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SEC's General Counsel Cautions Against Poorly Structured Internal Investigations

SEC General Counsel Giovanni Prezioso, in remarks at the Vanderbilt Director's College in September, suggested questions a board may want to consider when it obtains information about potential misconduct. He also cautioned boards about conducting internal investigations. Once an internal investigation is undertaken, Prezioso said it is "worse than useless" if it is conducted ineffectively. Prezioso's prepared remarks were recently posted on the SEC's Web site.

Prezioso said that directors should consider whether new information that has been presented to them makes sense from a business perspective, but also as a matter of logic and experience. He said that in a remarkable number of enforcement cases, senior company officials failed to ask questions about information that should have seemed suspicious. Prezioso also urged directors to apply a healthy degree of skepticism to information from any source, but especially where there may be conflicts of interest. He pointed to related party transactions in particular.

Prezioso urged directors to seek independent opinions about legal or technical information, as needed. Ignorance of the law is no more an excuse for directors than for anyone else, he advised. Prezioso maintained that there is no reason for a director to serve on the board of a public company without a basic familiarity with securities laws and other obligations affecting public companies and their directors. He also emphasized the importance of having enough time to thoroughly review materials, given that many of the SEC's enforcement cases involve situations where actions were taken in such haste that obvious red flags were missed. Prezioso suggested that directors rely on an updated variation on the "New York Times test" --imagine that your deliberations are being videotaped and will be played in a closed Commission meeting room.

Potential misconduct by a company's officers or employees poses one of the most difficult issues for directors to evaluate, according to Prezioso. He reported that the number of whistleblower cases handled by the Department of Labor is growing, with almost 200 complaints reported earlier this year.

The number of independent investigations also has increased due to the strong incentives for cooperation in SEC and criminal investigations. While Prezioso applauds that development, he sounded a cautionary note. The company's interests may not be served by an internal investigation if it is not structured correctly, he warned. Directors cannot take a passive approach if they launch an investigation or when considering the results.

Prezioso explained that the staff has seen investigations in which the lawyers or other professionals conducting the investigation were not given sufficient authority or resources. In other cases, he said companies have unduly circumscribed the scope of the inquiry. Prezioso advised that the injury to a company from a poorly executed investigation can be substantial. Once the enforcement authorities become aware of the full story, the company's credibility may be damaged or its claims of cooperation may be jeopardized, he explained.

Prezioso also addressed the SEC's rule that permits attorneys to reveal confidential information to the SEC to prevent a material violation or substantial injury to the company or its investors. He noted that while a debate "is raging within the bar" about whether the rule is a good thing, it basically conforms to the law that has been applied for years in most states. The rule is part of the new landscape that everyone must deal with, according to Prezioso. In his view, the rule provides more opportunities for directors than peril. Knowing that lawyers' interests are fully aligned with those of the board can help when dealing with recalcitrant officers, he explained.

The test of the new regulatory regime will be how directors use the new tools, Prezioso said. Early evidence suggests that the new rules are starting to achieve their intended effects, he concluded.