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PLI Panelists Discuss Litigation and Enforcement Developments

At the Practising Law Institute's recent Securities Litigation and Enforcement Institute in San Francisco, George Brown, with the Menlo Park office of Heller Ehrman LLP, predicted that loss causation will continue to be an important issue in cases against auditors. Panelists discussed the impact of the Supreme Court's Dura Pharmaceutical decision involving loss causation and the resulting debate regarding accounting firm defendants. The issues in loss causation cases involving auditors will include macroeconomic factors (industry, market), the passage of time since the auditor issued an opinion, the company's performance, the relationship between the auditor's opinion and the damage claim, and any corrective disclosure versus the materialization of risk, according to Brown.

The panel discussion on securities auditor liability also covered stock options. Joel Bonner, associate general counsel for the Los Angeles office of Ernst & Young LLP, said he is aware of very few cases involving auditors. Bonner said his firm enters into alternative dispute resolutions with its clients. In most situations, auditors would sample test the client's minutes against the equity portion of the accounting records. If they matched, Bonner said that would be the extent of the test.

David Siegel, with the Los Angeles office of Irell & Manella LLP, believes the stock option cases will expand. Auditors are now asking more questions, he explained, and companies will get caught in the net. Siegel said these inquiries are a source of friction between companies and auditors that verge on the adversarial.

On the second day of the conference, John Reding, with the San Francisco office of Paul, Hastings, Janofsky & Walker, LLP, led a panel discussion on internal investigations. Internal investigations are a search for the truth, he said. They are good if done properly. Many internal investigations are now triggered by calls to 800 numbers, he said, but academia can also trigger an investigation. Reding pointed to the research by an academic that uncovered the stock option backdating problem. Reding added that he was struck by the inability of auditors to uncover this practice given how plain it is when you look for it. Siegel noted that the AFL-CIO recently sent a letter asking the Big Four accounting firms to explain why they did not spot the backdating issue.

David Kistenbroker, with the Chicago office of Katten Muchin Rosenman LLP, pointed out that hedge funds are now writing whistleblower letters. It's amazing what they are doing, he said. Kistenbroker said that hedge funds are causing companies to conduct huge internal investigations. These companies may have to issue disclosures that can affect the market treatment of their equity, he added, so one could question whether certain hedge funds are being good citizens or are involved in market manipulation if the hedge fund is shorting the stock while issuing these allegations.

Reding emphasized the importance of having independent outside counsel conduct the internal investigation. While many parties may conduct internal investigations, Reding said independence is crucial to gaining any credit from the regulators. He added that those conducting the investigation must be credible with the SEC and the Department of Justice.

Kistenbroker said that companies should tell their IT people to take the backup tapes out of rotation when an internal investigation begins. He said that IT people do not speak the same language as everyone else, but must be made to understand that they answer to the CEO. Reding said the tension with auditors is intense during internal investigations. Auditors' concern is how to avoid being tainted by any discoveries, he said, so companies will spend a lot of time dealing with auditor demands. It's a little bit of a brinkmanship game, he said. Auditors are fully aware of their leverage with respect to the company's ability to certify its financials and remain listed.

Kistenbroker advised that lawyers are being deposed with declarations of waivers of attorney-client privilege. This is a tough area of the law, he said, and raises many questions. Privilege is tough to maintain in the current environment. Reding advised lawyers, when interviewing witnesses, to make clear who they represent and that there is no guarantee that what they say will remain confidential. At the same time, Reding said that lawyers should tell witnesses to be truthful because they don't want to get it wrong.

From William Lerach's perspective, an internal investigation is never bad. Lerach, the chairman of Lerach Coughlin Stoia Geller Rudman Robbins LLP, said that something has happened if an internal investigation is triggered. If there's a whitewash, his firm will see it, he added. The whitewash may become more important than the issue being investigated, he warned.

Reding cited a story reported on the news wires on September 11 that a group of former Justice Department officials had sent a letter to Attorney General Gonzalez criticizing DOJ's corporate fraud investigations. The group singled out the Thompson memo which they believe is flawed and harms companies' ability to conduct effective internal investigations.

Lerach said that internal investigations are not a good defense. He believes there will be more investigations that lead to selective prosecutions of claims. Lerach said the large institutional investor community is frustrated over its inability to use remedies other than litigation to effectuate change. Investors have seen scandalous self-dealing by insiders. The AFL-CIO has tried to use the proxy process to get results, he said, but even if its recommendations gain shareholder approval, they are ignored by management.

Lerach said the currently lurking financial scandal is the underfunding of pension funds worldwide. He characterized it as a grotesque financial risk and predicted that it will make the S&L crisis pale in comparison. This "quiet crisis" contributes to the frustration of pension fund trustees when they see the self-dealing by executives, he said. When asked which corporate governance changes he would seek, Lerach said insider trading controls. Insiders should be required to hold onto their shares for some period of time before selling, he said. Lerach believes that skepticism is growing that governance procedures can change behavior.