May 30, 2003 THE INCREASED NEED FOR INTERNAL INVESTIGATIONS BY PUBLIC COMPANIES AND THEIR AUDIT COMMITTEES by Gerald E. Boltz Presented at the Rocky Mountain Securities Conference (May 30, 2003) Copyright 2003. Gerald E. Boltz * * * * * Presentation follows * * * * * * Gerald E. Boltz is Of Counsel at Bryan Cave LLP in its Los Angeles (Santa Monica), California office. His practice focuses on securities compliance and litigation matters, white collar crime and audit committee counseling. For additional information, contact him at: (310) 576-2134, geboltz@bryancave.com This Client Bulletin is published for the clients and friends of Bryan Cave LLP. Information contained herein is not to be considered as legal advice. This Client Bulletin may be construed as an advertisement or solicitation. 2003 Bryan Cave LLP. All Rights Reserved.
THE INCREASED NEED FOR INTERNAL INVESTIGATIONS BY PUBLIC COMPANIES AND THEIR AUDIT COMMITTEES Gerald E. Boltz Bryan Cave LLP 120 Broadway, Suite 300 Santa Monica, CA 90401 (310) 576-2134 A. The Need for Corporate Internal Investigations The prevalence of accounting fraud among public companies and the recent enactment of the Sarbanes-Oxley Act and related California statutes, coupled with increased SEC and criminal enforcement activity in this area, make it imperative and, indeed, a statutory requirement that public companies, usually through their audit committees, make inquiry, obtain relevant facts and take appropriate action when they receive reports of any possible improper accounting practices. The use of internal investigations by public reporting companies and their boards began in the 1960 s as a result of SEC and private actions into improper corporate payments. Since then, the use of internal investigations has widened to include all financial reporting issues, as well as insider trading and officer misconduct.. The SEC s voluntary disclosure program for corporations provides an additional significant incentive for conducting internal investigations. In addition, the adoption in 1991 of the Federal Sentencing Guidelines, as applicable to corporations, encourages the use of such investigations. B. The Value of Internal Investigations Internal investigations have proven invaluable in defending or preventing corporate and board member liability, both in private civil actions, including class and derivative suits, and in SEC, Department of Justice and other regulatory and law enforcement actions. They permit internal corporate analysis of complex factual situations and are invaluable to the board of directors and audit committees in making decisions regarding appropriate action, required disclosure and personnel decisions. In addition, internal investigations have been recognized by the courts as an appropriate basis for the exercise of the business judgment rule by boards of directors. The enactment of the Private Securities Litigation Reform Act of 1995 added Section 10A(b)(1) to the Securities Exchange Act of 1934. Under this provision, an accounting firm for a public company is required to determine if it is likely that an illegal act has occurred. If such determination is made, the accounting firm must not only determine the effect such act may have upon the company s financial statements, but must also report such conclusion to management and the Audit Committee unless the illegal act is clearly inconsequential. Following such report, and where the act may have a material effect on the financial statements, it is now required that the audit committee take appropriate action to determine the nature and scope of the problem. Should the audit committee or the company fail to take remedial action, the accountants are required to notify the entire Board of their conclusions. Following such notice, the Board has one business day to 2
inform the SEC of such report and advise the accounting firm that it has done so. If the accounting firm does not receive such notice, it must either resign or provide the SEC with its own report. These requirements, particularly the one requiring a company to take appropriate remedial action, has brought the internal investigation into significant prominence in accounting related issues since a company must have all of the pertinent facts in order to determine what remedial action is required. For example, there must be a determination of whether there were other similar illegal acts, whether there was a pattern of improper conduct and the extent to which employees, and particularly senior management, cooperated or were involved in such conduct. C. The Impact of the Sarbanes-Oxley Act Upon Audit Committees The Sarbanes-Oxley Act mandates that an audit committee s primary duty is to the board and the investing public not management. Under the Act, audit committees must now be informed of all disagreements with management on accounting issues. In addition, the outside auditors are now required to discuss all specific accounting issues with the audit committee and members of the committee must have the opportunity to question the auditors without the presence of management. Audit committees must also have procedures in place which permit the anonymous reporting of accounting complaints and related information from employees regarding accounting issues. After such information is received by an audit committee, whether from an employee, the auditors or otherwise, the committee has an strict obligation to determine the scope, duration and persons responsible for any improper accounting treatment or practices. In order to make such determination on a privileged basis, audit committees must retain outside counsel to conduct an investigation. Under the Sarbanes-Oxley Act, audit committees now have the authority to retain separate counsel to be funded by the company. D. Who Should Conduct an Internal Investigation? While termed internal, most investigations are conducted by outside counsel in order for the company, its audit committee or board of directors to be assured it may avail itself of the attorney client and attorney work product privileges. While inside counsel normally may know the company quite well and might otherwise be able to conduct an investigation, the privilege claims are more vulnerable to attack since inside counsel may have other responsibilities or may be acting in a dual capacity. On some occasions, the conduct of in-house counsel itself may also be the subject of the inquiry. The use of regular outside counsel may be itself be a disadvantage, particularly if the firm s prior advice or actions may themselves be subject to question or inquiry. For this reason, it is prudent for companies to retain special outside counsel experienced in conducting such investigations to conduct the investigation. In addition, the independence and credibility of the investigation and any report thereon, as viewed by regulators, law enforcement officials and the public, may be substantially enhanced if special outside counsel is utilized rather than in-house or regular company counsel. In choosing special outside counsel, it is important to assess the law firm s experience not only in conducting such investigations but also in dealing with the underlying accounting issues and the actions which may arise from the facts in the matter. E. Important Engagement Considerations and Decisions It is important that the formal engagement letter with counsel documents both the purpose and scope of the inquiry. It is also essential in the preservation of the attorney client privilege that 3
the engagement letter recite that the investigation is being conducted to provide advice and counsel and is not merely a factual inquiry. If the attorney work product privilege is to be successfully asserted, it is preferable to state in the engagement letter that the investigation is being conducted in anticipation of potential litigation, whether private or regulatory, which should be specified if possible. The engagement letter might also recite that the decision to conduct such investigation is an exercise of the business judgment rule, inasmuch as courts have been more prone to uphold the work product privilege if it is documented that the investigation was undertaken for legal and not simply business reasons. It is also important to identify the client as the audit committee, particularly if any person in management may be a subject of the inquiry. It should be taken into consideration that counsel conducting the investigation may be required to consult with another accounting firm or other outside experts. In such instances, such should be authorized in the engagement letter, which will document that such accountants or experts are working at the direction of counsel pursuant to the applicable privileges. In addition, decisions must be made regarding whether the company will provide separate counsel to officers and employees who are witnesses and may request counsel. F. Maintaining the Attorney Client and Attorney Work Product Privileges After conclusion of the investigation, it is frequently desirable to maintain the attorney client and attorney work product privileges. However, such decisions can be made after the facts are known. In some instances, waiver of the privileges is beneficial to the company. However, when a decision is made to preserve the privileges, such decision can create a tension between the audit committee and its auditors since the refusal to report back to the auditors may not provide the accountants with any basis upon which to determine that appropriate remedial action has, in fact, been taken. This can be resolved if the audit committee is able to at least report what action it and/or the company is taking as a result of the investigation Two recent court cases in the Southern District of New York illustrate the care which must be taken in reporting back to the auditors. In In re Subpoena Duces Tecum served on Wilkie Farr & Gallagher, 1997 WL 118369 (SDNY, March 14, 1997), after assertion by the company s auditors that it could not provide an unqualified audit opinion without access to the results of the investigation, investigative counsel provided the auditors with limited information from interviews during the investigation together with hypotheticals which were verified as factual. The court held that this waived the attorney client privilege. In another case involving an internal investigation, however, In re Woolworth Corp. (1996 WL 306576 SDNY, June 7, 1996), the privilege was upheld. In this case, the company published a report summarizing the investigation s findings. Class action plaintiffs thereafter sought notes and other details regarding the investigation. In upholding the attorney work product privilege, the court found that the investigation was conducted for legal not business purposes. It also found that publishing a summary of the findings and conclusions and sharing such with the auditors did not waive the privilege with regard to the underlying documents. The court also noted that failure to uphold the privilege would discourage corporations from taking the responsible step of employing outside counsel to conduct an investigation. 4
Federal legislation is now under consideration which would permit reports of internal investigations to be furnished to the Securities and Exchange Commission without waiver of the attorney client privilege. G. Recommended Corporate Procedures The following additional procedures should be considered when undertaking internal investigations: 1. Sequestration and preservation of all relevant records and documents. 2. Compliance with any immediate disclosure obligations, possibly including the disclosure of the investigation itself. 3. Preparation of a notice to certain or all employees reminding them of their duty to cooperate with the investigation and their right to counsel. (See Section H for further discussion.) 4. Initial determination that all illegal activity has ceased. Failure to take this step may impact the company s civil and regulatory liability and may also impair viability of the attorney client privilege because of the crime fraud exception. 5. Assessment and possible revision of any related company policies and procedures. 6. Determination of whether any immediate notification or disclosures to the company s auditors is appropriate or required. (The Federal Private Securities Reform Act of 1995 requires auditors of public companies to assess the response to various types of abuses, including those involving financial reporting and internal controls.) 7. Determination whether any union contractual provisions require disclosures to such union. 8. Consultation with counsel to plan possible strategies and responses in the event SEC or other regulatory inquiries are initiated. 9. Consider whether formal notification to the company s insurance carrier is appropriate. 10. Consider any employee whistleblower issues by checking state law as well as the need for any immediate possible personnel actions. H. The Rationale and Importance of a Notice to Employees A printed notice form to employees is recommended in order to uniformly inform and document information given to potential employee witnesses. Such notice should inform employees that counsel has been engaged to conduct the investigation and the nature and purpose of the inquiry. It should also explain the attorney client privilege, including the fact that the matter should not be discussed with others, and only the audit committee may waive such privilege. Such notice also should inform witnesses that they have the opportunity to consult with their personal counsel. The notice should recite the duty of employees to cooperate and to provide copies of all relevant documents and notes. Finally, the notice form should provide that employees sign a copy thereof acknowledging that they have read, understood and agreed to its provisions. Providing a form or memorandum to all potential witness employees or employees also tends to prevent individual witnesses from reacting adversely when only a personal notice is given them at the time of their interview. 5
I. Related Investigative Techniques and Procedures by Counsel The investigation must be thoroughly planned, giving consideration to the time period under review and all potential witnesses. Steps should be taken to assure that all communications with outside experts be made through counsel. Procedures should be devised for preserving and obtaining from witnesses all relevant personal documents and notes. Generally it is advisable to avoid use of a hostile approach in conducting witness interviews. Counsel must be prepared to respond to requests for indemnity, requests that the company provide personal counsel for the employee and the possible assertion of the Fifth Amendment. Counsel should remind witnesses that judgments will be made based not only on the truth of what information they provide but also on the basis of information they are subsequently found to have known but did not disclose. Counsel may also wish to ask witnesses to advise them if they are subsequently contacted by regulators. Counsel should also be aware that an employee may secretly go to the government to make a deal. In instances where a witness statement is particularly critical, it may be advisable to obtain a sworn statement or testimony. In some cases it may be preferable to quickly conduct an initial interview of key witnesses who are suspects in order to obtain their documents, pin down their explanations and permit a further in-depth probe based upon their explanations. After the subsequent interviews of other witnesses, counsel may circle back to more closely examine key witness suspects. In other instances, however, it may be preferable to first develop the facts from documents and peripheral witnesses, leaving the interview of key witnesses or suspects until after counsel has developed the facts. If it appears that there will be related personnel complaints, consideration must be given to any duty to investigate those complaints as well. Counsel should be aware that employees may sometimes fear retribution, adverse personnel actions, or being made a scapegoat by the company or management. Whistleblower employees present unique concerns Care must be taken that response to whistleblower reports are not viewed as retaliatory in nature, particularly if it varies from positions taken against other similarly situated employees. A review of the applicable state whistleblower statutes is appropriate before taking action in these instances. J. Should the Report be Written or Oral? Investigative reports involving complex factual situations are difficult to deal with without a written report. However, a written report involves the risk that it may fall into the hands of class action plaintiffs, the SEC or other regulators by accident, because the claimed privileges are deemed to have been waived, or because of employee disloyalty. In some instances the SEC has insisted upon receiving a copy of the written report as a condition of settlement. Since a conditional waiver of the attorney client privilege is not generally recognized, furnishing a copy of such written report to the SEC waives the privilege and, thus, also makes it available to private action plaintiffs and others. As a result, many audit committees specify that only an oral report shall be provided to the client. Such oral report, however, even when supported by counsel s notes and documents, may have more limited use and value. 6
When written reports are provided, they should, in all instances, integrate the factual aspects of the report with counsels mental impressions, legal conclusions, recommendations and advice in order to preserve the attorney client privilege for the entire document. Because it may ultimately be decided to disclose the report to the SEC or others, it is also prudent to avoid statements which may give rise to possible libel claims. In all instances the report should avoid overstatement and adhere strictly to fact based conclusions. K. Voluntary Disclosure to the Regulators Voluntary disclosure of the nature of the problem and the existence of the internal investigation may be helpful in demonstrating to the SEC or other regulators the integrity of the company. Such disclosure also enables the company to bring exculpatory or mitigating facts to the regulator s attention and to present the matter and its defenses in the most favorable light. When the report of investigation is oral, an oral report may be given the Commission staff. It should also be noted that voluntary disclosure may significantly reduce a fine against a company under the Federal Sentencing Guidelines. At an early stage in the matter, however, it should be taken into consideration that a voluntary disclosure may increase the risk of possible regulatory action or private action. This may be particularly true if the matter is not likely to come to the attention of the regulators and is one which would not otherwise require public disclosure. L. Corporate Ethics Policy and Internal Controls Requirements The Sarbanes-Oxley Act requires public companies to disclose in their filings whether they have adopted a code of ethics for senior financial officers and, if they have not adopted such a policy, to explain the reasons for such decision. Any change in a company s existing code of ethics or any waiver thereof must also be disclosed via an 8-K filing. The code ethics is designed to promote honest and ethical conduct, full and accurate disclosure, and compliance with SEC and other governmental rules and regulations. Annual reports filed by public companies must now report on and provide management s assessment of the company s internal controls. In addition, the company s auditors must include in its audit, a testing of the company s internal controls and provide an assessment thereon in their audit report.. Corporate compliance programs generally have taken on vastly increased significance since the enactment of the Federal Sentencing Guidelines, which became effective in 1991. Under such guidelines, companies may be subject to criminal fines, remedial action (including restitution) and probation. However, companies which have an effective compliance program will receive significant reductions in sentences imposed under these guidelines. For example, fines may be reduced by 60% by reason of such compliance programs. Such programs, however, must have reasonable standards and procedures, must be communicated within the company and be consistently enforced. 7
M. Conclusion The recently enacted federal and state statutory requirements and related new SEC Rules make the use of internal investigations invaluable in order to assure compliance with these statutes as well as to prevent or limit civil liability and SEC and other governmental action. The requirements of Section 10A(b)(1) of the Securities Exchange Act also make such investigations important to the company and its audit committee in discharging their responsibilities under this provision and in providing required response to the auditors. Internal investigations conducted for any purpose must be undertaken by counsel experienced and knowledgeable regarding the legal issues and the procedures and techniques discussed herein. 8