When you become a target of the SEC: what directors need to know about an SEC enforcement investigation and the thoughtful, immediate actions that need to be taken.

• Author: Winer, Kenneth B.
• Position: Regulatory Oversight

NEVER BEFORE have financial reporting and accounting issues been as prominent in the public consciousness as they are now, and never before have they been as high a priority for the U.S. Securities and Exchange Commission's Division of Enforcement. As of November 2001, the SEC reported 260 current investigations into financial fraud. The targets of these investigations include a record number of Fortune 500 companies. The SEC reports that it is opening two new investigations each day.

In the current climate, directors in any public company may find that their company has become the target of an SEC investigation. If that day comes, the result for the company may well depend on its directors taking action that is thoughtful, responsible, and immediate.

Notice of an SEC investigation can be a warning that directors should initiate their own investigation to determine whether any laws or corporate policies were violated. This may be prudent not only to protect the corporation's interests, but also to fulfill the directors' duty to ensure that the corporate information and reporting system is adequate. By demonstrating their willingness to gather and act on information, directors can put both themselves and their company in a favorable light.

Designing the investigation

Once the decision to investigate is made, the board must decide whether to investigate using the company's employees or outside professionals. An investigation conducted by outside professionals may be more expensive and disruptive. On the other hand, an outside investigation, particularly one conducted by lawyers who are not regular counsel to the company, may be viewed as independent of management and thus more credible. In many instances, the law firm conducting the internal investigation also represents the company before the SEC.

Another key question is who should direct the investigation. Should it be management, the full board, the audit committee, or a special committee composed of independent directors? The answer will depend on the facts and circumstances, but common sense suggests that those implicated in the alleged misconduct shouldn't direct the investigation, and that disinterested and independent board members will have the most credibility with the SEC or the courts.

The design of the investigation should include the goal of providing information to assist management and the board in assuring that the company's information and reporting systems are adequate. The investigation should aim to give the board what it needs to make informed judgments, especially in regard to the extent of any necessary remedial measures -- for example, disciplining those who engaged in improper conduct or strengthening internal controls.

Perhaps most important, the investigation should be designed to gather the evidence that the company and its lawyers will need to respond effectively to the SEC. The SEC often takes the testimony of board members, and an informed director who can point to responsible...