Conducting Internal Investigations

In the current regulatory environment, companies are increasingly conducting internal investigations focused on potential wrongdoing. U.S. laws and law enforcement agencies increasingly expect that companies will police their own conduct and report potential misconduct to the appropriate federal law enforcement agency. Many federal and state agencies have adopted a formal disclosure protocol under which potential misconduct or unlawful activity can be reported. Additionally, the Department of Justice has adopted Federal Guidelines on the Prosecution of Corporations that specifically require consideration of "[the] corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate with the government’s investigation . . . ." State Attorney General Offices, including the New York Attorney General Office, likewise provide far more lenient treatment to companies that make voluntary disclosures of potential wrongdoing and voluntarily take remedial action. This regulatory landscape highlights the critical importance of the issues that we will be covering today relating to internal corporate investigations and government disclosure.

There is no standard definition of the term "internal investigation." For purposes of this seminar, we mean to include the full range of information-gathering activities that a company engages in upon learning of possible wrongdoing. In some instances, the internal investigation may appropriately be limited to a few interviews and the gathering and review of a limited number of documents. In other instances, the internal investigation will require a far-reaching and comprehensive search for documents, the review of vast quantities of documents and other records, and extensive interviews of large numbers of witnesses.

For the most part, this outline focuses on internal investigations conducted as a result of concerns that a company may have violated U.S. law. Similar issues (as well as certain important differences) are involved in internal investigations where the company is the potential victim of misconduct (e.g., theft of company assets) and we will touch upon those distinctions throughout the day.

What follows is a thumbnail discussion of seven steps for conducting internal investigations from the initial stages, to document collection, to corrective action and government disclosure.

I. Deciding Whether To Initiate An Internal Investigation

The initial issue to be considered upon uncovering potential wrongdoing is whether an internal investigation is warranted. If it appears that the government has already initiated an investigation or that one is probable, then the case for undertaking an internal investigation is likely to be compelling. When faced with a government investigation, it is almost always in the best interests of the company to gather information to enable the company to respond effectively to the government’s investigation.

There are several respects in which information gathered during an internal investigation can assist in forming an effective response to a government investigation. The internal investigation may uncover persuasive evidence from which the company can argue either that no violative conduct occurred or that the matter otherwise does not warrant prosecution. The results of the internal investigation can assist the company in deciding whether to attempt to settle the government investigation. The results of the internal investigation might assist the company in persuading the government to agree to a settlement that the company finds acceptable. Disclosing the results of the investigation can assist the company in persuading the government either that no government investigation is necessary or, more likely, that the government investigation need be far less extensive and disruptive than it might otherwise be. Evidence gathered in the internal investigation can also assist in preparing witness testimony. The internal investigation might uncover evidence that refreshes a witness’s recollection so that the witness recalls exculpatory events or appears more credible than might otherwise be the case. In addition, an internal investigation might enable the company to develop themes that are helpful to the company and that place the alleged misconduct in an appropriate context.

In the context of a possible criminal prosecution, the federal sentencing guidelines for corporations provide for an increase in criminal fines to be imposed on corporations in connection with criminal violations of federal law if senior corporate personnel "participated in, condoned, or [were] willfully ignorant of the offense" or if "tolerance of the offense by substantial authority personnel was pervasive throughout the corporation." Guidelines Manual §8C2.5. Conversely, the federal sentencing guidelines for corporations provide for a reduction in the criminal fine to be imposed on a corporation, under certain circumstances, if the criminal offense occurred despite "an effective program to prevent and detect violations of law." Id. There is a presumption that the program was not effective if senior management participated in, condoned, or were willfully ignorant of the offensive conduct. §8C2.5(f). In addition, certain government agencies have formally implemented programs that are designed to encourage companies voluntarily to disclose misconduct to the government before the government begins an investigation.

The fact that, upon uncovering red flags, a company promptly undertook an internal investigation and implemented appropriate remedial action can also assist a company in arguing against the imposition of civil penalties. See United States v. Phelps Dodge Industries, Inc., 589 F. Supp. 1340 (S.D.N.Y. 1984). In Phelps Dodge, in considering the civil penalty to be imposed on Phelps Dodge in connection with an alleged violation of an FTC cease and desist order, the district court considered the company’s failure to investigate indications of misconduct as one factor indicating the company’s bad faith. Id. at 1364.

The case for an internal investigation is also likely to be compelling if private litigation has been commenced or is probable. An internal investigation can greatly assist a company in mounting an effective response to a private action. For example, in response to an allegation of discrimination, a prompt and effective investigation followed by appropriate remedial action can assist the company in successfully asserting an affirmative defense pursuant to Burlington Industries, Inc. v. Ellerth, 524 U.S. 742 (1998) and Faragher v. City of Boca Raton, 524 US. 775 (1998). Similarly, the extent, if any, to which the company may be exposed to punitive damages in a private action may be affected by whether a company conducted a prompt and effective investigation in response to indications that an employee or agent may have engaged in misconduct. The Restatement of Torts provides that punitive damages may properly be awarded against a company for the misconduct of the company’s employee or agent if, among other things, the company "ratified or approved of the" misconduct. Restatement (Second) of Torts § 909 (1979). Failure to conduct a prompt and effective internal investigation may be treated as a ratification for this purpose. See Davis v. Merrill Lynch Pierce Fenner & Smith, Inc., 906 F.2d 1206, 1224 (8th Cir. 1990) (Merrill Lynch "may have ratified [an employee’s conduct] by failing to investigate the unusual increase in [trading] activity in [the account of an elderly widow]."). In addition, in determining the extent to which punitive damages are appropriate against a company, a trier of fact may consider whether company’s management responded appropriately to indications that an employee had acted inappropriately. Id. at 1225.

Determining whether to undertake an internal investigation is more difficult where the government has not yet initiated an investigation and where it appears improbable that the government will initiate an investigation or that a private action will be brought. Internal investigations can have a number of negative consequences to a company. They can be expensive and disruptive. They can distract the energy of management and create morale problems. They can uncover wrongful conduct that might otherwise never have become known. Moreover, the process of conducting an internal investigation can increase the likelihood that information regarding possible misconduct will reach the government and/or the press. Accordingly, in the absence of a government investigation or the threat of a lawsuit, management might hesitate to authorize an internal investigation.

There are a number of reasons why management nevertheless often authorizes internal investigations even when it does not appear that the government has initiated an internal investigation or is likely to do so. First, the willingness and capacity to conduct internal investigations in response to red flags is an important component of an effective compliance program. Company personnel are likely to take a company’s procedures and policies less seriously if they learn that the company does not pursue indications of wrongdoing. For example, if employees observe both that company personnel routinely make improper payments to foreign officials in order to secure business for the company and that senior management appears indifferent to these payments, employees will be more likely to ignore company policies prohibiting such payments.

Second, senior management has an obligation to take steps when confronted with indications of wrongful conduct. Recent case law indicates that members of the board of directors might be personally liable for fines, penalties and losses incurred by a company as a result of unlawful conduct by the company or its employees unless the directors have "assur[ed] themselves that information and reporting systems exist in the corporation that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation’s compliance with the law and its business performance . . . ." In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959, 967 (Del. Ch. 1996). In Caremark, the court opined that, under Delaware law, a director "has a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards." Id. at 970. See also McCall v. Scott, 2001 WL 118037 (6th Cir. Feb. 13, 2001). In addition, underwriters often require companies to maintain a compliance program as a condition to the issuance of an insurance policy covering officers’ and directors’ liability.

In bringing an enforcement action against senior officials of a major securities dealer, Salomon Brothers, Inc., the Securities and Exchange Commission ("SEC") took the position that supervisors have a duty to gather information in response to red flags:

In this particular case, the SEC sanctioned senior officials of Salomon Brothers on the grounds, among others, that upon receiving information that an irregularity had occurred, they failed to "take action to investigate what had occurred and whether there had been other instances of unreported misconduct."²

Third, and perhaps most importantly, companies recognize that even where it does not appear that the government has commenced or is likely to commence an investigation, future developments might result in a government investigation. In that event, for the reasons set forth above, the information gathered during the internal investigation is likely to assist the company in responding effectively to the government’s later investigation and in preparing the company’s defenses.

II. Staffing The Investigation

Once the decision is made to conduct an internal investigation in response to a red flag or other indication of wrongdoing, a decision must be made regarding who will conduct the investigation. In many instances, indications of possible wrongdoing can be quickly addressed and resolved by company personnel without the involvement of outside counsel. In certain cases, company personnel have the experience and expertise necessary to obtain the information and can do so with less disruption and expense to the company than outside counsel can. For example, the human resource department often has the skills and expertise necessary to investigate allegations of employment discrimination or sexual harassment. Similarly, the internal audit department might have the skills and expertise necessary to investigate allegations of theft or embezzlement.

Companies often elect to involve attorneys in the direction and conduct of internal investigations. While there is no requirement that internal investigations be conducted or directed by attorneys, there are several reasons why this task is often delegated either to attorneys or to company personnel acting under the direction of attorneys.

First, attorneys, particularly former prosecutors or other law enforcement personnel, often have the skills and substantive expertise to direct and conduct an internal investigation effectively and efficiently. Such attorneys have been trained to plan investigations, gather and review documents, question witnesses, and organize and assess the resulting information.

Second, attorneys are often asked to provide legal advice and services based on the results of the investigation. For example, if the investigation involves possible improper payments to a foreign government official, an attorney conversant with the Foreign Corrupt Practices Act will be able quickly to assess which factual issues are legally significant to the issue of whether the FCPA has been violated. Furthermore, in many instances, it is possible that there will be a need for the company to deal with law enforcement or regulatory agencies in connection with the subject matter. In these instances, there are benefits to utilizing attorneys who are familiar with the internal procedures and operations of those agencies.

Third, the involvement of attorneys will assist the company in successfully asserting the attorneyclient privilege and the work product doctrine. See Upjohn Co. v. United States, 449 U.S. 383, 101 S.Ct. 677 (1981) (applying the attorney-client privilege to notes that attorneys prepared while conducting an internal investigation); In re Allen, 106 F.3d 582, 602 (4th Cir. 1997) (holding that an investigation may constitute legal services for purposes of the attorney-client privilege); United States v. Rowe, 96 F.3d 1294, 1297 (9th Cir. 1996) ("fact finding that pertains to legal advice counts as professional legal services"). The benefit of using attorneys to conduct the internal investigation is illustrated by In re Grand Jury Subpoena, 599 F.2d 504 (2d Cir. 1979). This subpoena enforcement action involved two internal investigations conducted on behalf of a single company. The first investigation was conducted "mainly by non-lawyer senior officials" of the company and the results were reported to the Board of Directors. The audit committee then retained a law firm to assist the company’s vice president and general counsel in conducting a second investigation. The Court of Appeals held that the first investigation was not protected by the attorney-client or work-product privileges, even though the general counsel was one of the senior officials who participated in the investigation, but that the second investigation was protected by both privileges. Id. at 510-11. Significantly, interviews conducted by a non-attorney should be treated as privileged so long as they were conducted under the direction of an attorney and the purpose of the interviews was to assist counsel in rendering legal advice. See Carter v. Cornell University, 173 F.R.D. 92 (S.D.N.Y. 1997) (holding that interviews conducted by Associated Dean of Human Resources were privileged).

The preceding considerations apply to both in-house and outside counsel. There are a number of reasons why companies sometimes choose outside counsel to conduct an investigation. First, outside counsel often are hired because of a perception that they are more independent than company employees. This perception of greater independence can be important for a number of reasons. If the subject matter of the investigation implicates senior management or the legal department, the independence of the outside law firm might provide the board of directors additional comfort in relying on the results of the investigation. In matters that pose a potentially serious threat to the company, it often is appropriate to retain outside counsel. In determining whether the investigation is sufficiently serious to warrant the retention of outside counsel, companies consider the title and prominence of the individuals whose conduct will likely be the subject of the investigation, the potential financial exposure to the company, and the extent that the subject matter of the investigation is likely to result in law enforcement activity and/or substantial media coverage. In order to heighten both the reality and the perception that the investigation was independent, responsibility for overseeing outside counsel is sometimes assumed by the Board of Directors, the Audit Committee, or by a special committee consisting of independent members of the board of directors. This is especially appropriate where the investigation potentially involves conduct by the senior management of the company.

A second reason for utilizing outside counsel is the need to dedicate substantial resources to responding promptly to a red flag or other indication of possible wrongdoing. It often is difficult for even large companies to pull a team of employees from ongoing tasks and devote them to an internal investigation.

A third reason for utilizing outside counsel is the possibility that members of the legal department will have relevant knowledge or that the conduct of the legal department will become an issue. For example, retaining outside counsel might be appropriate if the legal department had been consulted with respect to the transaction or activity at issue and had advised the client concerning the matter.

A fourth reason for utilizing outside counsel is the reality that specialized outside counsel might have the experience and expertise to conduct the particular investigation more effectively or more efficiently than company personnel who do not specialize in this particular type of investigation. In addition, to the extent that the subject matter of the investigation is likely to result in interaction with a law enforcement or regulatory agency, it is often useful for a company to be represented by counsel who is familiar with that agency. Similarly, if there is likely to be litigation, it often is appropriate to retain counsel with relevant litigation and trial experience.

A fifth reason for utilizing outside counsel is a desire to increase the likelihood that the results of internal investigation will be protected by the attorney-client privilege and the work product doctrine. While both the attorney-client privilege and the work product doctrine can apply to the work of an in-house attorney, see United States v. Rowe, 96 F.2d 1294, 1296 (9th Cir. 1996), a court is less likely to find that a business purpose was the primary purpose behind the investigation if the investigation was conducted by outside counsel. Paul R. Rice, Attorney-Client Privilege In The United States, 7-28 (Lawyers’ Cooperative 1993) ("the courts have held that communications to and from in-house counsel can be sheltered ‘only upon a clear showing that [in-house counsel] gave [advice] in a professional capacity.’") (quoting In re Sealed Case, 737 F.2d 94, 99 (D.C. Cir. 1984) (in-house counsel also had "responsibilities outside the lawyer’s sphere")). If the company elects to utilize in-house counsel, and not outside counsel, it may be appropriate to take steps to ensure that the in-house counsel conducting the investigation is not also performing a business advisory function and does not have non-legal responsibilities that are arguably relevant to the investigation.

If the decision is made to retain outside counsel, the company should consider whether it should retain one of its regular law firms or whether it should retain a law firm with little, if any, prior association with the company. There are a number of potential advantages to utilizing regular counsel. Regular counsel is likely to be familiar with the company and its operations, products, and personnel. On the other hand, there are a number of reasons why it might be appropriate to retain counsel with little or no prior association with the company. First, the conduct of regular outside counsel might be an issue in the investigation. Second, regular outside counsel might lack the skills to conduct the investigation, the skills and experience to handle the anticipated litigation and/or law enforcement activity, or the expertise in the relevant statutes. Regular outside counsel may also lack either actual or perceived independence. For example, if a law enforcement action is considered likely, the company should seriously consider retaining counsel who has experience with the relevant agency and statutes. This experience will likely enhance counsel’s credibility with the relevant law enforcement agencies.

If outside counsel is retained to conduct the internal investigation, the company should assign an employee to act as a liaison between the company and the outside counsel. The liaison can be an invaluable resource regarding background information regarding the company, its history, its operations, and its recordkeeping practices. The liaison can assist outside counsel in identifying individuals and departments that are likely to possess relevant information. The liaison can facilitate the interview process by making the initial introductions between the outside counsel and the company employees with relevant knowledge. In terms of supervision of the investigation, it is usually appropriate for the Legal Department or for other senior company officials to supervise the work of outside counsel, though in some instances, outside counsel should report to the Audit Committee or a special committee of the Board of Directors. Reporting to the Audit Committee or a special committee is especially appropriate in matters where it is important to establish the independence of outside counsel and its investigation.

Internal investigations often require the assistance of individuals with accounting, engineering, or other areas of substantive expertise. One of the decisions that must be made early in an investigation is whether to rely on company personnel or outside experts for that expertise. While it frequently appears that the individuals who can most efficiently assist counsel in analyzing company information are the company personnel already familiar with the matters at issue, the costs of relying on such personnel may outweigh the benefits. In Six Grand Jury Witnesses,³ six corporate employees, who were responsible for monitoring the costs associated with certain contracts, had been asked by corporate counsel, in anticipation of litigation, to perform an analysis of those costs. The grand jury sought testimony regarding this analysis. The corporation argued that the analysis was protected by the work product doctrine. The court held that the witnesses could be compelled to testify regarding the analysis performed, and stated that "factual information is not protected . . . just because the information was developed in anticipation of litigation."⁴ To the extent that company personnel are assigned to assist counsel in the investigation, they should be careful to keep confidential any documents that they generate in such capacity and to mark all such documents confidential, privileged, and prepared for the purpose of assisting counsel.⁵

If the decision is made to retain an accounting firm, consideration should be given to whether the company should retain a firm other than its auditors. The major advantage to using the audit firm is that its personnel are familiar with the company, its procedures, and its personnel. There are, however, a number of potential problems with using the audit firm. First, in many instances, the individuals who worked on the audit are potential witnesses. Using a potential witness in an investigation can be a problem because they may not be able to compartmentalize the information that they learned during the investigation from the information they possessed before the investigation commenced. In addition, there is both a danger that the auditor will not be viewed as sufficiently independent and a danger that there will be a conflict of interest between the auditor and the company. Furthermore, there might be instances when the investigative personnel of the accounting firm feel compelled to share otherwise privileged information with the audit practice of the accounting firm. This sharing of information can jeopardize the ability of the company to control the dissemination of the investigation results and protect the appropriate privileges.

If a private investigator is retained to assist the investigation, steps should be taken to assure that the investigator does not engage in conduct that might be viewed as improper by either law enforcement agencies or triers of fact. Thus, investigators should be carefully controlled and instructed that they should not to engage in misrepresentations in order to obtain desired information or in any other conduct that would be improper for counsel.

In order to maximize the likelihood that all such work product is fully protected, counsel should prepare a letter or memorandum to each expert that specifies that the expert has been retained (or in the case of company employees, detailed) to assist counsel in providing legal advice and services; that the expert is being retained or detailed in anticipation of litigation; and that the expert agrees to keep confidential any work performed pursuant to the engagement or detail.

III. Defining The Scope Of The Investigation And Developing An Action Plan

An initial assessment must be made regarding the scope of the investigation. For example, if the internal investigation is being triggered by an allegation that a specific company employee might have made an improper payment to a Mexican government official in return for the government’s awarding a specific contract to the company, the scope of the investigation will include determining: (1) whether the payment was offered or made to a person who was a foreign official within the meaning of the Foreign Corrupt Practices Act (the "FCPA") and (2) whether the offer or payment violated the antibribery provisions of the FCPA. The scope of the internal investigation will also include: (1) identifying the company personnel and agents who made the offer or payment; (2) identifying any other company personnel who knew that the offer or payment was made or was being considered; (3) determining whether the company personnel responsible for the offer or payment had involved the company in any other improper payments or offers to Mexican officials; (4) determining whether any false company records had been created in connection with the transaction; (5) determining the extent, if any, to which company procedures were violated or circumvented; and (6) determining the extent to which the appropriate compliance materials had been disseminated to the involved personnel and the extent to which proper training programs had been implemented.

Determining the scope of the investigation involves a delicate balancing of the factors discussed above in determining whether to undertake an internal investigation. In the above example, for instance, consideration should be given to: (1) whether the scope of the investigation is broad enough to determine whether misconduct did in fact occur; (2) whether the scope is broad enough to uncover evidence that might assist the company in responding effectively to a government investigation; (3) whether the scope is broad enough to enable the company to take appropriate remedial action, including determining the extent, if any, to which company personnel should be disciplined; the extent, if any, to which company records were falsified; the extent to which compliance procedures should be enhanced and/or the company’s compliance policies should be clarified or expanded; and the extent, if any, to which other remedial action should be taken (e.g., if company personnel made an improper payment for the purpose of influencing the government to award a concession to the company, consideration should be given to asking the government to reopen that decision); (4) if it is anticipated that the results of the internal investigation might be disclosed to the government, whether the scope of the internal investigation is broad enough to satisfy the government; (5) the expense and disruption caused by the internal investigation; (6) the need for speed; and (7) the need to maintain the confidentiality of the internal investigation.

At the outset of the investigation, the company should issue a charter setting forth the mandate pursuant to which the internal investigation is being conducted. This charter can consist of one or more of: a resolution of the Board of Directors; a resolution of the Audit Committee; an engagement letter; or a memorandum issued by senior management or the General Counsel. The charter should instruct the investigators to conduct a confidential internal investigation, define the scope of the investigation, authorize the investigators to inform company personnel that they are instructed to cooperate in the investigation, and specify (if appropriate) that the investigation is being conducted in anticipation of litigation and for the purpose of obtaining legal advice. Because some courts cease to protect attorney work product once the litigation relating to the work product has been concluded,⁶ the charter should be drafted broadly enough to cover all conceivable litigation likely to arise, including securities class actions, derivative actions, and related commercial litigation. Such a charter forces the company to focus on the scope of the internal investigation and will assist the company in successfully seeking the protection of the attorney-client privilege and the work product doctrine in the event that discovery is sought for documents generated in connection with the investigation.

This initial memorandum should also identify the client. Usually, the client will be the corporation. Sometimes, the client will be the Board of Directors of the corporation, a standing committee of the Board of Directors (e.g., the Audit Committee or the Compliance Committee), or a special committee of Board of Directors.

The scope of the investigation should be constantly reevaluated as information is gathered and analyzed. While the initial red flags or indications of possible wrongdoing might have warranted an investigation of limited scope, the investigation might uncover information that warrants a substantial expansion of the scope of the investigation. For example, an initial indication that a company improperly reexported certain U.S. technology to Iraq could trigger an internal investigation that uncovers evidence that additional U.S. technology was improperly re-exported to Iraq. It might sometimes be appropriate, on the other hand, to curtail the initial scope of the investigation once information is obtained that casts a new light on the initial red flag or other indication of possible wrongdoing. It is important that an internal investigation be conducted quickly, efficiently and effectively, especially if the company anticipates that the government may initiate its own investigation. In many circumstances, the government will not defer its investigation pending completion of the company’s internal investigation. Factors that the government considers in evaluating whether to defer its investigation include: (1) the amount of time expected to elapse during the company’s internal investigation; (2) the nature of the suspected violation and whether it is potentially ongoing; (3) whether the internal investigation is being conducted by outside counsel; and (4) whether the government will be permitted to see all of the notes and records compiled during the internal investigation.

In developing the action plan, the investigative team must always consider the need for speed. This urgency can arise from several sources. There might be a need to complete the investigation before the government becomes aware of the matter. Management might need the results of the investigation so that it can make informed decisions or required disclosures. In some contexts, (e.g., the employment context), speed might be essential to establishing an affirmative defense.

The action plan should describe the documents to be gathered and identify who should be responsible for gathering the documents. The plan should also identify the witnesses to be interviewed, the nature of the questions to be posed during the interviews, and where the witnesses will be interviewed. The plan should address the order of the interviews and the extent, if any, to which potential witness interviews can be conducted by telephone or other means. In connection with both searching for documents and conducting interviews, consideration should be given to the extent, if any, to which foreign language skills will be required.

One important issue that often arises in developing an action plan is the extent, if any, to which the investigators should contact third party witnesses. In many instances, third parties are likely to possess information significant to the investigation. For example, in an investigation involving revenue recognition, customer personnel might have significant information regarding when sales contracts were executed and whether the sales contracts were accompanied by any side agreements. On the other hand, contacting third parties might endanger the confidentiality of the investigation or jeopardize the company’s relationship with the third party. In many instances, an investigative plan can be developed that will enable the investigators to obtain the information they need while minimizing the associated risks.

It is important to stress that the action plan will often evolve during the investigation as documents are gathered and reviewed and as witnesses are interviewed. This evolution can result from a redefinition of the scope of the investigation, from the identification of new avenues of investigation, from the initiation of a government investigation or the receipt of a government subpoena, or from a conclusion that one of the issues initially identified has been resolved and that some of the avenues of investigation initially identified are no longer warranted.

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