Independent Examiners And Monitors: An Evolving Approach To Addressing Corporate Misconduct

Corporate fraud scandals like Enron, Tyco and WorldCom were the catalysts for the implementation of the sweeping corporate governance reforms embodied in the Sarbanes-Oxley Act of 2002. In reaction to such scandals, the SEC and DOJ embarked upon a zealous campaign of enhanced scrutiny and aggressive prosecution of corporate misconduct, with varied results and far-reaching impacts. The 2002 conviction of Arthur Andersen for obstruction of justice in connection with its audit of Enron, unanimously overturned by the U.S. Supreme Court in 2005, led to the demise of the public accounting giant. Likewise, the trials of former Credit Suisse First Boston investment banker Frank Quattrone resulted in his 2004 conviction for obstruction of justice, which was overturned by the U.S. Court of Appeals for the Second Circuit.

In the wake of these nullifications of highly-publicized criminal convictions, and recognizing that the acts of a few bad individuals do not justify substantial harm to the corporate entity as a whole, the SEC and DOJ seem to be turning to more cautious, unique and creative alternatives to prosecution of corporate misdeeds. In particular, the appointment of independent third parties to serve in the roles of examiner or monitor, usually in conjunction with settlements or deferred prosecution agreements, has become more prevalent. Through the use of such approaches, the government or the company under investigation can effectively outsource further investigation and even decisionmaking authority as to matters unresolved in a settlement, providing an important measure of transparency and accountability. And when reports are generated by these independent third parties, to the extent publicly available, they are often specifically intended to provide suggestions as to corporate governance reforms for consideration by all public companies.

By way of example, a company investigated for violations of federal securities laws might consent to a settlement including the appointment of an independent examiner to continue investigating where the SEC left off, and to issue a report of findings and recommendations binding on the company. Such was the case for Time Warner Inc., which agreed in 2005 to the appointment of an independent examiner to review whether certain advertising transactions between its AOL division and companies identified by the SEC were recorded in compliance with generally accepted accounting principles. In August of last year, the examiner provided an extensive report to Time Warner's Audit and Finance Committee, concluding that transactions with many of the companies were not recorded properly. Consequently, Time Warner agreed to restate nearly $600 million in advertising and other revenues.

Perhaps the best known example of an experiment with an independent monitor, however, is that of WorldCom. As part of a settlement with the SEC in 2002, WorldCom agreed to retain an independent monitor to review the effectiveness of WorldCom's accounting and financial reporting policies on an ongoing basis. In August 2003, the examiner released a report entitled "Restoring Trust," which he emphasized was not only relevant to WorldCom, but to all public companies as a "blueprint" for a system of corporate governance. The examiner's report detailed 78 recommended corporate governance changes, which, absent leave of court, WorldCom was required to implement.

In addition to WorldCom's use of an independent monitor in connection with its 2002 SEC settlement, the court handling the WorldCom bankruptcy also appointed an independent examiner charged with monitoring the company for signs of mismanagement, fraud or other irregularities. The examiner's second interim report, filed in June 2003, declared that his investigation "strongly suggested" that "WorldCom personnel responded to changing business conditions and earnings pressures by taking extraordinary and illegal steps to mask the discrepancy between the financial reality at the Company and Wall Street's expectations." The report further detailed a variety of problems reflecting, in the independent examiner's estimation, "a virtual complete breakdown of proper corporate governance principles, making WorldCom the poster child for corporate governance failures." The examiner specifically suggested in the report that it could be of value to all public companies for purposes of bolstering their existing corporate governance policies.

Also in 2003, the SEC settled charges against Spiegel Inc. for alleged violations of federal securities laws arising from Spiegel's failure to publicly report advice from its auditors that the company did not have the ability "to continue as a going concern for a reasonable period of time." As part of the settlement, Spiegel consented to the appointment of an independent examiner. The examiner was directed to provide a report to the court identifying, among other things, any material accounting irregularities in the company's books. The examiner's report concluded that Spiegel had failed to make required SEC filings and had failed to disclose material information about its financial condition to investors and other stakeholders, and that its books reflected multiple undisclosed material accounting irregularities.

More recently, in January of this year, the San Diego City Council retained an attorney to serve as an independent monitor at the behest of the SEC, as part of the City Council's settlement with the SEC relating to alleged financial misreporting. This independent monitor is charged with overseeing the City Council's financial reporting process and assessing internal controls and financial policies.

As an alternative form of settlement of allegations of corporate wrongdoing, a company under investigation might opt to avoid criminal charges by entering into a deferred prosecution agreement, somewhat akin to "corporate probation." As part of such an agreement, the company can be required to appoint an independent monitor, charged with broad oversight powers and the authority to make corporate governance recommendations or decisions for a specified period of time. Independent monitors appointed under such circumstances are often tasked with preparing detailed written reports setting forth their recommended or mandatory corporate governance reforms.

Such was the case for KPMG, which avoided criminal indictment in 2005 for selling allegedly illegal tax shelters by consenting to the appointment of an independent monitor, charged with acting as head of the company's compliance department for three years. Moreover, just last year, Bristol-Myers-Squibb Co. fired its CEO and General Counsel at the recommendation of its independent monitor. The monitor was appointed as part of a deferred prosecution agreement, and was tasked with conducting a comprehensive review of the company's internal controls and financial reporting systems.

Independent consultants have also been put to frequent use in conjunction with SEC settlements of alleged violations of the Foreign Corrupt Practices Act, or FCPA. For example, in 2005, Titan Corporation and DPC (Tianjin) Ltd. settled charges of violations of the FCPA's anti-bribery provisions, in part by agreeing to secure an independent consultant to assess and monitor the companies' compliance with the FCPA. Before that, in 2004, a General Electric subsidiary entered into a similar settlement with the SEC, which required that the company retain an independent consultant to monitor the effectiveness of its FCPA compliance program.

In each of these instances, independent third parties were commissioned to act essentially in the role of corporate probation officers or, more colloquially, "hall monitors," charged with undertaking appropriate investigative activities to ferret out corporate misconduct, and then making recommendations or decisions intended to steer the company back onto the right path and keep it on its best behavior.

Individuals appointed for service as independent examiners, monitors or consultants are most often lawyers or accountants, and must satisfy a variety of criteria in order to qualify for such positions. In particular, the SEC commonly requires that the individual must be "acceptable" or "not unacceptable" to the SEC. The individual must also be "independent" from the company under investigation, to ensure full disclosure to the SEC of all relevant information that may be discovered. In this regard, independent examiners and monitors are often asked to agree that neither they, nor their firms, will have any business relationship with the company at issue during the course of the engagement, and for one or more years after it is concluded. Finally, the prospective examiner or monitor must ensure that any and all conflicts that may exist between his or her firm and the company at issue are appropriately addressed and resolved.

Another recent example of corporate misconduct that cries out for the use of independent third party examiners or monitors, even before government regulators become involved, is stock option backdating. The manipulation of stock option grant dates has come to light as a pervasive corporate practice designed to enhance executive and employee compensation and is currently the subject of numerous SEC and DOJ investigations across corporate America. In December of last year, for example, Home Depot disclosed that it failed to record $200 million in expenses as a result of routine backdating of stock option grants over a period of almost 20 years. That same month, Monster, Inc. admitted to backdating options and restated nine years of income, and Monster's founder, Andrew McKelvey, stepped down as CEO and resigned from the company's board of directors. The CEOs of McAfee and UnitedHealth Group are also among those who have left their positions amidst allegations of impropriety involving stock option backdating.

In an effort to avert a scandal and restore credibility in the face of corporate misconduct, a public company would be well-advised to retain independent counsel capable of reviewing the company's conduct, policies and practices, and making recommendations for remedial action to the extent that any problems may be discovered. The SEC and DOJ are likely to look more favorably upon companies who proactively seek the assistance of independent third parties to investigate allegations of corporate accounting fraud, stock option backdating or other wrongdoing, which assistance might enable the company to minimize the scope of, or even altogether avoid, a full-scale government probe or criminal prosecution.

Published April 1, 2007.