Corporate Investigations Update

This is an updte on the past year's developments in government enforcement in the area of business crimes. One year ago, we sponsored a seminar entitled "The Brave New World of Corporate Criminal Enforcement," which explored the many new corporate law enforcement efforts and their impact on corporate counsel and executives. In the ensuing year we have witnessed a continuation of that same pattern. Here is a review of the latest developments.

I. CORPORATE SCANDAL SCORECARD

Response To Government Investigation Remains Critical

Both federal and state authorities have scrutinized company responses to the discovery of potential wrongdoing and to government investigations. Indeed, the company’s response has become nearly as important to charging decisions as the underlying matters under investigation. This places an enormous responsibility on corporate counsel and the board of directors, particularly the audit committee, to insure that the company response is prompt and careful.

Continuing the pattern begun with the prosecution of Arthur Andersen in the Enron investigations, both Federal and state authorities have been extremely sensitive to any hint of possible obstruction of justice. In a number of highly publicized cases the response to a government investigation has dwarfed the actual underlying activities. Clearly, the prosecutions of Martha Stewart and of Frank Quattrone of Credit Suisse First Boston are the most notorious examples.

Like the Department of Justice ("DOJ"), the Securities and Exchange Commission ("SEC") has increasingly scrutinized the cooperation of business organizations during investigations. Recently, in an investigation into the trading of securities by Banc of America Securities employees, the SEC fined the institution $10 million for violating laws on record keeping and access requirements. Imposed before the completion of the underlying investigation, the SEC’s order cited the following activity: (1) failing to promptly furnish e-mail, compliance reviews and compliance records; (2) providing misinformation regarding the availability and production status of those documents, including what material had been lost and what had been recovered by the bank; and (3) taking other steps which delayed the Staff’s investigation.

The SEC is likely to invoke this fine as strong precedent to press for quick compliance with its discovery requests. That same government sensitivity to a company's response has been displayed in virtually every investigation over the past year, regardless of the agency involved. Thus, corporate counsel must be vigilant in taking steps at the outset of every internal investigation to preserve all evidence, particularly e-mail, that might relate to the matter.

The DOJ has taken the lead in imposing a hard-line attitude in corporate investigations. This has been displayed in everything from evaluating company cooperation to the extremely tough stance taken in aspects of the corporate sentencing process.

On January 20, 2003, Deputy Attorney General Larry Thompson issued a memorandum on the Principles of Federal Prosecution of Business Organizations (the "Thompson Memorandum"). In substance, the Thompson Memorandum is substantially similar to a predecessor memorandum on the same topic, the 1999 Justice Department Guidance on the Prosecution of Corporations (the "Holder Memorandum"). The main changes in the Thompson Memorandum, however, are "the increased emphasis and scrutiny of ": (i) the authenticity of a company’s cooperation in a criminal investigation; and (ii) the efficacy of corporate governance mechanisms in place within a corporation.

With respect to corporate cooperation, the Thompson Memorandum states that a prosecutor should evaluate whether the corporation is engaging in conduct that impedes the investigation, while purporting to cooperate with the government. The Thompson Memorandum cites the following examples: "overly broad assertion of corporate representation of employees or former employees, inappropriate directions to employees or their counsel, such as directions not to cooperate openly and fully with the investigation including, for example, the direction to decline to be interviewed; making presentations or submissions that contain misleading assertions or omissions; incomplete or delayed production of records; and failure to promptly disclose illegal conduct known to the corporation."

As for corporate compliance programs, the Thompson Memorandum urges prosecutors to consider whether the programs "effectively detect and prevent misconduct." In a passage which mirrors the Sarbanes-Oxley Act, the Thompson Memorandum states that prosecutors should carefully assess the actions of a corporation’s directors in ensuring effective compliance. Specifically, the memorandum directs the prosecutors to consider whether: (i) the corporation’s directors exercise independent review over proposed corporate actions rather than unquestioningly ratifying officers’ recommendations; (ii) the directors are provided with information sufficient to enable the exercise of independent judgment; (iii) internal functions are conducted at a level sufficient to ensure their independence and accuracy; and (iv) the directors have established an information and reporting system in the organization reasonably designed to provide management and the board of directors with timely and accurate information sufficient to allow them to reach an informed decisions regarding the organization’s compliance with the law.

The Thompson Memorandum also reaffirmed the Holder Memorandum’s position that prosecutors may request the waiver of the attorney-client and work product protection in the context of cooperation with a government investigation. While not an "absolute requirement", it should be considered a factor in evaluating cooperation. James Comey, the current Deputy Attorney General and former U.S. Attorney for the Southern District of New York, spoke about this at our New York seminar last year. He indicated at that time that prosecutors will attempt to work with cooperating companies without eradicating these protections. Recently, he confirmed that position in a published interview. This policy is in a state of flux, however, and its application can vary from district to district.

In the Prosecutorial Remedies and Other Tools to End the Exploitation of Children Today Act (the "PROTECT Act"), passed on April 30, 2003, Congress stated that there were too many downward departures from the sentencing ranges set forth in the federal Sentencing Guidelines. In the PROTECT Act, Congress instructed the Sentencing Commission to take measures to "ensure that the incidence of downward departures [is] substantially reduced." Pub. L. No. 108-21, § 401(m)(2)(A). (See infra pp. 5-6).

Shortly after the passage of the PROTECT Act, on September 23, 2003, Attorney General John Ashcroft issued a memorandum to all prosecutors concerning the charging of criminal offenses, the disposition of cases, and sentencing (the "Ashcroft Memorandum").

The Ashcroft Memorandum directs prosecutors to charge and pursue the most serious, readily provable offense in all federal prosecutions, unless authorized to do otherwise by an Assistant Attorney General, United States Attorney or designated supervisory attorney in certain limited situations, such as substantial assistance or in cases of post-indictment reassessment (i.e., where there is a change of evidence or unavailability of a witness that makes it not possible to prove the most serious offense). This severely limits "charge" or "sentencing" bargaining in plea negotiations.

Similarly, with respect to downward departures in sentencing, the Ashcroft Memorandum notes that Congress, in the PROTECT Act, instructed the Sentencing Commission to reduce the incidence of downward departures. Accordingly, prosecutors must not accede or "stand silent" to downward departures except in specific, limited circumstances and only with approval from an Assistant Attorney General, United States Attorney or designated supervisory attorney.

Another major development that has heightened the pressures on corporate response to investigations is the new aggressive role taken by state authorities, particularly New York Attorney General Eliot Spitzer, in regulatory enforcement, especially in the securities and mutual fund businesses.

Spitzer’s aggressive moves have directly challenged other authorities, particularly the SEC, to accelerate the pace of investigations to avoid losing out to Spitzer. This competition has forced the SEC to frequently abandon many of its former investigative practices such as the formal depositions and written Wells submissions that were its hallmark. In fact, SEC lawyers are now often conducting joint interviews of witnesses alongside federal or state prosecutors.

In another significant development, SEC Director of Enforcement Steven Cutler recently stated that the SEC is now conducting industry-wide "sweeps" when it discovers corporate wrongdoing at an individual firm. Cutler indicated that when the SEC now learns of a company with corporate integrity problems, the SEC will open an investigation into the entire industry or sector, regardless of whether the agency has any evidence of wrongdoing on an industry-wide basis. The apparent rationale for this new practice, called "wildcatting," is to ensure that the SEC gets on top of a problem before it spreads. The SEC has already launched a number of wide-ranging investigations of industries whose members use similar accounting methods. This new policy will force companies to prepare for an investigation by the SEC shortly after a peer firm discloses a problem, and companies may have to do so in short order if a peer firm makes a confidential disclosure to the SEC. Another concern is the damage that a company may suffer by disclosing an SEC investigation to the investing public even where there is no evidentiary basis for that investigation.

The competition among authorities, along with the rapidity of charging decisions, often places counsel and the company in extremely difficult straits. They are now often faced with accommodating multiple conflicting requests for information and making decisions without full factual assessment based on a thorough internal investigation.

Under the Sarbanes-Oxley Act, the United States Sentencing Commission was directed to review the sentencing guidelines for a number of corporate criminal offenses. In November, 2003 the Sentencing Commission made permanent certain sentencing enhancements that it had made on an emergency basis earlier last year. The new Guidelines substantially increase the sentencing range for a variety of business crimes. When coupled with the increase in maximum fraud sentences from 5 years in prison to 20 years (and 25 years for securities fraud) under the Sarbanes-Oxley Act, the potential for long periods of incarceration is now very real.

Perhaps the best recent example is that of the mid-level oil company executive who was recently sentenced to 24 years in prison. His sentence was four times longer than under the pre-2001 sentencing guidelines. Had he been sentenced under the current version of the guidelines, his maximum sentence could have reached life imprisonment.

• The base sentencing guidelines for obstruction of justice and perjury have both increased. The potential minimum exposure is now 15 - 21 months in prison. Obstruction of justice sentences may be further enhanced if the violation: (i) involves the destruction of a substantial number of records; (ii) is extensive in scope, planning, or preparation; or (iii) includes the destruction of essential or probative evidence.

• Fraud violations involving catastrophic financial losses have increased offense levels for the defendant. Where losses exceed $200 million, the potential sentence can reach nearly 20 years and where they exceed $400 million, the potential is well over 20 years in prison.

• Public company officers and directors have been singled out for much increased punishment for securities fraud offenses. The Guidelines now provide for a significant enhancement if the offense is committed by an officer or director of a publicly traded company, by a registered broker or dealer, or by an investment adviser.

• Fraud offenses which endanger the solvency of company or the financial security of more than 100 victims also lead to significantly increased sentences. Similarly, fraud sentences will increase progressively, where the offense involves more than 10, 50, or 250 victims.

After the passage of the PROTECT Act, the U.S. Sentencing Commission also passed an emergency amendment which addressed the issue of downward departures from the sentencing range found in the Sentencing Guidelines. The amendment significantly restricts the availability of downward departures and prohibits the consideration of some factors altogether. The amendment also specifies what departures are appropriate for certain offenders and clarifies when certain departures are proper.

The following grounds no longer justify a downward departure: (i) the defendant’s community ties; (ii) the defendant’s acceptance of responsibility for the offense; (iii) the defendant’s mitigating role; (iv) the defendant’s decision to plead guilty to the offense or to enter into a plea agreement; (v) the defendant’s fulfillment of restitution obligations; and (vi) the defendant’s physical condition or substance abuse.

Restrictions have been imposed on the following: (i) use of multiple offender characteristics or circumstances to justify a downward departure; (ii) the defendant’s family ties and responsibilities if he has financial or caretaker duties; (iii) whether the crime was committed under coercion or duress; (iv) the defendant’s diminished mental capacity; and (v) the defendant’s aberrant behavior, including any prior criminal conduct.

These amendments have enormously restricted the ability of federal judges to depart below the increasingly severe Sentencing Guidelines and have provoked an outcry of protest from the judiciary.

Again, under a directive from Congress in the Sarbanes-Oxley Act, the Sentencing Commission has proposed revisions to the Organization Sentencing Guidelines, particularly with respect to the requirements for an "effective compliance program," which can mitigate sentencing for a corporation involved in criminal activity. The Sentencing Commission formally adopted these revisions on April 8. They will take effect on November 1, 2004, unless Congress disapproves them during the six month review period.

The new Guidelines proposal provides more detail concerning the original seven minimum requirements for an effective program. It imposes a general obligation on the company to establish an "organizational culture that encourages a commitment to compliance." It further mandates that the board of directors be knowledgeable about the compliance program and exercise reasonable oversight. The proposal adds a provision requiring the company to engage in an ongoing risk assessment of the compliance program and take appropriate actions in light of the risks identified. In other additions, the proposal requires mechanisms for "anonymous reporting" of potential violations and encourages "incentives," as well as disciplinary measures, to enforce compliance.

In another interesting comment, the proposal indicates that waiver of attorney-client privilege is not a prerequisite to a culpability reduction for substantial assistance to the government, but may be necessary in some circumstances.

The attorney-client and work product protections have continued to be under attack during the past year, with only a handful of court decisions upholding or extending their protection.

The doctrine of selective waiver, whereby a defendant voluntarily discloses the results of an internal investigation or other work product material to regulatory or investigative bodies but does not waive the attorney work product privilege, continues to receive, at best, mixed treatment by the courts.

Only a few courts have found there to be no waiver of the privilege in subsequent civil suits where the defendant and the government had explicit confidentiality agreements at the time of the disclosure. See Maruzen Co., Ltd. V. HSBC USA, Inc., 2002 WL 1628782 (S.D.N.Y. July 23, 2002); Saito v. McKesson HBOC, Inc., 2002 WL 31657622 (Del. Ch. Nov. 13, 2002); cf. In re Steinhardt Partners, L.P., 9 F.3d 230, 236 (2d Cir. 1993) ("Establishing a [per se waiver rule for disclosure] would fail to anticipate . . . situations in which the [government agency] and the disclosing party have entered into an explicit agreement") (dictum).

Most other courts have continued to hold that disclosure to government agencies constitutes waiver as to all other parties in later civil action, despite confidentiality agreements. In re Columbia/HCA Healthcare Corp. Billing Practices Lit., 293 F. 3d 298 (6th Cir. 2002) (presence of confidentiality agreement does not negate waiver) (citing Westinghouse Elec. Corp. v. Republic of Philippines, 951 F.2d 1414 (3d Cir. 1991)). United States v. Bergonzi, 216 F.R.D. 487 (N.D. Cal. 2003) (waiver with or without confidentiality agreement); McKesson HBOC v. Superior Court, 114 Cal App. 4th 1229, 9 Cal. Rtr. 3d 812 (Feb. 20, 2004) (waiver with or without confidentiality agreement).

However, a proposed congressional bill would eliminate the privilege waiver in an SEC investigation where the SEC agrees to confidentiality in writing. H.R. 2179, § 4 ("whenever the Commission and any person agree in writing to terms pursuant to which such person will produce or disclose to the Commission any document or information that is subject to any Federal or State law privilege, or to the protection provided by the work product doctrine, such production shall not constitute a waiver of the privilege or protection as to any person other than the Commission."). It is unclear at this time what the likelihood of passage will be.

Lastly, two recent cases suggest that the disclosure of privileged information to the government does not constitute a waiver of the underlying materials. See In re Grand Jury Proceedings, 350 F.3d 299 (2d Cir. 2003) (work product privilege protected an attorney’s notes of conversations with federal agents that were disclosed in letter memorandum to US Attorney’s Office); In re Keeper of the Records, 348 F.3d 16 (1st Cir. 2003) (materials referred to in pre-indictment proffers were not waived because the government’s silence regarding counsel’s oral privilege reservations indicated its "intent to acquiesce" in those reservations). In both cases, the disclosures to the government were accompanied by express preservations of all privileges.

One New York judge has extended the attorney-client privilege to public relations firms. In In re Grand Jury Subpoenas dated March 24, 2003/265 F. Supp. 2d 321 (S.D.N.Y. 2003), the attorney-client privilege was extended to communications between a prospective criminal defendant, her lawyers and a public relations firm hired by the lawyers to help the client avoid criminal indictment. Because the communication was advice directed at the handling of the client’s legal problems, the Court held that it was privileged. On the other hand, however, another court in Calvin Klein Trademark Trust v. Wachner, 198 F.R.D. 53 (S.D.N.Y. 2000), declined to extend the privilege to public relations consultants where, inter alia, the firm had a relationship that started before the litigation and it provided "ordinary public relations advice," unlike the advice at issue in In re Grand Jury Subpoenas.

Another Southern District of New York judge recently held that a "Wells submission" to the SEC is not entitled to protection as privileged. See In re Initial Public Offering Securities Litigation, 2004 WL 60290 (Jan. 12, 2004 S.D.N.Y.). The court rejected the defendants’ argument that Wells submissions were intrinsically settlement materials because they were typically submitted for various reasons to the Securities and Exchange Commission, only one of which was potentially settlement.

Section 307 of the Sarbanes-Oxley Act ordered the SEC to establish minimum standards of conduct for attorneys who appear before it. After much debate, the SEC issued rules, entitled "Standards of Professional Conduct for Attorneys," which became effective on August 5, 2003. (The SEC, however, declined to frame a final rule about an attorney's responsibility to report wrongdoing to outside authorities if the matter was not resolved within the company. Such a regulation is still under consideration.) Under these rules, attorneys representing public companies have specific reporting duties upon discovering evidence of corporate fraud. The rules are quite convoluted, but the following is a summary of essential points.

Upon becoming "aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer," the attorney must report such evidence to the company’s chief legal officer and in some occasions also to the CEO. 17 C.F.R. 205.3 (b)(1). Thereafter, the chief legal officer shall "cause such inquiry into the evidence of a material violation as he or she reasonably believes is appropriate to determine whether the material violation described in the report has occurred, is ongoing, or is about to occur." Id. 205.3(b)(2). If the conduct is ongoing or about to occur, the chief legal officer "must take all reasonable steps to cause the issuer to take a reasonable response, and shall advise the reporting attorney thereof." Id. Unless the reporting attorney believes that the chief legal officer or CEO provided an appropriate response in a reasonable time, he or she must report the evidence of a material violation to the board of directors. Id. 205.3(b)(3).

Unfortunately, the rule definitions pose a number of interpretative challenges. The regulations provide an expansive definition for a "material violation." Specifically, a material violation is defined as a "material violation of an applicable United States federal or state securities law, a material breach of fiduciary duty arising under United States federal or state law, or a similar material violation of any United States federal or state law." 17 C.F.R. §205.2(i). Meanwhile, "evidence of a material violation" means credible evidence based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur. 17 C.F.R. §205.2(c)

Outside counsel "may reveal to the Commission, without the issuer’s consent, confidential information related to the representation to the extent the attorney reasonably believes necessary:" (i) to prevent the commission of a "material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors;" (ii) to prevent the issuer from committing perjury or a fraud on the Commission; and (iii) "to rectify the consequences of a material violation by the issuer that cause, or may cause, substantial injury to the financial interest or property of the issuer or investors in furtherance of which the attorney’s services were used." Id. 205.3(d).

Recently, at least one example of a law firm resignation has become public when Akin Gump resigned as outside counsel for a Mexican company, TV Azteca. In December 2003, the NY Times published the substance of a letter from Akin Gump to TV Azteca’s board of directors regarding the disclosure of a selfdealing arrangement involving the company’s chairman and controlling shareholder worth $100 million. Unhappy with TV Azteca’s unwillingness to disclose the deal "pursuant to U.S. securities law," Akin Gump resigned. In its letter to the board of directors, Akin Gump stated that it reserved the right to inform the SEC of its withdrawal and the reasons for it.

• In response to the SEC's rules regarding an attorney's ethical responsibilities to report wrongdoing in public companies, the ABA last August made important revisions to its Model Rules concerning the disclosure of client confidences. These alterations are a significant departure from the ABA’s past positions on the privilege, although the ABA itself has merely characterized it as the extension of the existing crime fraud exception.

• Under ABA Model Rule 1.6, Sections (b)(2) and (3) an attorney is authorized to disclose privileged information when counsel reasonably believes that such action is needed: "to prevent the client from committing a crime or fraud that is reasonably certain to result in substantial injury to the financial interests or property of another and in furtherance of which the client has used or is using the lawyer’s services;" and "to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or has resulted from the client’s commission or a crime or fraud in furtherance of which the client has used the lawyer’s services." Furthermore, Comment 8 to Model Rule 1.6 states that the Rule permits a lawyer to disclose confidential information to enable affected persons "to attempt to recoup their losses."

• ABA Model Rule 1.13 has also been modified to require counsel for an organization to report offenses to higher authority within the organization, unless the lawyer reasonably believed it was not necessary in light of the organization’s best interests. If, after making this report, no appropriate action is taken, Model Rule 1.13 states that the lawyer "may reveal" this information, but "only if and to the extent the lawyer reasonably believes necessary to prevent substantial injury to the organization."

While these new Model Rules are only guidelines, they may cause many states to reevaluate their rules on attorney disclosure of confidential information.

In the wake of international terrorist threats and increased vigilance of anti-money laundering efforts in the international community, some international organizations and countries have adopted "Gatekeeper Initiatives" to combat financial fraud. Gatekeeper initiatives typically require professionals, including attorneys, who have become suspicious that their client has engaged in money laundering, to report these concerns to government authorities. Attorneys are then prohibited from telling clients that they have made this report. The Financial Action Task Force ("FATF"), which sets international standards for anti-money laundering efforts, has been a prime mover in this field. The United States has been pressed to adopt such initiatives and it is currently considering them. The American Bar Association and other domestic groups strongly oppose the adoption of a Gatekeeper Initiative so it is thought unlikely that one will be adopted in the near future. Nevertheless, this international movement may continue to place increased pressure on the confidentiality of the attorney-client relationship, particularly with respect to multi-national companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.