Project: Corporate Counsel Part II (Unintended Consequences) - Law Firms When The SEC Comes Knocking: What Corporate Counsel Needs To Know About Initiating An Internal Investigation In Response To An Inquiry By The Securities And Exchange Commission

Monday, August 1, 2005 - 01:00

Day after day we read: "Company X To Settle SEC Charges." Simply substitute "Company X" for the company of the day, or perhaps a few of the company's officers or directors, and you have tomorrow's headline. Despite their similarities, each of these headlines has its own story which began with an inquiry by the United States Securities and Exchange Commission ("SEC"). Unfortunately, the story sometimes has more to do with a disagreement over esoteric accounting standards, or the SEC's desire to expand existing legal boundaries, than it does with detecting some nefarious plot.

In today's environment, public companies and their officers and directors all too often play the villain in the high-stakes, high profile and seemingly endless probes aimed at uncovering and eradicating corporate malfeasance. Led by outgoing chairman William Donaldson, the SEC has vigorously sought to investigate and punish perceived corporate wrongdoers. During Donaldson's reign, the total amount of fines levied by the SEC skyrocketed from $44 million in 2001 to more than $1 billion in each of the past two years, and the number of individuals barred from serving as officers and directors rose from 38 in 2000 to 161 in 2004. These potentially severe penalties underscore the care with which a corporation must approach every inquiry by the SEC.

As corporate counsel, you are uniquely situated to shape the course of any prospective SEC investigation and to minimize the chance of your company making an appearance in the headlines. To that end, the goal of this article is to highlight certain key issues that corporate counsel must keep in mind when confronted with a pending SEC inquiry.

The Seaboard Doctrine: Getting A Handle On The SEC's Expectations

Any discussion about dealing with an SEC investigation must be set against the backdrop of the so-called "Seaboard Doctrine." In October 2001, in the process of settling a cease-and-desist proceeding, the SEC set forth 13 criteria for measuring a company's self-policing, self-reporting, remediation and cooperation. Among other things, these criteria ask:

1. Did the misconduct result from inadvertence, honest mistake, simple negligence, reckless or deliberate indifference to indicia of wrongful conduct, willful misconduct or unadorned venality?

2. How did the misconduct arise?

3. How high up in the chain of command was knowledge of, or participation in, the misconduct?

4. How long did the misconduct last?

5. How much harm has the misconduct inflicted upon investors and other corporate constituencies?

6. How was the misconduct detected and who uncovered it?

7. How long after discovery of the misconduct did it take to implement an effective response?

8. What steps did the company take upon learning of the misconduct? Did the company immediately stop the misconduct? Are persons responsible for any misconduct still with the company?

9. What processes did the company follow to resolve many of these issues and ferret out necessary information?

10. Did the company commit to learn the truth, fully and expeditiously?

11. Did company employees or outside persons perform the review? If outside persons, had they done other work for the company?

12. What assurances are there that the conduct is unlikely to recur?

13. Is the company the same company in which the misconduct occurred, or has it changed through a merger or bankruptcy reorganization?

In the Matter of Gisela de Leon-Meredith, Exchange Act Release No. 44969 (October 23, 2001), at

The SEC places significant emphasis on the Seaboard factors when determining whether to close its investigation or, in the alternative, to seek penalties from an alleged wrongdoer. Although introduced as flexible "guidelines," the Seaboard factors have since become more akin to mandatory requirements. That is, the SEC now expects companies to do more than simply fulfill their legal obligations to turn over requested information. To avoid a formal investigation, an enforcement proceeding or the imposition of stiff penalties, companies must recognize that proactive cooperation with an SEC investigation is required (even if such cooperation involves waiving the protections afforded by privilege or the work-product doctrine), including affirmative steps to uncover, halt and remediate potential wrongdoing.

When allegations of wrongdoing surface (either before an SEC request for information - in which case the company may need to self-report - or as the result of it), the company must carefully consider whether or not to conduct an internal investigation. While every allegation need not trigger a full-scale investigation, each allegation requires serious examination. If the allegation proves credible and indicates the possible existence of severe financial irregularities or fraud, the company may best position itself for future interaction with the SEC by initiating an internal investigation. Likewise, if the SEC requests a chronology of the events leading up to the alleged wrongdoing or other specific information, the need to draft an adequate response may leave you with no choice but to conduct an internal investigation.

Document Retention: Averting Problems Down The Road

At the outset, the company must instruct its employees to preserve potentially relevant documents and information. Ordinarily, to ensure that this instruction is properly documented, it should be disseminated in the form of a memorandum or email. The notice should enumerate the type or category of documents to be preserved and emphasize that the instruction applies to records stored electronically, as well as all drafts and hand-written notes. The company must then identify the potential recipients of the memorandum or email. Although companies are often sensitive about disclosing the existence and nature of an internal investigation, the notice must be broad enough to reach everyone who could possess relevant documents. In today's corporate world, it is critical to involve information technology personnel in the document preservation effort so that potentially relevant electronic information is not lost as a result of the normal functioning of a company's information systems.

The First Step: Who Conducts The Internal Investigation?

Once it appears that an investigation might be necessary, the company must decide who will conduct it. In some situations, corporate counsel can most efficiently and effectively conduct the internal investigation. In-house counsel will have greater knowledge of the company's operations, its people and the issues involved. As a result, an internal investigation by in-house counsel will substantially reduce the costs and inefficiencies associated with retaining outside counsel.

In other cases, however, circumstances may require that the Board of Directors, the Audit Committee or a Special Investigative Committee obtain outside counsel to investigate the alleged wrongdoing. The calculus concerning who should undertake the investigation is often driven by the locus of the alleged wrongful conduct. If the alleged conduct implicates the company's senior officers or members of the Board, in-house counsel's independence will fall into question, which, in turn, will undermine the credibility of the internal investigation and cause the SEC to increase its scrutiny of the company. In addition to examining corporate counsel's independence, the company should also consider whether other factors, such as the need for more attorneys, additional resources or specialized expertise, weigh in favor of retaining outside counsel.

Where the company has chosen to retain outside counsel, it is usually prudent to engage a firm which has previously done little or no work for the company. Although using your regular outside counsel is often more cost-effective because the firm knows your company, its management, and its business, that same familiarity undermines, in the SEC's view as reflected in the Seaboard factors, the independence of the investigation. In order to ensure the regulators that your company has truly and fully committed itself to uncovering the truth, you should carefully consider retaining special counsel if the independence of regular counsel could be questioned.

The Report: Striking A Balance Between Documenting Your Results And Creating A "Roadmap"

Deciding if, how and to what extent to document your investigation can be difficult. An investigation typically involves, among other things, reviewing documents, conducting interviews, and reporting findings to an officer, the Board, or to a committee. As with everything else lawyers do, these activities generate paper and lots of it. In the end, the resulting report, and all of the documents needed to create it, may eventually fall into the hands of private plaintiffs, creating a roadmap in civil litigation of what went wrong and why. An oral presentation of the investigation's findings is one solution to this problem, so long as the matter under investigation is relatively simple and straightforward. However, there are various situations in which a company cannot avoid the creation of a written report. In such cases, the written report and its underlying documents will be protected only to the extent afforded by privilege or similar protections ( i.e., attorney-client, self-evaluative and work product).

In order to satisfy the SEC's expectations of cooperation, as set forth in Seaboard, the company should be prepared to produce the reports, notes of interviews, and other materials generated during the course of an internal investigation. This expectation places companies in a precarious position because of the significant risk that disclosure of some or all of these documents to the SEC may result in a complete waiver of privilege and the work product doctrine in subsequent private or criminal litigation. While there are, unfortunately, no easy answers to this dilemma, the SEC and other regulators have shown an increasing willingness to enter into non-waiver or confidentiality agreements with companies. While several courts have found such agreements ineffective to preserve privilege, there is little to be lost from seeking such an agreement. In the end, the decision about whether or not to produce investigatory materials to the SEC (or any third party, including the company's outside auditor) will ultimately depend on the circumstances in which the company finds itself. Accordingly, a company faced with a pending SEC inquiry must carefully evaluate the costs and benefits of such disclosure.


Structuring an internal investigation in response to an SEC inquiry, whether it be a voluntary request for information or a subpoena, requires in-house counsel to grapple with a host of complex and difficult issues, only a few of which are discussed above. Dealing with these issues effectively and efficiently involves preparation, planning, and foresight. Understanding the playing field can mean the difference between a successful, cooperative process that strengthens the company's internal control systems and its relationship with the regulators, and one in which your company finds itself in tomorrow's headlines.

William M. Uptegrove is an Associate in the Litigation Department and a member of the Securities Litigation and Enforcement Practice Group of Lowenstein Sandler PC, based in Roseland, New Jersey. He can be reached at (973) 422-6424. Matthew M. Oliver is Counsel to the firm's Litigation Department and a member of its White Collar Criminal Defense Practice Group. He can be reached at (973) 597-2318.

Please email the authors at or with questions about this article.