The ongoing crisis now gripping the financial and credit markets undoubtedly will give rise to a multitude of internal investigations as the affected investment and retail banks, brokerages, rating agencies, private equity firms and hedge funds scurry to determine precisely what went so egregiously awry in their trading and underwriting activities to inflict such harm to their respective institutions. The anticipated proliferation of such exercises in corporate self-examination, the inevitable onslaught of all manner of litigation — including shareholder derivative and class action suits — and the unavoidable parallel regulatory and criminal inquiries arising in the wake of this enormous market meltdown prompted a bit of reflection on my part upon the corporate disasters of the past.
Some years ago, while involved in structuring a number of internal corporate investigations arising from some rather widely reported and notorious corporate calamities, I somewhat jokingly suggested that the ultimate shareholder derivative suit might be one fashioned to challenge the massive diversion of corporate assets thrown seemingly indiscriminately at every outside law firm that could be found with no prior substantive relationship with the corporation to assist in some discrete aspect of the investigation. Many is the time I found myself in courtroom galleries in the company of any number of senior partners of the most prominent (read, costly) law firms in the nation, all awaiting the opportunity to report to the court on the status of the still ongoing internal investigation, pursuant to which the corporation theretofore had managed to keep dissident shareholders and unwelcome class and derivative suits at bay pending the conclusion of the (seemingly interminable) investigation at some yet-to-be-determined date far off in the future. As the company’s legal fee meter churned at a brutally rapid rate, given the large assemblage of such highly paid attorneys cooling their heels for extended periods of time, the long-awaited interim report almost invariably was solemnly delivered by a single attorney in the space of just a few seconds.
As a rule, no opportunity was given for the other lawyers in attendance to address the court. Consequently, the richly compensated attorneys representing the outside directors, the management directors, the Board’s litigation committee, senior executives, management and certain employees of the company and the specifically denominated subsidiaries of the corporation involved in the alleged malfeasance all sat silently. The esteemed gathering would disband soon after the brief anti-climactic status report was delivered to the court, with most of the attendees scrambling to the airport for their first-class return flights to their far-flung offices around the country.
Unassailable integrity and utter impartiality of the investigative process at any cost was then the sine qua non insisted upon by the courts in determining whether to accept the final recommendations reached at the conclusion of the internal investigation.
Unquestionably, much has changed in the intervening years; the proverbial pendulum has swung decisively in the opposite direction. True independence, objectivity, impartiality and thoroughness –- all of which once were revered as the talismanic requirements of any internal investigation that was to be accepted and blessed by a court to foreclose shareholder litigation –- have all but disappeared entirely.
By many recent accounts, corporate investigations now regularly are carried out by in-house attorney employees, whose “conclusions” are then presented to the company’s corporate counsel and then in turn to the board for ratification. Plainly, no semblance of objectivity or impartiality possibly can attach to such procedures, yet they appear to gain in popularity as the favored means of addressing all manner of corporate irregularities.
“The proverbial pendulum has swung decisively in the opposite direction. True independence, objectivity, impartiality… have all but disappeared….”
Similarly bewildering and frustrating to adherents to principles of corporate integrity and accountability are those situations in which the company professes to “go the extra mile” by retaining “outside counsel” to conduct the internal inquiry into allegations of improprieties.
In practice, however, this is more likely than not to play out as follows:
(1) the company’s general counsel contacts the company’s most favored outside law firm;
(2) the (most frequently, corporate/transactional) partner of the outside firm with primary responsibility for the client speaks with his (typically, underengaged) counterpart in the firm’s litigation department to formulate a response to the internal problem;
(3) the litigation partner rounds up every available (read, underbilling) associate attorney at the firm to descend T upon the company and disrupt its daily operations by reviewing every available email, document and file, and interviewing every available employee over an implausibly extended time period;
(4) digests and, in turn, summaries the digests of these far-flung and disorganized activities are amassed for repeated summarization and ultimate preparation as a “final report”; and
(5) the report is presented to the board of directors for immediate (read, rubber stamp) ratification.
While such a process is designed to suggest thoroughness –- at an enormous diversion of corporate assets and a staggeringly high price tag for the company and its shareholders –- can it seriously be argued that the findings and recommendations resulting therefrom are the product of any measured and objective analysis by attorneys who are truly independent from the company?
The reasons for skepticism are manifest. While company management may never before have dealt personally with members of the outside firm’s litigation group, the company’s relationship with that firm’s corporate/transactional department is well developed, and it contravenes daily business realities to suggest that such an investigation will not be monitored closely, if not influenced outright, by the corporate partner whose primary objective, of course, is to protect and perpetuate his law firm’s preexisting relationship with the company.
Where then, one might reasonably ask, are the non-management directors as such events unfold? I deliberately choose the word “non-management” to reflect the well-nigh universally held presumption that the objectivity and impartiality of today’s outside directors are dangerously compromised to some degree by, among other things, close personal relationships to management and their cross-memberships on overlapping and interlocking boards of directors.
In common situations, such as those described above, the directors are expected merely passively to await the presentation of a “final report” and then to ratify its findings and recommendations. In the unlikely event that any concerns are raised as to the integrity or objectivity of the investigation, they can be adroitly deflected by pointing to the sheer number of attorneys involved, the fact that the outside litigation attorneys were largely unknown to the company and, of course, the staggeringly high bill for legal fees generated in connection therewith. The steps along the path of convenience and least resistance thus have been carefully choreographed for the convenience of the outside directors, whose acquiescence is only too common.
The critical and heretofore indispensable element wholly absent from these all-too-frequent self-serving corporate exercises in internal fact-finding is, of course, any evidence of truly independent counsel.
Given the recent confluence of reports that procedures similar to those described above are being deployed with alarming frequency in the aftermath of all manner of corporate misdeeds, the time has arrived for a thoughtful re-examination of the most basic tenet of corporate governance and the primary fiduciary responsibility of outside directors -– i.e., ensuring internal financial and operational oversight, integrity and accountability –- and how it is swept aside all too frequently in the context of internal corporate investigations.
Such disregard for this cornerstone of corporate governance appears to be occurring at a particularly perilous juncture for management. Enhanced reporting requirements, more vigorous enforcement activity, heightened expectations of the fiduciary obligations of outside directors, and intensified judicial scrutiny and skepticism of the conclusions reached by such internal investigations have converged to underscore the need to engage truly independent outside counsel. Moreover, the shareholder activists demanding greater management accountability today are more likely to emerge from highly sophisticated and well-financed hedge funds and private equity firms, rather than from the dog-eared Rolodexes of the plaintiffs’ securities bar, who possess both the market savvy and resources aggressively to challenge the integrity and bona fides of the “recommendations” or “conclusions” that result from internal corporate exercises so lacking indicia of actual independence or impartiality.
Within the context of the present dislocation of our financial and credit markets and the myriad interconnecting and overlapping layers of complexity underlying the meltdown, it would appear that the need for objectively independent investigation has never been more pronounced. The putative defendant firm will be under siege from an astonishingly wide array of potential litigants. Disgruntled investors of all stripes, including hedge funds, private equity firms, mutual funds and pension funds, secured and unsecured creditors, underwriters, credit rating agencies, risk insurers, class and derivative shareholders, and all manner of counterparties to the underlying collateralized debt obligations, credit default swaps and investment instruments can be counted on to institute litigation at some point in an attempt to recoup at least some small portion of their losses.
It will be difficult indeed, if not well-nigh impossible, to identify and retain attorneys to conduct and coordinate a credibly objective internal investigation who are not compromised by a prior significant relationship with one or more of the many potential litigants. Yet, I submit that the imperiled firm would be well advised to locate such unencumbered legal counsel if the beleaguered company is to have any hope of emerging from the litigation morass. Challenges to the findings and conclusions of the internal investigation by characterizing it as an impartial corporate “whitewash” can be repelled only by a clear demonstration of the unassailable impartiality of the investigating attorneys and the thoroughness of their work.
It bears emphasis also that in all likelihood the substantive and procedural aspects of the investigation are likely to come under scrutiny. In this respect, the investigating lawyers should draw upon the expert assistance of outside advisers to address and attempt to unravel the highly complex and, in the current circumstances, arcane securitized instruments underlying the company’s losses. (The involvement of such non-lawyer third parties also raises a host of privilege and work-product implications that only a seasoned attorney can navigate so as to best protect the company; such issues, will of critical importance, are beyond the scope of the present writing.) The outer limits of the business judgment rule will be probed with great intensity as the validity of management and the board’s ratification, vel non, of such exotic investments is weighed. This analysis undoubtedly will entail an examination of the extent to which the proper company officials actually fully understood the investment strategies and the volatility of the underlying securitized instruments that led to the company’s involvement in such trading activities. Such an examination, in turn, also necessarily will focus at least in part on whether or not adequate risk exposure analyses were in place and properly observed.
The critical importance of the internal inquiries and the conclusions emerging therefrom can hardly be sufficiently emphasized. The supervising outside attorneys will need to devise an overarching strategy to mount the best defense possible for the company and its shareholders, taking into account all of the anticipated lawsuits as well as the parallel governmental investigations. Beyond the incredibly complex privilege issues to which I already have alluded, the outside lawyers in charge of the internal investigation must also be mindful of the ultimate endgame to position the company most advantageously with respect to possible regulatory and criminal sanctions.
In this regard, the overall integrity, impartiality and credibility of the investigation must be above reproach. The lead investigating attorneys cannot be perceived as having an axe to grind (as in having been in some way involved in advising the company in connection with the trading and investment activities giving rise to the company’s predicament and, consequently, being predisposed to upholding such activities) stemming from a prior relationship with the putative defendant firm. Moreover, I submit that truly independent investigating attorneys will, by definition, lend an air of overarching credibility that may well go a long way toward assuaging the concerns of the regulatory and criminal investigators.
“As a prophylactic measure, I suggest that outside directors should consider retaining counsel with no prior ties to the corporation….”
Outside directors in all instances are looked to as the shareholders’ ultimate arbiters of management’s stewardship of the corporation. Yet, in recent instances of company misdeeds, irregularities and even outright scandals, outside directors appear only too willing to rubber-stamp the (perhaps pre-ordained) findings of internal investigations conducted entirely without the involvement of truly independent counsel. Speaking somewhat topically, it seems inconceivable that any experienced attorney not otherwise entangled with a company’s ongoing operations would think it anything other than insanely inappropriate to subject board members to aggressive electronic surveillance measures. It is worthy of note, if many press accounts are to be believed about this unfortunate incident, that it was not until an outside director sought counsel from his own independent attorney that this situation was properly brought to light and addressed.
Given the increasingly frequency with which outside directors’ oversight of companies where corporate misdeeds have occurred is being examined with heightened scrutiny (and, in some instances, well-deserved outright skepticism) by the courts, as well as by the investing public at large, it seems appropriate at this moment for sober reflection by non-management board members as to whether their fiduciary obligations to the shareholders can fully be satisfied in the absence of truly independent legal counsel.
As a prophylactic measure, I suggest that outside directors should consider retaining counsel with no prior ties to the corporation to provide advice on an ongoing basis, perhaps through the formation of an oversight or litigation committee of outside directors, which then would be formally authorized to retain such independent outside counsel.
At a bare minimum, non-management directors should insist that independent counsel with no prior affiliation with the company be engaged immediately upon the mere suggestion that any significant corporate irregularities may have taken place. In this manner, independent attorneys can survey the situation and perform an initial inquiry as to the purported impropriety and, if found, assume primary responsibility for structuring the procedures pursuant to which whatever necessary internal employee interviews and document review are to be conducted.
I note also that, in light of recent judicial developments, outside directors may no longer expect to enjoy the deferential insulation and protections that heretofore have been routinely afforded them unless they are able to demonstrate active supervision of, and constructive involvement in, a truly independent internal investigation. The mere reflexive ratification of neatly pre-packaged, pre-ordained “final reports” prepared by attorneys affiliated with the company should no longer suffice as evidence of effective corporate oversight or adequate satisfaction of bedrock fiduciary obligations to shareholders.
The procedures prescribed above by no means should be taken to suggest uncontrolled “witch hunts” on massive scales; quite to the contrary, counsel experienced in such internal investigations easily should be able to craft an internal inquiry that is narrowly tailored to meet, and carefully circumscribed to address, the discreet area of concern swiftly and with surgical precision.
Virtually any redirection of company assets away from productive uses to the investigation and the correction of corporate misdeeds should otherwise be unnecessary and is, therefore, wasteful by definition. The perpetrator(s) and origins of such misdeeds and the scope of their impact on company operations can be identified and remedied much more efficiently and cost-effectively through the engagement of experienced attorneys who are truly independent of the company. And, in order to vest the investigation and its resulting conclusions with any presumption of credibility and objectivity in the face of state and federal government criminal and regulatory inquiries, true independence of the supervising attorneys must be established.
In addition, substantial economies can be realized by minimizing (and, in many cases, eliminating outright) the otherwise attendant costs of litigating the issues of the impartiality and objectivity of the investigating attorneys, the overall integrity of the investigative process, and the unimpeachably appropriate conduct of the outside directors if, of course, such prudent measures are employed.
Edward Gallion is a law partner at the firm of Gallion & Spielvogel and officer with the International Network of Boutique Law Firms (www.inblf.com). His areas of expertise include structuring internal corporate investigations, defending complex corporate and civil litigation matters, white-collar criminal defense representation, contract disputes and securities litigation and regulation.