Use of Special Committees in Conducting Internal Investigations

Since the enactment of the Sarbanes-Oxley Act of 2002, the role of independent directors of public companies has become more pervasive and complex. The recent spate of financial restatements and options backdating has focused attention on the role of independent directors in conducting internal investigations of corporate misconduct. Internal investigations of alleged corporate wrongdoing have a critical importance. In instances where the conduct implicates management and the corporation itself in fraud or other more serious forms of corporate illegality, the effective use of an internal investigation, including a proper response to the findings of the investigation, can influence the sec and the federal and states attorney general offices to not sue the corporation. In its October 2001 section 21{a) Report in the Seaboard matter, and later in its January 2006 release concerning financial penalties, the sec has emphasized that a prompt and thorough internal investigation is an important factor in the Commission's decision whether to institute formal enforcement proceedings against the public corporation. In the 2004 "Principles of Federal Prosecution ol Business Organizations," authored by Deputy Attorney General Larry D. Thompson, the Justice Department suggested that an effective internal investigation can influence the Justice Department's decision to indict a corporation for the acts of its officers and employees. An effective internal investigation can also positively influence the outcome of shareholder litigation. In October 2006, the Federal District Court for the Western District of North Carolina dismissed a shareholder derivative lawsuit alleging accounting fraud based on the findings of a special committee of the board.

No "one size fits all" approach

There is no "one size fits all" approach to internal investigations and the use of special committees in their conduct. The proper approach, including threshold decision concerning whether an independent investigator is even necessary, will depend on the particular facts and circumstances and applicable corporate law. As a general rule, where the misconduct is more pervasive than not, involves senior management and could impact the company's financial performance or stock price, an independent investigator is warranted.

While the investigation by the special committee can significantly further the interests of the corporation and its shareholders, the benefits of the investigation are only as good as the investigation itself. As a general rule, a special committee and its decisions will be legally respected only if: (i) the committee is made up of two or more directors whose competence and independence are beyond reproach; (ii) the committee inquiry is reasonable based on the nature of the issues raised; and (iii) the committee at all times acts in good faith with an undivided loyalty to the interest of the corporation and its shareholders.

The recurring issues in structuring and implementing a special committee of the board for purposes of conducting an internal investigation include:

Structuring and implementing a special committee

* Proper Formation ot the Special Committee. A special committee and its findings are only as good as its credibility, and a special committee's credibility will be determined by the experience and independence of its members. When selecting the committee members, include directors that have knowledge of and experience in the subject area. As to independence, a director's actual independence is not enough. The director must be free of any appearance of a lack of independence as well.

* Clear Articulation of the Committee's Mandate. All board committees derive their authority from the board of directors and the resolutions of the board establishing the committee. Those resolutions should clearly set forth the committee's authority and any restrictions on the scope of its authority. The resolutions should specify the subject matter of the committee's investigation and whether it has authority to implement corrective action, including disclosure of any wrongdoing to government agencies, without full board approval. The resolutions should expressly provide for the committee's authority to hire and compensate legal and other advisors as the committee sees fit. Once the committee has been formed and has engaged its own counsel, the committee's first action should be to review its mandate from the board and confirm that its mandate is clear and proper, and that it has the authority and powers necessary to carry out that mandate.

* Assumption of Responsibilities. Boards of directors can easily become passive and reactive. Typically their meetings, agenda and discussions are led and shaped by the chief executive officer. Even the audit and other traditional independent committees have certain routines that can lead to a rote sense of activity. In order to be seen as a legitimate body and to have its findings and decisions respected, a special committee formed to conduct an internal investigation must be seen as proactive, thorough and at all times acting in the best interests of the company and its shareholders. While the committee is likely to engage and rely on counsel and other advisors, the committee must be seen as actively involved in all facets of the process.