Good Corporate Behavior Redux - The Federal Self-Evaluative Privilege

Friday, June 1, 2007 - 00:00

An increasingly litigious environment for public companies and the requirements imposed by the Sarbanes Oxley Act have forced U.S. corporations to be more aggressive in establishing pro-active compliance programs, managing risk, and ferreting out corporate malfeasance and employee misconduct. The current litigation environment coupled with the need for more effective corporate compliance programs makes this the appropriate time to consider the establishment of "self-evaluative privilege."

The concept of a self-evaluation privilege was recently endorsed by the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a bipartisan group of experts and industry leaders formed by the U.S. Chamber of Commerce to study and report on how to keep the U.S. capital markets competitive vis--vis foreign markets like London and Hong Kong.1 Although the Commission's recommendation in this area was limited to the establishment of a federal self-evaluation privilege for SEC-regulated institutions (e.g., broker-dealers and investment advisors), the underlying principle extends to all U.S. corporations - notably, that a self-evaluation privilege leads to enhanced corporate compliance.

Ideally, in a self-evaluation, a corporation or other business entity (collectively referred to herein as "corporations") would take a critical and probing look into its operations in order to identify and assess areas of risk and to detect weaknesses or investigate actual malfeasance or employee misconduct. The self-evaluation would result in a report to management that would contain candid reflections on such things as the company's processes, procedures and management depth. As a tool, the self-evaluation would reflect the serious attitude of corporations that use it to become better corporate citizens.

But just as self-evaluation reports could become an effective tool for corporations to strengthen controls and fight internal fraud and other illicit activities, self-evaluations should not also become litigation roadmaps for the plaintiffs' bar. Materials produced in a self-evaluation should be candid and unfettered by concerns that outside third parties or the media could obtain access to the reports.

By its nature, a self-evaluation report would necessarily point to the risks to which a corporation is exposed or to corporate malfeasance which may have already occurred. Plaintiffs' lawyers are all too happy to get their hands on this type of report. There would be no incentive for a corporation to perform a thorough and effective self-evaluation if the evaluation will be given to the plaintiffs' bar to be used as litigation fodder or to the media to be used for sensational front page articles. If there is a risk that a self-evaluation will be shared with plaintiffs' lawyers, it becomes more likely that the self-evaluation will amount to a hollow and meaningless exercise.

Accordingly, there is a strong need for corporate self-evaluations to be afforded protection from the plaintiffs' bar. One such protection could take the form of a separate, stand-alone "self-evaluation privilege." Such a privilege is needed because existing privileges are inadequate to meaningfully protect information produced in the self-evaluative process. For example, protections afforded by the attorney-client communications privilege and attorney work product privilege are limited because they apply only to advice on legal matters provided by legal counsel. Oftentimes the self-evaluation process does not involve attorneys.

Moreover, the protections offered by these existing privileges often have not held up under judicial review when used to protect such self-evaluative processes as a final report of a corporate internal investigation. Corporations must be able to investigate corporate wrongdoing and share the results with government investigators and agencies under a firm and reliable privilege that will protect self-evaluations from disclosure to third-party litigants. The self-evaluation privilege will provide this needed protection.

The self-evaluation privilege would not affect a public company's obligation to self-report to the Securities and Exchange Commission any compliance problems or other evidence of wrongdoing, whether discovered in the process of a self-evaluation or in any other course of business.

Although to date some courts have recognized a general self-evaluation privilege, most courts either have created exceptions for the instant cases or generally have declined to recognize the privilege. However, the concept of the self-evaluation privilege is not without growing precedent in both the common law and statutory law. In the discussion below, we (i) provide a concise background on privileges generally and the attorney-client privilege in particular (and its limitations), (ii) briefly summarize various commonly recognized privileges that are similar to a self-evaluation privilege, and (iii) note certain efforts to establish (and in some cases broaden existing) privileges for self-critical analysis in the context of corporate internal investigations.

Privileges Generally And The Attorney-Client Privilege

Privileges are asserted to protect confidentiality before a party to a lawsuit is ordered to publicly disclose evidence. The main justification for privileges is that many professional relationships and functions that require complete candor would suffer if disclosure were compelled during litigation. While the Federal Rules of Civil Procedure recognize the attorney-client and work-product privileges, Congress has granted federal courts authority to develop privilege rules on a case-by-case basis.

In practice, the attorney-client privilege is the main evidentiary tool for maintaining the confidentiality of privileged documents. This privilege protects communications made in confidence to an attorney by a client for the purpose of seeking or obtaining legal advice. The policy rationale behind this privilege is to promote full disclosure of material information, and to encourage clients to be completely truthful so that their attorney can provide competent legal advice. Where an attorney offers both legal and business advice, courts will protect this mixed communication only if it is predominantly legal in nature.2

The attorney-client privilege only protects communications, and does not prevent the disclosure of underlying facts, even if those facts were communicated in a statement to an attorney.3 Additionally, the client, as holder of the privilege, waives the privilege if he or she communicates the information to third parties, other than for further professional legal advice.4 The client may also waive the privilege if he or she discloses or produces a subset of the privileged document or information.5

In the corporate setting, the privilege applies only when the employee acted as an agent to the corporation when he or she learned the information later communicated to the corporate attorney.6 There is disagreement among courts as to which agents represent the corporation in sufficient capacity to have their communication protected; as a result, the privilege is applied on a case-by-case basis.7 "Where an employer has used a non-attorney investigator, but has used counsel to review and critique the investigatory strategy employed, to review drafts of documents to be placed in the investigation file, and to provide advice regarding disciplinary alternatives at the conclusion of the investigation, each of these areas of attorney involvement is subjected to the attorney-client privilege."8 Note, however, that the privilege does not protect communications that are regular activities of a compliance committee.

Privileges Similar To A Self-Evaluation Privilege

Medical Peer Review Privilege

The medical peer self-critical analysis privilege, which is grounded solely in common law, protects non-factual deliberative documents, including opinions, evaluations, and recommendations generated from internal investigations. Today, the medical self-critical analysis privilege is widely accepted in the medical peer review context. Because hospitals are often targets for litigation, this privilege affords both the hospital and its physicians the reassurance to be as thorough and candid as necessary in the evaluation without fear of the results haunting them in a later malpractice lawsuit.

Environmental Audit Privilege

The self-critical analysis privilege has also developed in the context of environmental audits. The majority of states have legislation, or are in the process of adopting self-regulatory measures, which reflect the common law requirements of assertion of the privilege.9 The goal is to encourage corporations to engage in voluntary internal environmental audits of their compliance programs and to evaluate and improve compliance with regulations.10 Most jurisdictions apply the privilege to the evaluative portions of the audit, but some apply it to the factual materials, as well.11 Furthermore, some states extend the privilege to reports conducted by external auditors.12

Insurance Compliance Self-Evaluative Privilege

Currently, eight states have enacted insurance compliance self-evaluative privilege statutes, all of which are substantially similar and provide a privilege for insurance compliance audits. An insurance compliance audit is commonly defined as a voluntary internal evaluation, review, assessment, audit or investigation that is undertaken by an insurance company to identify or prevent noncompliance with, or promote compliance with, laws, regulations, orders or industry or professional standards.

Efforts To Establish A Self-Critical Analysis Privilege

In 1998, Illinois became the first state to pass an insurance compliance self-evaluative privilege. Since then, there have been initiatives in at least twenty other state legislatures to enact this privilege. Currently eight jurisdictions recognize a self-audit privilege for insurance companies.13 Additionally, Louisiana passed a self-evaluative privilege law for banks,14 and North Dakota has a self-evaluative privilege statute for financial institutions.15 The policy behind applying the self-critical analysis privilege in the corporate context is to encourage corporations to engage in voluntary self-correction to ensure compliance with industry standards. This goal is in the public's best interest because it promotes the free flow of internal information from the corporation to the regulatory agencies and avoids a "chilling effect" on employee cooperation which may result from disclosure.

Conclusion: A Self-Evaluation Privilege Would Improve Corporate Compliance

A general self-evaluation privilege would empower U.S. corporations to more candidly and effectively manage their compliance obligations. The significance of such a privilege is already recognized in many other analogous, yet more targeted, situations.

For example, as noted above, the medical peer review privilege promotes the free flow of ideas and complete candor in hospital staff meetings intended to help staff self-evaluate and make recommendations for improvement. The environmental audit privilege encourages corporations to engage in voluntary internal environmental audits of their compliance programs to evaluate and improve compliance with environmental regulations. Finally, the insurance compliance self-evaluation privilege permits insurance companies to identify noncompliance with legal or professional standards and to correct those deficiencies.

Without these privileges, compliance programs at hospitals, environmental firms, and insurance companies would suffer. Privileges such as these clearly empower organizations to constantly self-evaluate and improve their compliance programs. Benefits created by these privileges flow directly to corporations and entities that utilize them, as well as indirectly to shareholders, customers, and the general public.

Consideration should be given to broaden the scope and breadth of institutions permitted to take advantage of these more targeted privileges - and the benefits that they create - into a more general self-evaluation privilege for corporations and the auditors who assist with their controls. Such an initiative would go a long way to improve corporate compliance in the United States.1 The Commission released its report in March 2007, a copy of which is available at www.uschamber.com/ccmc/default. Additional information about the Commission is available at www.uschamber.com/portal/capmarkets/default.htm.

2 Theodore R. Lotchin, Note: No Good Deed Goes Unpunished? Establishing a Self-Evaluative Privilege for Corporate Internal Investigations, 46 Wm. & Mary L. Rev. 1137, 1153-54 (Dec. 2004).

3 Upjohn v. United States, 449 U.S. 383, 396 (1981).

4 Lotchin, supra note 3.

5 Id.

6 Edward J. Imwinkelried, The New Wigmore: A Treatise on Evidence, Evidentiary Privileges 749 ( Richard D. Friedman ed., Aspen Law & Business 2002).

7 Lotchin, supra note 3.

8 Tyler M. Paetkau & Jennifer Garber, Conducting Self-Audits Without Creating a Roadmap for Plaintiffs' Attorneys: A Delicate Balancing Act, American Bar Association, Section of Business Law, Committee on Corporate Counsel, eNewsletter, Spring 2006 (citing Kaiser Found. Hosp. v. Superior Court, 66 Cal. App. 4th 1217, 1221 (1998)).

9 Imwinkelried, supra note 6.

10 Id.

11 Id.

12 Id.

13 District of Columbia [D.C. Code 31-851 (2006)], Illinois [215 ILCS 5/155.35 (2005)], Kansas [60-3332 (2005)], Michigan [500.221 (2002)], New Jersey [17:23C (1999)], North Dakota [N.D. Cent. Code, 26.1-51 (2006)], Oregon [ORS 731.760-731.770 (2006)], Texas [751.001, 751.251 (2005)].

14 La. R. S. 6:284.1 (2006). Louisiana uses the term "financial institution" in its statute, but this term is defined narrowly as "any person organized to engage in the business of banking."

15 N.D. Cent. Code, 6-13 (2006). In this statute, "financial institution" is defined as "any organization authorized to do business under state and federal laws relating to financial institutions, including a bank, including the Bank of North Dakota, a savings bank, a trust company, a savings and loan association, or a credit union."

Christine A. Edwards is a partner and John E. Court is an associate in the Corporate Group of Winston & Strawn LLP. The authors may be reached at cedwards@winston.com (312-558-5571) or jcourt@winston.com (202-282-5869), respectively. Christine Edwards served as a Commissioner on the U.S. Chamber's Capital Markets Commission, and John Court provided counsel to the Commission during its deliberations and throughout the process of drafting of its report.

Please email the authors at cedwards@winston.com or jcourt@winston.com with questions about this article.