December 12, a WSJ article focused on another manipulation technique relating to the stock option backdating scandal:  avoiding paying income taxes.  See How Backdating Helped Executives Cut Their Taxes, Evidence Suggests Recipients Of Some Stock-Option Grants Manipulated Exercise Dates, By Mark Maremont and Charles Forelle.  The article suggests that an SEC economist, David Cicero, believes that there is “strong statistical evidence” that companies not only backdated stock options, but also manipulated the options’ exercise dates to avoid paying certain income taxes.  Generally under IRS rules, executives pay ordinary income tax [up to 35%], as well as payroll taxes, on any profit made when they exercise options and sell the resulting shares, i.e., the difference between the stock’s value as exercised and its strike price, the fixed purchase price set when the option was issued.  However, if the executives holds the shares, meaning they exercised their options but do not sell the shares for at least a year, they will pay only capital-gains tax [15%] on any profit. 

The WSJ article gives the following example:  Consider an executive who holds options on 100,000 shares with a strike price of $10. If he exercises and sells when the price is $20, he realizes $1 million in income and must pay $350,000 in income taxes.  If he instead can claim an exercise price of $16, he lowers his income tax to $210,000. If he then sells a year later and the stock is at the same price of $20, he pays $60,000 in capital-gains levies, for a total tax bite of $270,000. In other words, he has the same $1 million gain but saves $80,000 in taxes. The problem arises if the executive misrepresents when the exercise occurred to claim a lower exercise price. 

The article does acknowledge that without access to individual income tax returns it is difficult to assess which executives may have engaged in this conduct.  Also, the article does not assume that the practice was as wide-spread as option backdating.  Regardless of these limitations, however, the possibility that such conduct occurred should give executives and companies pause and provide yet another avenue to review when considering past practices.

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The much maligned Thompson Memo was superseded yesterday with the McNulty Memo.  Deputy Attorney General Paul J. McNulty issued a memorandum entitled “Principles of Federal Prosecution of Business Organizations,” which focuses on modifying cooperation standards for organizations in DOJ investigations.  Mr. McNulty’s modification of his predecessors’ memos (both Holder and Thompson) follows the introduction of legislation by Senator Specter addressing concerns repeatedly raised in Senate and House hearings and by various groups, including the ABA and the U.S. Chamber of Commerce.  The concerns charge that current DOJ and SEC standards of cooperation have created a “culture of waiver,” resulting in the erosion of individual constitutional rights, the attorney-client privilege, and the work product doctrine.  

The McNulty Memo largely reiterates the principles of prosecution contained in the Thompson Memo.  There are, however, two key differences.  The first is tone, which may ultimately be pivotal to changing the current environment and ending the culture of waiver.  The second concerns prosecution requests for privileged materials and interference with the payment of attorney fees.  Unfortunately, what is missing is a bright-line standard defining cooperation that would end the current coercive environment – the “culture of waiver” – where organizations believe they must waive key rights to avoid prosecution. 

Mr. McNulty set the tone for his redraft of the Thompson Memo in the first section by discussing the duties of federal prosecutors and corporate leaders.  The Memo notes that:  “A prosecutor’s duty to enforce the law requires the investigation and prosecution of criminal wrongdoing if it is discovered.  In carrying out this mission with the diligence and resolve necessary to vindicate the important public interest . . . . Prosecutors should be mindful of the common cause we share with responsible corporate leaders.  Prosecutors should also be mindful that confidence in the Department is affected both by the results we achieve and by the real and perceived ways in which we achieve them.” 

The emphasis of a common cause with business leaders, coupled with a concern about public confidence in the Justice Department, stands in stark contrast to the comments on business organizations in the Thompson Memo.  The Thompson Memo essentially rewrote the Holder Memo to direct prosecutors dealing with business organizations to give “emphasis on and scrutiny of the authenticity of a corporations’ [offers of ] cooperation.”  This tone helped set the stage for the decision in the KPMG case, U.S. v. Stein, which held portions of the Thompson Memo unconstitutional and contributed to the current crisis climate over cooperation standards. 

The McNulty Memo’s Section VII titled “Charging a Corporation:  The Value of Cooperation,” discusses requests for privileged material, common interest agreements and indemnification rights.  The basic principle stated here, following Thompson, notes that the corporation’s timely and voluntary self-reporting may be considered in the charging decision.  The comment section, however, is a response to the Specter bill, Stein, and other critics of the department’s policies on cooperation.  Building on the tone initiated in the Memo’s opening, the subsection opens by noting that “[t]he attorney-client and work product protections serve an extremely important function in the U.S. legal system.”  The section continues by specifying that waiver is “not a prerequisite to a finding that a company has cooperated in the government’s investigation.”  Government prosecutors are precluded from requesting a waiver of the attorney-client or work product protections unless there is a legitimate need and certain procedural safeguards are followed.  

Need is assessed by considering four factors and the type of information sought – either Category I or II.  The factors are:  (1) the likelihood and degree to which the privileged information will benefit the government’s investigation; (2) whether the information sought can be obtained in a timely and complete fashion from alternative means; (3) the completeness of the voluntary disclosures provided; and (4) the collateral consequences of a waiver to the company.  If the test is met, prosecutors must first seek Category I information which is “purely factual information which may or may not be privileged, relating to the underlying misconduct.”  The requesting prosecutor must submit a memo seeking authorization from the United States Attorney who then must consult with the Assistant Attorney General for the Criminal Division.  The corporation’s response to provide factual information may be considered in assessing cooperation. 

If the Category I information is insufficient for conducting the inquiry, prosecutors can seek a waiver of Category II information.  Category II information is non-factual attorney work product, such as legal advice given contemporaneous to the misconduct being investigated, attorney notes and similar material.  According to the McNulty Memo, this type of waiver should only be sought in “rare” circumstances and must be approved based on a written request by the United States Attorney and the Deputy Attorney General.  If the corporation does not produce the privileged material, that fact cannot be considered in the charging process.   

Federal prosecutors are not required to seek authorization to accept voluntary productions of privileged material.  The waiver must be reported to the United States Attorney who is required to maintain records on the issue. 

A subsection captioned “Shielding Culpable Employees and Agents” notes that prosecutors can consider whether the corporation appears to be protecting culpable employees.  In the charging decision, prosecutors can consider whether the company has retained employees without sanction for misconduct or is providing them with information about the government’s investigation under a common interest agreement.  Prosecutors “generally should not take into account whether a corporation is advancing attorneys’ fees to employees or agents under investigation and indictment.”  The comment about retaining culpable employees and common interest agreements essentially reflects the Thompson Memo practice, while the comment on indemnification and the payment of legal fees is clearly a response to Stein.  The McNulty Memo represents a welcome improvement over practice under the Thompson Memo.  The statement that waiver is not required to cooperate, coupled with the limitations on seeking waivers of privileged material and statements about the importance of the attorney-client privilege are significant.  Likewise, recognition that in many instances companies have an obligation to pay legal fees for employees should serve to protect this right.  

At the same time, the critical point will be how the DOJ implements the Memo.  While the Memo puts restraints on specific requests for waivers and limits consideration of legal fee payments where mandated by state law, frequently this is not the issue.  In DOJ and SEC investigations what government attorneys say or specifically request is often not as important as what is implied, suggested, common practice, or even not said.  One of the key problems with practice under the Thompson Memo and its analog the SEC’s Seaboard Release, is the vague and opened-ended nature of the concept of cooperation, particularly as it is administered in an inherently coercive environment.  Everyone involved in the process is well aware that organizations faced with a federal prosecution are typically desperate to avoid the severe impact of an indictment or enforcement action.  “Cooperation at any price” is often the only opportunity to avoid prosecution.     

In this hyper-charged environment it is no surprise that organizations seize on any suggestion of what to do or not to do to be viewed as cooperative.  Thus, most DOJ prosecutors and SEC officials claim that they seldom ask for waivers.  This theme was echoed in Stein, where prosecutors testified that they only asked questions about the payment of legal fees.  The reason is clear:  government lawyers know they do not have to ask for waivers – simply raising the topic by asking questions is enough to cause desperate organizations to waive their rights.  While the McNulty Memo declares that waiver is not required, it specifically notes that prosecutors can accept voluntarily waivers and that they can ask questions about the payment of legal fees.  This is typically enough to cause waivers of privilege and suspension of payment of legal fees, particularly where, as in Stein, there was a history of payment but no state law requiring the organization to pay legal fees. 

Additionally, the McNulty Memo notes that prosecutors may consider the retention of so-called “culpable” employees or the sharing of information with them in charging decisions.  As under the Thompson Memo, however, there are no standards for determining who is culpable.  While in some cases this may be clear, in others it may not.  Since the assessment will typically be made before any formal assessment of wrongdoing in a court, the organization will again be left at the mercy of the government – either fire employees the government believes are guilty or risk being labeled as uncooperative.  

Similarly, the Memo permits prosecutors to consider the fact that the company shares information with employees deemed culpable.  Again, a key issue is the government’s ability to dictate who is culpable before any formal adjudication and often at a very early state of an inquiry into the facts.  At the same time, without basic information about the claimed wrongful conduct at the company, employees will not be able to properly prepare to meet with prosecutors if requested, testify before the SEC, or otherwise defend themselves.  This can severely undercut the right of these employees to properly defend themselves.  This is the same dilemma organizations currently face. 

In the end the McNulty Memo does not solve one of the key problems of the Thompson Memo and the Seaboard Release – the lack of any bright-line standards defining cooperation.  It is the vague, open-ended nature of the current standards, coupled with the coercive atmosphere that causes many of the present difficulties.  While the Memo repeatedly cites to the “first out” program of the antitrust division, where a company can obtain amnesty if it is the first to self-report, it fails to establish such a bright-line standard.  Yet a simple bright-line standard could be established.  Such a standard could offer amnesty for a company that self-reports, furnishes all the fact to the government including the identity of those involved (to the extent known), and takes sufficient steps to ensure against a future occurrence of the conduct, absent compelling evidence of a long term pervasive problem involving senior company officials.  Such a standard would do much to end the current coercive atmosphere, encourage organizations to self-report, and conserve DOJ and SEC resources by reducing the need for extended investigations.  At the same time the government could, if appropriate, prosecute the individuals responsible for the wrongful conduct. 

While the McNulty Memo is a step in the right direction, it is only a beginning.  The key to its success may well be its tone and the statistics on waivers that it requires U.S. Attorneys to compile (this record keeping is a response to former Attorney General Edwin Meese’s September 12 testimony call for oversight).  The emphasis on the common cause government and business organizations share, coupled with a clear concern about public confidence in the Justice Department if filtered down to the rank and file may help end the current coercive environment and the culture of waiver.  We can only hope that the SEC will follow in the Justice Department’s footsteps and analyze its own created “culture” and consider changing and specifically defining its standards on cooperation.

McNulty Memo available at http://www.usdoj.gov/dag/speech/2006/mcnulty_memo.pdf

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