cfo.com

Print this article | Return to Article | Return to CFO.com

The Limits of Mercy

The cost of cooperating with the SEC is high. The cost of not cooperating is even higher.
Tim Reason, CFO Magazine
April 1, 2005

What happened to the kinder, gentler Securities and Exchange Commission? Less than four years ago, then-chairman Harvey Pitt wanted an agency that favored cooperation over confrontation. The SEC seemed headed in a business-friendlier direction, and critics feared that the agency would grow softer on financial fraud. In particular, they pointed to the precedent-setting case of Seaboard Corp., whose self-reporting of an accounting fraud enabled it to avoid charges and fines in October 2001—just days after the SEC opened its investigation of Enron.

As it turned out, the critics needn't have worried. In the SEC's next high-profile case after Seaboard, in April 2002, the agency slammed Xerox for financial fraud with a then-unheard-of $10 million fine, citing the company for its lack of cooperation. Since then, the SEC has come down increasingly hard on companies it deems uncooperative, specifically citing uncooperative behavior as a determining factor in huge fines for Qwest, Dynegy, Computer Associates (CA), and others (see "Who Played Ball?").

Today, few would call the SEC soft. Under Pitt's successor, William Donaldson, total fines levied by the agency have soared—from $44 million in 2001 to more than $1 billion in each of the past two years. Over the same period, the number of financial-fraud actions filed has increased 70 percent.

But the SEC's tougher stance has its critics, too. Some are troubled by the rapid escalation of fines, which the agency says is deliberate. "We have intentionally tried to make sanctions more meaningful [so] that their deterrent effect is increased," says SEC deputy director of enforcement Linda Chatman Thomsen. "It is important that the penalty portion have some sting."

Moreover, defense lawyers are concerned about what they see as a rationale for the large penalties: failure to cooperate with the SEC. "To exact a penalty for lack of cooperation by a public company is completely without statutory basis," complains Greg Bruch, a former SEC assistant director of enforcement, now with Foley & Lardner LLP in Washington, D.C.

Indeed, several of the defense lawyers interviewed by CFO—all former SEC enforcement division attorneys—charge that companies that don't follow the recommendations in the SEC's Seaboard report are automatically considered uncooperative by SEC staff. "The Seaboard factors, originally held out as a carrot, are now used more often against companies as a stick," claims attorney Russell G. Ryan, a former assistant director of enforcement at the SEC, now a partner in the Washington, D.C., office of Atlanta-based King & Spaulding LLP.

Whether Seaboard is a carrot or a stick, of course, depends largely on perspective. What is clear is that the tougher enforcement environment has made Seaboard more costly as well. While following its recommendations to the letter offers no guarantee of leniency, doing so is likely to increase a company's exposure to shareholder suits. And in an era of heightened personal liability, Seaboard can pit executives and the company against each other from the moment the first call from the SEC comes in.

Extraordinary Cases
The Seaboard recommendations include 13 factors that may earn companies credit for good behavior—and three often-overlooked caveats that note the SEC retains broad discretion, particularly in cases where great harm has been done. Seaboard was never meant to be a get-out-of-jail-free card, says Thomsen. And while the SEC's press releases clearly connect fines with uncooperative behavior, Thomsen insists the fines are prescribed by the securities laws the companies violate. Meanwhile, she says, Seaboard "absolutely" remains SEC policy. "We intend to, and do, reward extraordinary cooperation."

But extraordinary means just that. Since Seaboard, only two public companies—Homestore Inc. and Electro Scientific Industries Inc. (ESI)—have entirely avoided both penalties and charges. The SEC's explanation in both cases was nearly identical, covering the essential provisions of Seaboard cooperation. In the case of Homestore, that meant "reporting its discovery of possible misconduct to the Commission immediately upon the audit committee's learning of it, conducting a thorough and independent internal investigation, sharing the results of that investigation with the government (including not asserting any applicable privileges and protections with respect to written materials furnished to the Commission staff), terminating responsible wrongdoers, and implementing remedial actions designed to prevent the recurrence of fraudulent conduct."

Last year, a third company, Royal Ahold, avoided an SEC fine (but settled civil charges) by fully cooperating with the agency's investigation into accounting fraud at the grocery-chain giant. "We all felt good and gained confidence at the outcome of the SEC decision," says Royal Ahold CFO Hannu Ryöppönen. Thomsen insists there are many more instances of companies receiving consideration for cooperation. The Seaboard report, she notes, actually lays out a range of reduced penalties and sanctions; the "extraordinary step of taking no enforcement action," as the SEC describes it, is clearly intended to be rare.


No less an authority than Seaboard's author agrees with Thomsen. "It's a mistake for people to look at [Seaboard] as a contract that says if they do x, the SEC will do y," warns Harvey Pitt, now CEO of director-advisory firm Kalorama Partners. Pitt says he put Seaboard in place to make sure companies understood that cooperation "was their obligation, whether or not they got any benefit."

Pitt argues that Seaboard's aim of promoting a proactive internal response remains misunderstood. "When I read in the press [of] companies saying they are cooperating fully," he says, "it's sort of a euphemism for 'We are sitting back and waiting for the government to tell us what went wrong and how to fix it.'" Echoes Thomsen: "We haven't met a company that hasn't told us they have been fully cooperative and complying with Seaboard."

Just the Facts
The trouble is, complying with Seaboard could also do harm. One of its most controversial provisions is the recommendation that companies share the results of their internal investigations with the SEC—despite the fact that such reports are protected by attorney-client privilege. Often compiled by forensic accountants and ex-SEC lawyers, such reports amount to "a road map" for SEC investigations, says Foley & Lardner's Bruch. "It's an enormous labor saver for the government."

While Seaboard only acknowledges the privilege issue in a footnote, many of the SEC's subsequent settlements (including Homestore, ESI, and Ahold) emphasize willingness to waive this privilege as a sign of good behavior. But waiving privilege potentially increases exposure to the shareholder suits that inevitably accompany a formal SEC investigation, says Derek M. Meisner, an attorney at Boston's Kirkpatrick & Lockhart Nicholson Graham LLP. Although the SEC typically promises to keep such reports confidential, he explains, handing over an internal investigation to a government agency generally makes it fair game for plaintiffs' attorneys, too. "The concept of a limited waiver of the privilege has had, at best, mixed success in the courts," observes Meisner, a former enforcement branch chief who left last July after five years with the SEC.

In the case of McKesson HBOC Inc., which came under investigation for accounting irregularities in 1999, plaintiffs' lawyers filed multiple suits seeking access to the internal investigation report that McKesson turned over to the SEC. Delaware's courts sided with McKesson, but Georgia's and California's did not. The company settled the Georgia case before being forced to release the documents, and has appealed the California case to the 9th Circuit. The SEC weighed in on that case (which will likely end up in the Supreme Court) with amicus briefs defending its confidentiality agreement and McKesson's right to keep the documents private.

Thomsen says the SEC also has lobbied Congress to allow selective waiver, though so far with little success. "We are sensitive to the issues surrounding waiver of privilege," she says. Moreover, she says, it's important to note that the SEC is seeking to obtain after-the-fact investigative reports, not legal advice received by companies under investigation. "We are interested in getting the facts, not a waiver as such," she says.

Nonetheless, "there's a growing belief that you can get punished if you choose not to waive privilege," says former SEC enforcement chief William McLucas, now at Wilmer Cutler Pickering Hale and Dorr LLP. Thomsen acknowledges that sentiment, but says the SEC cannot and does not insist on a waiver. "When an entity decides not to waive for whatever reason, we work very hard not to punish," she says.

I Fought the Law
Another thorny issue is that while companies have little choice but to pursue the best settlement possible, the calculus of cooperation for individual officers and directors may be heading in the opposite direction. Not only do both the SEC and the Department of Justice try to hold individuals accountable whenever possible, but Sarbanes-Oxley lowered the SEC's threshold for barring individuals from serving as directors and officers, causing the number of such bars to soar from 38 in 2000 to 161 in 2004.

Faced with financial penalties, career-ending bans, and possible criminal prosecution, more individuals are choosing to fight the SEC. In the SEC's fiscal-year 2004, for example, 43.7 percent of the administrative actions or cases it brought in federal district court against individuals were litigated upon filing, meaning that at least one defendant refused to settle. That's up from 38.1 percent in 2003, 43.3 percent in 2002, and 34.2 percent in 2001. "Individuals now are not seeing a lot of choice but to litigate," observes Bruch. "The financial incentives are pretty pronounced, particularly if they are insured or indemnified."

"The government's push for individual accountability is a rational and wise approach to trying to improve governance," says McLucas. "But it also creates very real practical problems in getting your hands around information. Everybody is worrying about their own liability and getting their own lawyer, and there are instances where that does not contribute to cooperation."


"No doubt there is a tension between entrenched management who may have done wrong and a board that may have been defrauded," concedes SEC commissioner Roel Campos. After all, one of the factors specified in Seaboard is "Are persons responsible for any misconduct still with the company?" Several companies initially cited for lack of cooperation—such as Del Global, Symbol Technologies, and Gemstar—were given credit after the company cleaned house. In each case, the SEC claimed management was not only responsible for the fraud, but also for impeding the ensuing investigation.

In serious accounting-fraud cases, of course, it's more common for the company and management to part ways early on. In Electro Scientific's case, the SEC filed fraud charges against CFO James T. Dooley and controller James E. Lorenz III, and announced that the U.S. Attorney's office was simultaneously filing criminal charges against them. Likewise, Homestore CFO Joseph Shew and two other finance department employees settled with the SEC and pleaded guilty to criminal charges.

Of course, if management is responsible for fraud, it makes sense for the company to toss them overboard. But condemning or exonerating management has become a more formal and expensive process as the level of liability for companies, directors, and executives has risen. "In a formal inquiry, you may need to talk to company officers with their individual counsel present," says Bruch. "I don't know that it has improved the truth-seeking function of internal reviews, [but] I know it has increased the cost."

And executives have some right to be cautious of company investigations. The SEC noted in a court brief that access to McKesson's report helped it file a raft of enforcement actions against individual employees, including former CFO Jay Gilbertson and three of the company's former accountants. "Understand that the stakes couldn't be higher," Bruch advises employees and officers who talk to their own company counsel about an SEC investigation. "You have to approach talking to company counsel with the same level of care you would if you were talking to the government."

That warning was vividly illustrated last year, when Computer Associates CFO Ira Zar, senior vice president of finance and administration David Kaplan, and vice president of finance David Rivard all pleaded guilty to charges of obstruction of justice for lying—not to SEC, FBI, or grand-jury investigators, but to their own company's law firm, and to the law firm hired by CA's audit committee.

According to Zar's indictment, the company had publicly announced that it was cooperating with multiple government investigations into its accounting practices, and Zar "knew, and in fact intended, that the Company's Law Firm would present these false justifications to the United States Attorney's Office, the SEC and the FBI." Identical charges were later brought against CEO Sanjay Kumar and several other CA executives.

Although company lawyers are ethically bound to note that they represent the corporation, many say the CA precedent will put a further chill on executive cooperation with a company investigation. "The notion that [the government] has conscripted every lawyer is a mistake," warns McLucas. "I think it will hurt the system."

There are, however, signs that the SEC is trying to strike a balance between the incentives offered to companies and those offered to individuals. "We reward cooperation on behalf of individuals as well," says Thomsen, "[although] it's probably a little harder to articulate." In January, for example, the SEC settled insider-trading charges against Jun Singo Liang, executive of a Beijing-based Internet company. Although Liang paid more than $1 million in penalties and was barred from acting as officer or director of a public company for five years, he also received a rare acknowledgement for cooperation. The SEC explained that it levied "a lower penalty than it might otherwise have pursued [because it] took into consideration Liang's voluntary disclosure of his trading activity to his employer and to the Commission staff."

No Shrinking Violets
While levels of cooperation clearly vary, few companies can afford to actually fight the SEC. "That would mean several years of being viewed as a corporate outlaw," says King & Spaulding's Ryan, noting that the punishment meted out by the market in the interim would likely be severe. Most companies, then, hope cooperation will settle the matter quickly. But does that mean that Seaboard has stifled the ability of securities lawyers to aggressively advocate on behalf of their clients? "It sure doesn't feel that way around here," says Thomsen. "[Corporate] defense lawyers are not shrinking violets."

Still, because companies almost always settle, the SEC wields unusual power as both prosecutor and judge. "In 90 percent of what it does, this agency operates outside of judicial review and scrutiny," says McLucas. Most of the SEC's decisions, remedial actions, and policy initiatives are never reviewed by the court system, he notes. "You can't always be deferring to young, aggressive government lawyers and accountants about what's right. That's where you see frustration from the defense bar," he says. "What used to be construed as good solid advocacy may be construed by the government as a lack of cooperation."


Besides, even dropping all defenses and cooperating fully may not be enough. That's a point made in the Seaboard report itself, but one often overlooked by the defense bar. "At the end of the day, conduct rules," Thomsen explains. "If the behavior is sufficiently grotesque—if it went on a long time, at the highest levels—then there may not be a lot the company can do to get credit."

Tim Reason is a senior writer at CFO. Additional reporting was provided by CFO.com assistant editor Craig Schneider and editorial intern Laura DeMars.





CFO Publishing Corporation 2009. All rights reserved.