Copyright 2005 James C. Mann; Farella Braun + Martel LLP

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1 KEY ISSUES CONFRONTED DURING THE REPRESENTATION OF DIRECTORS AND OFFICERS FACING SEC ENFORCEMENT ACTIONS, CRIMINAL PROSECUTION, AND DERIVATIVE LAWSUITS by James C. Mann 1 Farella Braun + Martel LLP, San Francisco Copyright 2005 James C. Mann; Farella Braun + Martel LLP I. SEC ENFORCEMENT ACTIONS/WELLS SUBMISSIONS A. Informal vs. Formal Investigations 1. Before beginning a formal investigation, incident to which subpoenas may be issued, the SEC often begins with an informal preliminary investigation in which information is gathered on a voluntary basis. 17 C.F.R a. In such preliminary investigation no process is issued or testimony compelled. 17 C.F.R (a). However, voluntary interviews may be conducted on the record and under oath. 2. The SEC staff may seek a formal order of investigation if witnesses have not been cooperative, or if subpoena power otherwise is required to obtain the necessary information. William R. McLucas et al., A Practitioner s Guide to the SEC s Investigative and Enforcement Process, 70 Temple Law Review 53, (1997). a. In a formal investigation, testimony is compelled, but unlike a grand jury, the SEC permits those testifying to have counsel. B. What are Wells Submissions? 1. Wells submissions are voluntary written statements from persons who become involved in preliminary or formal investigations by the SEC, setting forth their interests and position in regard to the 1 James C. Mann is a litigation associate in the San Francisco law firm of Farella Braun + Martel LLP. Mr. Mann s white collar criminal defense practice focuses the representation of corporate executives facing SEC enforcement actions and criminal prosecution, and internal corporate investigations relating to accounting and securities issues. Mr. Mann can be reached at or at jmann@fbm.com. 1

2 subject matter of the investigation. 17 CFR 202.5(c). They are usually made in an effort to persuade the SEC that either no violation has occurred or that any violation that has occurred is not as serious as the SEC may believe. Bullard v. City of New York, 2004 WL , *3 (S.D.N.Y.). Wells submissions are submitted to the SEC staff. If the staff makes a recommendation to the Commission regarding an enforcement action, the Wells submission is forwarded along with the staff memorandum. a. The submissions are named for John A. Wells, a New York lawyer who chaired the SEC Committee which recommended the procedure in While there is no requirement that the Commission provide a Wells notice to persons or entities which may be the subject of an enforcement recommendation by the staff, and although no due process rights attach to this practice, the staff generally provides the opportunity for such a submission as an investigation nears completion. The Commission, however, does not provide such an opportunity when there are concerns about dissipation of assets, destruction of documents, or any other situations which may require the Commission to act quickly to protect the public interest. William R. McLucas et al., A Practitioner s Guide to the SEC s Investigative and Enforcement Process, 70 Temple Law Review 53, (1997). 3. The Wells notice usually details the laws or regulations allegedly violated and what relief the staff will recommend (civil penalty, director & officers bar, etc.). C. Considerations for Wells Submissions. 1. Defense counsel... often request a Wells meeting, at which the staff presents a more detailed account of its case: their view of the relevant facts, the applicable law, and their theory of any violations. The Wells meeting is less a forum for defense counsel to obtain discovery of the Commission s case than it is a dialogue in which defense counsel can appreciate whether there are any issues factual, legal, or otherwise that may affect the Commission s deliberative process. In re Initial Public Offering Securities Litigation, 2004 WL 60290, *1 (S.D.N.Y.). a. Defense attorneys have many reasons for filing a Wells submission, including persuading the... staff: (1) not to recommend an enforcement action; and (2) to drop certain charges, change the forum for the enforcement action, or 2

3 request different relief. Even if the staff does recommend an enforcement action, a Wells submission may be used to persuade the Commission (1) to reject the staff s recommendation; or (2) to settle the case on terms more favorable to the client than those recommended by the staff. Initial Public Offering, supra, at *2. b. While the time afforded by the Commission staff for the receipt of a Wells Submission will vary from case to case depending on the staff s perceived need to proceed expeditiously and the length and complexity of the investigation, one can expect to receive two to three weeks following the Wells Meeting. Gary G. Lynch and Katherine M. Choo, Wells Submissions: Effective Representation Following the Completion of the Staff s Investigation, 703 PLI/Corp 373, 382 (1990). 2. Whether to provide a Wells submission can be a difficult decision. a. The submission provides a road map of possible defenses and allows the staff to test the weaknesses in their own positions. b. [S]ubmissions by prospective defendants or respondents will normally prove most useful in connection with questions of policy, and, on occasion, questions of law, bearing upon the question of whether a proceeding should be initiated, together with considerations relevant to a particular prospective defendant or respondent which might not otherwise be brought clearly to the Commission s attention. Securities Act Release No. 5310, 1973 WL , at *2. 3. There is no statutory or even procedural right to make a Wells submission. See Wellman v. Dickinson, 79 F.R.D. 341, (S.D.N.Y. 1978); SEC v. National Student Marketing Corp., 538 F.2d 404, 407 (D.C. Cir. 1976). a. But not allowing it is irregular. For example, in SEC v. Zahareas, 374 F.3d 624 (8th Cir. 2004), a broker recuperated attorneys fees after the court held the SEC s case was not substantially justified. The failure to allow a Wells submission was a key element in this finding the court noted that had Tuschner and Zahareas been able to make a Wells Submission, they would have presented the SEC with relevant information allowing the SEC to come to the same 3

4 conclusion that our court ultimately did,... [and] this litigation would never have occurred. Id. at 629. b. The SEC is under no obligation to reply to a Wells submission, and its failure to do so erects no estoppel against filing a complaint. See SEC v. Sands, 902 F. Supp. 1149, 1167 (C.D. Cal. 1995). D. Discoverability and Admissibility of Wells Submissions. 1. A leading case holds that because Wells submissions are voluntarily disclosed, to an adversary, work product protection is waived. See, In re Steinhardt Partners, LP, 9 F.3d 230 (2d Cir. 1993); accord, Bullard, 2004 WL , at *3. 2. Other circuits are currently split over whether disclosure to the government waives privileges in later civil discovery. Compare In re Columbia/HCA Healthcare Corp. Billing Practices Litigation, 293 F.3d 289, 302 (6th Cir. 2002) (rejecting concept of selective waiver where privileged documents had previously been produced to Department of Justice and other administrative agencies), Westinghouse Electric Corp. v. Republic of the Philippines, 951 F.2d 1414, 1425, 1429 (3d Cir. 1991) (finding waiver of attorneyclient and work product privileges upon voluntary disclosure of information to SEC and Department of Justice), In re Subpoenas Duces Tecum, 738 F.2d 1367, (D.C. Cir. 1984) (concluding voluntary disclosure of information to SEC waives work product and attorney-client privileges), and Permian Corp. v. United States, 665 F.2d 1214, (D.C. Cir. 1981) (rejecting selective waiver), with Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 611 (8th Cir. 1978) (en banc) (holding only limited waiver of attorneyclient privilege occurred through disclosure of information to SEC). Joshua A. Naftalis, Wells Submissions to the SEC as Offers of Settlement Under Federal Rule of Evidence 408 and their Protection From Third-Party Discovery, 102 Columbia Law Review 1912, 1914 n.10 (2002).. 3. A recent federal case, however, has held that Wells submissions are not protected from discovery in a later civil action merely because they may contain an offer of settlement. In re Initial Public Offering Securities Litigation, 2004 WL 60290, *1 (S.D.N.Y.). 4. The Division of Enforcement s long-standing position is that Wells Submissions, unlike offers of settlement and statements made during negotiations, may be used as evidence in subsequent proceedings for impeachment or corroborative purposes or as admissions by a party 4

5 II. opponent. Because of this position, the Division includes a statement in the letter advising a prospective defendant of a proposed recommendation of an enforcement action that the staff routinely seeks to introduce Wells Submissions as evidence in Commission enforcement proceedings, if the staff deems it appropriate. Wells Submissions that purport to be privileged, submitted for settlement purposes or otherwise barred from use as evidence against the submitter are returned to the submitter. McLucas, supra, 70 Temple Law Review at 115. a. To limit the use of a Wells submission as an admission in the future, it is often wise for counsel only, rather than the client, to sign the submission. 5. Although not publicly released during the pendency of an investigation, a Wells submission can be obtained through the Freedom of Information Act. Requesting confidential treatment under 17 CFR may mitigate this problem in individual cases. CRIMINAL PROSECUTIONS OF CORPORATIONS AND INDIVIDUALS. A. The government s current policy regarding the criminal prosecution of corporations is reflected in a January 2003 memorandum entitled Principles of Federal Prosecution of Business Organizations by United States Deputy Attorney General Larry D. Thompson (hereafter Thompson Memo ), which lists the following prosecutorial considerations: 1. Tendency of a prosecution to have a deterrent effect within an industry; 2. Ordinary prosecutorial considerations, including a. sufficiency of the evidence and likelihood of success at trial, b. probable deterrent, rehabilitative, and other consequences of conviction, and c. adequacy of non-criminal approaches; 3. The nature and seriousness of the offense, including the risk of harm to the public; 4. The pervasiveness of wrongdoing within the corporation, including the complicity in, or condoning of, the wrongdoing by corporate management; 5

6 a. Charging a corporation for even minor misconduct may be appropriate where the wrongdoing was pervasive and was undertaken by a large number of employees or by all the employees in a particular role, [but] it may not be appropriate to impose liability upon a corporation, particularly one with a compliance program in place... for the single isolated act of a rogue employee. The role of management is the most important factor. 5. The corporation s history of similar conduct, including prior criminal, civil, and regulatory enforcement actions, and prior warnings; 6. The corporation s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents ( to identify the culprits ), including waiver of attorney-client and work product protection; a. In this regard, the government also considers whether the corporation has protected the culpable employees by advancing their attorneys fees, providing information under a joint defense agreement, or continuing to employ them. 7. The existence and adequacy of the corporation s existing compliance program, as well as the enforcement of the compliance policy a paper program itself is not good enough; 8. The corporation s remedial actions, including restitution and the implementation of effective employee discipline programs; 9. Collateral consequences of wrongdoing, including disproportionate harm to shareholders, pension holders, employees and others; and 10. The adequacy of the prosecution of individuals and civil or regulatory enforcement actions. B. Once the decision to charge has been made, the Thompson Memo directs that the prosecutor charge the corporation with most serious offense... that is likely to result in a sustainable conviction. C. The government s current policy regarding the prosecution of individuals is reflected in a memorandum by United States Attorney General John Ashcroft, dated September 22, 2003, entitled Department Policy Concerning Charging Criminal Offenses, Disposition of Charges, and Sentencing (hereafter Ashcroft Memo ). 6

7 D. Similar to the Thompson Memo, the Ashcroft Memo directs that the prosecutor charge the individual with the most serious, readily provable offense or offenses, which generate the most substantial sentence. Indeed, the use of statutory enhancements is strongly encouraged. E. Exceptions to this general policy are limited to the following: 1. If the sentence would not be affected by the omission of certain readily provable offenses; 2. If a fast-track program is applicable (e.g., to deal with the heavy dockets in San Diego resulting from immigration and drug importation offenses); 3. If the defendant provides substantial assistance (although departure in this regard should usually be reserved for sentencing); 4. If other exceptional circumstances are presented, such as an overburdened United States Attorneys Office. F. Despite the Ashcroft Memo, there appears to be an emerging a trend toward prosecution of lesser crimes in certain circumstances. 1. Examples include mail and wire fraud, technical disclosure violations, document retention violations, tax evasion, and obstruction of justice. The prosecutions of Martha Stewart for false statements and Frank Quattrone for obstruction of justice are two notable examples of this strategy. In addition, prosecutors often opt for a more easily proven insider trading violation rather than prosecuting a complex securities fraud action. 2. Lesser charges can be easier to prove than the true core violations, and can satisfy public demand for a conviction without excessive depletion of the prosecutor s resources and the risk of failing to convict. 3. This device can be useful to the defense also, as it affords an opportunity to resolve the case by pleading to (or even being convicted of) a lesser charge. 4. Obstruction of justice. a. In 2004 two Computer Associates employees pleaded guilty to obstruction of justice after making false statements to the company s outside counsel, which were later memorialized 7

8 and turned over to the government, because the employees knew their statements would be turned over to federal officials. This was a new enforcement technique at the time, because the false statements were not made to government officials but to agents of the company. See Alex Berenson, Case Expands Type of Lies Prosecutors Will Pursue, New York Times, May 17, Sarbanes-Oxley Provisions. a. Section 802(a) of the Sarbanes-Oxley Act makes it a felony, punishable by up to 20 years in prison, to knowingly destroy or create documents in an effort to impede, obstruct or influence an existing or contemplated federal investigation. David Duncan, Arthur Andersen s partner in charge of the Enron account, pleaded guilty to a criminal charge of obstruction, confessing intent to impede the SEC investigation by shredding documents. See United States v. Arthur Andersen LLP, 374 F.3d 281, 290 (5th Cir. 2004), rev d sub nom. Arthur Andersen LLP v. United States, --- U.S. ---, 2005 WL (reversing conviction of partnership). b. Section 802(a)(1) of the Sarbanes-Oxley Act requires auditors to maintain all audit or review work papers for five years. (The SEC adopted a rule to increase the retention period to seven years.) Willfully failing to do so can result in a felony conviction punishable by up to 10 years in prison. c. Section 1102 of the Sarbanes-Oxley Act makes it a crime, punishable by up to 20 years in prison, for any person to corruptly alter, destroy, mutilate, or conceal any document with the intent to impair the object s integrity or availability for use in an official proceeding or to otherwise obstruct, influence, or impede any official proceeding. In September 2003, in the Northern District of CA, former Ernst & Young audit partner Thomas C. Trauger was one of the first accountants criminally charged with a violation of section 1102 of the Sarbanes-Oxley Act. The U.S. Attorney s Office and the SEC allege that 8

9 while responding to a subpoena from the OCC, Trauger helped alter and destroy E&Y s workpapers related to the audit of NextCard (a publicly traded company whose subsidiary was under investigation by the OCC). Trauger pleaded guilty in October 2004 and was sentenced in January 2005 to 12 months in prison. d. Section 1107 of the Sarbanes-Oxley Act makes it a crime, punishable by up to 10 years in prison, to knowingly, with the intent to retaliate, take any action harmful to any person, including interference with the lawful employment or livelihood of any person, for providing to law enforcement any truthful information relating to the commission or possible commission of any federal offense. Under section 806 of the Sarbanes-Oxley Act, an employee may also have a civil remedy against a public-company employer for retaliation. In March 2004, an administrative law judge reinstated the CFO of Roanoke, VA-based Cardinal Bankshares and awarded him backpay after determining that he had been wrongfully terminated after reporting suspected accounting irregularities. G. Corporate cooperation with the government. 1. Waiver of the attorney-client privilege. a. The Thompson Memo suggests that target corporations should waive their attorney-client and work-product protections or risk being charged in part because they did not do so. Here are two significant excerpts from the memo: i. One factor the prosecutor may weigh in assessing the adequacy of a corporation s cooperation is the completeness of its disclosure including, if necessary, a waiver of the attorney-client and work product protections, both with respect to its internal investigation and with respect to communications between specific officers, directors and employees and counsel. Such waivers permit the government to obtain statements of possible witnesses, subjects, and 9

10 targets, without having to negotiate individual cooperation or immunity agreements. ii. Another factor to be weighed by the prosecutor is whether the corporation appears to be protecting its culpable employees and agents. 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 attorneys fees, through retaining the 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. b. The waiver of the attorney-client privilege and attorney workproduct privilege will not be limited to the criminal or SEC investigation, but once the privileges have been waived, plaintiffs in shareholders suits and derivative actions will likely be able to gain access to the once-protected documents. For example, when McKesson HBOC shared the results of its internal investigation with the SEC, including interviews protected by the attorney-client privilege and investigation results protected by the attorney work-product privilege, it was then required to turn over the same documents to the plaintiffs in the shareholders class action. McKesson HBOC, Inc. v. Superior Court, 115 Cal. App. 4 th 1229 (2004). i. McKesson HBOC has faced this issue in other jurisdictions as well, with varying results. In Saito vs. McKesson HBOC, Inc., 2002 WL (Del.Ch.), McKesson was able to preserve the privilege in substantial part. In McKesson HBOC, Inc. vs. Adler, 254 Ga. App. 500, 562 S.E.2d 809, (2002), McKesson was ordered to produce the previouslyprotected documents. Likewise, in the United States District Court for the Northern District of California, the Court ordered McKesson to turn over the previously privileged documents shared with the government. United States v. Bergonzi, 216 F.R.D. 487 (N.D. Cal ) In the latter case, McKesson was ordered to share those documents with former 10

11 2. Exclusion of targeted executives. employees of McKesson who have now been criminally prosecuted by the government. Id. a. The Thompson Memo encourages corporations to oust potentially culpable executives by firing them, refusing to advance attorneys fees, and refusing to provide information pursuant to a joint defense agreement. b. For example, the actions of KPMG, accused of marketing improper tax shelters, demonstrate the extent to which companies now feel themselves obliged to go against their own employees in order to appear cooperative to prosecutors. See Laurie P. Cohen, Prosecutors Tough New Tactics Turn Firms Against Employees, Wall Street Journal, June 4, According to the article, KPMG: i. advances defense costs to its employees only if they cooperate with prosecutors; ii. iii. will not share information with its employees under a joint defense agreement; and gives the government copies of all documents it provides to employees for use in their defense, but will not tell its employees what other documents it has given the government. c. Statutes in many states require corporations to indemnify employees and to advance their legal fees in most situations. However, the statutes do not uniformly require corporations to advance an employee s attorneys fees. d. Settlements between the SEC and individual defendants have recently begun to require the individual defendants to agree not to seek indemnification or reimbursement for penalties and disgorgement paid to the SEC. H. Fifth Amendment concerns 1. Faced with potential criminal liability, an individual may invoke his or her Fifth Amendment right against self-incrimination, refusing both to testify and to produce documents. 11

12 a. The act of production doctrine allows an individual to invoke his Fifth Amendment right rather than producing documents in response to a grand jury, SEC, or other governmental subpoena. See U.S. v. Hubbell, 530 U.S. 27 (2000). 2. While individuals who invoke the Fifth Amendment in a criminal proceeding are protected against an adverse inference from their silence, this is not necessarily so in a civil proceeding. 3. Accordingly, a target or witness in a parallel investigation may face the choice of invoking the Fifth Amendment in the civil proceeding and risking the adverse inference, or by not invoking it and choosing to testify, providing the prosecutors with potentially incriminating statements. a. A common solution is to request a stay of the civil proceeding until the criminal proceeding is completed. But this stay is not constitutionally required and is granted only after a factspecific balancing of the equities. See Keating v. Office of Thrift Supervision, 45 F.3d 322 (9th Cir. 1995). 4. Choosing to testify and waiving one s Fifth Amendment right in one proceeding does not waive it in another. See U.S. v. Licavoli, 604 F.2d 613, 623 (9th Cir. 1979). 5. However, if documents have been produced voluntarily in a criminal case, the Fifth Amendment is waived as to those documents in a subsequent civil case since the authorities already have the information and there is no further risk of self-incrimination. See Henry v. Sneiders, 490 F.2d 315, 317 (9th Cir. 1974). 6. The Fifth Amendment privilege is not applicable to corporations. See Braswell v. United States, 487 U.S. 99 (1988). a. Consequently, the custodian of records of a corporation may not assert the Fifth Amendment to protect corporate records, even if the documents would be incriminating to them personally. See United States v. White, 322 U.S. 694, 699 (1944). 7. The government may overcome an individual s assertion of the Fifth Amendment by granting the individual immunity. See Kastigar v. United States, 406 U.S. 441 (1972). 12

13 III. a. Use immunity prevents the government from using the compelled statement directly in the prosecution of the immunized individual. See Kastigar, 406 U.S. at 460. b. Derivative use immunity denies the government the right to use evidence derived from compelled testimony. See id. at 445. The evidence may be used only if there is an independent source. c. Use and derivative-use immunity are the two types of immunity available under the current federal statute, 18 U.S.C d. Transactional immunity is equivalent to amnesty for the entire matter about which the individual testifies. This type of immunity is no longer provided for under the federal statute, although it can still be granted by authorities in individual negotiations. DERIVATIVE LAWSUITS A. Collateral Estoppel Following Criminal Or SEC Enforcement Action 1. In the case of a criminal conviction based on a jury verdict of guilty, issues which were essential to the verdict must be regarded as having been determined by the judgment. Emich Motors Corp. v. General Motors Corp., 340 U.S. 558, 569, 71 S.Ct. 408, 414 (1951) (allowing plaintiffs to introduce the prior judgment to establish prima facie all matters of fact and law necessarily decided by the conviction and the verdict on which it was based ). 2. [T]he doctrine of collateral estoppel has limitations to assure that the precluded issue was carefully considered in the first proceeding. For the bar to apply: (1) the issues in both proceedings must be identical, (2) the issue in the prior proceeding must have been actually litigated and actually decided, (3) there must have been a full and fair opportunity for litigation in the prior proceeding, and (4) the issue previously litigated must have been necessary to support a valid and final judgment on the merits. Gelb v. Royal Globe Ins. Co., 798 F.2d 38, 44 (2d Cir. 1986) (holding conviction for fraud based on false insurance claims after arson barred litigation of claims against insurance company). 3. An acquittal does not form the basis for collateral estoppel against a civil claimant. [T]he difference in the burden of proof in criminal and civil cases precludes application of the doctrine of collateral estoppel. The acquittal of the criminal charges may have only represented an adjudication that the proof was not sufficient to 13

14 overcome all reasonable doubt of the guilt of the accused. As to the issues raised, it does not constitute an adjudication on the preponderance-of-the-evidence burden applicable in civil proceedings. One Lot Emerald Cut Stones and One Ring v. U.S., 409 U.S. 232, 235, 93 S.Ct. 489, 492 (1972) (citation and quotation apparatus omitted). * * * * 10750\