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In a post-Sarbanes-Oxley world, general counsel increasingly juggle significant risks managing and evaluating claims related to accounting and audit committee issues. A host of new regulations and rules promulgated under the umbrella of the Sarbanes-Oxley Corporate Fraud and Accountability Act of 2002 — including rules the Public Company Accounting Oversight Board submitted and the U.S. Securities and Exchange Commission approved — require general counsel to identify correctly and address appropriately various compliance issues ushered in under these new provisions. A Dec. 6, 2004, article in The Wall Street Journal demonstrates that companies and auditing firms still are struggling to bring their business practices in line with the new auditor-independence rules. According to the article, the Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF) — a “longtime standard-bearer for the corporate-governance movement” — is undergoing a formal SEC inquiry for an alleged violation of auditor conflict-of-interest rules involving two of its trustees and its outside auditor, Ernst & Young. The allegations facing TIAA-CREF, in addition to the auditing troubles facing many other companies, highlight that even though Sarbanes-Oxley was enacted approximately two-and-a-half years ago, issuers and auditing firms still struggle to comply with provisions addressing auditor independence. One primary objective of Sarbanes-Oxley was to restore investor confidence in the objectivity and fairness of an auditor’s opinions by demanding more independence between auditors and the companies they audit. One facet of the new regulations was the alteration of independent audit committees (IACs). Before the Enron Corp. debacle, senior management traditionally oversaw outside auditing firms. Not anymore. Now, Sarbanes-Oxley vests IACs with the responsibility of hiring, monitoring and, where necessary, firing firms conducting audits of their respective companies. Sarbanes-Oxley provides that in the absence of an IAC, the issuer’s entire board of directors is charged with the same duties and responsibilities of the audit committee. The IAC also must establish clear procedures for the following: 1) addressing complaints received by the issuer regarding accounting irregularities; and 2) handling anonymous submissions by employees of the issuer concerns regarding questionable accounting or auditing issues. To assist IACs in their oversight duties, they must have the authority and funding to engage independent counsel or other necessary advisers. In the wake of Enron-related litigation, courts seem increasingly willing to tip the scale more in favor of plaintiffs seeking to impose liability on secondary participants in auditing irregularities. For example, in 2002′s In Re: Lernout & Hauspie, the U.S. District Court for the District of Massachusetts found that audit committee members could be held liable as “controlling persons” under 20(a) of the Securities and Exchange Act of 1934. Remarkably, Lernout involves allegations occurring before passage of Sarbanes-Oxley. As such, one can imagine that audit committee members granted an even greater degree of control under Sarbanes-Oxley) arguably are even more exposed to personal liability today. RULE COMPLIANCE If an IAC (or in the absence of an IAC, the board of directors) learns of evidence of a material violation, it must conduct an investigation into the matter. The general counsel’s office can do the investigation internally or, pursuant to Sarbanes-Oxley, the IAC can retain outside counsel and advisers to conduct the investigation and report their findings to the IAC. Then, the IAC must determine if any material violation has occurred, is occurring or likely will occur. If so, the IAC must adopt appropriate remedial measures to stop any material violations that are ongoing, or to prevent those that are likely to occur. The difficulty for general counsel stems from determining if, in fact, the company adequately implemented the appropriate remedial measures to address the material violation. General counsel must carefully evaluate how to proceed in light of the SEC’s new rules for attorney conduct under Part 205 to Title 17, Chapter II of the Federal Code of Regulations (Part 205). There is certainly no one-size-fits-all answer in these scenarios. The most important provisions of Part 205 require that any general counsel or outside counsel who become aware of material violations must report “up the ladder.” Part 205 also divides attorneys into two categories: “supervisory attorneys,” who must adhere to more onerous standards; and “subordinate attorneys,” who most often can fulfill their reporting obligations by reporting up to supervising attorneys. Significantly, general counsel and assistant general counsel are expressly designated as “supervisory” attorneys under Part 205.4 and, as such, must carefully ensure compliance with the full panoply of rules. Attempting to determine if the IAC has made an appropriate response to a report of accounting irregularities is an inherently ambiguous task for general counsel. First, a general counsel may elect to conduct his or her own internal investigation into the adequacy of the IAC’s response. An internal investigation by a general counsel would reflect at least some level of diligence in addressing the potential problem. However, one can certainly foresee a criticism of having a general counsel, entrusted with legal compliance within the issuer, conducting his or her own investigation to ensure compliance. Alternatively, the general counsel’s office could retain outside counsel to conduct the investigation and issue a report of its findings to the general counsel. Many commentators and practitioners increasingly recommend hiring outside independent counsel. A report by truly independent outside counsel may prove, in hindsight, to be invaluable in demonstrating a general counsel’s good-faith efforts to comply with Sarbanes-Oxley. Part 205.6(c) provides a “safe harbor” for an attorney who attempts to comply in good faith with its provisions. Furthermore, outsourcing the investigation should add an increased measure of credibility if compliance with Sarbanes-Oxley later comes under attack. The risks of noncompliance with the new auditor-independence rules and regulations cannot be overstated. General counsel who fail to comply face stiff civil fines and penalties, including losing the right to practice in SEC-regulated matters. In a world replete with daily reports about chief executive officers, chief financial officers, other corporate executives and auditing firms facing various allegations of securities fraud, general counsel must proactively seek out all areas of their companies’ audit structure that may give rise to liability — not only liability of the issuer-company, but also the possibility of personal liability. Mike Stenglein is a partner in Dewey Ballantine in Houston, where he represents clients in complex litigation involving all types of financial accounting issues and sophisticated damage models. Before attending law school, he was a certified public accountant with Coopers & Lybrand for five years.

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