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In this post-Enron age of whistle-blowers and widespread panic over the prospect of receiving a phone call from Eliot Spitzer’s office, perhaps the most significant decision a general counsel will be forced to make is whether or not to launch an internal investigation in response to an allegation of corporate wrongdoing. Perhaps the second most important decision is whether or not to hire outside counsel to conduct the investigation. In considering whether or not to investigate, the general counsel must first understand that, in today’s corporate environment, the consequences of failing to investigate a credible allegation of misconduct are especially dire. For example, both the Securities and Exchange Commission and the Department of Justice now routinely expect to see a meaningful internal investigation by a company as they determine whether civil or criminal charges may be appropriate against that company. In its October 2001 Section 21(a) report in the Seaboard matter, the SEC explained that a prompt and thorough internal investigation is a key factor in assessing whether regulatory action against the company is appropriate. Similarly, Justice Department guidelines for prosecuting corporate entities issued in a January 2003 internal memorandum (known as the “Thompson Memo”) also stress the importance of an effective internal investigation in determining whether a company should face criminal charges. The Sarbanes-Oxley legislation provides further grounds for caution. Top corporate officers of public companies are now required under Sections 302 and 906 of Sarbanes-Oxley to certify that corporate financial statements are fairly presented, along with being subject to personal, civil and criminal liability. Finally, chief legal officers at reporting companies are now required under Section 307 of Sarbanes-Oxley to investigate evidence of material violations that are reported up to them by in-house or outside counsel. Obviously, in today’s environment a company’s general counsel would be foolish to simply turn a blind eye to a credible allegation of corporate misconduct, particularly if the allegation includes wrongdoing that is pervasive, not isolated and allegedly occurring at high levels within the company. In addition, an internal investigation would almost certainly be required if the general counsel learned that prosecutors or regulators had begun their own inquiry into the company’s affairs, and general counsel are now obligated to investigate certain allegations of wrongdoing reported up to them by other attorneys. Even so, and despite the reasons for extreme caution already mentioned, most companies simply cannot launch costly full-blown investigations into every single anonymous e-mail or letter of complaint, no matter how trivial. Judgment is required. An in-house attorney must, of course, make a judgment about the credibility of the specific complaint. The facts and circumstances will vary, but common sense dictates that, in general, the more detailed the complaint, the more credible the complaint — and the more attention it requires. In the Enron investigation, for example, the infamous and anonymous Sherron Watkins whistle-blower letter was credible not only because it contained the phrase “implode in a wave of accounting scandals” but also because it contained detailed information about a questionable accounting treatment for particular transactions. As a result, Enron’s general counsel made the determination to launch an investigation into the allegations contained in the letter. Unfortunately, because it’s not always clear whether anonymous letters are being written by in-the-know officials or only corporate malcontents, virtually all complaints must be taken seriously. After all, even malcontents and crackpots may be right from time to time. In today’s environment, the potential cost of dismissing out of hand all but the most outrageous complaints is just too high. However, the scope of the investigation actually undertaken will vary widely depending on the facts at hand. Some investigations may reasonably require only a small amount of investigating. Others will require much more. Having made the decision to investigate, the next question is who will actually do the investigating. Should the general counsel rely on in-house lawyers or hire outside counsel? If outside counsel is preferred, should the company use a law firm with whom it has an ongoing relationship or a firm that is more independent? These are difficult questions because they require the general counsel to consider budgetary restraints and priorities and to make some assessments about the potential merits of the alleged problem at a very early stage. While it is almost always safer, from a risk-avoidance perspective, to engage independent outside counsel, most legal departments do not have budgets that permit this course of action. There are no fixed rules when it comes to making the decision as to who will conduct an internal investigation. However, general counsel would be wise to consider three broad areas of inquiry in every case. First, is the alleged misconduct pervasive or isolated? Second, does the alleged misconduct involve relatively high-level or relatively low-level employees? Third, did the alleged misconduct have a material impact on the company’s financial performance? As a general rule, the more pervasive the conduct, the more material the conduct and the higher the level of employee involvement, the more desirable it is to engage independent outside counsel to conduct the investigation. Conversely, the more isolated, the more immaterial and the lower the level of relevant employees, the more appropriate it is for in-house counsel to run the investigation. And why is the choice of in-house or outside counsel so important in an internal investigation? The pivotal issue here is credibility. The investigation must have credibility with government investigators and prosecutors, shareholders and potential investors, banks and other lenders and the company’s board of directors. This point is largely intuitive — the methods and conclusions of an independent investigator are likely to be given more credence than of an investigator who is financially beholden to the company (or the people) that he or she is investigating. The need for credibility extends to all facets of an investigation, including methodology, strategic and tactical decision-making, collection and interpretation of evidence, conclusions and remedies. The government, the marketplace and the board of directors all want the investigation to be free of any influence or taint by the alleged wrongdoers. The SEC has stressed the importance of an independent internal investigation. In its Seaboard Report, the commission explained that its reasons for not taking regulatory action against the company itself included the fact that the company hired “an outside law firm to conduct a thorough inquiry.” The SEC wrote that it would consider the following questions in deciding whether to take action in future cases: “Did management, the board or committees consisting solely of outside directors oversee the review? Did company employees or outside persons perform the review? If outside persons, had they done other work for the company? Where the review was conducted by outside counsel, had management previously engaged such counsel? Were scope limitations placed on the review? If so, what were they?” In criminal matters, the decision of whether to hire outside counsel is equally important. A central question, both in the Justice Department’s determination of whether or not to bring criminal charges and in the district court’s imposition of a criminal sentence, is whether the corporation conducted an adequate and thorough investigation. A weak investigation that is designed to protect senior executives and that fails to root out wrongdoing can result in the indictment of the entity itself and a tougher sentence from a judge at the end of the case. Appearance is important in this area. If prosecutors and regulators believe that an internal investigation is weak or compromised, they will approach the company with an already jaundiced perspective and may be quick to ascribe bad motives to decisions regarding the investigation and conclusions made by in-house or regular outside counsel regardless of the merits of those decisions. Again, the Sherron Watkins example is instructive. After wisely deciding to conduct an investigation into the allegations outlined in Watkins’ letter, Enron’s general counsel retained outside counsel to conduct the investigation. However, the law firm that was brought in to undertake the so-called preliminary investigation had been involved in structuring many of the transactions that were being investigated. Not surprisingly, this internal investigation had little credibility with the government and contributed to the perception that the company had something to hide. Does this mean that an expensive internal investigation needs to be conducted by independent outside counsel in all cases? No. Experienced in-house lawyers are often able to conduct an effective internal investigation because of their greater initial familiarity with business operations and information technology. And they are less likely to interfere with the normal business operations of the company. Investigations into possible violations of employment law, internal corporate policies and self-dealing by relatively low-level personnel are all commonly and appropriately handled by in-house counsel. But in situations where there is a legitimate concern that the integrity of the investigation might be attacked, outside lawyers should lead the investigation. Five principal reasons come to mind for using outside counsel, particularly where alleged or suspected misconduct by employees is involved:

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