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special to the national law journal Timothy E. Hoeffner is a partner, and Susan M. Rabii is an associate, at Philadelphia’s Saul Ewing. While internal investigators of alleged corporate wrongdoing are routinely scrutinized by parties seeking to challenge the findings of an investigation, the spotlight has never been brighter than it is today. As corporate fraud continues to make headlines, internal investigators are subjected to unprecedented attention in the press, from the government and in litigation and bankruptcy court proceedings. The benefits of an investigation to a corporation and its board of directors are diminished and can even be destroyed if the integrity of the investigation is successfully attacked. The recent investigations of financial reporting at Enron Corp. and Global Crossing Ltd. highlight issues that may undercut the integrity of an internal investigation. Although the negative publicity received by the well-respected law firms that conducted these investigations is unfortunate, the criticism of the investigations offers valuable lessons to corporations that may conduct future investigations. The adequacy of the internal investigation conducted by Vinson & Elkins into alleged accounting fraud at Enron has been the subject of extraordinary attention in the media, lengthy congressional hearings and, now, a multibillion-dollar shareholder class action. Following the commencement of Chapter 11 proceedings by Enron, a special committee of Enron’s board of directors was commissioned to investigate Enron’s related-party transactions. The results of this investigation are set forth in what is known as the Powers Report, which discusses the Vinson & Elkins investigation. See Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. by Wilmer, Cutler & Pickering, dated Feb. 1, 2002. The Vinson & Elkins investigation at Enron was initiated after whistleblower Sherron Watkins sent her now-famous letter to Enron CEO Kenneth Lay, warning about Enron’s “aggressive” accounting strategies and concluding, “I am incredibly nervous that we will implode in a wave of accounting scandals.” Lay brought the letter to the attention of Enron’s general counsel, James V. Derrick Jr., and the two agreed that an outside law firm should investigate the allegations. The law firm selected was Vinson & Elkins, Enron’s long-standing outside counsel. Enron was Vinson & Elkins’ largest client, reputedly accounting for more than 7% of the firm’s revenues, and several Vinson & Elkins attorneys had left the firm over the years to work in Enron’s in-house legal department. See complaint filed in In re Enron Corp. Sec., Derivative & ERISA Litig., MDL No. 1446, No. H-01-3624 (S.D. Texas) at ¶¶ 800-801. Significantly, Watkins cautioned Lay against using Vinson & Elkins to conduct the investigation, warning that Enron “[c]an’t use V&E due to conflict . . . they provided some ‘true sale’ opinions on some of the deals.” See In re Enron complaint at ¶ 800; In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 657-58 (S.D. Texas 2002). According to the Powers Report, Lay and Derrick recognized the potential risk inherent in retaining the firm that assisted in creating and documenting certain transactions to investigate the propriety of those same transactions, but apparently concluded that the risk was outweighed by the benefit of retaining a firm familiar with the company. Vinson & Elkins was to conduct a preliminary investigation only, and, if warranted by the findings, Enron would then hire another firm to conduct a complete investigation. The Powers Report reflects that Vinson & Elkins accepted the representation, and agreed, at Enron’s request, that its preliminary investigation would not involve questioning Arthur Andersen’s accounting advice, or conducting a comprehensive review of the transactions at issue. During a one-month period, the attorneys reviewed selected documents and conducted interviews of several senior-level officers from Enron, Watkins, two Andersen partners, Enron’s in-house counsel and the attorneys at Vinson & Elkins who had worked on the relevant transactions. Vinson & Elkins then issued a report concluding that “the facts revealed in its preliminary investigation did not warrant a further widespread investigation by independent counsel or auditors,” but noting that “the bad cosmetics [of certain transactions] . . . created a serious risk of adverse publicity and litigation.” Powers Report at 173-76. Destined to fail The Powers Report concluded that Vinson & Elkins’ investigation was almost destined to fail because of the “scope and nature of the investigation and the process employed,” and that absent a comprehensive analysis of the relevant transactions and consultation with accounting experts, uncovering the problems in the transactions would be difficult. The report pointed out that Vinson & Elkins only interviewed the most senior people at Enron, many of whom had “substantial professional and personal stakes in the matters under review,” and concluded that “the scope and process of the investigation appear to have been structured with less skepticism than was needed to see through these particularly complex transactions.” Id. at 176-77. In upholding claims against Vinson & Elkins for primary liability pursuant to § 10(b) of the Securities Exchange Act of 1934, the district court in the Enron shareholder class action found, in part, that the “purported ‘whitewash’ investigation and report” by Vinson & Elkins could serve as the basis of a § 10(b) claim. 235 F. Supp. 2d at 705. The court commented on the potential “serious conflict of interest” raised by Vinson & Elkins’ undertaking of this investigation not only because Enron was the firm’s largest client, but because of the firm’s “extensive involvement” with the allegedly fraudulent transactions. Id. at 668 n.103. As a result, the firm is now a defendant in a complex litigation seeking billions of dollars of damages. A recent report by Coudert Brothers as part of its independent investigation of accounting issues at Global Crossing criticized another top-tier law firm, Simpson Thacher & Bartlett, for the adequacy of an internal investigation the firm had conducted in response to questions about certain accounting practices. The internal investigation was also triggered by an employee whistleblower complaint. Global Crossing’s acting general counsel, also an active Simpson Thacher partner, responded to the complaint by retaining the company’s primary outside counsel, Simpson Thacher, to conduct the investigation. See Coudert Brothers’ Feb. 18, 2003, letter to the board of directors of Global Crossing Ltd., summarizing Coudert’s representation of the Special Committee on Accounting Matters, at 3-4. The inquiry consisted of one interview with Global Crossing’s chief accounting officer, who was the whistleblower’s boss. Simpson Thacher did not interview the whistleblower himself or any other officers or employees, nor did it review any documents or advise Global Crossing’s outside auditors of the allegations made in the whistleblower’s letter. Coudert agreed with the conclusion reached by Simpson Thacher that the transactions identified by the whistleblower as improper were in fact legitimate. Yet Coudert found that the “manner in which the investigation was conducted suggested that . . . ST&B breached [its] professional obligations to the company.” Id. at 3-4. In response to the report, Simpson Thacher stated that it advised the company to disclose the whistleblower’s letter to the company’s outside auditors. See statement by Simpson Thacher in Legal Times, March 17, 2003, at 17. Coudert was particularly critical of the general counsel’s oversight of the investigation, finding that he failed to meet his obligation to “ensure that the allegations were properly addressed.” Coudert’s report concluded that the general counsel’s simultaneous service as Global Crossing’s acting general counsel and as a Simpson Thacher partner “compromised the Company’s relationship with ST&B; led to misunderstandings; and ultimately gave rise to a conflict of interest upon the failure of ST&B to adequately investigate [the whistleblower's] allegations.” Once the conflict was obvious, the report stated, Simpson Thacher either should not have continued its representation with respect to the internal investigation, or should have obtained Global Crossing’s consent to the continued representation after full disclosure of the conflict. Finally, Coudert blamed Simpson Thacher’s failure to provide Arthur Andersen either the whistleblower letter or a report documenting the conclusions of its investigation for Andersen’s suspension of Global Crossing’s 2001 audit. Coudert concluded by stating that Global Crossing’s inability to obtain audited financial statements “subjected it to otherwise avoidable costs, losses, regulatory burdens, and reputational damage” which could have been avoided “but for ST&B’s . . . failure to manage the Company’s response to [the whistleblower's] allegations in a timely, transparent, and appropriate manner.” See letter at 4-5. Lessons learned The criticism unleashed in the Enron and Global Crossing cases can offer important guidance regarding issues to be considered to protect the results of an internal investigation from attack. The first issue that should be considered is when a duty to investigate an issue arises. Although there is no hard and fast rule, the Securities and Exchange Commission in 1992 provided guidance in a report of investigation issued pursuant to § 21(a) of the Securities and Exchange Act of 1934 in connection with an administrative proceeding against three officers of Salomon Brothers for failure to supervise under § 15(b) of the Exchange Act. See In re Gutfreund, Securities Exchange Act Release No. 34-31554, 51 S.E.C. 93, at 15 -16 (Dec. 13, 1992). A company should act promptly to investigate when “red flags” or “suggestions” of misconduct arise. To that end, management should establish clear policies and procedures to facilitate reporting of indications of misconduct or irregularities, as well as directives for the immediate commencement of an internal investigation when an allegation or suggestion of misconduct first surfaces. The more difficult issue raised is the extent of the investigation required. Since a comprehensive internal investigation can be costly and disruptive, a company will often conduct a preliminary review consisting of only a few interviews and a review of selected documents to determine if a full-scale investigation is merited. In light of the Enron and Global Crossing investigations, however, many companies and their investigators have expanded the scope of this preliminary review. A more in-depth preliminary review may be particularly advisable if the alleged misconduct relates to financial reporting and accounting issues. The investigators should consult with accountants and other independent experts when needed, even during the preliminary stages of an investigation. Finally, the investigator should speak to a whistleblower, or document the reasons why this is not possible, even in the context of performing a preliminary review. The next critical decision is to choose the right individual(s) to conduct the investigation. Generally, inside counsel or even internal auditors may investigate corporate misconduct, although it may be beneficial to have outside counsel available for consultation. But if the conduct of inside counsel or senior management is at issue, it is prudent to retain outside counsel to preserve the independence of the investigation. Similarly, if the conduct to be investigated is the subject of a parallel government inquiry, engaging independent outside counsel to conduct the investigation may help establish credibility with the government. Above all, consideration should be given to whether outside counsel had any involvement in the transactions or conduct to be investigated. After selecting the appropriate investigator, it is equally important to determine to whom the investigator should report. If the conduct of lower-level personnel or issues of a lesser magnitude are involved, it is generally sufficient for the results of an investigation to be reported to the appropriate representative of the in-house legal staff or internal audit department. When, however, the investigation involves the conduct of senior management or in-house counsel, the report should be made to a committee of independent board members. Maintaining the integrity of the investigation, by eliminating any suggestion that the investigator sought to protect a person within the company, is of paramount importance. If the investigation involves a whistleblower, a report should be made in accordance with the internal procedures that public companies are now required to implement pursuant to the Sarbanes-Oxley Act. See § 301(4) of the act. An important lesson to be learned from Enron and Global Crossing is that the individual conducting an internal investigation should assume that his or her conduct will be scrutinized by numerous skeptical, inquiring and potentially adverse parties-including the government, the media, a court-appointed examiner, shareholders’ counsel and creditors’ counsel. Thus, it is imperative that the company and the investigators take adequate precautions to preserve the integrity of the investigation. If adequate steps are taken to ensure that the investigation is perceived as independent, timely and thorough, the company, as well as the investigators, will be far less susceptible to criticism, and the goals of the investigation are more likely to be achieved.

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