More On Attorney Conflicts of Interest in SEC Investigations

As discussed in my last post, the SEC is saying that the availability of cooperation credit for individuals will pose serious potential conflicts between the interests of persons with knowledge about the events under investigation such that separate counsel might be required under the applicable ethical rules. SEC Staff will scrutinize such potential conflicts in a way that was not customary in SEC investigations before the new policy was announced. However, neither Mr. Khuzami nor Mr. Reisner have indicated whether the same will be true regarding potential conflicts in corporate representations.

If the law firm represents the company and individual officers and directors, the clients' interests can and often do diverge at some point. Traditionally, many firms have chosen the point at which the SEC Staff provides a Wells notice to notify individuals that the Staff intends to recommend an enforcement action against them as the time at which there is a divergence of interests between the company and its employees. This has been called into question by Messrs. Khuzami's and Reisner's recent comments and other comments by Enforcement Staff. Companies will need to provide separate counsel for employees at an earlier stage under the new regime. What about other conflict issues involving the corporate entity?

In 2001, the SEC issued a report of investigation known as the "Seaboard Report," named after a parent company against which the SEC did not take any action following an investigation into misstated financial statements at one of the company's subsidiaries. (See http://www.sec.gov/litigation/investreport/34-44969.htm). The SEC explained the reasons for its decision not to punish the company and laid out criteria for similar "cooperation credit" or "Seaboard credit" to be extended to other companies in future investigations. Among other things, Seaboard voluntarily self-reported its financial misstatements, gave complete cooperation to the SEC Staff, provided detailed reports of its internal investigation, and waived the attorney-client privilege and work product protection with respect to facts uncovered in the investigation.

In evaluating whether and how to provide Seaboard credit to a company, the Commission noted that one question it would examine would be whether the internal investigation was conducted by outside counsel (rather than internal personnel), whether such counsel had represented the company previously (implying that new counsel would be preferable), and whether and, if so, what scope limitations were placed on the review. This analysis in essence questions whether there is a basis for the SEC to believe that the internal investigation was not properly conducted due to a pre-existing relationship between the law firm doing the work and the company's senior management or because there was a limitation placed on what the law firm could consider in forming its conclusions.

Although the SEC Staff has, in a number of investigations, considered the independence of a law firm in evaluating what weight to give to a report, the SEC has to date never given this element the sort of prominence that is now being given to the potential conflicts issue in the context of individual cooperation. This begs the question: will potential conflicts issues become more important in the corporate context as well?

Several potential conflicts exist when a firm undertakes an investigation that will be shared with the SEC in order to obtain Seaboard credit.

If the law firm that conducts the investigation also currently represents the external audit firm (in unrelated litigation), for example, there is a potential conflict between two current clients. In a financial misstatement investigation where the facts indicate that the company's accounting treatment did not comply with GAAP, a conclusion that the auditor was aware of the underlying facts could be detrimental to the audit firm but favorable to the company and its management. The company's interests would be served by including this fact in the investigation report that is shared with the government, but this is likely to run counter to the interests of the audit firm.

Other potential conflicts exist in the corporate context. What will be interesting to follow is whether the SEC applies a similar parsing of the attorney-client relationship in these circumstances.