The Cost of Cooperation

Cooperation with government investigators has long been important for companies under the specter of an investigation. Under current agency policies and practices of the Securities and Exchange Commission (SEC) and U.S. Department of Justice (DOJ), and relevant provisions of the Sentencing Guidelines for Organizational Offenders, a “cooperative” corporation can realize substantial reductions in penalties or even avoid an enforcement action altogether. Seaboard Corporation in 2001 and HomeStore, Inc. in 2002 are excellent examples — both were able to avoid SEC enforcement actions because of the extent and nature of their cooperation with investigators.

The multi-million dollar question is what will be defined as “cooperation.” Over the past 10 years, the answer has evolved, and at each step, the requirements have increased. Waiver of the attorney-client privilege and work product protection is one of the “costs” that a corporation will likely have to pay. Recent enforcement actions also strongly suggest that a corporation will likely not be deemed “cooperative” without divulging its privileged internal investigation findings.

The SEC, in its recent Lucent Technologies action, raised the bar for what constitutes cooperation. See “Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud: Lucent Agrees to Pay $25 Million Penalty: SEC Charges 10 Individuals with Securities Fraud,” SEC press release of May 17, 2004, available at http://www.sec.gov/news/press/2004-67.htm. The Lucent penalty suggests government investigators will scrutinize a corporation's policies and practices concerning indemnification in evaluating the extent of its cooperation. This new focus has implications for the corporate entity and its officers, directors, and employees. When companies want the benefits of cooperation, they may be precluded from advancing the cost of representation for employees, even where their indemnification obligations require it. Individuals who find themselves subjects or targets of a criminal or civil enforcement action may now be on their own when it comes to paying for defending themselves.

The Lucent Settlement

On May 17, 2004, Lucent agreed, without admitting or denying misconduct, to pay a $25-million fine for failing to cooperate in the SEC's investigation over Lucent's alleged role in a $1.1 billion accounting fraud. The SEC cited four aspects of Lucent's conduct as non-cooperation:

• Incomplete and untimely document production;
• After the company and the SEC reached an agreement in principle to settle the case, Lucent's outside counsel told a magazine the conduct challenged by the SEC was a “failure of communication” and not an accounting fraud;
• After the agreement in principle, “Lucent expanded the scope of employees that could be indemnified against the consequences of this SEC enforcement action” beyond that required by state law or its corporate charter; and
• “Lucent…failed over a period of time to provide timely and full disclosure…on a key issue concerning indemnification of employees.”

The SEC called Lucent's expanded indemnification “contrary to the public interest.” SEC officials have been sending the message that indemnification and cooperation are often incompatible. Shortly before the Lucent settlement, Stephen Cutler, Director of the SEC's Division of Enforcement, said that “to enhance deterrence and accountability, the Commission recently has adopted a policy requiring settling parties to forgo any rights they may have to indemnification, reimbursement by insurers, or favorable tax treatment of penalties.” Speech on April 29, 2004, available at http://www.sec.gov/news/speech/spch042904smc.htm. At the time of the Lucent settlement, Paul Berger, SEC Associate Director of Enforcement, told the Bureau of National Affairs that “[a]nyone who settles with us is going to agree not to be indemnified” for costs and penalties.

What the Future May Hold

After Lucent, a corporation runs the risk of being found uncooperative if, after agreeing to settle an enforcement action, it pays for legal representation of corporate employees whom the company is not required to indemnify by state law or corporate charter. It remains an open issue whether, in future enforcement actions, the SEC will force a “cooperating” company to breach indemnification obligations contained in its employment contracts or bylaws.

The Department of Justice also considers a company's indemnification policies and practices in evaluating cooperation. In June 1999, then Deputy Attorney General Eric Holder issued a memorandum attaching what would become the department's first formal guidance on prosecuting corporations. It focused on companies' payment of defense costs as a factor in evaluating corporate cooperation:

“Thus, while cases will differ depending on the circumstances, a corporation's promise of support to culpable employees and agents, either through the advancing of attorney's fees, through retaining employees without sanction for their misconduct, or through providing information to the employees about the government's investigation pursuant to a joint defense agreement, may be considered by the prosecutor in weighing the extent and value of a corporation's cooperation.” DOJ Criminal Resource Manual, Section 162, VI.B.

That comment did acknowledge, albeit in a footnote, that “[s]ome states require corporations to pay the legal fees of officers under investigation prior to a formal determination of their guilt. Obviously, a corporation's compliance with governing law should not be considered a failure to cooperate.” However, it is important to note that no mention was made of the obligations companies may have by virtue of their corporate bylaws, or employment contracts.

In January 2003, then Deputy Attorney General Larry Thompson issued revised prosecutorial guidelines that admonished prosecutors to consider “whether the corporation, while purporting to cooperate, has engaged in conduct that impedes the investigation … ” The guidelines further explained that “ [e]xamples of such conduct include: overly broad assertions of corporate representation of employees or former employees … ” Id.

It is difficult to predict where the indemnification restrictions will lead. However, these developments will 1) almost certainly strain the relationship between corporations and their employees, 2) shift a significant cost to the employees themselves, and 3) could actually end up impeding the government's investigation.

KPMG and Indemnification

The recent DOJ investigation of KPMG and a former partner, Jeffrey Eischeid, involved in marketing tax shelters, provides insight on upcoming indemnification issues. In an effort to be cooperative, KPMG waived the attorney-client privilege for interviews that lawyers conducted of employees and turned over internal documents concerning the tax shelters. KPMG also told the current and former employees and partners identified as subjects by the U.S. Attorney that it would advance up to $400,000 in legal costs on the condition that they meet with government investigators. Eischeid and others rejected the conditions, but the prospect of separate litigation over fees looms. In addition, KPMG will not enter into joint defense agreements with employees and, according to lawyers for some of the employees and partners, even agreed to tell prosecutors which documents employees requested for their defense. Whether KPMG will receive the benefits of being deemed cooperative remains to be seen.

The Lessons of Lucent

Companies would be wise to examine their indemnification policies and practices closely before they are embroiled in an investigation. As an initial step, companies should examine the law of the state in which they are incorporated to assess the scope of a mandatory indemnification. Typically, state indemnification statutes apply to officers and directors but not other employees.

Next, companies should examine their bylaws, articles of incorporation, and partnership agreements and employment contracts on the issue of indemnification. Key questions include: Do the relevant provisions “require” the advancement of attorneys' fees, or is the decision left to management discretion? Is there a sound rationale supporting the decision to indemnify certain categories of employees? Are there clear limits on when the obligation to indemnify ceases? Appropriate action should then be taken to implement a thorough and well-reasoned indemnification policy.

This review must take into account the current enforcement climate. Notwithstanding a thoughtful rationale for a company's indemnification policies, the DOJ may deem them “overly broad” or impeding an investigation. Similarly, the SEC's strong position on the issue suggests it will frown upon virtually any move by a company to indemnify an individual that the SEC thinks is culpable.

In the event a company under scrutiny decides not to indemnify a certain individual, it should brace for the likelihood of separate litigation over the indemnification issue. This prospect is particularly likely if the company breaches a pre-existing agreement with the individual. If the rationale behind penalizing companies for indemnifying potentially culpable employees is to relieve the shareholder of footing the bill for those costs, ironically the shareholder may end up footing the bill for both the litigation and the indemnity costs, should the company lose.

Finally, companies should keep in mind the effect on their relationships with their employees. For partners, directors, officers, and employees, the stakes have no doubt been raised. For individuals brought into the investigation, either by virtue of their own questionable conduct or simply for the information they may have, they will likely find themselves having to make some very difficult choices. Deciding whether and how to “cooperate” will mean balancing their job, possible self-incrimination, and the prospect of paying their own legal expenses if they want to consult with counsel.

Cooperation with government investigators has long been important for companies under the specter of an investigation. Under current agency policies and practices of the Securities and Exchange Commission (SEC) and U.S. Department of Justice (DOJ), and relevant provisions of the Sentencing Guidelines for Organizational Offenders, a “cooperative” corporation can realize substantial reductions in penalties or even avoid an enforcement action altogether. Seaboard Corporation in 2001 and HomeStore, Inc. in 2002 are excellent examples — both were able to avoid SEC enforcement actions because of the extent and nature of their cooperation with investigators.

The multi-million dollar question is what will be defined as “cooperation.” Over the past 10 years, the answer has evolved, and at each step, the requirements have increased. Waiver of the attorney-client privilege and work product protection is one of the “costs” that a corporation will likely have to pay. Recent enforcement actions also strongly suggest that a corporation will likely not be deemed “cooperative” without divulging its privileged internal investigation findings.

The SEC, in its recent Lucent Technologies action, raised the bar for what constitutes cooperation. See “Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud: Lucent Agrees to Pay $25 Million Penalty: SEC Charges 10 Individuals with Securities Fraud,” SEC press release of May 17, 2004, available at http://www.sec.gov/news/press/2004-67.htm. The Lucent penalty suggests government investigators will scrutinize a corporation's policies and practices concerning indemnification in evaluating the extent of its cooperation. This new focus has implications for the corporate entity and its officers, directors, and employees. When companies want the benefits of cooperation, they may be precluded from advancing the cost of representation for employees, even where their indemnification obligations require it. Individuals who find themselves subjects or targets of a criminal or civil enforcement action may now be on their own when it comes to paying for defending themselves.

The Lucent Settlement

On May 17, 2004, Lucent agreed, without admitting or denying misconduct, to pay a $25-million fine for failing to cooperate in the SEC's investigation over Lucent's alleged role in a $1.1 billion accounting fraud. The SEC cited four aspects of Lucent's conduct as non-cooperation:

• Incomplete and untimely document production;
• After the company and the SEC reached an agreement in principle to settle the case, Lucent's outside counsel told a magazine the conduct challenged by the SEC was a “failure of communication” and not an accounting fraud;
• After the agreement in principle, “Lucent expanded the scope of employees that could be indemnified against the consequences of this SEC enforcement action” beyond that required by state law or its corporate charter; and
• “Lucent…failed over a period of time to provide timely and full disclosure…on a key issue concerning indemnification of employees.”

The SEC called Lucent's expanded indemnification “contrary to the public interest.” SEC officials have been sending the message that indemnification and cooperation are often incompatible. Shortly before the Lucent settlement, Stephen Cutler, Director of the SEC's Division of Enforcement, said that “to enhance deterrence and accountability, the Commission recently has adopted a policy requiring settling parties to forgo any rights they may have to indemnification, reimbursement by insurers, or favorable tax treatment of penalties.” Speech on April 29, 2004, available at http://www.sec.gov/news/speech/spch042904smc.htm. At the time of the Lucent settlement, Paul Berger, SEC Associate Director of Enforcement, told the Bureau of National Affairs that “[a]nyone who settles with us is going to agree not to be indemnified” for costs and penalties.

What the Future May Hold

After Lucent, a corporation runs the risk of being found uncooperative if, after agreeing to settle an enforcement action, it pays for legal representation of corporate employees whom the company is not required to indemnify by state law or corporate charter. It remains an open issue whether, in future enforcement actions, the SEC will force a “cooperating” company to breach indemnification obligations contained in its employment contracts or bylaws.

The Department of Justice also considers a company's indemnification policies and practices in evaluating cooperation. In June 1999, then Deputy Attorney General Eric Holder issued a memorandum attaching what would become the department's first formal guidance on prosecuting corporations. It focused on companies' payment of defense costs as a factor in evaluating corporate cooperation:

“Thus, while cases will differ depending on the circumstances, a corporation's promise of support to culpable employees and agents, either through the advancing of attorney's fees, through retaining employees without sanction for their misconduct, or through providing information to the employees about the government's investigation pursuant to a joint defense agreement, may be considered by the prosecutor in weighing the extent and value of a corporation's cooperation.” DOJ Criminal Resource Manual, Section 162, VI.B.

That comment did acknowledge, albeit in a footnote, that “[s]ome states require corporations to pay the legal fees of officers under investigation prior to a formal determination of their guilt. Obviously, a corporation's compliance with governing law should not be considered a failure to cooperate.” However, it is important to note that no mention was made of the obligations companies may have by virtue of their corporate bylaws, or employment contracts.

In January 2003, then Deputy Attorney General Larry Thompson issued revised prosecutorial guidelines that admonished prosecutors to consider “whether the corporation, while purporting to cooperate, has engaged in conduct that impedes the investigation … ” The guidelines further explained that “ [e]xamples of such conduct include: overly broad assertions of corporate representation of employees or former employees … ” Id.

It is difficult to predict where the indemnification restrictions will lead. However, these developments will 1) almost certainly strain the relationship between corporations and their employees, 2) shift a significant cost to the employees themselves, and 3) could actually end up impeding the government's investigation.

KPMG and Indemnification

The recent DOJ investigation of KPMG and a former partner, Jeffrey Eischeid, involved in marketing tax shelters, provides insight on upcoming indemnification issues. In an effort to be cooperative, KPMG waived the attorney-client privilege for interviews that lawyers conducted of employees and turned over internal documents concerning the tax shelters. KPMG also told the current and former employees and partners identified as subjects by the U.S. Attorney that it would advance up to $400,000 in legal costs on the condition that they meet with government investigators. Eischeid and others rejected the conditions, but the prospect of separate litigation over fees looms. In addition, KPMG will not enter into joint defense agreements with employees and, according to lawyers for some of the employees and partners, even agreed to tell prosecutors which documents employees requested for their defense. Whether KPMG will receive the benefits of being deemed cooperative remains to be seen.

The Lessons of Lucent

Companies would be wise to examine their indemnification policies and practices closely before they are embroiled in an investigation. As an initial step, companies should examine the law of the state in which they are incorporated to assess the scope of a mandatory indemnification. Typically, state indemnification statutes apply to officers and directors but not other employees.

Next, companies should examine their bylaws, articles of incorporation, and partnership agreements and employment contracts on the issue of indemnification. Key questions include: Do the relevant provisions “require” the advancement of attorneys' fees, or is the decision left to management discretion? Is there a sound rationale supporting the decision to indemnify certain categories of employees? Are there clear limits on when the obligation to indemnify ceases? Appropriate action should then be taken to implement a thorough and well-reasoned indemnification policy.

This review must take into account the current enforcement climate. Notwithstanding a thoughtful rationale for a company's indemnification policies, the DOJ may deem them “overly broad” or impeding an investigation. Similarly, the SEC's strong position on the issue suggests it will frown upon virtually any move by a company to indemnify an individual that the SEC thinks is culpable.

In the event a company under scrutiny decides not to indemnify a certain individual, it should brace for the likelihood of separate litigation over the indemnification issue. This prospect is particularly likely if the company breaches a pre-existing agreement with the individual. If the rationale behind penalizing companies for indemnifying potentially culpable employees is to relieve the shareholder of footing the bill for those costs, ironically the shareholder may end up footing the bill for both the litigation and the indemnity costs, should the company lose.

Finally, companies should keep in mind the effect on their relationships with their employees. For partners, directors, officers, and employees, the stakes have no doubt been raised. For individuals brought into the investigation, either by virtue of their own questionable conduct or simply for the information they may have, they will likely find themselves having to make some very difficult choices. Deciding whether and how to “cooperate” will mean balancing their job, possible self-incrimination, and the prospect of paying their own legal expenses if they want to consult with counsel.