Letís Make A Deal: The Question of Privilege
National Association of Securities Dealers
September 13, 2006
Good afternoon. Thank you very much for that introduction.
It is a pleasure to be here with you today.
I am very honored to address members of the Division of Enforcement of the National Association of Securities Dealers. It’s great to be speaking to a group of people who are on the front lines of enforcement in the securities industry, because we, at the Department, have the same mission that you do. Like you, the Department seeks to foster investor confidence through our enforcement efforts to combat corporate fraud and protect our nation’s financial markets. In fact, I cheer for your victories because when your enforcement efforts are successful, it’s less work for us!
Many of you know that Washington, D.C., gets very hot in the summer – so hot that our nation’s leaders escape the heat by staying in their homes on the Potomac enjoying the river’s breezes or driving out to their cabins in the country. But after Labor Day, we don’t need the summer sun, because Washington has a way of generating its own heat. I’ve been experiencing the rising temperatures recently in testifying before Congress on the Department’s corporate charging practices yesterday, and I am also going to be experiencing more of it next week when I testify about Departmental practices in issuing grand jury subpoenas to reporters.
Let me just say this - It’s nice to be among friends today.
As many of you know, the Department has been receiving a lot of criticism lately about the Thompson Memorandum. That Memo outlines the factors that federal prosecutors should consider when deciding whether to charge a corporate entity. Many former DOJ officials, now in private practice and representing those corporations, have made public statements or sent correspondence to the Hill and to newspapers complaining that the Department is too aggressive in its corporate investigations and that its prosecutors “coerce” waivers of privilege from corporations that want to cooperate. These former officials include former Attorneys General, Deputy Attorneys General, and Assistant Attorneys General. I haven’t heard from Larry Thompson yet – the Deputy Attorney General who actually issued the guidance. If Thompson objects to the Thompson Memo, I know things are bad.
And I’m here today to talk to you about the Thompson Memorandum. It is guidance that influences all of our enforcement efforts and in many respects, it has been misconstrued by our critics. I especially welcome the opportunity to discuss it with members of the enforcement community because in doing law enforcement work, you are uniquely able to understand the issues we face from the government side of the counsel table.
Every day in the crowded corridors outside the criminal court rooms in New York, Chicago, and LA, prosecutors are approached by defense attorneys representing drug dealers, thieves, and gun criminals. And every day, these defense attorneys start their conversation with the prosecutor with the following words, “My client wants to cooperate. Can we make a deal?” – Maybe we should have some Law and Order music in the background. – When the defense attorney makes that offer, that attorney knows that his client is going to give up some very important rights when he pleads guilty - the right to a jury trial, the right to confront and cross-examine the witnesses against him, and the right against self-incrimination. These rights form the very bedrock of our judicial system; they derive from the Constitution. Yet that defendant is willing to waive these rights because he sees a concrete benefit for himself. If he pleads guilty and cooperates with the government, there is a possibility he will face reduced charges or knock some time off his sentence.
Now let’s fast forward to a plusher setting – the lawyers are still there but the business suits are more expensive, the coffee is from Starbucks rather than a vending machine, and the client is a business entity reporting earnings in the hundreds of millions of dollars. But the reason that lawyers for the government and the corporation are all sitting in the same room is the same reason that those lawyers were standing in the crowded corridor. The corporation is facing the real possibility of criminal charges for the criminal activity of its employees. And corporate counsel says to the prosecutor, “We want to cooperate. Can we make a deal?”
The style is different, but the words are the same.
Why that corporate concession? Well, by now, we are all familiar with the story. Two months ago, that corporation announced that it was restating its earnings for the previous five years. As a result of its own internal investigation, the corporation discovered that the CFO and two other top financial managers, the CFO’s deputies, committed an accounting fraud to understate the corporation’s expenses so that the company could report an increase in earnings every year. The earnings reported coincidentally matched management projections of increased profits each year and have resulted in a steady increase in the company’s stock price. The three executives at the company were paid handsomely for their individual performance, including generous deferred compensation packages. These executives exercised stock options and sold their stock in the past five years, making personal profits in the millions of dollars.
Of course, the real accounting picture was grim. The corporation had actually been stacking up unreported liabilities and the wrongdoers with their fancy accounting tricks, had managed to deceive the corporation’s stockholders and the investing public. Relying on the information provided by these executives, the corporation filed false earnings reports. It made deceptive filings with the Securities and Exchange Commission, and it misled outside auditors. As that corporate counsel studies the prosecutors across the table, counsel knows as a result of an internal investigation, that the corporation and its culpable executives can be charged with a host of criminal violations: securities fraud, mail and wire fraud and false statements.
That is the setting for the Department of Justice’s use of the Thompson Memorandum. That is what we often face in corporate fraud investigations. The guidelines have been criticized for being unfair to corporate America, but, just in case this gets missed along the way, the guidelines have no relevance to the vast majority of good corporate citizens in America who are obeying the law. The guidelines are triggered only with those companies that can be charged with a crime. Before negotiations even begin in this situation, government prosecutors are considering the possibility of criminal charges against the corporation.
So, what does the Thompson Memorandum tell prosecutors to do? It gives us nine factors to consider.
First, prosecutors should examine the nature and seriousness of the offense. In our example, the facts we know about the offense indicate that it is significant. We have five years of earnings restatements because of an accounting scheme that essentially “cooked the books” to benefit the company and these executives. The scheme harmed the public by causing an artificial inflation of the stock price even though the company’s real financials would not have supported such an increase. In fact, with the public announcement of a restatement of earnings, the share price of this company plummeted 20%.
Second, prosecutors should look at the pervasiveness of wrongdoing within the corporation, including the complicity in the wrongdoing by corporate management. In our example, the CFO and two of his subordinate managers orchestrated the inflation of earnings and hid the problems from outside auditors. That factor would weigh in favor of charging.
Third, did the corporation have a history of similar conduct, prior criminal, civil, or regulatory offenses against it? Here, in our hypothetical, let’s say the corporation does not have a history of other conduct. It was a company that grew too big, too fast and became slipshod in its internal controls without any regulator finding out about it. These three executives ran the show on the financial side, but to whom were they reporting? Are others involved?
Fourth, did the company disclose its wrongdoing? Well, in our case, the company restated earnings. The prosecutors noticed that there was a problem with the earning restatements and they initiated contact with the SEC. The SEC had an open investigation already and agreed to share the information it had obtained with prosecutors. The company publicly announced the restatement and corrected its inaccurate regulatory filings for the past five years.
Fifth, did the corporation have a compliance program? In this case, the corporation, as we often see, had a compliance program on paper. The compliance program was not fully functional or vital to the company’s daily activities. It was a policy book that new employees were obligated to read the first day of employment but never referred to again. Because of a lack of internal controls, corporate executives were able to direct this accounting scam without any independent oversight of an audit committee or a strong and independent accounting department.
Sixth, the prosecutors take a look at the corporation’s remedial actions after the fraud was discovered. Did the corporation institute a compliance program, adequate internal controls, or enlist the help of an outside audit team? Has it changed its organizational structure or replaced management? Is it cooperating with its regulator, the SEC, by opening up its books and records? Let’s just say, in this case, the corporation was initially very resistant to change. Its organizational structure stayed the same and management was not replaced. When the SEC sought documentation, the corporation was not producing the information it sought. The prosecutor suspects that other management officials are involved.
Seventh, the government considers the collateral damage to the corporation. Is there disproportionate harm to shareholders, employees and pensioners? This corporation had thousands of employees in a number of domestic and international branch offices. Criminal charging of the company would likely result in a loss of business and a severe reduction in work force, a decrease in stock price and a long-term reduction in company value.
Eighth, do the prosecutors believe that prosecuting individual executives is enough to excise the “cancer of corruption” in this corporation? If the prosecutors elect to indict only individuals, do they feel fairly confident that there is sufficient change in the corporate culture so that this criminal activity will never occur again?
And finally, the ninth factor, asks the prosecutor to consider whether civil or regulatory actions are enough. Can we resolve this in a civil injunctive action and obtain disgorgement of profits or an administrative proceeding with civil monetary penalties? Is that sufficient? Do we need a criminal prosecution?
In assessing these facts, you can make a fairly strong case for charging the corporation. The nature of the crime is very serious because the accounting fraud misled the shareholders and the investing public. The crime also appears pervasive because it involved three of the most senior executives with the likely possibility there were more involved. And finally, there were inadequate internal controls at this corporation and its first reaction in the first months of discovery was to leave management in place and decline to restructure the organization to deal with this problem. It looks like the cancerous tumor in this company may be so big that we can’t operate.
But today, in these negotiations, corporate counsel is taking a different approach. Counsel requests a meeting with the prosecutors to show the government that they want to cooperate. On their big conference table is a huge three ring binder. It contains employee interviews about the criminal activity, relevant documents and a specially prepared time line of events prepared by their attorney-investigators. The prosecutor anticipates a lengthy grand jury investigation, subpoenaing 40 to 50 witnesses into the grand jury, obtaining thousands of pages of documents and tasking FBI analysts with doing a financial analysis of the accounting fraud when the documents are obtained. He estimates that working fast, the investigation will probably take 24 months, most likely three years. And who knows where the investigation may take him? There may be more executives and lower level employees out there who participated in these crimes. This may take even more effort than anyone realizes.
At corporate counsel’s request, the prosecutor has communicated this best estimate of the time table for his investigation. Counsel must report to the Board about the outcome of this meeting and he is very concerned about the disruptive effects of a lengthy investigation on the corporation. Certainly, any lawyer can feel sympathy for his position. The investigation will be disruptive – employees will appear before the grand jury for months to come and various departments at this company will be told to search and collect documents responsive to government subpoenas. Counsel urges the government to complete the investigation within six months because of the anticipated effect on the corporation’s ongoing operations.
So what do you do as a prosecutor? You have a duty to investigate and prosecute criminal activity, but you don’t want to unduly disrupt business operations if you can avoid it. Counsel is telling you the corporation wants to cooperate and pledges to cut out the cancer and make major changes in the organizational structure.
Now is the time to discuss waiver of privilege.
Far from being a shocking thought – as has been recently suggested by the critics of the Thompson Memorandum – a discussion of waiver is part of the natural progression in this negotiation. The corporation has made an initial determination that it has criminal exposure: that is, criminal activity occurred, it was committed by its employees, and the corporation is vicariously liable for those acts. And the company wants a resolution – preferably a prosecutor’s assurance that he will not charge – as soon as it can get it. In this case, corporate counsel has even brought the binder containing the results of the internal investigation to the negotiations because he is going to offer to produce it, so the government does not even have to ask. But production is a waiver of attorney client and work product protections, and the corporation is not going to give that up frivolously. It will attempt to limit the scope of the production because it does not want to give a “blanket” waiver.
The untold story is that the prosecutor, doesn’t want a blanket waiver either; he is not seeking to peek under every privileged rock. To do that is time-consuming and bears little usable evidence. What does the prosecutor really want from these materials? An experienced and savvy prosecutor takes a Joe Friday approach, “just the facts, ma’am.” A prosecutor wants to know what happened, not how a corporation’s attorneys are advising it to respond in a corporate criminal investigation. He doesn’t want litigation strategy. He doesn’t want mental impressions.
He just wants the circumstances surrounding the fraud – who knew what; when. (And if relevant to an advice of counsel defense, legal advice given contemporaneous to the criminal activity.) This corporate disclosure will allow the prosecutor to move much faster – it will forestall searches through warehouses of legal documents and interviews of dozens of employees who may have relevant knowledge because of their title or job description on paper, but in reality, may not know anything of value to the investigation. The prosecutor will now be able to use a surgical strike to remove that cancer – a targeted approach to obtain only the information that is needed to complete the investigation. This saves taxpayer money and conserves corporate resources.
And shouldn’t the corporation should get credit for its efforts?
The Thompson Memo gives the corporation consideration for cooperation when it waives its privilege and provides these facts to the government. Waiver is not the only thing we consider when we look at the company’s cooperation, but it one of things we look at. Our decision-making in this context is not wrong or coercive; it is simply good practice. Critics ask that waiver of privilege not be considered at all in making a determination as to whether a company cooperated. But is that really what the corporate bar wants from the Department of Justice? Do they want to give us this information – the product of weeks and months of their time and effort – but receive no benefit for it? That just doesn’t make sense. In this case, the prosecutor is asked to, and will properly consider, the corporation’s production of privileged information.
Why give credit towards cooperation in a charging decision? When the corporation disclosed the results of the internal investigation, that investigation revealed a lot of information that the government did not have. The new facts paint a slightly different picture, which the prosecutor can verify through a targeted investigation. The facts now show that the activity was isolated to the three executives and other employees were not implicated. The prosecutor’s first instincts were wrong. He feels comfortable in concluding that the CEO, CFO, and Board of Directors had no knowledge of the fraud. In the last month, as the facts of the fraud have been corroborated, the responsible executives were terminated, the proper compliance procedures were put into place, and the corporation revamped its internal controls and organizational structure. The company now pledges to provide ongoing cooperation in the government’s investigation. As a result, the investigation is completed in eight months, rather than three years, and the three executives are charged and convicted within a year. The corporation enters into a deferred prosecution agreement with the government for a 24-month period and, as part of that agreement, pledges to maintain the compliance standards it has recently established and to make periodic reports to the government. If it complies with the agreement for that 24-month period, the government will not prosecute.
Is this a good resolution for the investing public? Yes.
Does it conserve public resources? Yes.
Does it benefit the corporation? Yes.
Does it preserve company value? Yes
Besides the evident conclusion that a quick but thorough investigation is in everyone’s best interests, the Thompson Memo means much more to corporate charging than protecting investigatory resources. The guidance is founded upon a simple concept: Duty. A federal prosecutor has a duty to the taxpayer to enforce our nation’s criminal laws and a corporation has a duty to its shareholders to act responsibly to protect their interests. The Memo guides the prosecutor on what to do in discharging that duty, but it also gives companies a roadmap on what it means to be a good corporate citizen and how to discharge its own duty to its shareholders.
When a corporation finds that its employees committed crimes, its first response should be, “We are on the side of the government. We want to promote a good corporate culture. How do we get back on the right track as fast as we can?” The Thompson Memorandum shows a corporation how to do just that: by giving credit in a charging decision for compliance programs, remedial measures, and cooperation, including waiver of privilege where necessary. It doesn’t “force” the corporation to do anything; it doesn’t coerce privilege waiver; it doesn’t thwart the company’s ability to conduct an internal investigation. What does it do? The Memo promotes specific aspects of good corporate governance and presents a rational plan of action to a corporation facing criminal charges. The corporation is free to accept or reject that plan. But no matter what choice the company makes, it can never complain that the government’s charging decision was made behind closed doors. The analysis in the Thompson Memo is transparent, simple, and relies on the common sense prosecutors have been using for decades.
Imagine the scene without the Thompson Memo. Let’s say I signed a memo today withdrawing it entirely – “The McNulty Memo.” Individual prosecutors would be free to pursue corporate fraud investigations in whatever manner they see fit. Corporate officers and directors would have no idea how to approach a criminal investigation. Without the transparency provided by the Thompson Memo, they would have to guess at how to resolve the matter without criminal charges being leveled at the company. Most corporate defense counsel would consult the old Memo and hope that the prosecutor will be following a similar practice. Many will still waive the attorney client privilege and turn over the results of their investigations in the hope that the prosecutor won’t indict the company.
So what would we accomplish by eliminating the consideration of waiver from the Thompson Memo? Nothing positive. For corporations who have committed crimes a harsher, less predictable and less transparent environment. For prosecutors and share holders, less incentive for corporations to cooperate will lead to less accountability, less integrity, and more fraud in our markets. I have a duty to speak against a change that would benefit no one and potentially harm law-abiding citizens. Don’t misunderstand me. I am considering changes, and there may well be changes, to the Thompson Memorandum. But any changes will be consistent with these principles.
Duty is the concept our critics miss. Our duty does not change because the defendant is a corporation, rather than a drug trafficker. Our duty doesn’t change because of the size of the defendant’s bank account. As prosecutors and law enforcement officials, we have a duty to enforce the law and bring corporate criminals to justice. We have a duty to the American people – whose hopes and dreams are tied to the value of their investments – to provide an incentive for corporation to act with integrity.
The Department of Justice has been doing that over the past five years, and, with your help, we will continue to pursue corporate criminals and protect the American Dream.