Global Policy Forum

By Kathleen Day and Ben White

When a whiff of accounting irregularities at Enron Corp. rocked Wall Street in the fall of 2001, the energy-trading firm's board of directors hired the law firm of Wilmer Cutler & Pickering to do an internal investigation of the company. Board members expected the lawyers to find a few pieces of dirty laundry that, once aired, might be embarrassing. But they hoped the investigation also would allay investors' worries about widespread fraud, allowing Enron to move out of crisis mode and back to business as usual. The Wilmer lawyers weren't as sanguine.

"We didn't know if we would find bodies buried in the basement or simply a broken door latch that could be easily fixed," said William R. McLucas, former head of enforcement at the Securities and Exchange Commission and Wilmer's lead attorney in the investigation. McLucas cautioned the Enron board that his team would have to follow the investigation wherever it led and that serious problems might be uncovered. The directors, already facing damage to Enron's viability and their own reputations, decided the risk was worth taking. At least it would forestall an investigation by the SEC, which had opened one but agreed to stand down until the board's review was finished. As it turned out, the report McLucas handed the Enron board in February 2002 detailed widespread fraud at the company. In doing so, it also provided a guide to wrongdoing for criminal and civil prosecutors -- and investors eager to file class-action lawsuits.

Despite that painful outcome, Enron-style self-initiated internal investigations have become the tool of choice for corporate directors under siege from charges of wrongdoing at the companies they are supposed to oversee. Boards at Merck & Co., WorldCom Inc., Tyco International Ltd., Adelphia Communications Corp., Riggs Bank, the New York Stock Exchange, Hollinger International Inc. and Freddie Mac all have used them. More recently, mortgage funding giant Fannie Mae, accused of accounting misstatements that could wipe out $9 billion in earnings, has commissioned an independent investigation led by former senator Warren B. Rudman. All have hoped that by baring their souls they would placate regulators and prosecutors, get ahead of bad news and minimize disruption to the companies' -- and their own -- reputations. "Formal, outside, counsel-driven investigations have become so much more frequent in the last few years that it just spins your head," said former federal prosecutor Jonathan D. Polkes, a partner in the business fraud and complex litigation practice at Cadwalader, Wickersham & Taft LLP. "It's going on all the time, which is consistent with what you would expect given the new focus that the New York attorney general, the SEC and various U.S. attorneys are putting on white-collar crime in general." The investigations have become so widespread, Polkes said, that big law firms are trying to get in the action. "Lots of places are trying to do it. It's a growth industry."

But while increasingly popular, internal investigations are extremely delicate undertakings that present directors with a number of tough questions: Should the results be disclosed to the public? Should directors confess to regulators if they find questionable, but not clearly illegal, practices? Do the investigations simply provide powerful ammunition, free of charge, to aggressive plaintiffs' lawyers? Subjects of the investigations also sometimes bite back. At Hollinger, former chief executive Conrad M. Black filed a libel suit after the release of the company's internal review, which was conducted by former SEC chairman Richard C. Breeden. Black said the report amounted to a gossipy novel filled with nuggets that, while perhaps titillating, reflected no wrongdoing. He also accused investigators of leaking information to the press. "If you were reading coverage of the investigation, you would have thought that at any minute they were going to lead him away in handcuffs," said Black spokesman James Badenhausen.

Former New York Stock Exchange chairman Dick Grasso, who was sued by New York state Attorney General Eliot L. Spitzer over his $139.5 million compensation package, filed a $50 million countersuit against the exchange and Chairman John S. Reed in July alleging breach of contract and defamation of character. And he hired one of the nation's top litigators, Brendan V. Sullivan Jr., to press his case.

The issue of whether to disclose is always sensitive and generally depends on how much trouble a company is in. For instance, Tyco directors, facing criminal indictments of former top executives, never seriously considered keeping private the results of an internal investigation conducted by lawyer David Boies. Failure to disclose, they believed, would enrage investors and suggest that wrongdoing at the company spread well beyond the actions of former chief executive L. Dennis Kozlowski and former chief financial officer Mark H. Swartz. A criminal case against Kozlowski and Swartz ended in mistrial in April, and the two are scheduled to be retried on conspiracy, grand larceny and securities fraud charges next month. "There was never any debate," said Eric M. Pillmore, who was brought in by Kozlowski's successor, Edward D. Breen, to overhaul Tyco's corporate governance policies. "[Breen's] commitment to shareholders was that he was going to be entirely transparent. . . . We understood the potential downside. But the commitment we had made didn't allow us to do anything different."

At mortgage-finance giant Freddie Mac, which hired former SEC chief counsel James R. Doty of the law firm Baker Botts LLP to conduct an investigation, the board members also thought they had no choice but to make Doty's report public. They reasoned it was the only way to assure public debt markets there were no further problems lurking in connection with the company's $5 billion restatement of earnings. Rattling the debt markets would have raised the company's cost of borrowing, a problem potentially more damaging to earnings than any lawsuit. But the NYSE, which is not publicly traded, kept its Grasso investigation by former prosecutor Daniel K. Webb under wraps because of concerns that it would be too "embarrassing" to directors who approved the pay, according to Reed.

Regulators and prosecutors generally applaud internal investigations -- as long as they are truly independent, thorough and objective. Paid for by the company, the investigations often save the government time and money. But not always. Prosecutors in Spitzer's office were not able to simply use Webb's report -- which was provided to them, though not made public -- as the basis for their case. While it portrayed a highly dysfunctional institution, the prosecutors did not find that it documented clear violations of law. So they re-interviewed everyone involved and essentially built a case from scratch, which took four months.

Internal investigations are also filled with potential conflicts. Outside lawyers hired to conduct the investigations in effect have two different sets of constituents: independent board members on the one hand and SEC and Justice Department lawyers, who will decide how far to pursue the matter, on the other. Potential conflicts of interest can also arise when directors who order investigations are themselves being investigated by the government for possible culpability. That's the situation at Riggs Bank, where regulators have found widespread violations of laws intended to prevent money laundering and evidence of possible money laundering for international figures such as former Chilean dictator Augusto Pinochet.

The full boards of Riggs and its holding company hired a former Secret Service agent to conduct an internal review, with help of lawyers at Sullivan & Cromwell LLP. But the role the directors themselves played in the bank's operations is one of the issues under review in ongoing federal investigations. The problem also arose at Hollinger, where every board member was considered a possible subject of Breeden's investigation. So the board elected three new members, including Gordon A. Paris as interim chief executive, who together formed a special committee to oversee the investigation. Breeden said the special committee provided vital support when subjects of the investigation began to balk at requests for documents and interviews. "It's not until you start asking for documents that people say, 'Whoa, wait a minute, you are getting into that?' " Breeden said. "But there was never any question at Hollinger that if there was not full compliance all three [members of the special committee] would have resigned together. . . . Under no circumstance would I have tolerated people limiting what we could look at."

Another potential tension in internal investigation is that they can pit a company and its board against individual employees. Employees are asked to disclose any wrongdoing they know about and any role they might have played in it to investigators and lawyers, who may then use that information against them. But while investigations may open companies up to criticism, they also can help directors prove they have been active in trying to get to the bottom of any wrongdoing, which in turn could limit damages from potential suits.

The downside of the trend is that in-house lawyers at companies are much less likely to document -- in memos, letters, e-mails or otherwise -- complaints about wrongdoing, for fear a paper record could come back to haunt them during an internal investigation. They may be even less likely, not more, to bring potential problems to superiors. Ronald C. Minkoff, who helps run seminars for lawyers on how to walk the fine lines required during such investigations, said companies' chief counsels are apt to tell attorneys who report to them, "You better be very careful about what you bring to my attention." Internal reports often wind up as weapons in the hands of plaintiffs' attorneys.

Directors at Walt Disney Co., for example, hired audit firm Pricewaterhouse in 1996 to document corporate spending by former Disney president Michael S. Ovitz. The report, titled project MSO (for Ovitz's initials) detailed $4.8 million in spending by Ovitz and has been a central and embarrassing piece of evidence in an ongoing shareholder lawsuit over Ovitz's $140 million severance package, which he received after just 14 months on the job. "Every time you do a report you are creating a road map for the plaintiffs' firms, and there is just nothing you can do about it anymore," said Cadwalader's Polkes. "They are going to get it and they are going to use it."

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