Helping Clients Defend Against SEC Actions
Finding the "right" lawyer changes with the context.
Where a company’s audit committee wishes to conduct an investigation into potential violations (this may happen before any government investigation starts), they should probably not use a law firm that regularly does work for the company. There are a few, related reasons for this.
First, any such investigation should be independent in order to be credible. It’s not independent if the firm conducting the investigation has other ongoing work for the company or frequently does work for the company and expects to continue doing work for the company.
Second, it may represent an actual conflict of interest for the law firm if issues the company consulted with the firm on in earlier periods become (or should become) subjects of the investigation.
Third, after the investigation concludes, the audit committee or the company may wish to present the results of the investigation to government regulators such as the SEC or DOJ; if the law firm that conducted the investigation is found to have a prior or ongoing relationship with the company, the government may worry that the investigation “pulled punches” as to the issues it covered or the involvement of company officers or directors in a position to award legal work to the firm.
Fourth, the audit committee and the Board have duties to the shareholders to ensure that any members of company management that were involved in directing or allowing violations to take place are properly dealt with, which might be more difficult to ascertain if the lawyer or firm making recommendations about company managers has had extensive, friendly relationships with the individuals being evaluated.
Finally, and we’ve seen this principle violated in the past with not-so-great results, the law firm that represents the company in the government investigation should not be the same firm that conducted the investigation. This is because the law firm would be put in the position of urging the government to rely on the firm’s own work (the “independent” investigation that the same firm just completed) at a time when the firm is charged with defending the company’s interests. This puts the law firm in the position of vouching for the integrity of its own investigation at a time when the government knows that the firm’s actual job is to minimize liability and protect the company’s interests—which could (and probably should) cause the government to question the impartiality and reliability of the investigation the law firm (and company) wants the government to take seriously.
When it comes to representing the company’s interests in an SEC or DOJ investigation, it may be entirely appropriate that the lawyer or law firm that has previously represented the company in other contexts also defend the company’s interests in what may be a protracted, years-long investigative process with potential litigation at the end.
Choosing a law firm that has done work for the company, is familiar with the business model, and has developed a solid rapport with the business executives and in-house counsel is often a very good idea and can cut down on the costs associated with bringing in lawyers who know nothing of the company or its industry. This must always be subject, however, to making sure that the law firm has the necessary expertise with the relevant agencies. It seldom makes sense to use the lawyer who regularly assists the company in its FDA labeling and advertising issues in an SEC enforcement investigation into whether the company’s financial statements were intentionally misstated. If the FDA lawyer doesn’t have colleagues at the firm with the SEC or DOJ backgrounds necessary to handle such an investigation, the company needs to find a new firm that does have such expertise; this is no time for on-the-job learning.
If a different law firm has completed an independent investigation, the law firm charged with the company’s defense will want to point to the findings and recommendations of the internal investigation and persuade the government that the company has figured out what went wrong, taken appropriate remedial action in reliance on the investigation conducted by an independent firm, and should therefore not be excessively penalized for problems that have already been exposed, investigated, and properly addressed.
Most companies of any size will have considered purchasing a D&O insurance policy and most corporate insurers will suggest such a policy as a prudent investment. As discussed further below, most corporate by-laws require the company to indemnify and advance to its directors and officers legal costs incurred in a lawsuit or investigation related to their service as corporate board members or executives. A D&O policy is one way for the company to offset or mitigate its liability for the costs of defense of these individuals if and when a lawsuit is filed or an investigation commenced.
General Counsel and those responsible with dealing with the company’s risks should consider retaining counsel with expertise in coverage issues in evaluating D&O policies and should also make sure the insurance company has the necessary depth and experience in D&O coverage to adequately address the company’s needs. In our experience, this is not an area in which it pays to have taken out “bare bones” coverage.
The costs of defending against a securities class action lawsuit or a government investigation into potential securities fraud at the company escalate very quickly. Adequate coverage can save tens of millions of dollars in the long run.
As with most insurance, a company with a D&O policy must pay careful attention to its notice obligations under the policy. Insurance companies are very happy to take premiums in on the front end, but each and every excuse to delay payment or to invoke an exclusion can and will be exercised. Accordingly, at the first indication of a potential issue where D&O coverage may be needed (for example, a subpoena received from a government agency), the company must notify its insurance carrier in accordance with the policy’s requirements.
One fraught area can be the decision whether and when to secure separate counsel for individual company employees. Separate counsel is required when the company’s and the individual’s interests materially diverge and the firm representing the company cannot ethically represent the employee as well. Sometimes this is apparent right away and at other times this only becomes apparent later during the course of an investigation. In either event, the lawyer that ends up representing an employee (or, sometimes, a group of employees) must be as qualified and well-versed in the relevant legal issues and have experience with investigations of the same type, or there could be serious missteps, to the detriment of both the individual employee and the company. No one is well-served if the lawyer taking on the representation is not qualified to do it.
Many company executives hesitate to retain their own, separate counsel, whether concerned about expensive legal fees and costs or worried that having their own lawyer will make it appear to either their employer or the government that they “have something to hide” or aren’t a “team player.” Generally speaking, such concerns are usually misplaced.
First, the government is never surprised when an individual is represented by counsel and, in our experience in government as well as private practice, no conclusions are ever drawn on the basis that an individual has retained a lawyer.
Second, a good lawyer will make it his or her business to communicate early and often with counsel for the company to ensure that the employee’s position is clear, that cooperation with the company is facilitated where appropriate, and that the employee’s personal interests are not forgotten in the midst of the company’s strategy to address and get beyond whatever issue prompted the government investigation to begin with.
Finally, with respect to fees and costs, most companies’ corporate by-laws (or an LLC’s operating agreement) require the company to indemnify and advance costs and fees incurred by an officer of the corporation in connection with an investigation and/or litigation related to the officer’s job responsibilities for the company. Moreover, even an employee who is not an officer often may have such fees and costs indemnified and advanced by the company on a discretionary basis. In either case, the lawyer an employee speaks with should be able to determine the company’s indemnification obligations at the outset and gain clarity from the company early on in the representation.
Below are some specific issues we’ve considered from the unique points of view of certain categories of employees we have represented in the past.
Chief Executive Officer
A company’s CEO, who in some instances may also be Chair of the company’s Board of Directors, is in a unique position because, almost by definition, what he or she says or does is attributable to the company under the doctrine of respondeat superior. Often, this means that defending the CEO’s interests may almost be identical to defending the company’s interests, at least for past statements and conduct.
However, at times, the Board or the Board committee that orders an independent investigation may take the view that there was misconduct on the part of the CEO (and/or other executives) and will take the step of firing the CEO in order to put distance between the company (on a going forward basis) and the CEO and to underline the fact that the company has “cleaned house” by terminating those responsible for prior bad actions. This admittedly drastic action has the benefit (to the company) of providing government investigators with a ready target for the purpose of assigning liability. Not inconsequentially from a Board’s point of view, this also may signal to the government that the Board was not aware of what was going on and, having asserted control over the situation, the Board will take steps to avoid repetition.
From the point of view of a CEO, the above scenario is less than optimal . . . and generally not what the CEO signed up for. Most CEOs do not go into that role believing that such an outcome is likely or even possible. But when things go badly wrong, a scenario such as the above happens more frequently than one might think. Because the CEO should have the benefit of independent advice, it is never a bad idea to retain separate counsel at an early stage of any investigation which might involve the company’s senior-most executive. Even if there is no need for counsel to interact with the government and the CEO is never in real danger of termination, it is prudent to have counsel with whom the CEO can consult to ensure that his or her interests continue to align with the company’s and to permit active cooperation with the investigation. Sometimes referred to as “shadow counsel,” this may be particularly appropriate if the company learns that there may be criminal interest (that is, the Department of Justice begins conducting an investigation, with or without the involvement of a grand jury).
Almost universally, legal fees and costs of representation will be subject to a right to indemnification and advancement for a CEO (along with other company officers or directors). In addition, it is very likely that D&O insurance coverage will be available as well—in either event, the company’s D&O insurance carrier should be alerted at the first sign of a government investigation.
Chief Financial Officer
In any investigation that involves potential errors or misstatements in a company’s financial statements filed with a company’s periodic reports to the SEC, the CFO’s role will be a critical area for review, both in the internal investigation and certainly in any investigation by the SEC or Department of Justice.
The CFO (like the CEO) attests each quarter that the company’s financial information included with its periodic reports to the SEC do not contain any material misstatements or omissions, fairly represent the company’s financial condition and results of operations, and the company’s internal controls are properly designed and effective to inform the CFO (and CEO) if there are any material issues with the company’s financial information. Unlike the CEO, however, the CFO usually is the direct supervisor of the company personnel responsible for preparing and finalizing the financial statements. As such, he or she is in a unique position to oversee the financial statements, a position which often places the CFO squarely in the crosshairs of an SEC or government investigation into potential financial fraud.
An SEC financial fraud investigation often begins with a restatement of a company’s financial statements. When a company initiates such a restatement, it is at least an acknowledgment that the original financial statements were misstated (contained an “error”) by a material amount. The objective of the investigation is usually at least in part to determine whether the misstatement was deliberate or accidental (by definition, the correction of a prior period financial statement by a restatement is “material” to the company’s financial statements). In the case of a restatement, the investigation generally attempts to determine who or what caused the misstatement, who knew of the relevant facts at the time, and what was their state of mind—was the misstatement a result of negligence, recklessness, or was it intentional or willful? In the case of simple negligence, there is no securities fraud, but where the misstatement was at least reckless, this would constitute securities fraud and subject those responsible to civil liability, whereas a knowing, intentional violation may also be prosecuted criminally in addition to civilly. The main difference between civil and criminal liability, of course, is that the former is mainly about monetary damages and injunctions whereas a criminal conviction can include stiff periods of imprisonment.
Even where no restatement occurs, a company insider may report his or her suspicions that the financial statements are materially wrong based on misconduct by executives at the company (we discuss different options for how such issues can surface and get handled [here]). In such cases, the CFO will also be a prime candidate as a subject of investigation due to the central role he or she plays in assembling and overseeing the company’s financial reporting.
In any investigation of a company’s financial statements, the CFO should consider retaining independent counsel to provide advice and assist the CFO with considering options at each stage of the investigation. As in the case of the CEO, when things go terribly wrong, it is often expeditious for a company’s Board to terminate the CFO and move forward with a new person in that role (preferably someone from outside the company who had no involvement in whatever precipitated the investigation). When this happens, a CFO needs a good lawyer to navigate what comes next and, for this reason, the earlier a lawyer is retained, the better.
Almost universally, legal fees and costs of representation will be subject to a right to indemnification and advancement for a CFO (along with other company officers or directors). In addition, it is very likely that D&O insurance coverage will be available as well—in either event, the company’s D&O insurance carrier should be alerted at the first sign of a government investigation.
Other Executives and Employees
What about other "C-suite" executives and other employees? Any “officer” of a corporation is likely to enjoy a right to retain their own attorney and to be indemnified for such expenses and, usually and under most modern corporate by-laws, to receive, in advance of indemnification, payment of legal fees and costs within a reasonable period of time from when incurred. “Indemnification” means the corporation is ultimately liable for the fees and expenses whereas “advancement” means the corporation must pay the fees and costs when incurred rather than waiting until the conclusion of the matter. In either event, the indemnification obligation is usually conditioned on the individual officer not ultimately being found to have engaged in criminal or fraudulent conduct. This determination is only made, however, after the conclusion of all investigations and litigation (which, in Delaware and most other states, is not until the exhaustion of the last appeal available to the officer).
Companies sometimes contest whether an executive is an “officer” of the company. Generally, in public companies, anyone with the title of vice president or higher will be viewed as an officer for purposes of the indemnification and advancement provisions of the by-laws. However, certain firms, like banks, throw around “vice president” titles to individuals who have no real role in the management of the bank. Delaware has, of late, indicated in such circumstances that even an employee with the title of vice president might not qualify to be considered an officer of the corporation. As with many things, these are fact-specific considerations and an attorney would need to look at the corporation’s by-laws, whether the employee exercises corporate responsibilities, how the corporation holds out that individual publicly, and other factors.
Finally, even if an employee is not an officer and therefore cannot require that the corporation indemnify and advance legal fees and costs, most corporations may do so anyway, either as specifically authorized in the by-laws or in using prudent business judgment, since an unrepresented employee may do or say things that are neither in that individual’s best interests or, more importantly from the company’s point of view, in the corporation’s best interests. Retaining counsel to save an employee from him or herself may help the company avoid liability or at least ensure that liability is not made unnecessarily worse.
Whether required to indemnify or not, a corporation should require any officer or employee whose legal fees and costs are going to be indemnified and/or advanced to first sign an undertaking that, should they ultimately be found to have engaged in a crime or fraud, they will repay the corporation for the amounts expended. As a practical matter, the decision about whether or not to recoup these expenses is made at the conclusion of the case and it is very rarely pursued, both because in the usual case someone who has been adjudicated as guilty will not have sufficient assets left to recoup these costs after paying restitution or other fines and penalties and because pursuing such a recovery might be just as expensive as the underlying costs the corporation is seeking to recoup; in either case, pursuing recovery is usually judged to be uneconomic (i.e., not worth the time and expense).