Mining new depths

No one is surprised that the government is continuing to investigate cases in options backdating, the latest corporate scandal du jour. And no one is surprised that some executives will be going to jail. After all, in today’s political climate, that’s become virtually de rigueur.

Catching many by surprise, however, is how persistent the legal actions are getting and who government prosecutors are targeting. Look, for example, at the options backdating investigation at Brocade Communications Systems. Former CEO Gregory Reyes was investigated, indicted and convicted. And former head of human resources Stephanie Jensen followed, on two counts of fraud. Her crime? Helping with the paperwork, even though she claimed not to know the options were illegal, and even though Reyes says he assured her that everything was on the level and correct.

The Department of Justice (DoJ) and SEC have targeted about 200 companies on options backdating and a good dozen executives are so far facing charges. Brocade should leave any corporate secretary and general counsel wondering how many other non-executive employees will face prosecution because they were involved in any perceived wrongdoing. Corporations need to understand how a legal action can affect morale throughout the business and what steps they can and should take in order to mitigate the problems that could result.

Because of the surprise at seeing Jensen convicted, it’s easy to forget that the government has always considered all levels of employees in a company fair game when it comes to prosecution.

‘There is a long history of prosecutors and regulators charging well down into the management structure of a company when fraud occurs,’ says David Esseks, a current partner in the litigation practice at Allen & Overy and a former prosecutor. He points to government actions against Worldcom’s controller, director of general accounting and two lower-level accounting department employees; Adelphia’s vice president of finance and accounting director; and the controller, director of purchasing and several division heads of Collins & Aikman.

But even these examples are relatively recent. ‘It’s certainly fair to say that since 2001, there has been more activity not only in charging, but charging fairly far down into the management structure,’ he says.

One factor making that post-2001 difference is the context of the cases. Historically, securities fraud prosecutions generally targeted CEOs, CFOs and controllers. ‘Many of those cases involved revenue recognition issues where they’re the responsible parties,’ says James Sanders, partner of McDermott Will & Emery and head of its LA trial department. Lower-level employees seldom had any practical involvement because the action in question was the decision to treat revenue one way or another.

Part of the action
Where Brocade and many other potential cases differ is in what part of the options process a CEO or CFO single-handedly controls. Yes, the CEO or CFO might make the decision, but it is usually someone else’s responsibility to fill out the forms. ‘In some of these cases, it could not be done without some participation of the personnel department,’ Sanders adds. And the snare is in the paperwork, which shows who authorized an action, who signed off on it, and who undertook it. Anyone involved in the paperwork is part of the action, and prosecutors at least will want to speak with them.

Essentially, prosecutors and regulators are still after the active participants, and many former prosecutors agree that the intent is not to take down people for the sake of some tally. ‘I really do think that prosecutors … don’t charge mid-level people unless they think they have enough evidence to convict them, and they don’t charge them just to make them say something,’ says Bill Leone, a partner with Faegre & Benson and a former US attorney.

However, where once offenses were the decisions that top corporate officials made, the actions today are the result of a web of people, rather than one or two people at the top. Stock options are a telling example. ‘Depending upon the company and how they’re structured, you can have the legal department, the HR department, the accounting department all involved,’ says Daniel Winters, a partner at Reed Smith.

‘I think what you see when prosecutors drop down from the C-suite and start prosecuting mid-level people, it’s a function of the mid-level people having their fingerprints on everything,’ Leone says. ‘They created the documents, and those are the kinds of evidence that give you insight into the intent. Sometimes the mid-level people get charged because there is the most evidence against them.’

Furthermore, the SEC and DoJ have become more familiar with how to undertake major corporate investigations, according to criminal defense attorney Charles A. Ross of Charles A. Ross & Associates. ‘I’ve represented chief executive officers and mid-management people and secretaries,’ he says. ‘There are situations where they do [go after lower-level people] and situations where they don’t.’

There are two imperatives driving the investigating or prosecuting attorneys, according to Sanders. ‘One is that the prosecutor wants to put the squeeze on someone who can talk, and certainly people at a lower level are valuable in being able to talk about their superiors,’ he says. ‘The second is that prosecutors want to avoid the defense [of executives] that the people who did this are at the lower level, and we had no knowledge of it. By indicting everybody, the prosecutors not only give themselves the opportunities to have a lower-level witness, but they take away one of the defense arguments.’

But I didn’t know
But a legal determination of guilt through action is not the same as a self-perception of breaking the law. ‘I prosecuted a group of executives once with a mixed sense because they didn’t personally profit from these documents,’ Leone remembers. ‘[I asked,] Did you think you were doing anything illegal? And the answer was, No, I didn’t think I was doing anything illegal.’ He was convinced that at least some of them saw themselves as innocent of wrongdoing. ‘Most courts are saying that there are some things that are so wrong that everybody either knows or should know they were wrong,’ says Leone. ‘It doesn’t matter whether you knew it was illegal. Falsifying documents is one of these things where courts say that if you prepared documents that you knew were false, even if you didn’t think they were illegal – that dichotomy is the most difficult part of any white collar case in the corporate context.’

The lack of regard for whether someone knowingly did something illegal is understandable. If claiming a lack of understanding were a good defense, then everyone who had committed any infraction of the law could claim ignorance, leaving it to the state to prove otherwise. Such an attitude would turn the legal process into a field day for knowing miscreants.

Yet, when it comes to many issues in the corporate arena – day-in and day-out – people walk through fields of gray. For example, strictly speaking, backdating options is not illegal, so long as the company properly handles its choice in accounting. If the option price is the same as the stock’s price that day, there is no problem. But if the option price was cheaper, then there is an immediate gain by the employee, and the company must reflect the expense in the books. If it doesn’t, that’s where the activity crosses the line of legality.

But some of the departments involved in the backdating might have no idea how the company would eventually treat the accounting issues. If they are assured that everything is on the up and up, how are they to know that the final handling of the activity would be enough to turn everything legally upside down? Because of the range of news stories on options-backdating scandals, people have likely heard that there have been problems and might be more careful when handling such requests and directives.

Plus, there may be a host of factors that cause employees to think that they are doing the right thing or to even forget that the issue of legality might come about. ‘There may be a corporate culture, there may be a particularly technical situation with respect to a disclosure issue or a taxation issue,’ Ross says. ‘While someone is doing their job, they’re not focused on the very, very close look that a regulator or prosecutor will bring to that process. It’s not always a cut-and-dry or black-and-white situation that suggests you’re on one side of the line of right and wrong.’

The tip of the iceberg
Unfortunately, options backdating is just today’s known problem. ‘What boards and management should understand is that they’re never more than one economic cataclysm from the next wave of enforcement action,’ says Leone. The news coming from subprime and other derivative lending could be one sparking the next round of enforcement action, in his opinion. Other potential hot topics for the government could be insider trading and Foreign Corrupt Practices Act violations, as there currently isn’t a lot of media attention in these areas, and like options backdating, there is a higher likelihood that employees at all levels in a company could find themselves snared.

Look to the area of civil liability, and you find that employees in all parts of a company could be named as a defendant in a derivative action, in which stockholders bring suits in the name of the corporation against someone who allegedly has harmed it. ‘In those cases, which are state law claims, it is surprising how little developed the law is about exactly what level of misconduct is required to be liable or to make somebody liable who is not a director,’ says Richard Brodsky, counsel at Squire, Sanders & Dempsey. ‘It’s really not clear whether it’s negligence, gross negligence, which nobody is able to define, recklessness, or actual intent. There are relatively few decisions in the Delaware courts defining what that standard is.’

When it comes to directors and executive officers, a corporation’s choice is clear: indemnify and provide D&O insurance, except in cases of willful misconduct. That is hardly a given when it comes to other employees, but boards might reconsider their positions for the sake of morale. Providing coverage for employee legal costs in an investigation costs nothing unless there is one, and if there is, seeing people bankrupt themselves for their defense causes others to reconsider whether an association with the corporation is wise.

Depending on employees talking to the general counsel is no solution, because often companies will waive attorney-client privilege because they believe doing so will benefit them. Once that happens, anything the employees have told the GC now becomes open to prosecutors or regulators. Someone frightened at the prospect of prosecution without the financial resources for competent defense might unconsciously or even intentionally misrepresent what those higher in the organization did or knew in an attempt to broker a deal.

Training is critical
There is a widespread concern at many companies that reimbursing the legal costs of employees beyond the board and officers will cause retaliation by the government. ‘It’s a somewhat overblown problem,’ Esseks says. ‘The government view on this was … a policy that, in certain circumstances, [offered] indemnification of employees for their legal fees  coupled with other conduct that looked like a company circling its wagons, can be a bad thing. But strictly read, the policy was and is quite limited in practice.’

In general, a company should set up an indemnification policy, or even extend insurance coverage, in advance of a problem, so that it does not look as though the company is trying to cover something up. Any coverage could be eliminated in the case of a willful action damaging to the corporation.

However, legal representation should be a need of the last resort. Far better is to find problems in advance and to take care of them before they can cause trouble. ‘I think training is critical,’ says Phillip Stern, co-chair of Neal Gerber & Eisenberg’s white collar criminal, regulatory and internal investigative services practice group, and a former SEC enforcement official. ‘People need to understand that if they’re being asked to do something that they have questions about or that seem out of the ordinary, that they have a channel to raise the question and not have their job in jeopardy.’

That means the channels must exist, and employees must know that even if they have a question about something that might be perfectly legal, someone knowledgeable will answer their questions. ‘If you learn of a problem that could be a significant problem, they should have an independent inquiry investigation into it to determine whether there is a problem, the scope of the problem, whether their procedures worked properly or not,’ Stern says. ‘That should be run by the audit committee or the board and be run by the independent directors.’

Think of the necessary structure to raise and answer questions as an extension of a whistleblower program. Instead of being a reaction to a red flag, it should add a more ordinary aspect of answering the questions that employees may have.

Furthermore, the corporate secretary and general counsel must stay alert to developing problems. ‘If I were corporate secretary, I’d want to keep abreast of what’s going on in these areas,’ says George Stamboulidis, head of Baker Hostetler’s white collar defense and corporate investigations team, whatever the ‘the crime du jour,’ might be. In addition to protecting employees, corporate secretaries also need to protect themselves. ‘When you think of the musical chairs scenario, who’s going to be left sitting?’ he asks. ‘If you’re the corporate secretary, you almost always want a letter somewhere that makes it clear you aren’t the person who took this upon himself. You’d better have, if not a paper trail of the actions, something that makes it clear. It’s very hard as people learn later to prove a negative. Either it did happen and you can’t prove it because you didn’t document it, or it didn’t happen because you didn’t think it necessary.’

By creating an active, rather than reactive, approach to investigation or prosecution – which could happen to any company – a corporation ensures its ability to continue business and to stop problems before they start.