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What Do You Do When You Become Aware of Some Wrongdoing?
John P. Beavers
Bricker & Eckler LLP
June 2003
If you are a director, officer, lawyer, accountant or even a volunteer of any
organization-for profit or charitable, taxable or tax-exempt, publicly held or
private-you are likely at some point during your service to come across evidence
of possible wrongdoing by someone within or associated with the organization. If
this happens, what should you do?
For example, let's say this one-page memorandum anonymously comes through an
unofficial channel to your attention. How should you handle this situation?
Sir or Madam:
Mr. CFO is using Reptile LLC and other special purpose entities to divert
assets away from the company to compensate himself. Shares of company treasury
stock have been pledged to secure loans obtained by these entities. Some of
the proceeds of these loans have been paid directly to Mr. CFO. The company is
paying for Reptile fees that are being used to pay the interest on these
loans. These fees are being accounted for as advisory fees, but none of the
other transactions are being reported because the entities are not reflected
on the company’s balance sheet. Mr. Manager who used to work in the audit
department was fired yesterday for raising questions about the accounting of
Reptile and for refusing to shred some accounting records. I am incredibly
nervous that we will implode in a wave of accounting scandals. Someone should
look into this.
This memorandum is similar to one written by Enron’s in-house lawyer,
Sherron Watkins, to Enron’s CEO, Kenneth Lay, which resulted in many of the
“accountability” provisions of the Sarbanes-Oxley Act of 2002 (SOX). The
intent of Congress in the accountability provisions of SOX was to eliminate an
alleged defense by Kenneth Lay that “I had no knowledge” or an alleged
defense by Sherron Watkins that “I did nothing further because I trusted him.”
Complex maze of corporate governance laws
Although SOX has received much publicity, it is just one law in a complex
maze of laws dealing with corporate governance. Other laws dealing with
corporate governance include federal and state securities laws that existed
before SOX; federal tax laws, especially with respect to tax exempt
organizations; standards of professional conduct of lawyers, accountants,
internal auditors and other professionals; and state statutory and common law,
including fiduciary duties of directors and officers and contractual obligations
arising from employment contracts and an organization’s governing documents.
Questions you should ask yourself
(1) What are your duties to the organization?
Why? Because if you do not have a duty to the organization, you may have no
obligation. Generally, you only have an obligation to take some action regarding
potential wrongdoing by or to the organization if you have a duty of care or
duty of loyalty to the organization.
Duties arise from a number of sources, including:
- State law duties of care and loyalty for directors and officers.
All 50 states have either statutorily or judicially created duties of care
and loyalty for directors and officers of an organization. Generally, the
duty of care is to act with the care that an ordinarily prudent person in a
like position would use under similar circumstances (duty of care). The duty
of loyalty is to act in a manner reasonably believed to be in, or not
opposed to, the best interests of the organization (duty of loyalty).
Contracts. Duties are often expressed in employment contracts. In
addition, contractual duties are often implied from an organization’s
governing documents, such as codes of business conduct and ethics as well as
bylaw and charter provisions (including audit and other committee charters). New and existing federal and state laws. These include the
executive, accountant and lawyer accountability provisions of SOX and
section 10A of the Securities Exchange Act of 1934, as well as new state law
provisions expanding those accountability provisions to companies other than
public reporting companies. New and existing rules of conduct. These include the rules of
conduct governing lawyers, accountants and internal auditors at the state
and federal levels through rules of the SEC and the Public Company
Accounting Oversight Board (PCAOB) created by SOX.
If you serve as a director, officer, lawyer or accountant for an
organization, you likely have duties of care and loyalty that will not allow you
to ignore a memo like the one from Sherron Watkins. However, if you serve as a
janitor or clerical secretary or in another non-professional, non-directorial
position, you probably do not have any legal duty to act on such a memo.
Because of the Sherron Watkins memo to Kenneth Lay, Congress enacted
provisions in SOX to require certain persons to take some action:
CEOs and CFOs are required to take action upon learning of a
material misstatement in financial statements or reports filed with the SEC,
significant deficiencies in internal controls, and any fraud, whether or not
material, involving internal controls; Lawyers for the organization are required to take action upon
learning of material violations of securities laws and material breaches of
fiduciary duty; and External accountants are required to take action upon
learning of material illegal acts and related party transactions and are
required to take action upon learning of defects in internal controls.
(2) What triggers you to take action?
Under most states’ laws, whether learning of some possible wrongdoing
triggers the need to take action depends upon the duty of care that an
ordinarily prudent person in a like position would exercise under similar
circumstances. This duty of care applies to any organization, for profit or
charitable, taxable or tax-exempt, publicly held or private. The problem with
the prudent-person duty of care is that it is open to subjectivity determined by
a jury or other trier of facts in courts. For this reason, SOX tries to bring
some certainty as to when action must be taken by officers, lawyers and
accountants of public reporting companies upon learning of evidence of
wrongdoing.
However, what triggers action under SOX is not much different than what
courts have held triggers action under the prudent-person duty of care. Under
either, any of the following will likely trigger a requirement to take some
action:
Illegal act, generally an act or omission that violates any law, or
any rule or regulation having the force of law;1 Violation of securities law or breach of fiduciary duty to the
organization or similar violation of federal or state law, including:
Failure or fraud in maintaining internal control and records underlying
the organization’s financial statements,2 Improper influence, coercion, manipulation, or misleading of any
independent public accountant engaged in the performance of an audit of
the organization’s financial statements,3 Failure or fraud in reporting by insiders of their trading in the
organization’s securities,4 Improper trading by insiders in the organization’s securities,5 Failure or fraud in enforcing the organization’s code of business
conduct and ethics,6 Unlawful loan to officers or directors,7 Unlawful destruction of documents,8 Unlawful retribution against employees for lawfully providing
information in any federal investigation;9
(3) What action has to be taken?
Under most states’ laws, the action to be taken depends upon the duty of
care that an ordinarily prudent person in a like position would exercise under
similar circumstances. Again, the problem with the prudent-person duty of care
is that it is open to subjectivity. For this reason, SOX tries to bring some
certainty as to what action should be taken. In fact, the rules under SOX
dealing with standards of professional conduct of lawyers is instructive.
SOX requires lawyers for public reporting companies to take some action upon
learning of evidence of material violations of securities or breaches of
fiduciary duty12. he rules dealing with standards of conduct of lawyers under SOX
require lawyers to take some action if the evidence is credible and the
violation, if true, is material13./p>
These rules dealing with standards of conduct for lawyers are consistent with
the holdings of courts across many jurisdictions regarding what a prudent person
with a duty of care to an organization should do upon learning of wrongdoing
involving or affecting the organization. Therefore, they can serve as guidelines
for anyone learning of possible wrongdoing. Whether an organization is publicly
or privately held, for profit or charitable, taxable or tax-exempt, a director,
officer, professional, or other person having a duty to the organization is
likely to act prudently if he or she follows these guidelines:
Make an initial inquiry as to:
Credibility. To determine whether the evidence is
credible, meaning unreasonable, under the circumstances, for a prudent
and competent person not to conclude that it is reasonably likely that a
problem has occurred, is ongoing, or is about to occur;14 Materiality. To determine whether or not the wrongdoing, if
true, would (1) in an absolute sense, be considered material or
significant to investors in general or security-holders of the
organization in particular or (2) in a relative sense,
Make any past financial statement or report filed with the SEC
materially misleading, Have a material effect on any future financial statements or reports
filed with the SEC, Have, either directly or indirectly because of resulting consumption
of time or expense, a material effect on current or future (1)
operations, assets, liabilities or prospects of the organization or (2)
results of operations or financial condition, Constitute a significant defect in the internal controls or records
underlying the organization’s financial statements, or Constitute fraud (whether or not material) involving management or
other employees who have a significant role in the issuer's internal
controls.
If credible and material, then report the evidence of the wrongdoing to
the appropriate authorized representative of the organization. If the
evidence demonstrates an illegal act or a violation of law or breach of
fiduciary duty, report it to the chief legal officer or, if more
appropriate, the CEO or CFO. If the evidence shows a misstatement in
financial statements or financial report filed with the SEC or another
governmental agency, or a deficiency or fraud in internal controls, report
it to the CEO or CFO. Request someone responsible to conduct a substantive investigation to
determine what remedial measures, if any, are necessary to (1) stop any
wrongdoing that is ongoing; (2) prevent any problem that has yet to occur;
(3) remedy or otherwise appropriately address any wrongdoing that has
already occurred; and (4) minimize the likelihood of any recurrence15. Finally, report any remedial measures taken or to be taken to the CEO,
CFO and CLO. If the wrongdoing will have a material effect on financial
statements, or involves a material misstatement in financial statements or
financial report filed with the SEC, or constitutes a significant
deficiency in internal controls or accounting records, or involves fraud
in internal controls or accounting records, then report remedial measures
to the audit committee or other appropriate committee of the organization’s
board, or the board itself, and the external auditor.
What would have happened if . . .
What would have happened with Enron if Kenneth Lay had received this type of
advice after receiving Sherron Watkins memo?
Wouldn’t he have made at least an initial inquiry to determine the
credibility of the evidence and the materiality of the alleged wrongdoing?
And, if he did make an initial inquiry, wouldn’t he have found the
concerns of one of his in-house attorneys credible and her evidence
material? In any event, wouldn’t Sherron Watkins have had a duty to continue
up-the-ladder reporting if she did not reasonably believe the matter had
been appropriately handled by Kenneth Lay? And, wouldn’t Sherron Watkins’ evidence have been reported to the CLO
and likely the audit committee and external auditor? Wouldn’t a substantive investigation have been undertaken and wouldn’t
some remedial measures have been taken that could have avoided the Enron
implosion.
If Kenneth Lay had received such advice and taken such actions, the fraud
perpetrated because of greed at Enron may not have been avoided. However, the
fraud may have been discovered two years’ earlier, and the implosion of Enron
may have been avoided.
Footnotes
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