Investigations into rumors of misconduct are part and parcel of a compliance officer’s job. Seldom, however, is the task as delicate as when investigating a board member.
The nightmare scenario is this: that an issue is raised—either internally by a whistleblower, or worse, externally by a regulator—and the problem traces back to a board member suspected of bribery, insider trading, or financial fraud. The list of investigative duties then explodes, from overseeing the probe itself to assessing D&O insurance policies to understanding required disclosures, and more. Maybe you need to help create special board committees; maybe the audit firm is clamoring for detail. Absolutely you want to keep the media and the directors as far apart as possible.
Put simply, investigating directors is a mess.
“You do want to get to the bottom of things as quickly as you can to understand the facts,” said Richard Strassberg, a partner with the law firm Goodwin Proctor. He took part in a panel on the subject at the Association of Corporate Counsel’s annual meeting in Boston last week.
Foremost, compliance officers want to collect the evidence, but that means you must first ensure the evidence is actually there to collect. “You want to, right away, make sure there is document preservation,” he said. “Preserve the data and start the process to try to get to the bottom of it.”
Each company will have its systems and protocols for handling internal communications. One immediate response is to demand that even routine e-mail deletion is halted. “When the rumors start to flow that there is going to be an investigation, it is not OK to do spring cleaning,” Strassberg said.
“Whatever you think you know at the beginning, you don’t know,” warned Adam Frankel, general counsel for Evercore, an investment bank with 1,300 employees. “You need to think about making decisions knowing that the facts may end up completely different than you thought once it is all done.”
Something as serious as investigating a director almost always requires the use of outside counsel. That raises the question of which managers and employees can be trusted to work with outside counsel and what data can be presented to them.
“You need to think about making decisions knowing that the facts may end up completely different, once it is all done.”
Adam Frankel, General Counsel, Evercore
“Some decisions are made before we get that call,” Strassberg said. “One of the things that is very typical in these scenarios is that there is a lot of information where accuracy is not established. You get a lot of allegations, many of which may not have any substance. There is a lot of this information going around, and part of the problem you are trying to solve is establishing an action plan for substantiating it. There is a lot of contradictory information you will hear.”
Trust is closely tied to that quest for information. The director in question, if guilty, may not have acted alone. Whistleblowers (if there are any) may be acting out of personal animosity or some similar motive, rather than the company’s best interests. “Some whistleblowers are involved in the conduct they are reporting on,” said Mei Lin Kwan-Gett, deputy general counsel and head of global litigation for Citi.
“I’m not sure that right away I would expose everything I have to senior officers,” says Steven Reich, general counsel-Americas, Deutsche Bank. “It is a judgment call, and you have to base your judgment based on your assessment of the players involved.”
Think Global, Act Local
The more geographically spread a company is, the more difficult all phases of an investigation into a board member will be. Consider China, where corruption can be punishable by death; the government also has a tendency to declare records and communications as “state secrets,” scuttling any hoped-for cooperation.
It may be necessary to keep multiple regulators apprised of each other’s progress. “Worry about what your disclosure obligations are wherever you are globally,” Reich said. “I’d be worried about regulators around the globe. If the DoJ has a piece of this, do you have obligations to regulators in China, the United Kingdom, or elsewhere that you have to let them know? They are going to be mightily annoyed if six months or a year from now that you have been working with the Justice Department and didn’t tell them.”
An important concern, however, is that not every country respects the legal protections of attorney-client privilege. Reich says this is another area where local counsel can be very important.
Be Prepared for Unwanted Surprises
A company may suspect a problem with a director and decide to launch an internal investigation into the suspicions. Keeping things in-house, however, offers no assurances that word won’t leak out.
WHAT IS OLD IS NEW
The following, an excerpt from a May 2014 speech by SEC Chairman Mary Jo White, references Section 20(b) of the Exchange At. It allows for enforcement actions against parties involved in disseminating false or misleading information to investors. The rule could be applied to executives and board members who allow misconduct on their watch.
One new approach to charging individuals is to use Section 20(b) of the Exchange Act. Although this section dates back to the original Exchange Act of 1934, chances are you may not be very familiar with it because, frankly, it has not been a common charge. Before you start reaching for your smart phones to look it up, let me save you the trouble. Section 20(b) imposes primary liability on a person who, directly or indirectly, does anything “by means of any other person” that would be unlawful for that person to do on his or her own. This is analogous in the criminal context to 18 U.S.C. Section 2(b), which provides for criminal liability as a principal for anyone who “willfully causes an act to be done which if directly performed by him or another would be” a criminal violation.
We are focusing on Section 20(b) charges where – as is frequently the case in microcap and other frauds – individuals have engaged in unlawful activity but attempted to insulate themselves from liability by avoiding direct communication with the defrauded investors. It is potentially a very powerful tool that can reach those who have participated in disseminating false or misleading information to investors through offering materials, stock promotional materials, or earnings call transcripts, but who might not be liable under Rule 10b-5(b) following the Supreme Court’s decision in Janus because they may not be the “maker” of the statement.
Just as importantly, though, as with 18 U.S.C. Section 2(b), Exchange Act Section 20(b) is a form of primary liability, rather than secondary liability, which would require proof of a separate violation by someone other than the defendant. So, we can use Section 20(b) where aiding and abetting or controlling person theories may fall short because there is no underlying violation by someone else, such as, for example, when the other person who publicly makes the misleading statements lacks knowledge that they were misleading.
“It’s a terrible sinking feeling when the government knows more about your company than you do,” Kwan-Gett said. “It lights a whole new fire to any sense of urgency you already had. Now, you know the allegations are concrete enough for the Department of Justice or Securities and Exchange Commission to be involved.”
The nature of the investigation may change—probably immediately—once regulators pay interest. “Sometimes the problem isn’t just what you thought it was,” Reich said. “It isn’t just a bribery issue; you now also have revenue issues and not only need outside counsel, but also a forensic accounting firm and probably need to set up a special committee.”
What’s This All Going to Cost?
Management is likely aware that the matter at hand may be costly to resolve, but counsel should nevertheless be ready to defend those costs.
“One tail that is going to wag the dog is how is this going to be paid for,” Frankel said. “It is going to start getting very expensive, and pretty soon you are going to start to get asked by your CEO how is all of this going to be paid. Is the insurance going to cover it? That’s a key factor, and you need to be thinking about indemnification and insurance issues.”
What happens, however, if an investigation is ongoing when the D&O insurance provider requests a meeting with executives to prepare the next year’s coverage? Should a compliance officer involved in the probe go?
“The first reaction is not to go to that meeting because I can’t say anything,” said Carl Metzger, a partner with Goodwin Procter. “But the D&O insurance process ends up being critical to your company’s ability to have coverage for all these matters and anything else that might come out of the woodwork that could affect your bottom line. Just having you could actually go a long way to ensuring that the company has the coverage that it is going to desperately need.”
What can, or should, you tell D&O insurance carriers? “You are going to give very limited statements,” Metzger said, suggesting that your statements reflect only what has already been made public or disclosed in a Form 10-K or 10-Q. “You don’t really need to go much beyond that.”
If the director’s malfeasance creates revenue recognition problems, or the need for a financial restatement, expect a chilled relationship between senior management and auditors before, during, and after the investigation.
“If you had a reasonably good relationship with your auditors, it will be tarnished,” Frankel said. “They are going to view you the same way that, frankly, the regulators view you. Everything will take much longer and undergo much more scrutiny.”