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Sarbanes Oxley : Law : Thought Leader
The Bigger They Are, The Harder They Fall?
In Today's Corporate Prosecutions, the
By
Michael Tankersley (and Betsy Whitaker)
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Michael Tankersley (and Betsy Whitaker)
Bracewell & Giuliani LLP
Bracewell & Giuliani
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We have all grown up hearing "the bigger they are, the harder they fall." With this in mind, a principal focus of the SEC and Justice Department in corporate fraud investigations historically has been to build their case with the objective of bringing down the most highly placed responsible officer that could be charged. The theory was that the sight of one of their own doing the "perp walk" or being carted off to jail would demonstrate to CEO's and other high ranking officers that no one is above the law, producing a strong deterrent effect downward throughout their organizations. The sheer number of massive frauds involving senior management reported in recent years has challenged the effectiveness of this approach.
Federal prosecutors today, pursuing a new model of deterrence, have begun turning the received wisdom on its head. As Betty Vinson and Troy Normand of WorldCom, Tim Despain of Enron, Renee Levault of Anicom and others have discovered, prosecutors are increasing their focus on bringing charges, and extracting punishment, against the "little guys"-- the subordinate employees whose ministerial assistance at the direction of their bosses has been essential to the execution of many of the most notorious frauds of recent years. The new theory is that if subordinate employees know they are at risk of going to jail, but are legally protected if they choose to "blow the whistle," they will refuse to follow their superiors' directions to implement schemes they believe are wrongful.
New enforcement tactics, supported by key changes in criminal and civil laws focused on corporate crime contained in the Sarbanes-Oxley Act of 2002 ("SOX") and related regulations, are creating a new, and riskier, environment for public companies and their employees, from senior management down to the rank and file. These changes need to be understood by all affected parties, and in many cases the strategies adopted by public companies to both assure compliance with the law, and to respond to allegations of violations, need to be reevaluated and revised accordingly. This article focuses on these issues from the perspective of their impact on lower-ranking employees, and some of the responses their employers may want to consider.
Turning Yesterday's Witnesses into Tomorrow's Defendants
The individuals named in the first paragraph are all subordinate employees who have found themselves under the same indictments as their bosses: - Vinson and Normand ? employees in WorldCom's general accounting department alleged to have made entries in WorldCom's general ledger that capitalized $3.8 billion of costs that under GAAP should have been expensed, at the direction of their supervisors.
- Despain ? assistant treasurer of Enron alleged to have communicated to rating agencies the enhanced cash-flow and operating results attributable to alleged fraudulent transactions engineered by his superiors, thus preserving Enron's debt ratings as the company's business deteriorated.
- Levault ? manager of Anicom's drop/ship billing department alleged to have provided ministerial assistance at the direction of her superiors to record fictitious sales and to back-date actual sales in order to misstate the company's financial statements provided to the public and the company's lenders.
It is likely that not that long ago, each of these employees would have been offered immunity in exchange for their testimony against their bosses, if they were deemed suitable targets for criminal prosecution at all. Things have changed. Law enforcement officials are more frequently pursuing strategies that will put lower-ranking employees like these behind bars, to deter their fellows from cooperating with questionable schemes instigated by their bosses. The prospect that prosecutors will accept a "Nuremburg" defense from subordinate employees ? that they were just following orders ? has been substantially reduced.
New Laws and Regulations Impacting Subordinate Employees
Among the new laws and regulations that are having a significant impact on the legal environment for subordinate employees are the following: Mandatory financial statement certifications by the CEO and CFO under SOX ?302 ? which are intended to make it more difficult for senior officers, particularly the CEO, to sidestep responsibility for misstatements in a company's financial statements. Of particular interest to subordinate employees is the SEC staff's recent suggestion that employees who provide internal certifications of a company's financial statements to support the CEO and CFO certifications could be the targets of enforcement if their certifications are incorrect, even though these "sub-certifications" are not legally required or filed with the SEC.
New remedies under SOX ?806 benefiting "whistle-blower" employees subjected to adverse employment actions in response to their reports of wrongdoing, and the threat of criminal liability under SOX ?1107 for anyone who retaliates against an employee who provides information to a law enforcement official relating to any federal offense. These protections are intended to counteract the coercion that might be brought to bear on subordinate employees to cooperate or stay quiet when confronted with illegality.
Encouragement or requirement that companies implement systems supporting ethical behavior, including the creation of "hotlines" allowing anonymous reporting of wrongful conduct or suspicious actions directly to the company's board or audit committee. With these arrangements in place, and enhanced whistleblower protections, too, an employee's plea that refusing to cooperate with an improper request by their boss would have cost them their job will receive less sympathy from prosecutors.
Increased focus on the creation of effective legal remedies and pursuit of active enforcement against the "gatekeepers" ? the lawyers and accountants whose assistance is necessary to allow companies access to the public markets, including the SEC's Rule 205 requiring "up the ladder reporting" by lawyers practicing before the SEC, the creation of the Public Company Accounting Oversight Board to regulate the accounting profession, and the creation of criminal penalties for destroying audit work papers under SOX ?802.
Creation of criminal penalties under SOX ?303 for anyone misleading the auditors of a public company. Subordinate accounting personnel who provide false or misleading information to auditors at the direction of their superiors will be much easier targets of prosecution under this statute than was the case prior to SOX.
Simplification of many obstruction of justice prosecutions based on the newly-enacted SOX ?802(a) (18 USC 1519). Unlike the statute utilized in the at this point unsuccessful prosecution of Arthur Andersen, 18 USC 1512, the new statute does not require that there be an "official proceeding" under way that is obstructed, or that the government prove "corrupt intent." Liability attaches if it is proven that a person "alters, destroys, mutilates, conceals" or otherwise falsifies a record or document "with the intent to impede, obstruct or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency" of the federal government or any case filed under Title 11, or "in relation to or contemplation of any such matter." New Tactics Adopted by Federal Prosecutors
The new laws and regulations have all been enacted in full view of the public, and their significance is generally appreciated. Much less publicized, however, have been some of the shifts in prosecutorial tactics in the past several years, particularly those focusing on subordinate employees. The development and implementation of these initiatives have been led by the Corporate Fraud Task Force established by President Bush in 2002 and currently under the supervision of Deputy Assistant Attorney General James B. Comey.
The Corporate Fraud Task Force brought together, for the first time, the leaders of the corporate anti-fraud enforcement community: relevant divisions of the Department of Justice, including the FBI, seven U.S. Attorney's offices, the SEC, FERC, FCC, CFTC, the Departments of Labor and Treasury and the Postal Inspection Service. Its objective is to develop a coordinated approach to the investigation and prosecution of cases of corporate fraud. The existence of the task force has greatly sped up the development and implementation across its member agencies and offices of new approaches to prosecution. Comments on prosecutorial attitudes in this article are drawn in part from speeches by Mr. Comey and other representatives of the Justice Department before the National Association of Corporate Directors and the ABA Business Law Section; the approach of individual prosecutors to these issues is subject to their discretion and can vary depending on the circumstances.
Three key shifts in prosecutorial tactics that are affecting the treatment of subordinate employees of public companies caught up in federal investigations and prosecutions include: Creation of enhanced incentives for a company to cooperate with investigations, and enhanced disincentives for a company to aggressively defend itself and its employees. Historically, the first reaction of a company under criminal investigation has been to circle the wagons, hire first-rate defense counsel for itself and its employees, and pursue a group defense through to the conclusion of the case. Current approaches to charging companies and settling cases, as reflected in the Justice Department's "Thompson Memorandum" and the revised U.S. Sentencing Guidelines released in April 2004, create powerful incentives for a company to provide the maximum possible cooperation to the government. Companies may be able to avoid indictment, or to receive deferred adjudication or significantly reduced penalties, by actively investigating allegations of illegal conduct and delivering to the government the prosecutor's case against the responsible employees with a bow tied around it.
Payment of an employee's legal costs of defense by the company is being treated by prosecutors as a failure to cooperate that will damage the company's prospects for avoiding indictment or receiving favorable settlement terms. Given that providing a competent defense to an individual employee caught up in a complex corporate fraud investigation or prosecution is a legally intensive and expensive undertaking, and that most employees have limited financial means, cutting off defense funding from the company can dramatically increase the pressure on employees to agree to a swift settlement.
Increased focus on bringing cases promptly after wrongdoing is identified by encouraging prosecutors to charge and litigate a smaller number of more easily-proven violations instead of spending years building large, multi-count cases.. Prosecution of old and stale cases, even when successful, is perceived to have had an unsatisfactory deterrent effect - the results appear on page 30 of the newspaper, not page 1. Fast-moving, simpler cases stay in the news, and put greater pressure on the defense by increasing the likelihood that witnesses are available and testimony is more convincingly based on fresh memories. Counsel for a subordinate employee in a fast-moving case has less ability to save time and money by relying on the work of more well-funded counsel for the company, CEO or CFO. These developments leave companies with only a small number of choices to improve their position, and potentially the position of their employees, when confronted with an investigation or prosecution powered by new laws and new prosecutorial tactics.
Some Responses to Consider
The U.S. Supreme Court decision to overturn the Arthur Andersen document destruction conviction (Arthur Andersen LLP v. United States, WL1262915) provides a measure of comfort to American corporations that the routine implementation and execution of document retention and destruction policies will not create per se liability for the responsible officers and employees under the broad language of SOX ?802(a), cited above. This decision puts additional emphasis on the importance of a company having and following consistently a clear document retention and destruction policy, as well as clear communication to rank and file employees that documents are not to be destroyed outside of this context.
Missteps by potential defendants, and sometimes by their lawyers, that amount to obstruction of justice in the earliest stages of a criminal investigation have frequently proven easier for the government to prosecute than the more complex underlying problems that led to the investigation. This was true of the charges brought against Arthur Andersen, Frank Quatrone and Martha Stewart, to name but a few. A number of in-house and outside lawyers have found that telling a company employee, who is not the lawyer's client, about his or her rights in dealing with government agents, including the rights to remain silent and seek counsel, can result in a charge of obstruction of justice. The problem is particularly acute when the discussion of legal rights and the expression of interest by the government occur in close proximity.
Extrapolating from the Arthur Andersen decision, companies may want to consider articulating basic information on legal rights, obligations and procedures for rank and file employees in the companies' policy manuals so that it is routinely available before a specific need for it arises. Subjects that should be considered for inclusion in a policy manual include: how to respond to requests by a supervisory person for actions that the employee considers improper; how to respond to the discovery of possible legal violations; how to respond to government agents and inquiries; a reminder that the company's lawyers represent the company and not the employee; a statement of the company's intention to cooperate fully with the authorities; and a statement that an employee's failure to cooperate with the company or the government can be grounds for dismissal. Providing this information in writing and before the need for it becomes specific should be helpful in avoiding inadvertent, or intentional, actions that could be construed as obstruction. The specifics should be confirmed with experienced labor and employment and criminal defense counsel.
Lastly, the company may want to consider implementing a broader program of mandatory contractual indemnity for its employees. In recent years prosecutors have begun to treat the voluntary payment of defense costs of employees as a failure to cooperate that will disqualify a company under investigation from receiving the most favorable treatment. On the other hand, they have reluctantly concluded that a company's compliance with pre-existing contractual obligations to pay defense costs should not be treated as a failure to cooperate. Ordinarily, most companies make the decision to pay for the defense of subordinate employees, or not, on a case-by-case basis based on consideration of where the company's best interest lies under the circumstances. Indemnity agreements providing contractual assurance that defense costs will be paid are typically reserved for the most senior officers and board members.
In the current environment, failing to provide some level of contractual assurance of defense costs to subordinate employees may in some cases undermine the company's best interests as under-represented employees fold their defense early, and on terms that may benefit them while damaging the defense of the organization or its senior management. If expansion of a company's obligation to pay defense costs is considered, a few refinements may be advisable. The company will want to exclude any mandatory right to indemnity in legal actions brought by or in the name of the company, or in investigations or prosecutions where the company is not named as a target or defendant so as to avoid having to pay the defense costs of embezzlers and others that it might choose to pursue legally.
The company might also consider making mandatory only the payment of defense costs prior to trial, or for a stated period of time or a stated amount of money. While defense counsel is likely to view this as limiting their effectiveness, it will provide some assurance that the employee receives effective defense counsel while serving to limit the company's exposure to the most expensive portion of an employee's defense. It will also put a limit on the risk that the company is paying to defend an unworthy rogue against valid charges that do not implicate broader concerns for the company. Further, it is likely that most enforcement actions against the company will be resolved before trial; if not, and the company is going to trial, issues of credit for cooperation may become secondary to putting on the best possible defense, making it easier to justify continuing voluntary payment of a key employee's defense costs if that appears advisable.
The onslaught of corporate fraud investigations and prosecutions arising out of the bull market of the late 1990's appears to be grinding toward the completion of a remarkable chapter in the development of American corporate governance and law enforcement. The notable shift in prosecutorial focus toward subordinate employees has created a more difficult environment for those employees, and indirectly their employers. These employees are more likely now to find themselves facing the full power of the federal government, with no financial resources other than their own and their employer acting in partnership with the government rather than defending them. It can be asked whether these developments will deny access to effective defense counsel for subordinate employees caught up in an illegal scheme instigated by their superiors. It remains to be seen whether the hard falls taken by these subordinate employees will in fact create the more effective restraints on their bosses that the government is seeking.
Michael Tankersley (and Betsy Whitaker)
Bracewell & Giuliani LLP
Bracewell & Giuliani
Michael W. "Mike" Tankersley
Partner, Bracewell & Giuliani
Mr. Tankersley is the group leader for Bracewell & Giuliani's corporate practice in North Texas. He regularly advises senior executives, boards and shareholders of public and private corporations regarding public and private offerings of debt and equity securities, complex financing transactions, acquisitions and dispositions of businesses, organization of joint ventures and other strategic relationships and restructuring troubled companies and investments. He counsels corporate boards and committees regarding fiduciary duty issues, conflicts of interest, disclosure and securities law compliance issues, including special committee investigations of alleged fraudulent activity.
Elizabeth D. "Betsy" Whitaker
Co-Managing Partner, Bracewell & Giuliani
Ms. Whitaker is a past president of the State Bar of Texas. In previous years, she served as chairman of the board of directors of the State Bar of Texas and chairman of the executive committee of the board of the State Bar. She also served as the chairman of the continuing legal education committee of the State Bar, the committee charged with overseeing the largest system for the delivery of legal education to lawyers in Texas.
She has served at the appointment of then-Governor Bush and, later, Governor Perry, as commissioner of the Texas Lottery Commission, a commission that is charged with oversight of approximately $3 billion of revenues each year, and one of the most advanced technology and telecommunication systems in the state of Texas. In her capacity as commissioner, she had jurisdiction over numerous appeals from state administrative proceedings, and participated in legislative hearings and briefings before the Texas State Legislature.
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