Introduction
When serious corporate wrongdoing is suspected, the corporation's board of directors often assumes responsibility for investigating the matter. The board will first seek to determine whether the allegations are true and then what, if any, action is necessary to remediate any damage that has been done to the corporation and to prevent any further harm. The board should, however, have a much broader focus. The board should be concerned with preventing or minimizing the erosion of confidence of the corporation's investors and customers. It should also be mindful of regulatory action that could arise if the corporate wrongdoing rose to the level of being illegal. If the regulator has confidence in the board's process, it may be prepared to rely on the work of the board rather than conduct its own investigation. If it is satisfied that the board has remediated the problems and put the corporation on a path that promotes compliance, the regulator may even conclude that there is nothing to be gained from imposing sanctions on the corporation.
The way in which the board handles the investigation is critical. An investigative process that is poorly conceived and executed is not only unlikely to meet the objectives described above, it can itself do a great deal of damage to the corporation – and to the reputations of the directors involved in the investigation. This paper deals with the elements of an effective board-led investigation.
Recent Examples of Investigative Committees
In recent years, there have been a number of public examples of board investigations – both successful and unsuccessful. In this section, we describe several of these situations, in order to provide some context for the discussion of effective processes for investigative committees.2 We have also included a description of a recent investigation into wrongdoing at the RCMP, because of the important lessons we learned through our role in that investigation.3
(a) CP Ships
CP Ships' problems began in 2004, when it failed to disclose that financial statements for the two previous years and for 2004 would have to be restated. The situation escalated when allegations were made that company insiders traded in shares of CP Ships while in possession of other non-disclosed information.4
A special committee of the Board (the "CP Ships Committee") chaired by Peter Dey was established in 2004. The CP Ships Committee was charged with responsibility for investigating the circumstances surrounding the restatement of the financial statements of the Corporation for the years 2002, 2003 and the first quarter of 2004 and stock trading activities by certain officers in May and June 2004. The committee was also charged with overseeing the defence against class action law suits filed following the restatement and with liaising with regulators. The CP Ships Committee and the process it followed is credited with saving the corporation from any regulatory sanction beyond a warning with respect to its disclosure.
(b) Hewlett Packard
In 2006, Hewlett Packard faced regulatory scrutiny and adverse publicity when an independent investigator was hired to look into information leaks at the board level. The scenario began in 2004 when the board began to discuss the future of then CEO Carly Fiori. Those discussions leaked from the boardroom in early 2005. In an effort to determine where the leaks originated from, board chair Patricia Dunn hired a private investigator. The results of the investigation were presented to the board in May 2005, identifying one of the members of the board as being the source of the leak.
The controversy surrounding this investigation related not to the leak, but to the methods used by the private investigator to identify the source of the leads. The investigator used a technique referred to as "pre-texting" to obtain personal phone records of certain members of the board. Whether the practice of pre-texting was illegal at the time, a strong sense emerged that it was at least highly inappropriate. Hewlett Packard became mired in a number of civil and regulatory actions, including with the Attorney General of California, the Justice Department, the Securities and Exchange Commission and the Federal Communications Commission. Among other things, the resulting scandal led to the resignation of board chair Patricia Dunn
(c) Nereus Financial Inc.
In Ellins v. Coventree Inc.5 it had come to the attention of the CEO of Nereus Financial Inc. that its controlling shareholder might be in breach of the shareholder agreement that precluded that shareholder from engaging beyond a certain level in the area of business identified as belonging to Nereus. Of the seven members of the board, two were nominees of the controlling shareholder, one was nominated by the minority shareholders, one was the CEO and three were fully independent directors. Over the objections of the controlling shareholder and the CEO, the board resolved to establish an investigative committee (the "Nereus Committee") to review breaches of the Shareholder Agreement. The facts of the case made it inappropriate for the nominees of either shareholder group or the CEO to sit on the investigative committee. That committee was ultimately constituted with two of the three independent directors. The court accepted the recommendation of the Nereus Committee that the corporation proceed to litigation on the basis of failure of the controlling shareholder to comply with the shareholder agreement.
(d) Hollinger International
In 2003, one of Hollinger International's largest stockholders, Tweedy Brown Company, LLC, demanded that the board investigate over $70 million in non-competition payments to Conrad Black and other members of management in connection with the sale by Hollinger International of certain of its assets. Because the Tweedy Brown letter complained not only about the payments, but also about the role of the board in authorizing those payments, a new director, Gordon Paris, became a one-person committee formed to investigate Tweedy Brown's concerns. Raymond Seitz and Graham Savage were recruited to join the board a short time later and they were added to the committee.
The Hollinger Committee retained Richard Breeden as its counsel and ultimately made public a report that described management at Hollinger International as a "corporate kleptocracy". It concluded, among other things, that payments of over $30 million had been made by Hollinger International without appropriate approval. Following the release of its report, the Hollinger Committee negotiated with Lord Black both over how to deal with its findings and the conditions under which a strategic process would be undertaken by Hollinger International. The resulting "Restructuring Proposal" contemplated a number of actions to repay Hollinger International for the amounts that had been improperly paid out, to amend or terminate certain management arrangements between Hollinger International and entities controlled by Lord Black and to ensure board involvement in the strategic process.
The Restructuring Proposal began to unravel almost immediately – Lord Black reneged on his covenant to repay certain amounts he had received on account of non-competition payments. He also took a number of steps that undermined the restructuring process. These and other aspects of Lord Black's relationship with Hollinger International have resulted in a variety of civil, regulatory and criminal actions. At the time this paper was completed, Lord Black had been convicted by an Illinois court of various criminal counts relating to these matters and Hollinger International had filed for bankruptcy protection.
(e) Nortel
Nortel Networks Corp enjoyed tremendous product and capital markets success throughout the 1990s. As conditions in the technology sector began to weaken, problems with Nortel's accounting began to emerge. Despite optimistic forecasts by management throughout 2000 and 2001, Nortel was forced to implement a company-wide restructuring program that included firing two-thirds of its global work force. CEO John Roth stepped down in November 2001 and was succeeded in that position by the chief financial officer Frank Dunn. Mr. Dunn led a return-to-profitability bonus plan designed to encourage employees to meet established targets. This plan, combined with market conditions that were continuing to deteriorate, led to more accounting problems.6
In late July 2003, Nortel's auditor reported to the board that it had found problems with the use of accounting reserves. The board ordered an internal review, which ultimately led to a $948 million restatement later that year. In early 2004, the audit committee (the "Nortel Audit Committee") hired independent investigators to review Nortel's accounting. Mr. Dunn and a number of other finance executives were fired several months later.
The summary report of the Nortel Audit Committee's independent investigators was disclosed publicly. That report recommended a number of remedial measures, all of which were adopted by the Nortel Audit Committee. In May 2007, Nortel reached a settlement with the OSC. Under the terms of the settlement, Nortel agreed to pay $1 million in costs, but was not required to pay any penalty. The OSC said that a financial penalty would not act as a deterrent at this point in time and would penalize the company for the past conduct of former executives. The Settlement Agreement commented favourably on the work of the Nortel Audit Committee. On October 2007, Nortel reached a settlement with the SEC in which Nortel agreed, among other things, to pay $35 million civil penalty. In the settlement agreement, the SEC also commented favourably on Nortel's process in investigating the restatement issues and reporting to the regulators.
(f) Oracle
The facts in the Oracle decision7 arose from allegations that four officers and/or directors of Oracle had engaged in insider trading by selling some of their shares in Oracle prior to an unfavourable earnings announcement. The four individuals named were Michael J. Boskin (a director), Lawrence J. Ellison (Chairman and CEO), Jeffrey O. Henley (CFO and a director) and Donald L. Lucas (a director and Chairman of Oracle's Executive Committee).
Certain stockholders of Oracle initiated a derivative action.8 In order to satisfy the board's obligations with respect to the derivative action, two of the directors were asked to form a special committee (the "Oracle Committee") to consider whether Oracle should take action against the named insiders. The Oracle Special Committee concluded that the insiders did not have material non-public information at the time of the sales and took steps to terminate the derivative action.
The two members of the Oracle Committee were both professors at Stanford University. Each of the three directors accused of trading with inside information also had ties to Stanford University. One was another Stanford professor who had taught one of the members of the Oracle Committee as a Ph.D. candidate and served with that member of the Oracle Committee on a committee at Stanford. Another was a major fundraising contributor to Stanford for whom a conference facility at that university had been named. The third was Oracle's CEO, who had made significant donations to Stanford (both personally and through Oracle) and who was contemplating further major donations at the time the two members of the Special Committee joined the board.
Vice Chancellor Leo Strine Jr. of Delaware's Court of Chancery denied the motion of the Oracle Committee to dismiss derivative claims brought by Oracle stockholders on the basis that the Special Committee had failed to establish its independence:
In the absence of a finding that the SLC was independent, its subjective good faith and the reasonableness of its conclusions would not be sufficient to justify termination. Without confidence that the SLC was impartial, its findings do not provide the assurance our law requires for the dismissal of a derivative suit without a merits inquiry.9
(g) YBM Magnex10
YBM was a TSX listed company, with its head office in Newtown, Pennsylvania. In August 1996, YBM's board became aware of suspicions on the part of U.S. federal authorities that YBM was connected to an organized crime syndicate in Russia and that it had falsified its financial statements and customer lists to disguise the fact that it was not engaged in any legitimate business. YBM's board of directors struck a special committee to investigate these suspicions. By April 1997, the YBM Special Committee had concluded, among other things, that there was no evidence to tie senior management or any of YBM's original shareholders to any wrongdoing, although it recommended a number of changes to YBM's operations and controls. Later that year, YBM sold securities to the public without disclosing in the prospectus that YBM was under investigation or providing any information about the YBM Special Committee's mandate, the information it had received or its recommendations. Six months after YBM closed its public offering, U.S. authorities raided YBM's Newtown, Pennsylvania office and the Commission cease traded YBM's shares. In 1999, YBM pleaded guilty to conspiracy to commit fraud in the United States. In the context of the settlement of a civil action relating to these events, an Ontario court estimated that persons who acquired YBM shares in the 1997 offering lost more than $100 million and persons who had traded those shares in the secondary market lost more than $250 million.
The OSC decision11 into this matter was critical of many aspects of the composition and process of the YBM Special Committee. Among other things, the chair of the YBM Special Committee was barred from being a director or officer of a public company for five years.
(h) RCMP Investigation
In 2003, allegations of mismanagement of the RCMP pension plan came to the attention of senior management of the RCMP.12 While then Commissioner Zaccardelli initially dealt with the allegations appropriately by ordering an internal audit, the process ultimately broke down when he failed to respond fully and in a timely manner to findings of that audit. Several of the individuals who had brought the matter to the attention of senior management and continued to push for more complete action were punished for their role, as was one member of the RCMP who was involved in the investigation of the matter.
The RCMP is an agency of the Federal Ministry of Public Safety and Emergency Preparedness. The federal government appointed David Brown as the Independent Investigator into matters relating to the RCMP pension and insurance plans. The report of the Independent Investigator13 found that the response of RCMP management to the issues in the pension and insurance plans had been neither complete nor timely. The report went further, however, concluding that events investigated had revealed a governance structure and culture that needed an overhaul.
Shortly after the report was released, the chief financial officer (who had ultimately been responsible for the controls that had proven to be inadequate) resigned.14 The five individuals who were instrumental in pursuing the issues were recognized for their contribution. The federal government accepted all of the recommendations of the Independent Investigator, including the appointment of a task force to deal with the governance and cultural issues identified as a result of the investigation.15
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Footnotes
1. Carol Hansell is a senior partner with Davies Ward Phillips & Vineberg LLP practising corporate and securities law. David Brown is counsel to Davies Ward Phillips & Vineberg LLP and served as Chair of the Ontario Securities Commission for seven years. The authors acknowledge with thanks the assistance of Ron Podolny, summer student with Davies Ward Phillips & Vineberg LLP, in preparing this paper.
This paper is current to June 2007. It was first published by Thomson Carswell in Todd L. Archibald & Randall Scott Echlin, eds., Annual Review of Civil Litigation, 2007 (Toronto: Thomson/Carswell, 2007) 307. It was subsequently published by LexisNexis Canada Inc., in Canadian Governance Report, edited by Ramandeep K. Grewal & Andrew Gorssman, Copyright 2008.
2. The facts set out in this section were taken from the public record
3. David Brown was the Independent Investigator for the Minister of Public Safety and the President of the Treasury Board with a mandate to examine certain questions and make certain recommendations relating to the handling of reports of mismanagement or irregularities in the administration of the RCMP's pension and insurance plans. Carol Hansell acted as counsel to the Independent Investigator.
4. The OSC estimated that those insiders avoided losses of nearly $1.5 million through their trades.
5. (2007), 28 B.L.R. (4th) 292.
6. In its settlement agreement with the OSC, Nortel agreed that at various times in 2000, 2002 and 2003, the emphasis by former members of Nortel's senior corporate finance management on meeting revenue and/or earnings targets led to a culture within the finance organization of Nortel that condoned certain inappropriate accounting practices which did not comply with applicable GAAP and were contrary to the public interest.
7. In Re: Oracle Corp. Derivative Litigation 824 A.2d 917 (Del. Ch. 2003). The nature of the relief sought in this case is not relevant for the purposes of this paper. As described in the decision: "[t]he Oracle stockholders who file this action as derivative plaintiffs now seek to dismiss this action voluntarily, over the objections of Oracle's 'Special Litigation Committee', which has been empowered to investigate and decide whether to prosecute this action. By their dismissal motion, the moving derivative plaintiffs do not hope to terminate all litigation relating to the claims asserted in this action. Rather, the 'Delaware Derivative Plaintiffs' seek to dismiss only this case, leaving derivative actions involving the same subject matter pending in the state and federal courts of California."
8. When stockholders wish to commence a derivative action, they must first advise the board that they believe that an action should be commenced in the name of the corporation. The board then determines whether it believes that action is merited. If the board agrees with the plaintiff stockholders, the corporation launches the action. If the board does not agree, then the plaintiffs may pursue the matters in the name of the corporation themselves.
9. In Re: Oracle Corp. Derivative Litigation Consolidated C.A. No. 18751 Court of Chancery of Delaware, New Castle 824 A.2nd 917; 2003 Del. Ch. LEXIS 55. Submitted: May 28, 2003. Decided: June 13, 2003 at 92.
10. The facts of the YBM matter set out here are drawn from the OSC decision relating to YBM.
11. (2003), 26 O.S.C.B. 5285 [YBM].
12. Allegations subsequently emerged about mismanagement in the RCMP insurance plan.
13. Government of Canada, Office of the Independent Investigator into RCMP Pension and Insurance Matters, A Matter of Trust: Report of the Independent Investigator into Matters Relating to RCMP Pension and Insurance Plans. (Canada, 2007) [A Matter of Trust].
14. Guiliano Zaccardelli, the Commissioner of the RCMP during the relevant period, had resigned in December 2006 as a result of the testimony he had provided to a parliamentary committee in connection with the Arar affair.
15. David Brown was appointed to Chair the Task Force. The other members of the task force are Richard Drouin, Linda Black, Norman Inkster and Larry Murray. Carol Hansell is counsel to the task force.
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