Publications

Upon discovering corporate misconduct, in-house or outside counsel are often faced with a difficult recommendation to senior management as to whether or not to self report to the government. While voluntary self-disclosure is frequently the best long-term approach, it can be a hard sell to corporate management. The disclosure will likely lead to a lengthy government investigation, as well as adverse publicity, where none existed previously. The benefits of self-disclosure, while often real and sizable, are uncertain at decision time, and counsel cannot guarantee fair or equitable treatment to her client by the government.

Recently, however, the Securities and Exchange Commission (“SEC”) provided some assistance to corporate counsel in this situation. On October 23, 2001, the SEC issued a Report of Investigation and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Securities Exchange Act Release No. 44969. The Report is significant because it is the first time the SEC has taken the unusual, and helpful, step of listing 13 specific criteria that it considers in deciding whether and how much to reward companies when they self-report, correct wrongdoing and cooperate with SEC staff in its investigation.

The SEC issued the Report and Commission Statement in conjunction with its announcement of the settlement of a cease and desist proceeding against a corporate controller at the center of an accounting scandal. In the Matter of Gisela de Leon-Meredith, Securities Exchange Act Release No. 44970. Together, the Report and the related Release again demonstrate the critical importance of self-policing, self-disclosure, remedial action and cooperation with government agencies when corporations themselves uncover wrongdoing within the company.

The subject of the Report and Commission Statement was an accounting irregularity investigation of Chestnut Hills Farms, a division of Seaboard Corporation, a diversified, international and publicly held company. From 1995 through early 2000, the controller of Chestnut Hill Farms improperly booked certain entries in its accounting records. By late 1998, the controller knew that the entries were improper and that they caused the company to significantly understate its expenses. Instead of disclosing these errors to her direct supervisors or to Seaboard, the controller continued her wrongdoing by intentionally concealing the errors through additional improper accounting entries and adjustments to the company’s books. The controller’s creative bookkeeping started to unravel in late 1999 and came unglued by mid-2000 when Seaboard’s internal auditors questioned the accounting discrepancies (by then, more than $7 million) created by the controller’s wrongdoing.

The controller was in no position but to consent to the entry of a cease and desist order due to her deliberately causing Seaboard’s books and records to be inaccurate and its periodic reports to be misstated for an extended period of time. But Seaboard avoided enforcement action as the parent company due to its prudent response after learning of the controller’s illegal conduct. Within a matter of days of learning of the misconduct, Seaboard took several measures to promptly weed out the wrongdoing and those responsible for it.

Among other things, Seaboard’s internal auditors conducted a review and informed company management who, in turn, notified the Audit Committee of the Board of Directors. The full Board was soon advised of the problem, and Seaboard hired outside counsel to conduct a thorough investigation. The company terminated the controller and two of her immediate supervisors, and disclosed the misconduct publicly and to the SEC. It gave complete cooperation to the SEC’s staff, produced relevant documents and did not invoke the attorney-client privilege, work product immunity or other privileges to shield the findings of its internal investigation. In addition, Seaboard recognized some shortcomings in its internal controls and took steps to strengthen its internal auditing and financial reporting process such as developing a detailed closing procedure for Chestnut Hill’s accounting personnel to follow and hiring new certified public accountants for its accounting department.

As part of its announcement, the SEC explained that its main concern would always be the protection of investors, that it was not adopting any binding set of rules to be used in every investigation and that it was, of course, retaining the discretion to evaluate cases individually based on their particular circumstances. Finally, it stated that the factors it identified (listed below) did not confer any formal rights on a party and were by no means the only considerations in deciding to bring enforcement actions. The thirteen identified factors are:

• The nature of the misconduct. Whether it was the result of inadvertence, simple mistake, negligence or recklessness, indifference or willful misconduct, and whether it involved company employees misleading or deceiving outside auditors?

• How the misconduct arose. Did it result from internal pressures on employees to meet financial goals, or from a tone of lawlessness set by management and executives at the company? What compliance procedures were already in place to prevent misconduct and, if so, how did those procedures fail to prevent the wrongful conduct?

• Where in the corporate ladder did the misconduct occur. How high up in the chain of command was knowledge of, or participation in, the misconduct? Did senior employees participate in or ignore obvious misconduct and how systemic was the wrongdoing?

• How long the wrongful conduct lasted. Was it a single quarter or one-time event or a long-term pattern of wrongdoing? If in connection with a company’s IPO, did it facilitate the IPO?

• How much harm did the misconduct inflict. Was it inflicted upon investors, and did the company’s stock drop sharply after discovery and disclosure of the wrongdoing?

• How was the wrongdoing detected. Who uncovered it?

• How long did it take the company to react. When after the discovery of the misconduct did it implement an effective response?

• What steps did the company take upon discovering the wrongdoing. Did the company terminate or discipline the responsible employees? Did the company disclose the wrongdoing to the public and appropriate authorities and did it make restitution to victims of the misconduct?

• What processes did the company follow to resolve the problem issues and ferret out the necessary information. Were the company’s Audit Committee and Board of Directors informed and, if so, when?

• Did the company commit quickly to learning the complete truth. Did management or the Board oversee a review and investigation? Did the company hire outside counsel and auditors to perform a complete investigation uninhibited by limits placed on the scope of the review by the company?

• Did the company provide the SEC with the results of its investigation and findings and sufficient documentation in response to the situation. Did the company sufficiently identify the real source of the misconduct? Was the company’s investigation and report thorough or was it cursory and superficial? Did the company cooperate with the SEC’s staff?

• What assurances has the company made going forward that the misconduct will not be repeated. Has the company adopted new and improved controls and procedures to prevent future misconduct, or adjusted its existing policies to prevent recurrence?

• Is the reporting company the same company in which the wrongdoing occurred. Did corporate structure, acquisitions or reorganization change?

The SEC also stated in the Report and Commission Statement that it hopes the public statement of these considerations will encourage more corporate self-policing and the attendant self-reporting and cooperation with its staff. Recent speeches and remarks by the new Chairman of the SEC, an SEC Commissioner and the Director of its Office of Compliance Inspections and Examinations indicate that the SEC is “saying what is on its institutional mind,” (1) and emphasizing the need for accurate financial reporting and auditing (2) and the continued importance of strong corporate compliance programs that quickly address and resolve misconduct (3). In light of the increase in the number of accounting investigations conducted by the SEC, corporations should be aware that the SEC’s(4) Report and Commission Statement likely signals a greater receptiveness to rewarding self-disclosure. While receiving the equivalent of a “pass,” as in the case of Seaboard, will likely remain infrequent, the SEC also stated its willingness to consider reduced charges, lighter sanctions and mitigating language in announcing the resolution of enforcement actions.

Beyond the context of securities enforcement actions and SEC investigations, the criteria in the SEC’s Report and Commission Statement are a blueprint for corporations on the questions they will likely face by a government enforcement office. Most corporations have established formal compliance programs, codes of conduct and best practices. A management recognition of the value of early detection, remediation and cooperation in appropriate cases is an important component of any such program. Indeed, several government agencies such as the Tax and Antitrust Divisions of the Department of Justice have created amnesty policies designed to reward corporations that self-disclose wrongdoing with reduced charges, and in certain situations outright relief from corporate liability, for the reported violations. Corporate strategy and long-term focus with these ingredients in mind can often be the best approach for companies when they discover wrongdoing.

Endnotes

1. Speech by SEC Chairman Harvey L. Pitt, Remarks Before the AICPA Governing Council (October 22, 2001).
2. Speech by SEC Commissioner Isaac C. Hunt, Jr., Accountants as Gatekeepers – Adding Security and Value to the Financial Reporting System (October 26, 2001).
3. Speech by Lori A. Richards, Compliance Professionals Play Proactive Defense (October 18, 2001).
4. Michael Schroeder, “SEC List of Accounting-Fraud Probe Grows,” The Wall Street Journal, Front Page (July 6, 2001) (reporting on SEC officials’ statements that it had 260 accounting investigations under way, a major increase from recent years).