Investigations Loom Large on Board Agendas
Date: 12/11/06
Reprinted with permission by Agenda, a Money-Media publication.
More than half of directors say they expect an increase in investigations into potential accounting irregularities at U.S. companies over the next two years, according to a new Deloitte & Touche poll. If that's true, directors can expect a full agenda in the coming years.“There likely will be increasing internal investigations, because in the current regime, the regulators in effect deputize the corporation to do the investigative work for them, as part of the cooperation that can help a company minimize or avoid the risks of prosecution,” writes Irwin Warren, a partner at Weil, Gotshal & Manges, in an e-mail to Agenda.
Boards can expect to take on most of these investigations as the SEC continues to look for board-led investigations independent from management and in-house counsel, lawyers say.
The current environment that saddles boards with the responsibility to investigate fraud is fostered in part by the so-called Thompson Memo. The memo was written by former U.S. deputy attorney general Larry Thompson and encourages prosecutors to hold criminal charges over companies' heads to encourage them to cooperate. But it has been widely criticized as turning the justice system on its head by assuming companies are guilty until proven innocent.
As the SEC seeks greater cooperation during investigations, it is also wants independent investigations led by outside directors, says Bart Friedman, a partner at Cahill Gordon & Reindel and a director at Allied World Assurance Holdings.
“The SEC appears to be very focused on whether people that did the investigation are independent of the company,” he says.
Internal investigations place a large burden on boards, specifically the audit committee, which typically runs such an investigation, according to Warren. What’s more, audit committees often get conflicting advice on the best way to run an investigation.
“It’s a big challenge for audit committees to wade through this,” says John Henry, general counsel at $696 million Investors Financial Services. “There are conflicts on all ends… Of course the general counsel has an interest in having control of [the investigation]… and the external counsel would like the revenue.”
Friedman, who provided legal counsel to online real estate company Homestore’s audit committee during its investigation into improper financial statements at the company in 2002, says there are certain best practices that board committees leading an investigation should follow. The Homestore investigation, which lasted six months, was applauded by the SEC for its methods and results.
Once the board uncovers potential fraudulent activities at the top of the organization, it should immediately seek outside legal counsel and report the preliminary findings to regulators, Friedman says. The audit committee — which Friedman says is usually best equipped to lead the investigation because it must be fully independent — should have ongoing communication with the public during the investigation through carefully worded, legally reviewed press releases, he says. Finally, Friedman recommends that the board carefully deliberate to determine which employees knowingly participated in the scandal.
In extreme cases, boards may need to hire new independent directors to help lead the investigations. You want the appearance of a completely independent and untainted board, says Denny Beresford, audit chair at Fannie Mae, who was brought in as an accounting expert after an internal investigation into accounting manipulation concluded earlier this year. Beresford was also recruited to WorldCom’s board.
Boards should be cautious against commissioning a lengthy investigation too soon, Beresford says. Now that companies are required to have whistle-blower hotlines, many of the complaints received don’t rise to the level of an independent board investigation, he says. Often the internal auditor or in-house counsel can lead the preliminary investigation into allegations of misconduct. If they uncover potential fraud or misconduct, they can hand the investigation over to the board and outside counsel.
Henry, the general counsel at Investors Financial Services, also cautions boards against quickly reacting to whistle-blower tips.
“There’s a real knee-jerk reaction from the board to obtain services of external counsel… The general counsel should lead the investigation unless the board has reason to think the general counsel would be connected,” Henry says.
Hiring outside counsel is costly and there is a learning curve in bringing them up to speed on the business of the company, Henry says. Nevertheless, he admits that a fully independent investigation without advisement from in-house counsel tends to look better to the SEC.
However, Friedman says there is almost never a circumstance where in-house counsel should be looking into allegations. During a preliminary investigation, the internal audit should look into allegations and report to the board. If it rises to the level of a full-board investigation, then the audit committee should hire outside counsel, he says.
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