GLOBAL COMPLIANCE | In the Twilight Zone

PARALLEL PROSECUTIONS AND THEIR COLLATERAL CONSEQUENCES

Parallel criminal and SEC prosecution presents new risks for companies—and complicated questions for their general counsel.

BY STEPHEN A. JONAS AND JONATHAN A. SHAPIRO

resumably no one from seized documents from its execu- IN BRIEF HealthSouth was in the tives’ offices as part of an investi- PAnn Arbor lecture hall in gation that later culminated in

An unprecedented spike in SEC-related November 2002, when the the first criminal prosecution for NEWSCOM.COM criminal cases demonstrates that Securities and Exchange Com- a violation of the Sarbanes-Oxley prime example—but by no parallel prosecutions may be here to mission’s enforcement chief certification requirements. The means the only one—of the stay. GCs facing such an investigation delivered the message to Univer- other shoe dropped the follow- government’s willingness to or prosecution should: sity of Michigan law professors ing day, when the SEC filed a bring parallel prosecutions: • Recognize the warning signs of a and students that “it’s a whole civil enforcement action against WorldCom, Enron, Qwest, potentially serious inquiry new ball game.” Instead of the company and then-CEO Adelphia, Rite Aid, and • Think disclosure “cajoling” criminal prosecutors Richard Scrushy, and a federal Imclone/ are • Assume that multiple agencies are into bringing securities cases, court entered a temporary just a few of the others. collaborating in the investigation director Stephen Cutler restraining order escrowing General counsel should expect • Understand that parallel does not explained that his Enforcement “extraordinary payments” by the the SEC and U.S. attorneys to mean simultaneous Division was “fending off calls.” company and freezing Scrushy’s continue to prosecute the • Remember that all conversations with Only the setting was academic: personal assets. To date, 15 same conduct, under the same the government are memorialized— the SEC and U.S. attorneys former HealthSouth executives or similar statutes, without and that the Fifth Amendment has now routinely prosecute public have pled guilty to various secu- any effort to divvy up investi- a downside company malfeasance with rities charges, and in gations for sole prosecution by • Ensure that cooperation with the “parallel” criminal and civil November an 85-count indict- one agency or the other. government is real, not cosmetic enforcement proceedings. ment was unsealed charging The trend is not limited to • Avoid being labeled obstructionist The SEC’s message arrived Scrushy with , headline cases: in Birmingham, , on mail and wire fraud, money • “SEC-related criminal cases” March 18, 2003. The FBI exe- laundering, , and were filed against 259 defen- cuted a search warrant at other federal offenses. dants during fiscal year 2002. HealthSouth’s headquarters and The HealthSouth case is a The last time the commission

42 CHIEF LEGAL EXECUTIVE CHIEFLEGALEXECUTIVE. COM From left: Joel Gordon, acting chairman of the board of directors at HealthSouth; Sage Givens, an audit committee member; Phillip Watkins, former compensation committee member; Larry Striplin, former chairman of the compensa- tion committee; and Robert May, acting CEO of HealthSouth, are all sworn in prior to testifying before the House Subcommittee on Oversight and Investigation on November 5, 2003, in Washington, D.C.

a broader investigation with help from the FBI, the National Association of Securities Dealers, the San Diego District Attorney, the British Columbia and Ontario Securities Commis- sions, and the Royal Canadian Mounted Police.) • The SEC has prosecuted pri- vate and public companies that engage in round-trip or side- letter deals that wind up as some- one else’s overstated revenue, reported the statistic was 1999, cops on the beat.” Smaller issuers which is what happened to a for- when, according to the annual and those accused of less egre- mer executive of Logicon (aiding report, there were just 64 indict- gious conduct may bear the and abetting securities violations ments or informations in “related General counsel should brunt of the SEC’s 800-plus by Legato Systems Inc.) and criminal proceedings.” Although additional lawyers, accountants, executives of a private company the SEC has not yet released offi- expect the SEC and U.S. and other personnel. that assisted Homestore in cial numbers for fiscal year 2003, • Since the summer, the SEC has implementing a round-trip by all indications the prosecutors attorneys to continue to aggressively prosecuted (some- transaction. Given this trend, again will break records. times in tandem with criminal counsel also may wish to moni- • Since its inception in 2002, prosecute the same conduct, prosecutors) “other participants” tor relationships with vendors prosecutors working with the in securities fraud, who before and other business partners. President’s Corporate Fraud Task under the same or similar now were probably out of dan- Force have investigated potential ger. Enforcement actions have Making Difficult Decisions corporate fraud involving more statutes, without any effort been brought against lower-level With Limited Information than 500 individuals and compa- employees, those who may not Companies under parallel crim- nies and filed at least 169 corpo- to divvy up investigations for have benefited (at least directly) inal and civil investigations rate fraud crime cases. (See from the alleged misconduct, or are extraordinarily vulnerable “Getting the Bad Guys,” p. 37.) sole prosecution by one didn’t benefit much, as in the because decisions that bolster the • Last fall, SEC Chairman recent case against an attorney defense of one proceeding may William Donaldson told a room agency or the other. who avoided a $922.14 loss compromise or even imperil of corporate directors and their by insider trading. (The SEC their position in another. counsel that he is putting “new brought the latter case as part of Unfortunately, general counsel

WINTER 2004 CHIEF LEGAL EXECUTIVE 43 GLOBAL COMPLIANCE | In the Twilight Zone

Timeline: From All Sides In just two years, Homestore, the online real estate company, has faced some two dozen shareholder suits, five rounds of prosecution, and more.

December 6, 2001 Resignation: Homestore CFO resigns (“personal reasons”). does “not bring any enforcement action against Homestore because December 21, 2001 Restatement: Homestore announces plan to restate of its swift, extensive, and extraordinary cooperation.” financials (extent and time period unknown) and inquiry into September–October 2002 Insurance: D&O insurer sues to rescind policies. accounting practices. Trading halted. January 9, 2003 Parallel Prosecution (Round 2): SEC and U.S. attorney December 27, 2001 Shareholder Suit: First of at least 19 class actions filed simultaneously prosecute former manager, who settles with SEC and (federal court). pleads guilty to criminal charges. January 2, 2002 Restatement: Homestore announces preliminary finding that April 23, 2003 Parallel Prosecution (Round 3): SEC and U.S. attorney simul- advertising expense in FY 2001 overstated by $54 million–$95 million. taneously prosecute three officers and directors of advertising agency January 4, 2002 Shareholder Suit: First of four derivative actions filed that did business with Homestore. (California and Delaware state courts). May–July 2003 Insurance: D&O insurers granted summary judgment; poli- January 7, 2002 Resignation: Homestore announces new CEO, CFO, and cies judged rescinded. Homestore appeals. COO. Former CEO resigns to pursue new technology venture. August 13, 2003 Shareholder Suit: Homestore settles class action for $13 January 16, 2002 Resignation: Seven more employees terminated or resign. million in cash, issuance of 20 million new shares common stock, February 22, 2002 NASDAQ: Trading resumes, but market initiates delisting and adoption of new corporate governance provisions. process for failure to timely file SEC filings. September 18, 2003 Parallel Prosecution (Round 4): SEC and U.S. attorney March 12, 2002 Restatement: Homestore announces that it overstated simultaneously prosecute three former Homestore managers; each FY 2000 revenue by $41.4 million. settles with SEC and pleads guilty to criminal charges. SEC also files April 3, 2002 Restatement: Homestore announces that it overstated enforcement proceedings against former Homestore VP and manager, FY 2001 revenue by $123 million. and against former CEO and CFO of private company that did busi- April 10, 2002 NASDAQ: Homestore announces that it will remain listed. ness with Homestore; each settles with SEC. September 25, 2002 Parallel Prosecution (Round 1): SEC and U.S. attorney September 26, 2003 Parallel Prosecution (Round 5): SEC and U.S. attorney simultaneously prosecute former CFO, former COO, and former VP; simultaneously prosecute former CFO of advertising agency that did each settles with SEC and pleads guilty to criminal charges. SEC business with Homestore.

must react to SEC and other responses required. The govern- as a seemingly “routine” inquiry inquiries before they understand ment sets the calendar, providing from the SEC, a customer calling the potential magnitude of the little, if any, warning before it with a “usual course” question Unfortunately, general investigation under way, perhaps files charges and issues press that may have been prompted even without knowing their releases, which beyond creating a by an investigator, or even a counsel must react to clients’ current and potential sta- legal problem, attract unwanted boilerplate information request tus (nonparty witness? target?) or publicity and disrupt investor from an SRO. Although many SEC and other inquiries the issues under scrutiny (last relations. As a result, public com- inquiries are as benign as they quarter’s revenue recognition? panies must quickly assess their sound, sometimes even a little before they understand the last year’s cost accounting?). It exposure and options before scrutiny of the conduct at issue often also is unclear if the SEC is unanticipated events in effect will unmask a problem that war- potential magnitude of the working alone, and if so, make decisions for them. rants closer review or should be whether criminal prosecutors or Although every case is differ- reported to senior management investigation under way or other agencies are likely to ent, general counsel facing an or the board. General counsel become involved. SEC investigation and possible should fine-tune and then regu- the issues under scrutiny. The SEC’s recent “real-time” parallel criminal prosecution larize their companies’ process enforcement initiative and crimi- should consider the following for responding to government nal prosecutors’ renewed enthusi- guidelines: inquiries in order to best under- asm have also accelerated the • Recognize the warning signs. Par- stand why the questions are being pace of investigations and the allel prosecutions may first appear asked, the significance of the

44 CHIEF LEGAL EXECUTIVE CHIEFLEGALEXECUTIVE. COM information sought, and what, if ter—will attract scrutiny and time lag may be significant; in any, steps should be taken. sometimes prove more problem- one recent case, the U.S. attorney • It’s all about process. Upon learn- atic than the underlying conduct. obtained an for secu- ing of a government investi- In 2002, Dynegy was fined $3 rities fraud more than six months gation, general counsel should million in part because, after the after the SEC filed a civil lawsuit remember the central message of SEC inquired of an accounting against the same defendant for Sarbanes-Oxley: corporate gover- irregularity, the CFO allegedly the same overstated revenue (and nance is all about the process of soft-pedaled the issue when com- well over a year after the SEC identifying, discussing, and fix- municating with investors. began its investigation). ing problems. The first steps are • Assume agency collaboration. • The Fifth Amendment. The SEC to avoid any further violations Those who provide documents (such as by silencing the CFO and testimony to the SEC should who is about to tell a room of assume that everything will go to institutional investors that the criminal prosecutors even if there The Still Bigger Picture quarter is on track), followed by is no indication that anyone out- General counsel should remind their public company clients a meaningful and, if necessary, side of the SEC is interested. that making peace with federal authorities often does not quell self-critical conversation with Sometimes, the SEC consults problems associated with parallel proceedings. appropriate management or the criminal authorities even before • Class actions. Class-action complaints can be drafted from board. How companies react to it makes information requests. admissions made by former officers who plead guilty, or from bad news can make a difference; Federal prosecutors in California (unproven) allegations taken from SEC complaints and press in August, the SEC said that filed criminal securities fraud and releases. Pending government investigations not only make it apparel maker Cutter & Buck’s other charges against the former easier for plaintiffs to sue, but they may also subject those under cooperation and prompt “reme- CEO of eConnect Inc. based on investigation to discovery that they may prefer not to provide dial acts” were part of the reason statements he made six days ear- until the SEC and/or criminal charges are resolved. that company was able to negoti- lier during an SEC deposition. • Waiver. Companies likely waive the attorney-client privilege ate a cease-and-desist order for Unbeknownst to the CEO, and work-product protection by reporting to the SEC the books and records violations the FBI had started “working details of internal investigations, even if such reporting is done despite the former CFO’s partic- closely” with the SEC before it pursuant to a nonwaiver agreement. Issuers should structure ipation in a $5.7 million fraud. took the critical deposition and, their cooperation to minimize the risk of future claims of • Think disclosure. Comprehensive in fact, an FBI special agent waiver, such as by only providing the government with non- disclosure may include the dis- expressly relied on the informa- privileged information. closure of a pending govern- tion collected by the SEC in an • Insurance. Cooperation may jeopardize insurance coverage, ment investigation or the facts affidavit filed as grounds for the which is what happened to Homestore Inc. (formerly Homestore. unearthed during the investiga- criminal complaint. com). Although Homestore avoided prosecution by helping the tion. Increasingly, issuers are dis- • Parallel does not mean simul- government obtain by three former officers and an SEC set- closing informal inquiries by the taneous. Notwithstanding the tlement (see “Timeline: From All Sides,” p. 44), praise from the SEC and other regulators, and recent pattern, parallel prosecu- U.S. attorney and the SEC did not stop the company’s D&O sometimes the issuer’s service tions often do not start with the carrier from suing to rescind the policies. Products are now being with civil and subpoe- simultaneous filing of criminal offered that may protect innocent directors and officers from loss nas, even where it appears that and civil charges. Sometimes the of coverage due to another’s wrongdoing. someone else is under investiga- SEC begins, and even concludes, • State authorities. This past fall, the attorney general of tion. Disclosure issues also may investigations and civil enforce- Oklahoma initiated a criminal investigation concerning arise in the context of certifica- ment actions before there are any WorldCom, more than a year after the SEC and U.S. attorney tions under Section 302 of the signs of involvement by criminal started prosecuting the same conduct. The specter of state action Sarbanes-Oxley Act or may flow authorities. Federal law specifi- brings still more complexity, expense, and uncertainty to com- from an issuer’s status as a gov- cally allows criminal prosecutors panies looking for a global resolution. The SEC has a track ernment contractor. Delayed dis- to rely on the SEC (and the fruits record of assisting state regulators, who have been given access closure—or spin control that of its subpoena power), regardless to the SEC’s files on more than 250 occasions within the past minimizes the significance of an of whether there is a criminal two years. investigation or its subject mat- grand jury investigation. The

WINTER 2004 CHIEF LEGAL EXECUTIVE 45 GLOBAL COMPLIANCE | In the Twilight Zone

and criminal prosecutors often • Avoid being labeled obstructionist. that as part of a parallel grand make “informal” requests for The government aggressively jury investigation, the FBI had witness interviews or serve for- prosecutes those who appear to wiretapped the former CEO (by mal subpoenas compelling depo- interfere with investigations or attaching a wire to a former CFO sition or grand jury testimony. other regulatory machinery. In who entered a guilty ) and Sometimes witnesses receive the securities fraud context, later executed a search warrant at unannounced calls or visits from obstruction-of-justice-type company headquarters. investigators from the SEC, FBI, charges can be more difficult to • Whistle-blowers. Many securities Postal Inspection Service, or defend than those based on the fraud cases begin with or are other agencies. Regardless of how complicated transactions or aided by the cooperation of the government poses its ques- accounting issues that may have current or former insiders. tions, the decision whether to triggered the government’s inves- Sometimes companies can avoid respond is critically important tigation in the first place. The investigations by addressing alle- and often complicated. Those risks are even greater in parallel gations of impropriety made by Although many inquiries who speak should remember that proceedings, when the same wit- employees promptly and effi- the government will memorialize ness may be interviewed or ciently, and even where govern- that accompany parallel their statements in interview deposed repeatedly by different ment scrutiny is inevitable, a memoranda (or depending on agencies, each of which will com- proper response can soften the prosecution are as benign the setting, a formal transcript), pare notes and look for inconsis- blow. Conversely, existing prob- which may be used as evidence tencies. For the same reason, lems become worse if reported by as they sound, sometimes against the speakers or others. companies and individuals under a potential whistle-blower who is On the other hand, those who investigation should ensure not taken seriously, or if manage- even a little scrutiny invoke the Fifth Amendment appropriate and consistent docu- ment conducts an internal inves- during an SEC deposition may ment preservation and compre- tigation that prosecutors perceive of the conduct at issue invite a prosecution and should hensive and careful document as superficial, as occurred in realize that the mere fact they production. The SEC recently Enron. Given the government’s will unmask a problem that invoked the Fifth creates an criticized a company for with- reliance on insiders, companies inference of wrongdoing that the holding a key document and for a should review official policies warrants closer review or SEC will highlight in (public) subpar document collection and practices so legitimate efforts papers filed with the courts. effort in response to SEC requests to protect business confidences should be reported • The cooperation decision. It often and subpoenas—contributing to are not misunderstood as an makes sense to cooperate with the a $10 million penalty. attempt to silence legitimate con- to senior management government, although the deci- • Cooperation can be a one-way cerns or cover up illegality. There sion of when, how, and with street. General counsel for com- are, of course, now criminal and or the board. whom to cooperate has become panies that cooperate should not civil sanctions for those that increasingly complicated. If the expect that their seemingly open penalize employees for assisting decision is made to cooperate, the dialogue with the SEC (or any with fraud investigations. • cooperation should demonstrate agency) entitles them to advance a willingness to go the extra mile. notice of what will come next in Stephen A. Jonas is co-chair of To maximize the benefit of coop- the investigation, much less in Hale and Dorr’s government eration, general counsel should any parallel criminal investiga- investigations and litigation consider opening similar lines of tion. For example, having spent group. Jonathan A. Shapiro is communication with other agen- months cooperating with an a senior partner in Hale and cies. Finally, companies can coop- SEC investigation that included Dorr’s corporate and securities erate with government investiga- the former CEO’s deposition, litigation group. Hale and Dorr’s tions without agreeing to waive HealthSouth and some of its offi- Andrea J. Robinson, Richard V. the attorney-client privilege or cers may have been surprised Wiebusch, and Daniel Gold work-product protections, even later to learn that the SEC was also contributed to this article. though the government increas- (or was about to begin) preparing E-mail any of these authors at ingly requests that they do so. a civil enforcement action and [email protected].

46 CHIEF LEGAL EXECUTIVE CHIEFLEGALEXECUTIVE. COM