The changing nature of internal probes: one result of the stringent regulatory environment is a change in the nature of internal investigations, with firms encouraged to conduct probes to uncover wrongdoing and provide that information to the government.

When even seemingly routine allegations of wrongdoing arise, corporations almost inevitably launch internal investigations. The proliferation of such investigations is a direct result of today's more stringent regulatory environment.

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With fast-moving and competing regulators and the intimidating specter of criminal prosecution of business activities, salient facts must be uncovered quickly so that senior management and the board of directors can make thoughtful and reasoned decisions. Protecting the best interests of the shareholders may mandate the use of an internal investigation to placate the increasing demands of government regulators. Unfortunately, senior executives are often thrown into this maelstrom with little or no guidance or preparation.

The Proliferation of Internal Investigations

Following Enron's initial internal investigation in August and September of 2001--which found no wrongdoing--prosecutors became increasingly skeptical of narrowly-constrained internal investigations performed by lawyers too closely aligned with the matters being investigated, and also of any corporate-directed internal probes that did not root out purported wrongdoing.

The result has been increasing pressures by the federal government, and the Department of Justice (DOJ) in particular, to change the fundamental nature of internal investigations. The hallmark of this governmental pressure was a memorandum issued in 2003 by Deputy Attorney General Larry D. Thompson entitled "Principles of Federal Prosecution of Business Organizations" (known as the "Thompson Memorandum").

This memorandum sets forth the factors federal prosecutors must weigh when deciding whether to seek an indictment against a company, and the U.S. Securities and Exchange Commission (SEC) has adopted a very similar approach.

To avoid the fate of the former accounting firm, Arthur Andersen, companies should take this guidance very seriously. As stated in the document: "The main focus of [the Thompson Memorandum] is increased emphasis on and scrutiny of the authenticity of a corporation's cooperation" with prosecutors. One of the major mechanisms a corporation can use to demonstrate its cooperation, and hence avoid indictment or SEC charges, is to conduct an internal investigation that uncovers wrongdoing and provides that information to the government.

The Thompson Memorandum has generated controversy since its release because, among other things, it identifies as considerations in assessing the "authenticity" of cooperation the entity's willingness to reject previously standard corporate practices. These include advancement of employees' legal fees and preservation of the company's attorney-client privilege.

Less often discussed, but in many respects even more significant, is the fact that the Thompson Memorandum presumes fraud. This presumption is reflected in the memorandum's numerous references to "the culprits" and its reminder that a corporation's willingness to "support culpable employees and agents" by paying their attorney's fees, retaining them as employees, or entering into joint defense agreements with them, weighs against receiving credit for cooperation. Thus, the DOJ provides a powerful incentive for a company at the outset to treat any employee involved in an internal investigation, as the Thompson Memorandum does, as a "culprit."

Once fraud by "culpable" employees is presumed by the government, any cooperation by the company that does not result in uncovering that fraud and identifying those guilty parties becomes suspect. The impact of this aggressive new posture has been dramatic and widespread, and the effect on internal inquiries has been particularly noticeable.

When meeting the government's expectations of cooperation becomes paramount to the survival of the company, satisfying the government can easily threaten to take precedence over the fundamental independence of any investigation--even when an independent analysis of the facts might well regard the conduct in question as aggressive business tactics and not fraud.

What an Internal Investigation Means for Senior Executives

In this atmosphere of culprits and cooperation, senior executives have multiple roles, particularly when an internal investigation focuses on allegations of financial irregularities. Senior executives should understand the purpose of the internal investigation while maintaining a distance from the actual conduct of the investigation so as not to call its independence into question.

* An Internal Investigation Must Be Independent. While truly self-regulatory investigations traditionally can be and have been handled by in-house counsel, for any investigation that has even the potential to garner interest from the government, the wisest course is to engage outside counsel. The need for truly objective, unaffiliated investigators is particularly strong for investigations involving significant financial concerns or the actions of senior management.

An outside law firm conducting an independent internal investigation generally will report to an independent committee of the board of directors, a role often fulfilled by the audit committee. If the allegations are significant or have the potential to implicate the audit committee or the board, outside investigators would then report to a special committee of the board consisting solely of newly appointed independent directors who can act without any suggestion of a conflict of interest.

* Gathering the Facts. An investigation should provide the information necessary for the company to make well-informed judgments and, when appropriate, engage criminal or regulatory authorities with a complete, objective view of the facts. This starts, of course, with determining what happened and why and, depending on the nature and scope of the investigation, may further include determining whether any laws, regulations or internal corporate policies were violated.

An investigation gathers facts from two primary sources: documents and employees. Finance executives likely will be responsible for assisting with the collection of documents. This begins by ensuring that all employees understand that they are to retain and preserve all documents and emails even potentially related to the investigation. It was, after all, Arthur Andersen's failure to preserve documents--and not its accounting advice to Enron--that led to its demise.

* Representation and Peace of Mind. Even with access to all relevant documents, however, a complete investigation is only possible when employees are candid and forthcoming. Importantly, an investigation's access to employees will be influenced materially by the company's decision whether to provide counsel to its employees at the company's expense.

Many companies have a policy to pay their employees' legal fees, and it is frequently in the best interests of the corporation to pay legal fees for counsel to represent employees--whether or not those employees are alleged to have participated in any alleged wrongdoing. Contrary to what some might assume, providing counsel for employees usually increases the efficiency and completeness of an investigation. An internal investigation is a stressful, anxious time for employees. Talking to an investigator can seem intimidating, and even the most well-intentioned employees who have done nothing wrong do not always know how best to respond.

Providing counsel to represent the interests of these employees often makes them more comfortable speaking with investigators and allows them to focus on their work while their lawyers focus on the investigation. Providing counsel also may be an important incentive for employees to stay with the company during a critical time.

Any internal investigation that focuses on financial irregularities will almost always, at one time or another, turn its sights to individuals at the top. With a multitude of lawyers from numerous law firms representing the company, the board of directors and many other employees, it is critical for executives to obtain counsel to represent their individual interests as well.

The last several years have seen dramatic changes in how the government addresses alleged corporate fraud. With potential investigatory situations developing daily--such as the current stock-option backdating issue--whenever an allegation of corporate wrongdoing arises, an internal probe is almost certain to follow. When faced with an internal investigation, the best advice for finance executives is to focus on the tasks at hand: preserve documents, manage your business and your staff, and leave the internal investigation to the investigators and the lawyers.

Michael N. Levy and Michael L. Spafford are Partners and Lothlorien S. Redmond is an Associate. All are in the White Collar/Investigations and Enforcement practice of the law firm McKee Nelson LLP in Washington, D.C.

RELATED ARTICLE: takeaways

* Since the Enron internal investigations, prosecutors have become more skeptical of narrowly-constrained internal probes performed by lawyers too closely aligned with matters being investigated and corporate investigations that did not root out purported wrongdoing.

* The result: increasing federal government pressure. The "Thompson Memorandum" has increased emphasis on and scrutiny of the authenticity of a corporation's cooperation with prosecutors, and it presumes fraud.

* The impact of this aggressive new posture has been dramatic and widespread, and the effect on internal investigations has been particularly noticeable.