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.
I. Introduction
A. Concern over the liability exposure of directors and officers has never been higher.
B. 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.
C. 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.
D. 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.
E. 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
B. 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.
C. 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.
D. 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.
E. 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.
F. Reporting lines.
1. Promptly establishing reporting lines through the company and from the company to counsel to ensure a thorough investigation.
G. 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 statements.
b. If auditors are included in the actual conduct of the investigation, any privilege applicable to that investigation may be waived.
c. Can the company merely apprise its auditors of the investigations’ final conclusions in summary form so as to avoid waiving the privileges?
3. In most cases, outside counsel, rather than the client, should retain the expert to ensure that all communications involving the expert are protected by the attorney-client privilege and that all documents created by the expert are considered work product.
H. What role, if any, should be given to the company’s outside auditors in conducting the investigation.
1. The role of outside auditors should generally be limited to:
a. limit the scope of the investigation; and
b. ensure the application of the attorney-client privilege and the work product doctrine to the investigation.
III. Attorney/Client and Work Product Privileges
A. Generally.
1. Brief description of each privilege.
a. Attorney-client privilege: applies to protect information shared between a lawyer and a client where the information is: (1) a communication, (2) made in confidence, (3) between a person who is, or is about to become, a client, (4) a lawyer, and (5) for the purpose of obtaining legal advice or assistance. In re Richard Roe, Inc., 68 F.3d 38, 39 (2d Cir. 1995)
b. Work product doctrine: documents and other materials prepared in anticipation of litigation or for trial are protected from discovery unless the party seeking discovery has a "substantial need" for the materials in the preparation of the party’s case and that the party is unable without undue hardship to obtain the substantial equivalent of the materials by other means. If the party seeking discovery makes the required showing, the court can order discovery, but in doing so, shall protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party concerning the litigation. FED. R. CIV. P. 26(b)(3).
2. The UpJohn decision.
a. In Upjohn Co. v. United States, the Court held that counsel’s communications with company employees will be protected by the company’s attorney-client privilege under certain circumstances.
b. The Court set forth guidelines, as opposed to a bright-line test, for determining when the company’s privilege applies to corporate employees. These guidelines include: (1) whether the communications were made by corporate employees at the direction of superiors for the purpose of obtaining legal advice; (2) whether the communications contained information necessary for counsel; (3) whether the matters communicated were within the scope of the employee’s corporate duties; (4) whether the employee knew that the communications were for the purpose of the corporation obtaining legal advice; and (5) whether the communications were ordered to be kept confidential by superiors. Upjohn Co. v. United States, 449 U.S. 383, 394-96 (1981).
c. Note, however, that this privilege belongs to the company, not its employees.
B. Issues of waiver.
1. Ordinarily, courts will find that disclosure of the written report constitutes a waiver of both the attorney-client and work product privileges.
a. See, e.g., In re The Leslie Fay Companies, Inc. Sec. Litig., 161 F.R.D. 274 (S.D.N.Y. 1995) (holding that production of audit committee’s report to the SEC waived attorney-client privilege, not only for the report itself, but for documents underlying the report).
b. In re Sealed Case, 676 F.2d 793, (D.C. Cir. 1982) (rejecting claim of privilege after disclosing to SEC).
c. In re Steinhardt Partners, L.P., 9 F.3d 230 (2d Cir. 1993) (voluntary submission of legal memorandum waived work product privilege).
2. Can the company selectively waive the privilege?
a. Can the company disclose the report to government regulators without risking a waiver of the privilege’s application to the report with respect to potential third party litigants?
(i) Some courts have upheld the concept of selective or "limited" waiver in the context of voluntary corporate disclosures of internal investigative findings to government agencies.
(a) Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 611 (8th Cir. 1978) (finding limited waiver of the attorney-client privilege where company disclosed privileged material to the SEC pursuant to an agency subpoena in a separate, nonpublic SEC investigation);
(b) In re LTV Sec. Litig., 89 F.R.D. 595, 620-21 (N.D. Tex. 1981) ("The voluntary disclosure of information to an agency, as part of an agency enforcement proceeding, often is viewed as only a partial waiver of the attorney-client privilege");
(c) Byrnes v. IDS Realty Trust Co., 85 F.R.D. 679, 687- 89 (S.D.N.Y. 1985) (endorsing the limited waiver theory outlined in Diversified Indus. Inc.).
(ii) Other courts have rejected the concept of a limited waiver.
(a) United States v. Mass. Inst. of Tech., 129 F.3d 681, 686 (1st Cir. 1997) (finding waiver of both the attorney-client and work product privileges by disclosure to the Defense Contract Audit Agency pursuant to contracts between MIT and the Department of Defense);
(b) In re Steinhardt Partners, L.P., 9 F.3d 230, 236 (2d Cir. 1993) (finding waiver of work product through voluntary disclosure to the SEC);
(c) Westinghouse Elec. Corp. v. Republic of the Philippines, 951 F.2d 1414, 1431 (3d Cir. 1991) (finding waiver of both attorney-client and work product privileges due to disclosure to the SEC and Department of Justice of internal investigation for purposes of cooperation);
(d) In re Martin Marietta Corp., 856 F.2d 619, 623-24 (4th Cir. 1988), cert. denied, 490 U.S. 1011 (1989) (finding that, where privileged material had been disclosed to the U.S. Attorney and Department of Defense, all related attorney-client material and all related non-opinion work product material would be discoverable).
b. There is also authority for the proposition that a limited disclosure of the report’s findings and conclusions will not waive the protection afforded to the report by the privilege.
(i) 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.)
(ii) 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. If the government agrees to enter into a confidentiality agreement and promises to keep any privileged materials confidential, will that protect the privilege?
a. The SEC endorses the practice of using confidentiality agreements to preserve the company’s privileges as to third party private litigants in related civil actions.
(i) "[A]llowing issuers to produce internal reports to the Commission … without waiving otherwise applicable privileges serves the public interest … [and] that preserving the privilege or protection for internal reports shared with the Commission does not harm private litigants or put them at any kind of strategic disadvantage." See Implementation of Standards of Professional Conduct for Attorneys, SEC Release Nos. 33-8185, 34-47276 (Jan. 29, 2003).
(ii) "[F]or these reasons, the Commission will continue to follow its policy of entering into confidentiality agreements where it determines that its receipt of information pursuant to those agreements will ultimately further the public interest, and will vigorously argue in defense of those confidentiality agreements where litigants argue that the disclosure of information pursuant to such agreements waives any privilege or protection." Id.
b. Some courts have suggested that production pursuant to a valid confidentiality agreement preserves the privilege and does not amount to a waiver as to third parties:
(i) Dellwood Farms, Inc. v. Cargill, Inc., 128 F.3d 1122 (7th Cir. 1997) (suggesting that privilege would not have been waived had the possessor of the privilege "been more careful, as by obtaining an agreement by the person to whom they made the disclosure not to spread it further");
(ii) In re Subpoenas Duces Tecum, 738 F.2d 1367, (D.C. Cir. 1984) (to protect the privilege, "the company can insist on a promise of confidentiality before disclosure to the SEC");
(iii) Maruzen Co. v. HSBC USA, Inc., No. 00 Civ. 1079 (RO), 2002 WL 1628782, at *1 (S.D.N.Y. July 23, 2002) (finding no waiver of work product protection where defendants had explicit confidentiality agreement with the U.S. Attorney’s Office);
(iv) In re M & L Business Mach. Co., 161 B.R. 689, 696 (D. Colo. 1993) (stating that allowing limited confidentiality agreements "strives to balance the policy goal of encouraging cooperation with the government … with the strict requirement of confidentiality").
c. Other courts have held that confidentiality agreements cannot prevent waiver of disclosed material:
(i) Westinghouse Elec. Corp. v. Republic of Philippines, 951 F.2d 1414 (3d Cir. 1991) ("Even though the DOJ apparently agreed not to disclose the information, under traditional waiver doctrine a voluntary disclosure to a third party waives the attorney-client privilege even if the third party agrees not to disclose the communications to anyone else.").
(ii) In re Columbia/HCA Healthcare Corp., 2002 WL 1270187, at *14 (6th Cir. June 10, 2002) (rejecting "any form of selective waiver, even that which stems from a confidentiality agreement").
4. Self-critical privilege.
a. In general, the self-critical analysis privilege may apply to protect self-evaluating documents or documents created during a company’s internal investigation into allegations of misconduct when the following three criteria are met:
(i) the information results from self-critical analysis undertaken by the party seeking protection;
(ii) the public has a strong interest in preserving the free flow of the type of information sought; and
(iii) the information is of the type whose flow would be curtailed if discovery were allowed. Note, The Privilege of Self-Critical Analysis, 96 HARV. L. REV. 1083, 1086 (1983).
b. "A privilege of self-critical analysis or a self-evaluative privilege serves the public interest by encouraging self-improvement through uninhibited self-analysis and evaluation." In re Health Management, Inc., No. CV 96-0889 (ADS), 1999 WL 33594132 at *7 (E.D.N.Y. Sept. 25, 1999).
c. Cases upholding the application of the self-critical privilege as a general principle:
(i) In re Health Management, Inc., No. CV 96-0889(ADS), 1999 WL 33594132 at *7 (E.D.N.Y. Sept. 25, 1999);
(ii) Lasky v. American Broadcasting Cos., Inc., No. 83 Civ. 7438 (JMW), 1986 WL 9223, at *2-3 (S.D.N.Y. Aug. 13, 1986) (holding that certain documents in question were protected by the self-critical privilege);
(iii) New York Stock Exchange v. Sloan, No. 71CV2912, 1976 WL 169086, at *4-5 (S.D.N.Y. Oct. 21, 1976) (recognizing self-critical privilege in securities law context).
d. Cases declining to apply the self-critical privilege, generally:
(i) In re Ashanti Goldfields Securities Litigation, 213 F.R.D. 102, 105 (E.D.N.Y. 2003);
(ii) Robinson v. U.S., 205 F.R.D. 104, 108-109 (W.D.N.Y.2001) (noting that the self-critical analysis privilege has not been adopted by the Second Circuit Court of Appeals and has been rejected in this district);
(iii) Spencer v. Sea-Land Service, Inc., 1999 WL 619637 (S.D.N.Y. Aug. 16, 1999).
e. Not at all clear that the "privilege" will apply to an internal report of this kind. No direct authority on point.
C. Employee and former employee interviews – the duty to warn of the employer’s right to waive the privilege: "I am not your lawyer."
1. UpJohn warning;
a. We are company counsel; what you say may be privileged; but it is the company’s right to waive any privilege that may apply.
2. What does counsel for the company say to employees who ask if they should obtain their own counsel?
a. You may obtain counsel; we have no opinion on whether you should do so; the company may not pay for it.
3. In light of In re Zar, counsel for the company should also consider "Mirandizing" all employees.
a. Counsel may explain that employees may be punished by the company as a result of what they say to company counsel.
b. Counsel may explain that the company may divulge what the employee says to the government.
c. Counsel may explain to the employees that if they are untruthful with counsel, and that untruth is repeated to the government, the employee could be prosecuted for obstruction.
D. Who is the client? (The Company or the Audit or Special Committee.)
1. Who controls the privilege if the audit committee directs the investigation and engages counsel?
IV. Potential Early-Stage Criminal Issues
A. General principles of obstruction, perjury, etc.
1. Perjury:
a. 18 U.S.C. § 1621 (general perjury statute proscribing willfully false testimony given under oath in any case in which a law of the United States authorizes an oath to be administered).
b. 18 U.S.C. § 1623 (applying to false declarations made in proceedings either before or ancillary to any court or grand jury).
2. Obstruction of justice:
a. category of crimes, which involve interference with the public administration of justice.
b. Three of the general obstruction statutes are relevant in the context if interviewing and preparing witnesses during an internal corporate investigation:
(i) 18 U.S.C. § 1512 (discussed below)
(ii) 18 U.S.C. § 1503 and § 1505, which prohibit "corrupt" efforts to interfere with the due administration of justice. Id. at 124.
B. The In re Zar case.
1. The U.S. Attorney’s Office in the Eastern District of New York filed a complaint against Ira Zar of Computer Associates, which includes as a cause of action, conspiracy to obstruct justice in violation of 18 U.S.C. § 1512 (c)(2).
2. 18 U.S.C. § 1512 is primarily a witness protection statute; however it was recently amended, and arguably broadened by section 1102 of the Sarbanes-Oxley Act of 2002. Pursuant to the amendment, there is a new provision in 18 U.S.C. § 1512, which imposes a fine or imprisonment on one who corruptly (1) alters, destroys, mutilates, or conceals a record, documents, 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; or (2) otherwise obstructs, influences or impedes any official proceeding, or attempts to do so. See 18 U.S.C. § 1512(c) (emphasis added).
3. The complaint against Zar alleges that he and other Computer Associates executives gave false information about the company’s accounting practices to the company’s counsel and to counsel for its Audit Committee. The obstruction of justice claim (under 18 U.S.C. § 1512 (c)(2)) is based on the allegation that Zar and other executives made these misrepresentations to the company’s law firm and to the Audit Committee’s law firm with the knowledge and intent that the information would be conveyed to the US Attorney’s office, the SEC and the FBI, thereby obstructing and impeding government investigations. Complaint at ¶¶16-17, United States v. Zar, No. 04-331 (ILG) (E.D.N.Y. 2004).
V. The Investigation and Report
A. The scope of the investigation:
1. Who determines scope?
2. Witnesses -- counsel conducting the investigation should, to the fullest extent possible, be given unlimited access to those witnesses with information relevant to the investigation.
3. Documents -- counsel should also be given unlimited access to all relevant documents.
4. Electronic discovery
a. Document retention is a crucial factor both prior to and during litigation.
(i) The so-called doctrine of spoliation dictates that a company has an obligation to preserve potentially relevant documents in the face of actual or potential litigation.
(ii) Potential violations of the catch-all obstruction statute, 18 U.S.C. § 1503, and the Sarbanes-Oxley Act, are heightened because of the complexity surrounding electronic discovery.
(iii) Possible sanctions for failing to preserve e-mails and other electronic evidence in civil cases include multimillion dollar fines, adverse-inference jury instructions, preclusion sanctions, default judgments and costs and attorneys fees.
(iv) Public relations problems might also arise from the mere accusation of destroying electronic evidence. Lower stock prices, shrinking customer and supplier bases, diminished company morale, alienating potential employees, and defending against shareholder litigations are all possible consequences.
b. Cases involving electronic discovery are really about document management, usually involving documents from dozens to hundreds of individuals and information from various corporate locations and systems.
c. The retention of an expert is an important first step.
(i) The expert should be conversant in all types of media and operating systems, including e-mail packages, and be able to explain the complexities of the various systems to the court and parties.
(ii) Examples of areas where an expert can give the court and parties guidance include: searching data by keywords, eliminating duplicate documents, limiting searches by relevant time period, and suggesting how confidential information can be protected.
5. Certification of completeness of document production.
a. It is not clear if officers or directors must certify the written report.
(i) Sarbanes-Oxley rules require the chief executive officer and chief financial officer to review and certify the material accuracy and completeness of quarterly and annual reports. Sarbanes-Oxley, however, does not appear to address onetime reports such as those written pursuant to an internal investigation.
(ii) CEOs and CFOs, as well as members of the disclosure committee (should one exist) may want to certify the written report for accuracy and completeness to raise the level of veracity surrounding the report.
(iii) Such a certificate by the company may be required by the SEC as part of a settlement.
B. Communications with the client; to whom should counsel report?
1. Point person on audit committee.
2. Management excluded from process?
a. An initial goal in determining to whom counsel should report is to identify an individual or group who possesses certain characteristics:
(i) has appropriate authority to act upon the results of the investigation;
(ii) is independent of the alleged wrongdoing and wrongdoers; and
(iii) will be perceived by those outside of the company as independent.
b. To the extent the management team does not meet these characteristics, they may need to be excluded from the investigation.
c. Some common individuals or groups that meet these characteristics may include: in-house counsel, the corporate compliance officer, the board of directors, the audit committee, or a special committee comprised of the independent members of the board of directors.
C. To write a report or not?
1. Caution must be exercised to consider both the benefits and costs before preparing a written report that summarizes or details the contents and results of an internal investigation.
a. Benefits
(i) The written report can be a valuable tool for management in planning the company’s response to the allegations of misconduct.
(ii) The report also creates a documented record of the scope and findings of the investigation that may be valuable to the company in future litigation or investigations.
(iii) May be more credible to the SEC.
b. Costs
(i) A written report may discuss potentially illegal or unethical conduct by company employees.
(ii) If the existence of such a report becomes known, prosecutors or government investigators will likely pressure the company to waive any applicable privilege and to disclose the report.
(iii) Civil litigants will seek the production of the report during discovery as it may provide a helpful roadmap to be used when attempting to prove their case.
(iv) Much harder to deal with a written document in defending a case, in contrast to an oral report.
(v) The potential for a leak must be considered.
D. How detailed should the report be?
1. The amount of detail necessary depends on the report’s intended purpose.
a. If a primary purpose of the investigation is to convince the government that the corporation is adequately policing itself and that government enforcement action is not warranted, the report should contain considerable factual detail.
b. If government agencies have already commenced their own investigations into the alleged misconduct, less detail may be more appropriate.
(i) A more detailed report will provide a detailed road map to the government and civil litigants in its prosecution of the company and Management.
(ii) A more detailed report may be treated as an admission of wrongdoing by the company or its Management.
2. Generally, written reports summarize the circumstances that led to the investigation; detail the investigative steps that were taken; summarize the facts revealed by the investigation; and identify internal policies, procedures or practices relevant to the events.
a. Depending on the purpose of the investigation, the report also may analyze the applicable law; develop arguments for or against prosecution, sanctions or liabilities; identify steps which the corporation may take to prevent future violations; and recommend appropriate remedial actions, such as product recalls or restitution.
b. If the corporation intends to disclose the report to the government, it should be drafted with careful attention to scope:
(i) When a corporation has determined that it will make information available to the government, it must decide the extent of the information which it will disclose. For instance, it may decide to make the entire report available to the government but try to maintain the confidentiality of the witness interview memoranda and other materials on which the report is based.
(ii) If the corporation’s disclosures are too limited, the government may seek additional disclosures. On the other hand, the greater the degree of disclosure, the more likely it is that any privilege over other information may be waived.
(iii) Cautionary and balanced language should be used in the report regardless of whether the report will be disclosed to ensure that it cannot later be used against the company.
E. Purpose? Internal vs. External.
1. An internally-used report allows the company and management to determine what went wrong. If the report is only for internal use, counsel preparing the report can be more frank and more critical as the report will generally be privileged.
2. If the report is publicized, it may help to address concerns raised by investors and regulators as it shows that the company is seriously addressing the improper conduct. If the report is written for this purpose, it should contain more cautionary language as it could be considered an admission by the company in litigation.
F. To whom should it be provided?
1. The report should be provided to the individual or committee that requested the report.
2. Obviously, there are also other possible recipients such as the government, auditors, or the marketplace.
G. Who makes the decision whether to write the report -- full board, audit committee, management?
VI. Representing the Special Litigation Committee (SLC)
A. The need for an SLC in response to a derivative claim.
1. It has been said that the development of SLCs has had a chilling effect on derivative claims.
a. If demand must be made on the board and the board refuses to sue, one view holds that the only recourse for the shareholder is then to sue the directors for wrongful refusal.
b. But if the existing board, or the committee to which the matter was referred, was not involved in the challenged transaction, the decision not to sue would be protected by the business judgment rule which insulates directors against an adverse ruling. c. If demand need not be made and suit is filed, as will generally be the case when the directors who were involved in the challenged decision still sit on the board, the typical response in recent years has been for the directors to appoint to the board two or three independent directors who constitute a special litigation committee with the task of determining whether the litigation against their fellow directors should go forward. Invariably the committee moves to dismiss the litigation. (68 WALR 79; 1 DEPAUL BUS. & COM. L.J. 49)
2. Another important aspect of the SLC is that, to the extent a corporation affirmatively relies on the committee’s report, courts may deem the attorney-client privilege waived and order the report disclosed. (1 DEPAUL BUS. & COM. L.J. 49)
a. Joy v. North, 692 F.2d 880, 893-94 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983) (holding report and supporting documentation must be disclosed to shareholders).
b. In re Perrigo Co., 128 F.3d 430 (6th Cir. 1997) (committee report ordered disclosed to derivative plaintiffs but not to public)
c. In re Cont’l Illinois Sec. Litig., 732 F.2d 1302, 1314 (7th Cir. 1984) (report ordered disclosure to a newspaper reporting on the litigation)
d. See, generally Jerold S. Solovy & Barry Levenstam, Special Litigation Committees, 9 A.L.I.-A.B.A. COURSE MATERIALS J. 5 (Apr. 1985). (all cases cited in 1 DEPAUL BUS. & COM. L. J. 49)
B. When creating an SLC, the company must make every effort to ensure that the SLC’s members are independent and have no interest in the issues in dispute. Otherwise, the court may reject any action, such as the filing of a motion to dismiss taken by the SLC.
1. In re Oracle Corp. Derivative Litig., 824 A.2d 917, 948 (Del Ch. 2003) (denying SLC’s motion to dismiss because ties among SLC members, university where they were tenured professors, and CEO and directors were so substantial that they caused reasonable doubt about members’ independence).
2. Beam ex rel. Martha Stewart Living Omnimedia Inc. v. Stewart, 833 A.2d 961, 980 n. 63 (Del Ch. 2003) (stating that plaintiffs may have been able to establish lack of independence of SLC, and therefore challenge its ability to consider and reject a demand, had plaintiffs used proper discovery procedure).
VII. The Sarbanes-Oxley Regime
A. New requirements for public companies.
1. Certification of financial reports.
a. Significant risks of increased litigation inherent in the increased certification requirements.
(i) Increased certification requirements may translate into benchmarks against which scienter and breach of fiduciary duty will be measured.
(ii) Increased certification requirements will inevitably lead to greater disclosure regarding the certification process.
(iii) Increased certification requirements will likely translate into greater liability exposure for the CEOs, CFOs and possibly others involved in the certification process.
b. Corporate responsibility for financial reports. Section 302 of the Sarbanes-Oxley Act certification requirements for chief financial officers ("CFOs") and chief executive officers ("CEOs") in each annual quarterly report.
(i) The signing officer has read the report.
(ii) The report does not contain any untrue statement of fact.
(iii) The information fairly presents the financial condition and results of operations of the issuer.
c. Corporate responsibility for financial reports. Section 906’s additional certification requirements, subject to the imposition of criminal penalty where the person "knows" that the report does not comply with these requirements.
2. Public company Audit Committees.
a. Section 301 of the Act makes Audit Committee members directly responsible for oversight of work done in conjunction with an audit.
(i) Section 301 mandates the establishment of audit committees for any public company.
(ii) Audit committees appoint and oversee auditors.
(iii) Audit committees take responsibility for resolution of audit disagreements between management and auditors.
(iv) Audit committees to be comprised of independent directors.
(v) Audit committees to have grievance procedures in place.
(vi) Audit committees to have authority and funding to preserve independence.
(vii) Audit committees to manage compensation issues for auditors and advisors.
3. Real time disclosure.
a. Section 409 amends section 13 of the Securities Exchange Act.
b. The amendment applies to issuers reporting under sections 13(a) or 15(d) of the Securities Exchange Act.
c. The amendment requires such issuers to "disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations, as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest."
4. Management assessment of internal controls.
a. Responsibility of CEOs and CFOs, as signing officers, for issues regarding internal controls and disclosure. Section 404 of the Act requires the SEC to adopt applicable rules.
(i) Annual reports of all issuers to contain internal control reports.
(ii) Reports must state management responsibility for internal controls and management’s assessment of the effectiveness of the controls.
5. Disclosure of all material correcting adjustments, off-balance sheet, and pro forma financial information. a. Section 401 of the Act enhances the type and degree of disclosures in periodic reports filed with the Commission.
(i) Every financial report that contains financial statements and prepared in accordance with GAAP must reflect material correcting adjustments identified by the accountant.
(ii) Each annual or quarterly report must disclose all offbalance sheet transactions with "unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses."
(iii) Pro forma financial information included in any periodic report or in any other public disclosure must be presented in a manner that is both "not misleading" and in conformance with GAAP.
6. Code of ethics.
a. Section 406 requires new disclosure rules for code of ethics policies of the issuer.
b. Each issuer is required to disclose in its periodic reports whether or not (and if not, why) the issuer has adopted a code of ethics for senior financial officers.
c. Any change or waiver of the code of ethics must be disclosed in the 8-K.
d. Under the act, "code of ethics" is defined as "such standards as are reasonably necessary to promote" three goals.
(i) "honest and ethical conduct, including the ethical handling or actual or apparent conflicts of interest between personal and professional relationships;"
(ii) "full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the issuer;" and
(iii) "compliance with applicable governmental rules and regulations."
7. The prohibition on loans to directors and officers.
a. Enhanced conflict of interest provisions. Section 402 prohibits any reporting company to lend money or extend credit to any director or officer. Personal loans are banned. How are advances for the purpose of litigation defense to be treated?
b. Disclosures of transactions involving management and principal stockholders. Section 403 of the Act amends Section 16 of the Exchange Act to provide that changes in beneficial ownership must be reported to the SEC in two business days following the date of the transaction.
8. Pension fund blackout periods.
a. Section 306 creates a new derivative action against directors and officers who trade in their company’s stock during a blackout period (i.e., when participants in the company’s benefits plan may not trade).
b. A "blackout period" refers to periods of more than three consecutive business days during which employee participants are prohibited from such transactions, subject to certain exceptions.
c. Any profits made in violation of this provision are recoverable by the reporting company.
9. Forfeiture of bonuses.
a. Section 304 creates a reimbursement rule for CEOs and CFOs who are given additional compensation prior to noncompliance with SEC reporting requirements.
b. If an issuer is required to prepare an accounting restatement due to a material noncompliance, as a result of misconduct, with any reporting requirement, the CEO and CFO must reimburse the issuer for certain funds paid as additional compensation.
(i) The CEO and CFO must pay back "any bonus or other incentive-based or equity based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement."
(ii) The CEO and CFO must also pay back "any profits realized from the sale of securities of the issuer during that 12- month period."
c. The Commission has the authority to exempt any person from these requirements.
B. Auditor independence.
1. Prohibited non-audit services.
a. Section 201 of Sarbanes-Oxley amended section 10A of the Securities Exchange Act by adding a new subsection prohibiting public accounting firms from providing, contemporaneous with an audit, any non-audit service.
b. Those prohibited non-audit services include:
(i) Bookkeeping or other services related to the accounting records or financial statements of the audit client;
(ii) Financial information systems design and implementation;
(iii) Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
(iv) Actuarial services;
(v) Internal audit outsourcing services;
(vi) Management functions or human resources;
(vii) Broker or dealer, investment adviser, or investment banking services;
(viii) Legal services and expert services unrelated to the audit; and
(ix) Any other service that the Board determines by regulation is impermissible.
c. A registered accounting firm can engage in any non-audit service not described in items (i)-(ix) above only if it is approved in advance by the audit committee of a company as provided in section 202 of Sarbanes-Oxley.
(i) Section 202 of the Act also amended the Exchange Act to require pre-approval by the audit committee of the issuer for all auditing services (including providing comfort letters in connection with securities underwritings or statutory audits required for insurance companies under state law) and non-audit services not listed in section 201.
(ii) The pre-approval requirement is waived with respect to non-audit services (but not audit services) if certain requirements are met.
(a) The aggregates of all non-audit services are not more than 5 percent of the total amount of revenues paid by the company to its auditor during the fiscal year in which the non-audit services are provided;
(b) such services were not recognized by the issuer at the time of the engagement to be non-audit services; and
(c) such services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or by one or more members of the audit committee who are members of the board of directors to whom authority to grant such approvals has been delegated by the audit committee. (17 No. 3 Insights 2)
2. Employment restriction on accountants.
a. Sarbanes-Oxley also enhances conflict of interest rules for accountants.
(i) Section 206 makes it "unlawful for a registered public accounting firm to perform for an issuer any audit service required by this title, if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity of that issuer during the 1-year period preceding the date of the initiation of the audit."
3. Audit partner rotation.
a. Section 203 of the Act amends Section 10A of the Securities Exchange Act to prohibit an issuer from using the same auditor for a period of more than five consecutive years.
b. "It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the 5 previous fiscal years of that issuer."
4. Audit record retention.
a. Section 802 of the Act requires "any accountant who conducts an audit of an issuer of securities to which Section 10A of the Exchange Act of 1934 (15 U.S.C. 78j-1(a)), applies, shall maintain audit or review work papers for a period of 5 years from the end of the fiscal period in which the audit or review was concluded."
b. A willful violation of this requirement may be punished by a fine and imprisonment of up to ten years.
5. Auditor reports to audit committees.
a. Section 204 of the Act amends the Exchange Act to require any registered public accounting firm that performs an audit to timely report to the audit committee of the issuer certain details of the audit.
b. Specifically, the auditor must report:
(i) "all critical accounting policies and practices to be used"
(ii) "all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management officials of the issuer, ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the registered public accounting firm"
(iii) "other material written communications between the registered public accounting firm and the management of the issuer, such as any management letter or schedule of unadjusted differences."
C. Increased authority for the SEC.
1. Increased frequency of SEC review.
a. Section 408 provides for "regular and systematic" review of disclosures by issuers (including those on Form 10-K) for the "protection of investors."
b. The Commission will schedule such reviews according to certain factors.
(i) Issuers that have issued material restatements of financial results;
(ii) issuers that experience significant volatility in their stock price as compared to other issuers;
(iii) issuers with the largest market capitalization;
(iv) emerging companies with disparities in price to earnings ratios;
(v) issuers whose operations significantly affect any material sector of the economy; and
(vi) any other factors that the Commission may consider relevant.
2. Bars on officers and directors.
a. Section 1105 empowers the SEC to bar, through its own administrative proceedings, persons from serving as officers or directors if they have violated Section 10(b) or Section 17(a)(1), and such conduct demonstrates "unfitness" to serve as a director or officer.
b. Section 302 changes old standard of "substantial unfitness" to "unfitness."
3. New forms of equitable relief available to the SEC.
a. The change from "substantial unfitness" to "unfitness" for those director and officer bars obtained through court injunction.
4. Standards of professional conduct for attorneys.
a. Section 307 of the Act called for rules setting forth "minimum standards of professional conduct for attorneys appearing and practicing before the commission."
b. The Act states that the new rules are "in the public interest and for the protection of investors."
c. One specific rule required by the Act was to require an attorney "to report evidence of a material violation of securities law or breach of fiduciary duty … by the company … to the chief legal counsel or the chief executive officer …."
d. If the counsel or officer does not properly respond (i.e., adopt appropriate remedial measures or sanctions), the attorney must report the violation to the audit committee of the board of directors, another committee of the board "comprised solely of directors not employed directly or indirectly by the issuer," or to the full board.
VIII. SEC Attorney Professional Responsibility Rules
A. Section 307 of Sarbanes Oxley and the rules promulgated by the SEC promulgated thereunder require an attorney representing an issue to report any evidence the lawyer uncovers of a material violation of the securities laws to the company.
B. How do Section 307’s reporting obligations work?
1. The lawyer must first report evidence of the material violation to the company’s "Chief Legal Officer" ("CLO").
a. The attorney may also report the alleged violation to the company’s CFO.
b. As part of the lawyer’s reporting of the alleged violation, the lawyer must demand that the CLO provide the lawyer with an appropriate response.
2. Upon receiving the "report" from the lawyer, the CLO must do one of two things:
a. The CLO must investigate the evidence of the material violation presented by the lawyer and either provide an appropriate response or assure the lawyer that no material violation has occurred; or
b. The CLO may refer the report to a Qualified Legal Compliance Committee if one has already been put in place by the company.
c. The SEC has defined a Qualified Legal Compliance Committee ("QLLC") as a committee of an issuer (which also may be an audit or other committee of the issuer) that:
(i) Consists of at least one member of the issuer’s audit committee (or, if the issuer has no audit committee, one member from an equivalent committee of independent directors) and two or more members of the issuer’s board of directors who are not employed, directly or indirectly, by the issuer and who are not, in the case of a registered investment company, "interested persons" as defined in section 2(a)(19) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(19));
(ii) Has adopted written procedures for the confidential receipt, retention, and consideration of any report of evidence of a material violation under § 205.3;
(iii) Has been duly established by the issuer’s board of directors, with the authority and responsibility:
(a) To inform the issuer’s chief legal officer and chief executive officer (or the equivalents thereof) of any report of evidence of a material violation (except in the circumstances described in § 205.3(b)(4));
(b) To determine whether an investigation is necessary regarding any report of evidence of a material violation by the issuer, its officers, directors, employees or agents and, if it determines an investigation is necessary or appropriate, to:
i. Notify the audit committee or the full board of directors;
ii. Initiate an investigation, which may be conducted either by the chief legal officer (or the equivalent thereof) or by the outside attorneys; and
iii. Retain such additional expert personnel as the committee deems necessary; and
(c) At the conclusion of any such investigation, to:
i. Recommend, by majority vote, that the issuer implement an appropriate response to evidence of a material violation; and
ii. Inform the chief legal officer and the chief executive officer (or the equivalents thereof) and the board of directors of the results of any such investigation under this section and the appropriate remedial measures to be adopted; and
(d) Has the authority and responsibility, acting by majority vote, to take all other appropriate action, including the authority to notify the Commission in the event that the issuer fails in material respects to implement an appropriate response that the qualified legal compliance committee has recommended the issuer to take.
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