Corporate Compliance Prof Blog

White Collar Crime Stats

The White Collar Crime Prof Blog has a great post about a NY Times Op-Ed that discusses the lack of statistics on the incidence of white collar crime.

Statistics in the compliance area are also quite scarce, largely because most of the real decisions about whether an organization had an effective compliance program are made in the exercise of prosecutorial discretion and thus rarely yield any documentation that explains (1) whether the compliance program was effective and why (or why not), and (2) what specific effect an effective compliance program (or lack of one) had on the prosecutor's decision.  And even if we had such documentation, it would be no more than persuasive authority (if that) in negotiating with the government.

Article of Interest -- Business Ethics

Courtesy of the Social Science Research Network:

Corporate Ethics in the Health Care Marketplace
Seattle Journal for Social Justice, Vol. 3, No. 1

Lynne Dallas (University of San Diego School of Law)

Consider three examples of problematic corporate decision making: first, in 2002, employees were less likely to have employer-provided insurance than thirty years ago and the price of health care for those who do receive it is ever increasing. Second, while many employees are without health insurance, the compensation for chief executive officers and other executive officers has increased dramatically. Third, consider the well-publicized examples of corporate decisions to engage in fraudulent and unethical business practices.

These problems will not be solved by glib references to market ideology that claims markets alone adequately regulate corporate behavior. Nor will these problems be solved by assuming that a few bad apples were responsible. Indeed, only by examining the environmental context in which decision making occurs will corporate ethics in the health care marketplace be furthered.

This article is a brief overview of the importance of an organization's structure, policies and practices in the establishment of an ethical climate. An organization's climate affects whether individual employees, as well as the leaders of the organization, make ethical or unethical decisions. Part II of this article begins by defining ethical climates and describes how they are ascertained. Part III discusses two contextual factors in more detail: workplace leadership and reward structures. Finally, this article concludes with some basic recommendations for motivating organizations to work toward creating ethical climates.

Case Analysis -- Sexual Harassment -- Ellerth and Faragher Affirmative Defense

Here is some analysis of Mueth v. Norrenberns Foods, Inc. (S.D. Ill., June 21, 2005), a sexual
harassment case mentioned in a post from yesterday.  On my reading, the case bungles the
applicable law.

First, a little background.  The United States Supreme Court established the employer vicarious
liability standard for hostile environment sexual harassment in two 1998 cases: Burlington Indus.,
Inc. v. Ellerth, 524 U.S. 742 (1998), and Faragher v. City of Boca Raton, 524 U.S. 775 (1998).
To let “you make the call,” I will quote liberally from Ellerth’s statement of the applicable rules.
The discussion begins with this statement:

An employer is subject to vicarious liability to a victimized employee for an actionable hostile environment created by a supervisor with immediate (or successively higher) authority over the employee.

Ellerth, 524 U.S. at 765.  So, the plaintiff carries her burden on employer vicarious liability by
proving that a supervisor committed hostile environment sexual harassment.  (If harassment was
committed by a co-worker, the plaintiff must also prove that the employer was negligent in
detecting and remedying the harassment.)

Once the plaintiff has carried her burden, the employer is liable unless it can prove a narrow
affirmative defense:

When no tangible employment action is taken, a defending employer may raise an affirmative defense to liability or damages, subject to proof by a preponderance of the evidence, see Fed. Rule Civ. Proc. 8(c). The defense comprises two necessary elements: (a) that the employer exercised reasonable care to prevent and correct promptly any sexually harassing behavior, and (b) that the plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to avoid harm otherwise.

Id.  Note two things here.  First, this is an affirmative defense, which means that the employer
bears both the burden of pleading and proving the defense.  Second, the defense is unavailable if
the plaintiff proves that she suffered a tangible employment action, which the Court defines as “a
significant change in employment status, such as hiring, firing, failing to promote, reassignment
with significantly different responsibilities, or a decision causing a significant change in benefits.”
Id. at 761.

So, here is a quick summary of employer vicarious liability under Ellerth:

• The plaintiff carries her burden by proving that a supervisor committed hostile environment sexual harassment.
• If the employee proves that she suffered a tangible employment action, the employer is vicariously liable.
• If the employee did not suffer a tangible employment action, the employer may avoid vicarious liability by pleading and proving the two element affirmative defense.

With these principles in mind, consider the district court’s statement of the law in Mueth:

When a supervisor engages in sexual harassment, the employer is liable only if the harasser took a tangible employment action as part of the harassment.  Faragher, 524 U.S. at 807. No affirmative defense is available under Faragher and Burlington Indus., Inc. v. Ellerth, 524 U.S. 742 (1998), when the supervisor’s harassment culminates in a tangible employment action. Durkin v. City of Chicago, 341 F.3d 606, 611 (7th Cir. 2003).

The first sentence is wrong because the negative implication is that an employer cannot be liable if
the harasser took no tangible employment action.  But that’s not the rule.  Under Ellerth, the
employer is still liable for supervisor harassment EVEN IF there was no tangible employment
action, UNLESS the employer pleads and proves the affirmative defense.  Oddly enough, the
second sentence gets it right, stating that the affirmative defense is unavailable if there was a
tangible employment action.

Now consider the next paragraph of the opinion:

Since no tangible employment action was taken, Mueth must show that Norrenberns was negligent in discovering or remedying the harassment. Durkin, 341 F.3d at 612. “An employer may defend against harassment charges by showing it exercised reasonable care to discover and rectify promptly any sexually harassing behavior.” Id. “Since an employer is not omniscient, it must have notice or knowledge of the harassment before it can be held liable.” Id. Courts “consider whether an employer had notice of the sexual harassment by considering the channel for complaints of harassment.” Id. (citing Hall v. Bodine Elec. Co., 276 F.3d 345, 356-57 (7th Cir. 2002)).

The upshot here is that the district court puts the burden on the plaintiff to prove the employer’s
negligence.  But that get’s the rule backward.  Under Ellerth, if no tangible employment action
was taken, the EMPLOYER must plead and prove an affirmative defense.  The district court
seems to be mistakenly applying the vicarious liability rule for co-worker harassment, which
requires the employee to prove the employer’s negligence.

The district court’s error likely stems from a confusing discussion of the applicable law in the
Seventh Circuit case its cites: Durkin v. City of Chicago, 341 F.3d 606, 611 (7th Cir. 2003).  In
Durkin, the court writes:

Whether an employer is liable in a hostile environment sexual harassment action is guided by Burlington Indus., Inc. v. Ellerth, 524 U.S. 742 (1998) and Faragher v. City of Boca Raton, 524 U.S. 775 (1998). These cases instruct us that the central question is whether the harasser is the victim's supervisor or merely a co-worker.  However, regardless of whether we find Officer Peck qualifies as a supervisor, the City cannot be held liable because Peck took no tangible employment action against Durkin.

This is unclear, largely because the court does not clearly distinguish supervisor and co-worker
harassment, which (as discussed above) are subject to different rules.  Even if there was no
tangible employment action, the employer is still liable for supervisor harassment unless it pleads
and proves the Ellerth/Faragher affirmative defense.

The confusion continued when the court appeared to speak only about supervisor harassment:

When a supervisor engages in sexual harassment, the employer is liable for the harassment only if the harasser took a tangible employment action as part of his harassment. Faragher, 524 U.S. at 807, 118 S.Ct. 2275. No affirmative defense is available under Faragher and Ellerth when the supervisor's harassment culminates in a tangible employment action.

As with the district court, this is only half right: the affirmative defense is unavailable if there IS a tangible employment action, but an employer can still be liable is there ISN’T a tangible employment action.

And then the confusion continues:

Since no tangible employment action was taken, Durkin must show that the City was negligent in discovering or remedying the harassment.

Not exactly.  If a supervisor committed the harassment, lack of tangible employment action means
vicarious liability unless the EMPLOYER proves the affirmative defense.  And if a co-worker
committed the harassment, the issue is whether the employer was negligent in discovering and
remedying the harassment, NOT whether the employee suffered a tangible employment action. 
This confused discussion is hard to explain, given that a prior Seventh Circuit case (which Durkin
cites) gives a rather clear summary of the applicable law: Parkins v. Civil Constructors, 163 F.3d
1027, 1032 (7th Cir.1998):

An employer's liability for hostile environment sexual harassment depends upon whether the harasser is the victim's supervisor or merely a co-employee. Faragher. Harassment "by co-workers differs from harassment by supervisors...."  Where the harasser is a supervisor and the victim suffered no tangible employment action, an employer is strictly liable, although there is the possibility of an affirmative defense. Faragher.  "An employer is subject to vicarious liability to a victimized employee for an actionable hostile environment created by a supervisor with immediate (or successively higher) authority over the employee." Ellerth.  Because employers do not entrust mere co-employees with any significant authority with which they might harass a victim, employers are liable for a co-employee's harassment only "when they have been negligent either in discovering or remedying the harassment." An employer's legal duty in co-employee harassment cases will be discharged if it takes "reasonable steps to discover and rectify acts of sexual harassment of its employees."

Id. at 1032 (citations omitted).

It seems like the next two moves for the plaintiff in Mueth are to: (1) get the district court to
apply the correct vicarious liability rule, and (2) move for summary judgment on the employer’s
Ellerth/Faragher affirmative defense.  Recall from a prior post that the Mueth opinion gave a
rather grim description of the employer’s anti-sexual harassment efforts:

By [the employer's] own admission, there was no formal sexual harassment policy in place, nor was there any information provided to [the victim] to allow her to mitigate or take corrective actions against [the harasser]. [The victim] did what [the employer] told her to do. She went to [a supervisor] to complain about [the harasser's] conduct. After speaking and meeting with [the harasser], [the supervisor] told [the harasser] to "work things out" with [the victim]. There was neither an investigation nor was any other action (except for the written reprimand) taken towards [the harasser]. Both [the harasser] and [the victim] testified that the comments continued long after the reprimand. Therefore, there is a question of fact as to whether or not Defendant took reasonable steps to prevent the sexual harassment from continuing. Furthermore, there is a question of fact as to whether or not [the employer] took prompt action to correct the problem. Thus, the Court denies [the employer's] motion for summary judgment based on her hostile work environment claim.

I don’t see how this could possibly raise a genuine issue of material fact (as would be the
employer’s burden in avoiding summary judgment on its affirmative defense) that the employer
had adopted reasonable measures to prevent and correct sexual harassment.

Articles of Interest

An article of interest from the Social Science Research Network:

Risk Management and Corporate Governance: The Importance of Independence and Financial Knowledge for the Board and the Audit Committee
HEC Montreal Working Paper No. 05-03

Georges Dionne (HEC Montreal)
Thouraya Triki (HEC Montreal)

The new NYSE rules for corporate governance require the audit committee to discuss and review the firm's risk assessment and hedging strategies. They also put additional requirements for the composition and the financial knowledge of the directors sitting on the board and on the audit committee. In this paper, we investigate whether these new rules as well as those set by the Sarbanes Oxley act lead to hedging decisions that are of more benefit to shareholders. We construct a novel hand collected dataset that allows us to explore multiple definitions for the financially knowledgeable term present in this new regulation.

We find that the requirements on the audit committee size and independence are beneficial to shareholders, although maintaining a majority of unrelated directors in the board and a director with an accounting background on the audit committee may not be necessary. Interestingly, financially educated directors seem to encourage corporate hedging while financially active directors and those with an accounting background play no active role in such policy. This evidence combined with the positive relation we report between hedging and the firm's performance suggests that shareholders are better off with financially educated directors on their boards and audit committees. Our empirical findings also show that having directors with a university education on the board is an important determinant of the hedging level. Indeed, our measure of risk management is found to be an increasing function of the percentage of directors holding a diploma superior to a bachelor degree. This result is the first direct evidence concerning the importance of university education for the board of directors.

Case Update -- Employer Liability for Sexual Harassment

This is the first real case law update I have done, and it is on a subject that I will cover in more detail next week.  The issue is the employer’s affirmative defense to a sexual harassment claim under the United States Supreme Court’s Ellerth and Faragher decisions.  In short, those two cases hold that an employer may avoid vicarious liability for supervisor sexual harassment that did not result in a tangible employment action (i.e., firing, demotion, etc.) if the employer can show:

(a) that the employer exercised reasonable care to prevent and correct promptly any sexually harassing behavior, and

(b) that the plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to avoid harm otherwise.

The following is an excerpt from a federal district court decision that denied an employer's motion for summary judgment on its affirmative defense:

By [the employer's] own admission, there was no formal sexual harassment policy in place, nor was there any information provided to [the victim] to allow her to mitigate or take corrective actions against [the harasser]. [The victim] did what [the employer] told her to do. She went to [a supervisor] to complain about [the harasser's] conduct. After speaking and meeting with [the harasser], [the supervisor] told [the harasser] to "work things out" with [the victim]. There was neither an investigation nor was any other action (except for the written reprimand) taken towards [the harasser]. Both [the harasser] and [the victim] testified that the comments continued long after the reprimand. Therefore, there is a question of fact as to whether or not Defendant took reasonable steps to prevent the sexual harassment from continuing. Furthermore, there is a question of fact as to whether or not [the employer] took prompt action to correct the problem. Thus, the Court denies [the employer's] motion for summary judgment based on her hostile work environment claim.

Mueth v. Norrenberns Foods, Inc., Memorandum and Order (S.D. Ill., Jun. 21, 2005).

Twenty-Five Years for Ebbers

From the CNN web site:

Ebbers was convicted in March of orchestrating an $11 billion accounting fraud at WorldCom, one of the country's telecommunications companies. WorldCom's bankruptcy filing in 2002 ranks as the largest in U.S. history.

A federal jury in New York found Ebbers, 63, guilty of committing nine felonies. The crimes carry a maximum prison term of 85 years.

Ebbers had asked for leniency, arguing that his failing health, community service and personal financial losses from WorldCom's collapse warranted a lighter sentence.

UPDATE: The New York Times has an account of the sentencing.

Bernie's Big Day

The Wall Street Journal has an article previewing Bernie Ebber's sentencing later today:

U.S. District Judge Barbara Jones could sentence Mr. Ebbers to as many as 85 years in prison. That would amount to life sentence for the 63-year-old, who was convicted in March of fraud, conspiracy and making false filings with regulators in the $11 billion scandal.

As WorldCom founder Bernard J. Ebbers faces sentencing today in what could be the final chapter in the criminal case of the U.S.'s largest-ever corporate-accounting fraud, he leaves behind an industry that has never quite recovered.

Yesterday, the judge denied Mr. Ebbers's request for a new trial. Mr. Ebbers's attorneys wouldn't comment on his sentencing hearing but have asked the court for leniency, citing what they say are his serious heart problems, among other factors.

. . . .

"Bernie Ebbers shows that white-collar murder does exist," wrote one WorldCom shareholder who claims losses of $40,000 due to the scandal.

Another investor asked the judge to sentence Mr. Ebbers to life in a trailer park or public housing, contending that's where some of the fraud victims ended up.

And another composed a poem: "Six years I labored for the man; all I got was an empty 401(k) plan." The writers' names were redacted from the letters.

Judge Jones also will weigh volumes of letters from Mr. Ebbers's family and friends, including a former head of the Southern Baptist Convention, a University of Mississippi chancellor, his fellow churchgoers and the beneficiaries of his charity.

"Bernie lived his faith and belief in God," wrote F. Joe Speights, a member of Easthaven Baptist Church, where Mr. Ebbers was a member in his hometown of Brookhaven, Miss. "His honesty and character is above reproach."

Other WorldCom executives, including former finance chief Scott Sullivan, are expected to be sentenced later this summer, but their terms are likely to be less severe than that of Mr. Ebbers because they cooperated with prosecutors.

And the Sentencing Law and Policy Blog has a great summary (with links) in advance of the day's event.

Another Corporate Responsibility Report

This Report is from Gap Inc., which has struggled (as have most manufacturers with overseas operations) with labor issues.  The Wall Street Journal gives this summary of the report:

In a candid report on labor conditions in the factories that make its clothes, Gap Inc. said it is improving inspections but still struggling to wipe out deep-seated problems such as discrimination and excessive overtime.

In its second annual social-responsibility report, scheduled to be released today, the San Francisco-based apparel retailer says it and other brands sometimes contribute to problems -- particularly overtime violations -- by making unreasonable demands.

After years of being targeted by critics pressing for better overseas working conditions, Gap and other apparel and footwear companies have begun providing more details on how they inspect factories and address problems.

In its 2004 report, Gap said it revoked approval for 70 factories that violated its code of vendor conduct, down from 136 cases in 2003. The retailer rejected 15% of the new factories it evaluated, roughly the same percentage as in the previous year. It inspected 99.9% of its contract factories, compared with 94% in 2003.

Gap said it found only a few instances of forced labor or child labor. In one case, a Chinese factory didn't let workers resign during a peak production period; Gap revoked the factory's approval. It also found three instances in China in which workers were hired before reaching the minimum working age of 16; orders to those factories were cut off.

Gap said it believes better-trained factory monitors are spotting more problems than they could in the past. Monitors are tweaking their auditing practices. For example, monitors now have more casual conversations with workers, which build trust better than formal interviews. But some violations, such as discrimination, remain particularly difficult to spot, the company said.

The retailer, which owns the Gap, Banana Republic and Old Navy chains, called for better enforcement of labor laws and strategies that encourage economic development, but said inefficient local governments and widely inconsistent labor codes complicate efforts.

With the end to apparel quotas at the beginning of this year, Gap said it is consolidating orders at fewer factories, which it believes will give it greater leverage to make sure factories obey its labor code. But as U.S. retailers shift more of their production to China, in particular, they are encountering new problems.

Gap also said it is becoming more strict about its own deadlines, to avoid dumping rush jobs on factories.

To give you a little taste of what the Report contains, here is the introduction to the section on monitoring of labor practices:

We believe that “what gets measured gets managed.” Despite its imperfections, monitoring data is an important tool to help us assess our performance, understand factory conditions and improve our efforts over time.

Factory monitoring remains a key element of our efforts to improve working conditions in the apparel industry. On-site inspections give us first-hand insight into whether factories are adhering to the labor, health and safety standards in our Code of Vendor Conduct (COVC). This helps us measure performance, guide improvement and shape our long-term strategy. Getting an accurate picture of factory conditions, however, is more difficult than it seems. In many ways, monitoring is more art than science.

A number of variables – ranging from the complexity of a violation to the level of trust among workers – can affect results. Nearly a decade after we formed our Global Compliance department, we are still exploring ways to better capture and measure the impact of our monitoring program.

The lack of consistent standards and enforcement mechanisms in our industry makes it virtually impossible to compare performance over time and across companies in a meaningful way. Just as Generally Accepted Accounting Principles (GAAP) took decades to evolve, we expect it will be years before the garment industry adopts a standardized approach to tracking, evaluating and reporting on factory compliance.

Still, we believe that “what gets measured gets managed.” Despite its imperfections, monitoring data is an important tool to help us assess our performance, understand factory conditions and improve our efforts over time.

That is a good mantra for compliance professionals: "What gets measured gets managed."  And it certainly is consistent  with the amended sentencing guidelines, which require organizations to both monitor compliance and evaluate the effectiveness of the compliance program, which requires some method for measuring compliance and effectiveness.  I particularly like the analogy to GAAP, with its suggestion that best practices and industry standards are a good way to benchmark your compliance program.  Otherwise, organizations are simply disconnected islands floating in the compliance sea, each doing their own thing (and trying their best), but unable to learn from one another.

White Collar Updates

Over at the White Collar Crime Prof Blog, they have updates on Bernie Ebbers' motion for new trial as well as various pending Enron matters.

Article on the Seaboard Report

There is an excellent article in the March 2005 Minnesota Lawyer that discusses what the Securities and Exchange Commission expects under the Seaboard Report.  The article begins with an ominous reminder that not every company that self-reports will avoid a penalty, as did Royal Ahold (a case discussed in a prior post):

While Royal Ahold is billed as the “poster child” for the benefits of self-reporting financial wrongdoing and cooperating with SEC enforcement actions, others have not been so fortunate despite revealing financial missteps to the government.

For example, Shell Oil was applauded for its cooperation in a recent SEC investigation but it still got walloped with a $120 million penalty. Fidelity also garnered kudos for its cooperation but was assessed $1 million to settle the enforcement action against it.

This will necessarily make organizations hesitant to go down the road of self-reporting and full cooperation:

Because favorable treatment following self-reporting is no sure thing, in-house counsel face a delicate situation when advising senior management.

Suggesting that a corporation report its financial missteps — deliver itself to its own slaughter, some might say — isn’t an option most CEOs and boards of directors want to hear.

“Management reaction is a whole world unto itself,” said Steven M. Honig, a securities law expert with Duane Morris in Boston. “There are two aspects. Management assessment of the advice you’re giving, and management’s innate desire to keep bad things under cover, running directly contrary to the disclosure trends being forced upon management by the entire regulatory scheme.”

Once made aware of financial wrongdoing, in-house lawyers must assess whether self-reporting is the best option under the circumstances of each case.

“You put yourself on their radar screen,” said Laura Ariane Miller, of Nixon Peabody in Washington, D.C. “On the other hand, it gives you the opportunity to work with them, choose with whom you’ll talk to present the case as you would hope they review it.”

She added: “If it’s a truly voluntary disclosure, you’re telling them something they didn’t know about before,” which should garner good favor. But then again, a company would be pointing the SEC’s attention in a direction the agency hadn’t been concerned with in the past.

As a general principle, self-reporting is “probably a, quote, ‘good thing,’” said Karl R. Barnickol of Blackwell, Sanders, Peper & Martin in St. Louis and former general counsel of Solutia, Inc., a $3 billion chemical company.

“But like a lot of things, the devil is in the details,” Barnickol said. “An advantage of self-reporting is that you start out with at least some greater control over the process. The difficult aspect is what you’re going to have to do to be considered cooperative.”

To that end, Honig said there’s a greater chance of avoiding civil fines “if you act quickly, if the response is global and if you make full disclosure to the SEC, together with documentation.”

However, Honig cautioned that cases of fraud involving high-level executives would likely not receive the same treatment even with full disclosure and cooperation.

“In situations of fraud dictated at the top, either expressly or by undue pressure, making disclosure is not likely to have a significant impact on reducing civil fines,” he said.

Walter Ricciardi, district administrator of the SEC’s Boston District Office, said he intends to support in-house attorneys who recommend that their companies self-report and cooperate.

For Ricciardi, self-reporting — or more particularly, supporting attorneys helping their companies self-report and ensuring they walk away feeling like it was the right decision — is a significant priority.

“My goal,” Ricciardi said, “and I speak for myself, I don’t speak for the commission or the staff, is when an advisor tells a firm or corporation to self-report, at the end of the day, they feel that was the right advice. They feel they did receive a benefit in terms of the outcome of that event due to self-reporting.”

This approach partly comes in response to criticisms Ricciardi’s heard from attorneys that cooperation is not sufficiently rewarded.

“What we need,” Ricciardi indicated, “are some outcomes and matters where at the end of the day attorneys will stand up and say, ‘I advised my client to self-report and I’m telling you it was the right thing to do, as demonstrated by the outcome.’”

Stressing he was not able to speak about any specific matter, Ricciardi noted there will likely be decisions coming from the SEC soon that demonstrate “that self-reporting will result in favorable consideration when deciding what appropriate sanctions might be, if any.”

One positive remark is that SEC personnel are hearing the message that organizations need to know that full cooperation will be rewarded.  Otherwise, why take the risk.

The article also mentions the following line of thinking: If we self-report, we just tell the government about something they might not have discovered in the first place.  Well, that might be true.  But, that is not necessarily the case.  The best answer I have heard to this view comes from a white collar defense lawyer who was encouraging orgaizations to adopt compliance programs and undertake self-reporting of violations: Pay me now, or pay me later – and if you pay me later, rest assured that it will be a lot more than if you had paid me sooner.  The notion is that while not all legal violations come to the government’s attention, many do, and any evidence that the organization ignored or (worse) buried the problem will increase the cost (both in penalties and defense fees) exponentially.

Seaboard Report in Action

Following up on yesterday’s post about the Seaboard Report, here is a case of the SEC’s policy in action.  Securities and Exchange Commission Litigation Release No. 18929 (October 13, 2004) describes accounting problems at Royal Ahold:

On October 13, 2004, the Securities and Exchange Commission filed fraud and other charges in the United States District Court for the District of Columbia against Royal Ahold (Koninklijke Ahold N.V.) (Ahold) and three former top executives: Cees van der Hoeven, former CEO and chairman of the executive board; A. Michiel Meurs, former CFO and executive board member; and Jan Andreae, former executive vice president and executive board member. The Commission also filed a related administrative action charging Roland Fahlin, a former member of Ahold's supervisory board and audit committee, with causing violations of the reporting, books and records, and internal controls provisions of the securities laws. The SEC's complaints allege that, as a result of the fraudulent inflation of promotional allowances at U.S. Foodservice, Ahold's wholly-owned subsidiary, the improper consolidation of joint ventures through fraudulent side letters, and other accounting errors and irregularities, Ahold's original SEC filings overstated: (a) net income by approximately 17.6%, 32.6%, and 88.1% for the fiscal years 2000, 2001 and first three quarters of 2002, respectively; (b) operating income by approximately 28.1%, 29.4%, and 51.3% for the fiscal years 2000, 2001 and first three quarters of 2002, respectively; and (c) net sales by approximately 20.8%, 18.6%, and 13.8% for the fiscal years 2000, 2001 and 2002, respectively. Ahold and three of the individual defendants have agreed to settlements with the Commission.

The Commission did not seek a penalty from Royal Ahold, with the Release offering the following explanation:

The Commission also did not seek a penalty from Ahold, among other reasons, because of the company's extensive cooperation with the Commission's investigation. Ahold self-reported the misconduct and conducted an extensive internal investigation. On its own initiative, Ahold expanded its internal investigation beyond the fraud at U.S. Foodservice and the improper joint venture accounting to analyze accounting practices and internal controls at seventeen operating companies. Ahold promptly provided the staff with the internal investigative reports and the supporting information and waived the attorney-client privilege and work product protection with respect to its internal investigations. Ahold also made its current personnel available for interviews or testimony, significantly assisted the staff in arranging interviews with, or testimony from, former Ahold personnel located in the United States and abroad. Ahold promptly took remedial actions including, but not limited to, revising its internal controls and terminating employees responsible for the wrongdoing.

If you are keeping a scorecard, the SEC credited Royal Ahold’s “extensive cooperation,” which included:

Self-reporting
Internal investigation that went beyond the narrow conduct discovered
Turn investigation report over to Commission
Waiver of attorney-client and work product privileges
Made current personnel available to testify.
Remedied internal controls
Terminated wrongdoers

Note that Royal Ahold conducted an internal investigation that went beyond the division where the misconduct that came to light.  The thinking must have been that a problem in one division is a red flag that similar problems might (barring reason to think otherwise) exist in other divisions.  This would be true particularly if the same processes and controls existed across divisions.  The message is that the Seaboard Report requires an organization to ask whether a detected violation indicates a weakness in the overall internal controls or compliance program, rather than treat assume that it as a discrete event.

Seaboard Report in Action

Following up on yesterday’s post about the Seaboard Report, here is a case of the SEC’s policy in action.  Securities and Exchange Commission Litigation Release No. 18929 (October 13, 2004) describes accounting problems at Royal Ahold:

On October 13, 2004, the Securities and Exchange Commission filed fraud and other charges in the United States District Court for the District of Columbia against Royal Ahold (Koninklijke Ahold N.V.) (Ahold) and three former top executives: Cees van der Hoeven, former CEO and chairman of the executive board; A. Michiel Meurs, former CFO and executive board member; and Jan Andreae, former executive vice president and executive board member. The Commission also filed a related administrative action charging Roland Fahlin, a former member of Ahold's supervisory board and audit committee, with causing violations of the reporting, books and records, and internal controls provisions of the securities laws. The SEC's complaints allege that, as a result of the fraudulent inflation of promotional allowances at U.S. Foodservice, Ahold's wholly-owned subsidiary, the improper consolidation of joint ventures through fraudulent side letters, and other accounting errors and irregularities, Ahold's original SEC filings overstated: (a) net income by approximately 17.6%, 32.6%, and 88.1% for the fiscal years 2000, 2001 and first three quarters of 2002, respectively; (b) operating income by approximately 28.1%, 29.4%, and 51.3% for the fiscal years 2000, 2001 and first three quarters of 2002, respectively; and (c) net sales by approximately 20.8%, 18.6%, and 13.8% for the fiscal years 2000, 2001 and 2002, respectively. Ahold and three of the individual defendants have agreed to settlements with the Commission.

The Commission did not seek a penalty from Royal Ahold, with the Release offering the following explanation:

The Commission also did not seek a penalty from Ahold, among other reasons, because of the company's extensive cooperation with the Commission's investigation. Ahold self-reported the misconduct and conducted an extensive internal investigation. On its own initiative, Ahold expanded its internal investigation beyond the fraud at U.S. Foodservice and the improper joint venture accounting to analyze accounting practices and internal controls at seventeen operating companies. Ahold promptly provided the staff with the internal investigative reports and the supporting information and waived the attorney-client privilege and work product protection with respect to its internal investigations. Ahold also made its current personnel available for interviews or testimony, significantly assisted the staff in arranging interviews with, or testimony from, former Ahold personnel located in the United States and abroad. Ahold promptly took remedial actions including, but not limited to, revising its internal controls and terminating employees responsible for the wrongdoing.

If you are keeping a scorecard, the SEC credited Royal Ahold’s “extensive cooperation,” which included:

Self-reporting
Internal investigation that went beyond the narrow conduct discovered
Turn investigation report over to Commission
Waiver of attorney-client and work product privileges
Made current personnel available to testify.
Remedied internal controls
Terminated wrongdoers

Note that Royal Ahold conducted an internal investigation that went beyond the division where the misconduct that came to light.  The thinking must have been that a problem in one division is a red flag that similar problems might (barring reason to think otherwise) exist in other divisions.  This would be true particularly if the same processes and controls existed across divisions.  The message is that the Seaboard Report requires an organization to ask whether a detected violation indicates a weakness in the overall internal controls or compliance program, rather than treat assume that it as a discrete event.

Update on Ebbers Sentencing, Etc.

The White Collar Crime Prof Blog notes that Ebbers is scheduled to be sentenced this week.  The post offers a thought-provoking discussion (with references to related posts) of whether the recent trend toward higher white collar criminal sentences is a healthy thing.  The post also mentions, with link to further discussion at the Sentencing Law and Policy Blog, the recent phenomenon of members of Congress attempting to influence judicial sentencing.

Compliance 101 -- The Seaboard Report

Previously, I reviewed the Thompson Memo, which sets forth factors that the Department Of
Justice considers in deciding whether to prosecute an organization.  Today, I will review the so-
called Seaboard Report, which is the Securities and Exchange Commission’s equivalent document.

The Seaboard Report appears in Exchange Act Release No. 44969, and is entitled, “Report of
Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission
Statement on the Relationship of Cooperation to Agency Enforcement Decisions.”  The Report
has both a narrow and a broad purpose.  First, on the narrow side, it announces that the SEC will
not take enforcement action against a parent company -- Seaboard Corporation -- for accounting
misdeeds at one of its divisions.  (Interestingly, though the Release has been dubbed the Seaboard
Report after the parent company that avoided enforcement action, the release nowhere mentions
the Seaboard Corporation by name.  You must go to Release No. 44970, which covers enforcement
action against the employee, to discover the parent company’s name.)  The Report summarizes
why it chose to give Seaboard Corporation a pass:

We are not taking action against the parent company, given the nature of the conduct and the company's responses. Within a week of learning about the apparent misconduct, the company's internal auditors had conducted a preliminary review and had advised company management who, in turn, advised the Board's audit committee, that Meredith had caused the company's books and records to be inaccurate and its financial reports to be misstated. The full Board was advised and authorized the company to hire an outside law firm to conduct a thorough inquiry. Four days later, Meredith was dismissed, as were two other employees who, in the company's view, had
inadequately supervised Meredith; a day later, the company disclosed publicly and to us that its financial statements would be restated. The price of the company's shares did not decline after the announcement or after the restatement was published. The company pledged and gave complete cooperation to our staff. It provided the staff with all information relevant to the underlying violations. Among other things, the company produced the details of its internal investigation, including notes and transcripts of interviews of Meredith and others; and it did not invoke the attorney-client privilege, work product protection or other privileges or protections with respect to any facts uncovered in the investigation.

The company also strengthened its financial reporting processes to address Meredith's conduct -- developing a detailed closing process for the subsidiary's accounting personnel, consolidating subsidiary accounting functions under a parent company CPA, hiring three new CPAs for the accounting department responsible for preparing the subsidiary's financial statements, redesigning the subsidiary's minimum annual audit requirements, and requiring the parent company's controller to interview and approve all senior accounting personnel in its subsidiaries' reporting processes.

Second, on the broad side, the Report announces factors the Commission (the Report is signed by
three Commissioners) “will consider in determining whether, and how much, to credit
self-policing, self-reporting, remediation and cooperation -- from the extraordinary step of taking
no enforcement action to bringing reduced charges, seeking lighter sanctions, or including
mitigating language in documents we use to announce and resolve enforcement actions.”  There
are 13 factors listed, of which one specifically mentions compliance programs:

2. How did the misconduct arise? Is it the result of pressure placed on employees to achieve specific results, or a tone of lawlessness set by those in control of the company? What compliance procedures were in place to prevent the misconduct now uncovered? Why did those procedures fail to stop or inhibit the wrongful conduct?

While the Report does not provide any discussion or sources for evaluating the effectiveness of an organization's compliance program, the Sentencing Guidelines are likely an important standard.

Like the Thompson Memo, several of the Seaboard Report's other factors are related to an effective ethics and compliance program:

1. What is the nature of the misconduct involved? Did it result from inadvertence, honest mistake, simple negligence, reckless or deliberate indifference to indicia of wrongful conduct, willful misconduct or unadorned venality? Were the company's auditors misled?

. . . .

3. Where in the organization did the misconduct occur? How high up in the chain of command was knowledge of, or participation in, the misconduct? Did senior personnel participate in, or turn a blind eye toward, obvious indicia of misconduct? How systemic was the behavior? Is it symptomatic of the way the entity does business, or was it isolated?

4. How long did the misconduct last? Was it a one-quarter, or one-time, event, or did it last several years? In the case of a public company, did the misconduct occur before the company went public? Did it facilitate the company's ability to go public?

. . . .

6. How was the misconduct detected and who uncovered it?

7. How long after discovery of the misconduct did it take to implement an effective response?

8. What steps did the company take upon learning of the misconduct? Did the company
immediately stop the misconduct? Are persons responsible for any misconduct still with the company? If so, are they still in the same positions? Did the company promptly, completely and effectively disclose the existence of the misconduct to the public, to regulators and to self-regulators? Did the company cooperate completely with appropriate regulatory and law enforcement bodies? Did the company identify what additional related misconduct is likely to have occurred? Did the company take steps to identify the extent of damage to investors and other corporate constituencies? Did the company appropriately recompense those adversely affected by the conduct?

9. What processes did the company follow to resolve many of these issues and ferret out necessary information? Were the Audit Committee and the Board of Directors fully informed? If so, when?

10. Did the company commit to learn the truth, fully and expeditiously? Did it do a thorough review of the nature, extent, origins and consequences of the conduct and related behavior? Did management, the Board or committees consisting solely of outside directors oversee the review? Did company employees or outside persons perform the review? If outside persons, had they done other work for the company? Where the review was conducted by outside counsel, had management previously engaged such counsel? Were scope limitations placed on the review? If so, what were they?

. . . .

12. What assurances are there that the conduct is unlikely to recur? Did the company adopt and ensure enforcement of new and more effective internal controls and procedures designed to prevent a recurrence of the misconduct? Did the company provide our staff with sufficient information for it to evaluate the company's measures to correct the situation and ensure that the conduct does not recur?

Here’s a quick rundown on how these factors relate to elements of an effective ethics
and compliance program:

Factors 1 and 3 ask about corporate culture and tone at the top.

Factors 4 through 10 address how the compliance program (1) monitors, audits, and receives
reports of wrongdoing (after all, how else will misconduct be discovered, investigated, and
ended); (2) investigates the upon learning of the misconduct; and (3) corrects misconduct
confirmed by the investigation.

Factor 12 asks whether the organization learned from the misconduct by modifying the
compliance program (when necessary) to better detect and prevent similar misconduct.