue in determining pervasiveness.

Managers are often the leaders that establish a corporation’s culture. As such, a violation perpetrated by several management level employees, as opposed to low-level employees, could weigh strongly in favor of prosecution.

(iii) The Corporation’s Prior History

(a) Prosecutors are instructed that a corporation, like a natural person, is expected to learn from its mistakes. A history of similar conduct may be probative of a corporate culture that encouraged, or at least condoned, such conduct, regardless of any compliance programs.

(b) Criminal prosecution of a corporation may be particularly appropriate where the corporation previously had been subject to non-criminal guidance, warnings, or sanctions, or previous criminal charges, and yet it either had not taken adequate action to prevent future unlawful conduct or had continued to engage in the conduct in spite of the warnings or enforcement actions taken against it.

(c) In making this determination, the corporate structure itself, e.g., subsidiaries or operating divisions, should be ignored, and enforcement actions taken against the corporation or any of its divisions, subsidiaries, and affiliates should be considered.

(iv) Cooperation and Voluntary Disclosure

(a) Prosecutors are asked to examine four factors to evaluate whether a corporation is cooperating:

i. the corporation’s willingness to identify the culprit(s) (including senior executives);

ii. produce witnesses;

iii. disclose the results of internal investigations; and

iv. waive the attorney-client privilege.

(b) One of the most controversial aspects of the new principles is the focus on waiving attorney-client privilege and work-product protection. Although waiving privilege is not "an absolute requirement," "prosecutors should consider the willingness of a corporation to waive such protection when necessary to provide timely and complete information."

(c) Another controversial aspect of this principle is the examination of a corporation’s cooperation through factors such as whether the corporation is protecting culpable employees by advancing attorney’s fees, continuing to employ the employees without sanction, providing information about the government’s investigation pursuant to a joint defense agreement or attempting to shield culpable officers by having the corporation plead guilty.

(d) While the memorandum allows for indemnification mandated by law, it makes no similar allowance for indemnification that is contractual or part of a company’s by-laws.

(e) Prosecutors are also told to examine "whether the corporation, while purporting to cooperate, has engaged in conduct that impedes the investigation (whether or not rising to the level of criminal obstruction)." This revision to the original articulation of this principle in the Holder Memorandum underscores that for corporations to receive "credit" for cooperating, they must continue to cooperate fully throughout an investigation and do nothing that would appear duplicitous to the government.

(v) Corporate Compliance Programs

(a) Prosecutors are instructed to scrutinize compliance programs closely to ensure that corporations have put effective programs in place.

(b) However, having a compliance program that appears adequate is no longer enough. Prosecutors are now directed to determine whether a compliance program is truly effective or whether it is merely a "paper program" -- i.e., a program that looks good on paper but is actually ineffective in practice.

(c) Factors that point to a satisfactory compliance program include:

i. the promptness of reporting wrongdoing by the company to the government;

ii. the company’s subsequent cooperation in the investigation;

iii. whether directors exercise independent review over proposed corporate actions;

iv. whether directors receive enough information to exercise independent judgment;

v. whether internal audit functions allow for independent and accurate audits; and

vi. whether there is an adequate information and reporting system that enables directors to receive the information they need. (vi) Restitution and Remediation

(a) Under the guidelines, prosecutors are compelled to examine three factors in determining whether to credit the claim that appropriate restitution and remediation have taken place:

i. employee discipline;

ii. monetary restitution; and

iii. reform of corporate practices and compliance programs.

(b) A corporation’s response to wrongdoing is taken as indicative of its willingness to curtail future wrongdoing.

(c) Any action by the corporation that suggests it is attempting to protect employees who have engaged in malfeasance will generally lead federal prosecutors to conclude that a corporation, and more specifically its management, condones such behavior and that wrongdoing has become part of the corporate culture. Any such action bespeaks pervasiveness and will strongly point towards the appropriateness of prosecution.

(vii) Collateral Consequences

(a) Prosecutors are told to examine the consequences of the proposed prosecution on officers, directors, employees and shareholders of the corporation.

(b) As with the prosecution of a natural person, any prosecution of a corporation will have unwanted collateral consequences and, according to the Justice Department, such a consideration alone should not stop a prosecution.

(c) Prosecutors should balance the consequences of prosecution against the pervasiveness of the conduct at issue, as well as the effectiveness of a company’s compliance program.

(viii) The Adequacy of the Prosecution of Individuals Responsible for the Corporation’s Malfeasance.

(a) While the Thompson Memorandum does not elaborate on this factor, prosecutors are likely to prosecute a company where, for whatever reason, the individuals responsible for a company’s criminal conduct have not been (or cannot be) prosecuted to the fullest extent of the law.

(b) For example, where the individuals responsible for the alleged criminal conduct are outside the jurisdiction of federal prosecutors, the company may well be prosecuted more aggressively than the criminal conduct would otherwise warrant.

(ix) Non-Criminal Alternatives

(a) Prosecutors are instructed to consider whether noncriminal alternatives would adequately deter, punish, and rehabilitate a corporation that has engaged in wrongful conduct.

(b) In evaluating the adequacy of non-criminal alternatives to prosecution, e.g., civil or regulatory enforcement actions, prosecutors may consider all relevant factors, including:

i. the sanctions available under the alternative means of disposition;

ii. the likelihood that an effective sanction will be imposed; and

iii. the effect of non-criminal disposition on federal law enforcement interests.

(c) Such an alternative is inappropriate, however, where the violation is egregious, there is a pattern of wrongdoing, or there exists a corporate history of violations.

(d) Thus, non-criminal alternatives appear to be adequate for small or first-time violations and play into the analysis under earlier principles such as compliance programs, severity, pervasiveness, and past corporate history.

(e) Over the last 16 years, the charging decisions by the United States Attorney’s Office for the Southern District of New York (the "U.S. Attorney’s Office"), as reflected in press releases issued by that office, illustrate which principles generally tend to be given the most weight by federal prosecutors.

i. Cases brought before the Holder and Thompson Memoranda demonstrate that full and complete cooperation by a corporation will almost always benefit a corporation, although it will not always ensure that a prosecution will not be brought.

ii. On the other hand, a lack of cooperation, or even worse, the obstruction of an investigation, will almost always tip the scale in favor of prosecution.

(f) In press releases from June 1987 through March 1998, the major reasons given for not prosecuting a corporation were:

i. the corporation’s full cooperation with the government;

ii. entry into a consent agreement or judgment with the SEC, government, or both;

iii. structural and management changes made by the corporation; and

iv. the collateral effect of the prosecution.

2. Comments on Adelphia, Martha Stewart, Quattrone and other recent cases of interest.

a. Adelphia

(i) On July 9, 2004, John Rigas, the founder of Adelphia Communications Corp., and his son Timothy Rigas, the former chief financial officer, were convicted of 18 counts of securities fraud, bank fraud, and conspiracy. Although neither has been sentenced yet, they each face a maximum of 30 years, but will probably be sentenced to less time under federal guidelines due to the Supreme Court’s ruling in Blakely v. Washington.

b. Martha Stewart

(i) On March 5, 2004, Martha Stewart was found guilty of four counts of obstruction of justice and lying to investigators and was subsequently sentenced to five months in prison, two years probation, five months of home confinement after release, and a fine of $30,000.

c. Frank Quattrone

(i) On May 3, 2004, Frank Quattrone, the ex-head of Credit Suisse First Boston’s ("CSFB") tech banking business, was sentenced to 18 months in prison and two years probation for obstructing justice and witness tampering. He was convicted on charges of trying to hinder a government investigation into whether CSFB sold shares of hot IPOs to favored clients in exchange for inflated commissions. See United States Attorney Southern District of New York Press Release, Frank Quattrone, Ex-Global Technology Official, Convicted On All Charges By Federal Jury In Obstruction Case (May 3, 2004).

X. The Auditors

A. SEC enforcement against auditors -- recent cases.

1. In re KPMG LLP

a. On October 20, 2004, the SEC sanctioned KPMG LLP for engaging in improper professional conduct as auditors for Gemstar-TV Guide International, Inc.

b. KPMG and the individual auditors involved agreed to settle the action. As part of the settlement, KPMG was censured and agreed to pay $10 million to harmed Gemstar shareholders and the auditors agreed to suspensions from practicing before the SEC.

c. This represents the largest payment ever made by an accounting firm in an SEC action.

d. The SEC’s administrative order states that from September 1999 through March 2002, the respondents’ conduct resulted in repeated audit failures in connection with KPMG’s audits of Gemstar’s financial statements. The order also finds that the respondents reasonably should have known that Gemstar improperly recognized and reported in its public filings material amounts of licensing and advertising revenue.

2. In re Grant Thornton LLP a. On August 5, 2004, Grant Thornton settled the following charges:

(i) causing and willfully aiding and abetting MCA Financial Corporation’s ("MCA") violations of Section 15(d) of the Exchange Act and Rules 12b-20 and 15d-1 thereunder;

(ii) willfully violating Section 10A of the Exchange Act;

(iii) recklessly failing to conduct MCA’s audit in accordance with GAAS; and

(iv) engaging in improper professional conduct within the meaning of Rule 102(e) of the Commission’s rules of practice.

b. Grant Thornton was censured pursuant to Rule 102(e) of the Commission’s Rules of Practice and was ordered to pay $1.5 million as a penalty and $59,749.41 in disgorgement. In addition, Grant Thornton must require its audit professionals to undergo fraud detection training conducted by the Association of Certified Fraud Examiners and for a period of 5 years, Grant Thornton shall cease all joint audit arrangements with other auditors in connection with audits of Commission registrants, other than joint audit arrangements required by foreign jurisdictions.

3. In re PriceWaterhouseCoopers LLP ("PwC")

a. On May 11, 2004, PwC settled charges that PwC willfully aided and abetted Warnaco’s violation of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder.

b. The SEC alleged that PwC willfully aided and abetted Warnaco’s violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder by issuing an audit report containing an unqualified audit opinion that incorporated the company’s misleading disclosures and stated that the company’s financial statements "presented fairly, in all material respects" Warnaco’s financial condition and results of operations.

B. The Section 10A investigation.

1. Section 10A of the Securities Exchange Act of 1934 ("Exchange Act") delineates the steps auditors must take in carrying out an investigation.

a. Section 10A of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), imposes both audit and reporting requirements on public auditors.

b. Section 10A(b) requires that if a public auditor in the course of conducting its audit "detects or otherwise becomes aware" of information that an illegal act, regardless of its materiality, has or may occur, then it is required "to determine whether it is likely that an illegal act has occurred."

c. If the auditor determines that an illegal act has "likely" occurred, then he must determine what possible effect the illegal act could have on the company’s financial statements. This analysis requires the auditor to look at any "contingent monetary effects, such as fines, penalties, and damages." Accordingly, unless the auditor determines that the illegal act is "clearly inconsequential" it must "as soon as practicable" inform the appropriate level of management.

d. Once the auditor has reported the illegal act to the company’s management, Section 10A(b) requires "timely and appropriate remedial action with respect to the illegal act."

e. If the management fails to take remedial action, then the auditor must determine whether the illegal act will have a "material effect" on the company’s financial statements. If the auditor determines that the illegal act will materially affect the company’s financial statements and that the act can be reasonably expected to warrant the auditor’s resignation or deviance from its standard audit procedures, then the auditor must report its conclusions to the company’s board of directors.

f. If at the end of the next business day the company has failed to notify the SEC as to the auditor’s conclusions, Section 10A provides the auditor with two options:

(i) First, the auditor can continue its engagement as the company’s auditor, but it must provide the SEC with a copy of the report made to the board of directors or documentation of an oral report within one additional business day, or

(ii) Second, the auditor can resign, but must still provide the SEC with the report or proof of an oral report within one business day from the date the company was supposed to inform the SEC.

C. Should the Report, or its substance, be provided to the auditors?

1. Disclosure of the Report or its substance may waive the company’s attorney client privilege.

2. A limited balanced disclosure of the Report’s findings and conclusions may not waive the company’s privilege.

a. In re Dayco Corp. Derivative Secs. Litig., 99 F.R.D. 616 (S.D. OH 1983) (The Dayco court stated, that since, "the press release did not summarize evidence found in the report, nor did it purport to combine those findings with those of the Directors it had not effected a waiver of the privilege).

b. In re Witham Memorial Hospital, 706 N.E.2d 1087 (Ct. App. Ind. 1999) (The Court held that because the press release did not "compromise the confidentiality of the report itself, the communications between the attorneys and the investigator during the investigation, or the analysis contained in the report," privilege was not waived.)

3. Thus, it is possible that a summary discussion of the report to the auditors might not waive the privilege.

D. Cooperation between the auditors and regulators.

1. To what extent should it be encouraged/permitted?

XI. Representing Directors and Officers After Sarbanes

A. Audit Committees and outside directors.

1. Composition of the Board.

a. Section 10A(m)(3)(A) of the Exchange Act requires that "[e]ach member of the audit committee of the issuer shall be a member of the board of directors of the issuer and shall otherwise be independent."

2. Independence rules.

a. Under the Exchange Act.

(i) Section 10A(m)(3)(A) of the Exchange Act states that to be considered an independent director, "a member of an audit committee of an issuer may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee (i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof."

(ii) Section 10A(m)(3)(C) of the Exchange Act provides the SEC with the authority to exempt audit committee members from the Exchange Act’s independence requirements, as it "determines appropriate in light of the circumstances."

b. Under the NYSE Corporate Governance Rules, codified in Section 303A of the NYSE’s Listed Company Manual.

(i) A director cannot qualify as independent unless the Board "affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company)."

(ii) "A director who is an employee, or whose immediate family member is an executive officer, of the company is not independent until three years after the end of such employment relationship."

(iii) "A director who receives, or whose immediate family member receives, more than $100,000 per year in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation is not contingent in any way on continued service, is not independent until three years after he or she ceases to receive more than $100,000 per year in such compensation."

(iv) "A director who is affiliated with or employed by, or whose immediate family member is affiliated with or employed in a professional capacity by, a present or former internal or external auditor of the company is not ‘independent’ until three years after the end of the affiliation or the employment or auditing relationship."

(v) "A director who is employed, or whose immediate family member is employed, as an executive officer of another company where any of the listed company’s present executives serve on that company’s compensation committee is not ‘independent’ until three years after the end of such service or the employment relationship."

(vi) "A director who is an executive officer or an employee, or whose immediate family member is an executive officer, of a company that makes payments to, or receives payments from, the listed company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million, or 2% of such other company’s consolidated gross revenues, is not ‘independent’ until three years after falling below such threshold."

3. Financial experts.

a. Section 10A was amended pursuant to Section 407 of the Sarbanes-Oxley Act to require that the SEC issue rules requiring that each issuer disclose in its periodic reports whether or not, and if not, why, the audit committee does not have at least one member who is a financial expert.

b. SEC Release No. 33-8177 defines an "Audit Committee Financial Expert" as a person who has all of the following:

(i) An understanding of generally accepted accounting principles and financial statements;

(ii) Experience applying such generally accepted accounting principles in connection with the accounting for estimates, accruals and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant’s financial statements;

(iii) Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant’s financial statements;

(iv) Experience with internal controls and procedures for financial reporting; and

(v) An understanding of audit committee functions.

c. In addition, the SEC’s rules require that such person shall have acquired such attributes through one or more of the following:

(i) Education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;

(ii) Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;

(iii) Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or

(iv) Other relevant experience.

4. Increased liability.

a. Section 407 of Sarbanes-Oxley does not appear to have been adopted to increase the duties, obligations or liability of any audit committee member, including the audit committee financial expert.

b. The SEC, in its final rules, affirmatively provided a safe harbor that asserts that a person who is determined to be an audit committee financial expert is not an "expert" for any purpose, including Section 11 of the Securities Act of 1933 and that such person does not have any greater duties, obligations or liability than those of any other member of the audit committee and board of directors in the absence of such designation.

c. Recent developments in both the SEC and class action context do, however, suggest that the enactment of Sarbanes-Oxley will result in greater penalties for directors accused of wrongdoing:

(i) Nortel – On January 11, 2005, Nortel announced that a number of its executives would repay $8.6 million in bonuses that they had received from the Company. Nortel made the announcement in connection with its release of its audited financial statements for fiscal years 2001 through 2003. The audited financial statements showed that Nortel’s earnings were not as high as previously expected and believed. Presumably, in an attempt to avoid SEC action, Nortel’s executives agreed to repay these bonuses which were tied to the previously expected higher results.

(ii) Enron – On January 7, 2005, ten former directors agreed to pay $13 million of their own funds to settle a class action litigation brought by shareholders.

(iii) WorldCom – In early January, 2005, ten of WorldCom’s former outside directors agreed to settle their portion of a class action lawsuit brought by bondholders and shareholders for $54 million. Of this amount, the former directors agreed to pay a total of $18 million from their own personal funds, or about 20% of their combined personal net worth.

5. Separate counsel for outside directors.

a. Given the current regulatory climate, outside directors may want separate counsel. Often the outside directors may have defenses not available to management.

b. Even if outside directors are not implicated in the alleged misconduct, they may want separate counsel to advise on their Sarbanes obligations.

XII. Cooperation with the SEC

A. Significance.

1. In 2001, in the wake of the Enron scandal, companies became increasingly exposed to liability from the SEC’s enforcement practice when Harvey Pitt, as SEC Chairman introduced a "real-time enforcement" program into the SEC’s enforcement practice.

a. Stephen Cutler has defined the "real-time enforcement program [as] one that seeks to respond quickly, effectively, and efficiently to wrongdoing" and stated that a vital element of this program includes "rewarding meaningful cooperation – because doing so will enable [the SEC] to bring more cases faster." b. For example, the SEC has already initiated 639 civil or administrative enforcement actions in 2004.

2. Accordingly, on October 23, 2001, the SEC issued a Report of Investigations Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions ("Seaboard Report"). The Seaboard Report’s purpose was to set forth "a framework for evaluating a company’s cooperation in determining whether and how to charge violations of the federal securities laws."

3. The Seaboard Report’s framework is comprised of four broad measures:

a. self-policing;

b. self-reporting;

c. remediation; and

d. cooperation. 4. Stephen Cutler, the SEC’s director of Enforcement, has made the following statements:

a. "[C]redit for cooperative behavior may range from taking no enforcement action at all to bringing reduced charges, seeking lighter sanctions, or including mitigating language in documents the SEC uses to announce and resolve enforcement cases."

b. There may be instances where a company’s "conduct is so egregious, and harm so great, that no amount of cooperation or other mitigating conduct can justify a decision not to bring any enforcement action at all."

c. The SEC "is placing a greater emphasis than ever before on assessing [and] weighing cooperation when making, charging, and sanctions decisions."

B. To cooperate or not? How to cooperate? Does it have to be all or nothing?

1. Cooperation means implementing the Seaboard Report’s four measures: self-policing, self-reporting, remediation, and cooperation.

a. Self Policing – generally, means implementing appropriate compliance and supervision policies and procedures to ensure that misconduct is prevented or detected as soon as it occurs.

(i) Cutler has stated that the SEC looks "to the company’s actions both before and after discovery of misconduct, including the rigor of its compliance and/or internal audit program and the tone set by senior management."

(ii) This sentiment is best conveyed by Cutler’s statement: "If you start thinking about the [Seaboard] Report only after you receive a subpoena, you’re too late."

b. Self Reporting – the company must "conduct[ ] a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely, and effectively disclos[e] the misconduct to the public, to regulators, and to self-regulators."

(i) This measure includes:

(a) stopping the misconduct;

(b) having independent counsel conduct an internal investigation; and

(c) disclosing the misconduct as soon as possible.

c. Remediation – includes "dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected."

d. Cooperation – generally refers to cooperation "with law enforcement authorities, including providing the Commission staff with all information relevant to the underlying violations and the company’s remedial efforts."

2. The SEC’s current approach is to measure a company’s cooperation at every point of the process, rather than looking at it as a whole.

a. In fact, Cutler has publicly stated that not only has he "directed the staff to keep an ongoing log recording parties’ cooperation, or lack thereof," but that the SEC "is using a more graduated scale when it assesses cooperation."

b. As explained by Cutler, the reality of this practice is that if a company’s initial cooperation with the SEC is not adequate, the SEC will take this into consideration "even if the conduct of the [company] was later exemplary."

3. The decision to cooperate; can cooperation be a two-way street with the SEC? Can the company selectively provide more information to the SEC in exchange for concrete steps by the SEC toward settlement?

C. What constitutes cooperation?

1. Remedial actions.

a. Terminate Employees

(i) In Seaboard, the company terminated Leon-Meredith, its former controller within 12 days of learning of the misconduct and two employees responsible for supervising Leon-Meredith were also terminated.

(ii) In Sec. Exch. Comm’n v. Ahold (October 13, 2004), "[t]he Commission [] did not seek a penalty from Ahold, among other reasons, because of the company’s extensive cooperation with the Commission’s investigation … including, but not limited to, … terminating employees responsible for the wrongdoing."

b. New Controls.

(i) In Seaboard, the company implemented several new controls. It strengthened its financial reporting processes to prevent a recurrence of such misconduct in the future. These steps included:

(a) the development of a detailed closing process for the subsidiaries’ accounting personnel;

(b) consolidating the subsidiaries’ accounting functions under a Seaboard CPA;

(c) hiring additional qualified employees responsible for preparing the subsidiaries’ financial statements;

(d) changing the subsidiaries’ annual audit requirements; and

(e) vesting Seaboard’s controller with supervisory responsibilities over the subsidiaries’ reporting processes.

2. No indemnification.

a. When, if ever, is indemnification permitted?

(i) In regards to In Re Lucent (May 17, 2004), Associate Enforcement Director Paul Berger stated that "[a]nyone who settles with us is going to agree not to be indemnified" and that the commission "may well ask [a company] not to indemnify an individual" employee who has incurred costs and penalties.

(ii) The basis for prohibiting indemnification is twofold:

(a) The cost of indemnification is borne by the shareholders.

(b) Employees who are indemnified by their companies have a greater incentive to repeat the corporation’s version of events, and less incentive to cooperate with federal investigators.

(iii) It is not yet clear if the SEC will view as uncooperative the indemnification of a company’s employee that is explicitly authorized under the company’s by-laws.

3. Self-Reporting.

a. In Seaboard, the SEC found significant the speed and candor in disclosing the wrongdoing. The audit committee and full board were notified in a timely fashion, and the company disclosed to both the SEC and the public that its financial statements would have to be restated.

b. In Ahold, before the company disclosed the misconduct and that it was going to restate its financial statements, it gave the SEC advanced notice of the content of its announcement.

4. Privilege waiver.

a. The SEC expects companies to waive all privileges if it desires to obtain cooperation credit.

b. In Seaboard, the SEC found it significant that Seaboard did not invoke the attorney-client privilege, work product protection, or other privileges or protection with respect to any information uncovered in the investigation.

c. In Ahold, the company explicitly stated that the company was cooperative because it "promptly provided the staff with the internal investigative reports and the supporting information and waived the attorney-client privilege and work product protection with respect to its internal investigations."

5. Joint defense privilege.

a. Even if a common interest does exist between the company and Management on certain issues, the SEC may frown on use of the joint defense privilege as it may encourage defendants to present a unified front and collaborate to present a "uniform" version of events.

6. Providing counsel to employees.

a. In In Re Lucent (May 17, 2004), the SEC warned corporations that paying its employees’ legal fees while an SEC investigation is ongoing could be deemed uncooperative.

D. The risk to the privilege.

1. To obtain full cooperation credit, the SEC expects companies to waive all privileges.

2. If the independent counsel conducting the independent investigation drafts a written report, its disclosure to the SEC or other third party, including the auditors, would waive the company’s privilege.

3. In an attempt to protect the privilege nature of the report, the SEC now offers to enter into confidentiality agreements that would prohibit the disclosure of the report to third parties. As discussed above, however, there is currently a split among federal courts as to whether confidentiality agreements can preserve privileges of disclosed materials.

4. One open question is whether the privilege can be preserved by the delivery of an oral proffer of the report?

XIII. Recent SEC Settlements and the SEC’s Statutory Power to Impose Fines.

A. Summary of recent major settlements.

1. Royal Dutch/Shell Group – the company agreed to a $120 million settlement after violating antifraud provisions by overstating its oil reserves by more than 20%.

a. Under the accord, the world’s third-largest publicly traded oil company also agreed to spend $5 million on an internal compliance program.

b. The $120 million civil fine is the third-largest imposed by the SEC for alleged accounting fraud, behind WorldCom Inc.’s agreement to pay investors $500 million in May 2003, and $150 million in a fine and restitution by Bristol-Myers Squibb Co. (discussed below)

2. Bristol-Myers Squibb – the company reached a final settlement of $150 million with the SEC, concluding an investigation concerning improperly recognizing $1.5 billion in revenue.

3. Vivendi Universal - Vivendi agreed on December 23, 2003 to pay $50 million to settle accusations by the SEC that it misled investors in its news releases and financial statements.

a. As part of the settlement, the company’s former chief executive, Jean-Marie Messier, who transformed the company from a water utility into a media empire but saddled it with huge debts, agreed to pay a penalty of $1 million and to give up any claims to a severance package worth 21 million euros ($26 million) that he says he negotiated before resigning in July 2002.

4. i2 Technologies - i2 Technologies agreed to settle its claims with the SEC for $10 million. The SEC alleged that it misstated $1 billion in softwarelicense revenues over five years.

5. Halliburton - In Halliburton, the SEC alleged that Halliburton violated the securities laws by failing to disclose that it had implemented a new set of accounting practices that, while technically proper under GAAP, should have been disclosed because they represented a departure from the practices previously used and previously disclosed by Halliburton.

a. The Staff’s settlement with Halliburton and Robert Charles Muchmore, Halliburton’s former controller, included:

(i) A cease and desist order prohibiting future violations of the securities laws;

(ii) A monetary penalty of $7.5 million to be paid by Halliburton;

(iii) A monetary penalty of $50,000 to be paid by Muchmore;

6. SEC v. Xerox Corp. – In Xerox, the SEC charged Xerox with financial fraud and settled the case for a $10 million civil penalty and other relief.

a. The Commission explained in its press release that the penalty, the largest imposed against a public company at the time, reflected the fact that the company’s management allowed the fraud to continue for several years and failed to cooperate with law enforcement – specifically that the penalty also reflected in part, a sanction for the company’s lack of full cooperation in the investigation.

7. SEC v. Rite-Aid – In Rite Aid, a financial fraud case involving two years of overstated income, and, at the time, the largest restatement of income by a public company, the SEC administrative order noted:

a. "Rite-Aid cooperated in the Commission’s investigation of this matter, including declining to assert its attorney-client privilege with regard to various matters relevant to the investigation and voluntarily providing the Commission staff with full access to an internal investigation conducted by Rite-Aid’s counsel," and "the Commission has considered the value of this cooperation in determining the appropriate resolution of this matter."

B. The Remedies Act generally.

1. History.

a. Prior to Congress’s enactment of the Securities Enforcement Remedies and Penny Stock Reform Act of (1990) ("Remedies Act"), the SEC’s ability to impose civil penalties was severely limited.

b. For instance, before the Remedies Act, the SEC’s authority to impose monetary penalties stemmed from two regulations.

(i) First, Section 32(b) of the Exchange Act permitted the SEC to impose a penalty of $100 per day against issuers that failed to file statutorily required reports. (15 U.S.C. § 78ff(b)).

(a) The SEC used this sanction so rarely that as of 1990, it invoked this authority only once.

(ii) Second, the Insider Trading Sanctions Act of 1984 granted the SEC the authority to seek significant monetary penalties in civil proceedings involving allegations of insider trading.

c. Consequently, in all other instances, the SEC’s enforcement authority was limited to remedial measures.

d. Therefore, Congress’s enactment of the Remedies Act revolutionized the SEC’s enforcement authority.

(i) First, it significantly broadened the scope of the violations for which the SEC could seek monetary penalties to any violation of any of the major securities statutes.

(ii) Equally important, it provided the SEC with authority to seek significant monetary penalties against companies that range from $120K to $600K per "violation."

2. Key provisions.

a. Section 21d(3) of the Exchange Act authorizes the SEC to bring a civil action to impose civil penalties and provides three tiers of penalties.

b. First tier - The amount of the penalty shall be determined by the court in light of the facts and circumstances. For each violation, the amount of the penalty shall not exceed the greater of

(i) $6,000 for a natural person or $60,000 for any other person, or

(ii) the gross amount of pecuniary gain to such defendant as a result of the violation.

c. Second Tier -- Notwithstanding clause (i), the amount of penalty for each such violation shall not exceed the greater of

(i) $60,000 for a natural person or $300,000 for any other person, or

(ii) the gross amount of pecuniary gain to such defendant as a result of the violation, if the violation described in subparagraph (A) involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.

d. Third Tier ---Notwithstanding clauses (i) and (ii), the amount of penalty for each such violation shall not exceed the greater of

(i) $120,000 for a natural person or $600,000 for any other person, or

(ii) the gross amount of pecuniary gain to such defendant as a result of a violation, if --

(a) the violation described in subparagraph (A) involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; and

(b) such violation directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons.

C. The future of cooperation with the SEC.

1. The SEC now views its role as a watchdog as more important than ever and its powers as stronger than ever.

2. Therefore, the SEC is likely to force companies to cooperate to an even greater extent.

3. Importantly, the SEC does not view its aggressive use of its powers as extreme. Indeed, in a speech recently given by Stephen Cutler, he made clear that he believes the efforts taken by the SEC are moderate in nature:

"Now before you conclude that we have come down too hard on corporate offices and directors, I wanted to read you a few lines from a recent article about the Chinese government’s response to corporate fraud. According to the article: China executed four people, including employees of two of its Big Four state banks, fraud totaling $15 million, the Xinhua state news agency said Tuesday, amidst a high-profile campaign financial crime. The executions come after a string of arrests in white-collar crime as China prepares to sell shares in its big banks."

4. Will the pendulum swing back to a traditional adversarial process in which penalties are more closely limited to the damages the SEC could likely recover under the Remedies Act?

a. The incentive to cooperate will remain high.

b. But the SEC needs to be careful not to overreach given its limited statutory powers to impose fines.

c. Companies will continue to have to see tangible results for this cooperation.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Mayer Brown is a combination of two limited liability partnerships: one named Mayer Brown LLP, established in Illinois, USA; and one named Mayer Brown International LLP, incorporated in England.