A second opinion in U.S. v. Stein, S1 05 Crim. 0888 (LAK) (S.D.N.Y. July 25, 2006) (“Stein II”), again concludes that the government’s actions in seeking the cooperation of KPMG with its investigation of the firm’s tax shelter practices violates the Constitution. In Stein II, the court finds that statements made by two former KPMG partners were coerced in violation of the Fifth Amendment and, therefore, must be suppressed. The ruling is based on the Thompson Memorandum and facts developed at an evidentiary hearing which demonstrate that KPMG, at the behest of the government, forced employees to waive their Fifth Amendment rights so the firm could “cooperate” and avoid a criminal prosecution. Stein I also concluded that actions taken by KPMG in an attempt to meet the Thompson Memorandum standards of cooperation violated the constitution (as discussed here in previous blog postings).

Stein I and II suggest that the government – both the SEC and DOJ – should reform their standards for assessing “cooperation.” Whether Judge Kaplan’s rulings are sustained on appeal or not is beside the point. Some may argue that the government has the right to set whatever standards it wants to assess cooperation. Such a position, however, ignores the inherently coercive position in which issuers find themselves when faced with a potential enforcement investigation and action. Most, if not all, issuers are compelled to “do whatever it takes” to avoid prosecution or at least mitigate the effects of a potential action. Entities know all to well the devastating effects a criminal or civil action can cause. Accordingly, often issuers react to government pressure by firing executives, waiving privilege and perhaps even cutting off payment of legal fees to garner “cooperative” status.

Unfortunately the current standards – perhaps as administered, rather than literally written – are misdirected. First, waiving privilege should generally not be necessary. Indeed, a policy built on waivers will eventually undercut the ability of a company to obtain quality legal advice, which is the reason the privilege exists. Nevertheless, the SEC has repeatedly sought to have Congress and the courts make privileged material available to them, largely to no avail. All of these actions which tend to erode the privilege are unnecessary because companies need not waive privilege to give “just the facts” to the government.

Frequently, the privilege debate devolves to a question of whether interview notes created during internal investigations will be turned over. The SEC seems to believe that these notes contain “more truth” than the subsequently prepared interview memoranda. Regardless of the accuracy of this supposition (or perhaps paranoia), production of internal investigation notes are unnecessary. In most cases, the SEC staff should be able to assess if it has the pertinent facts from reviewing non-privileged material. If in some exceptional case there is a compelling need for attorney work-product, the staff can surely raise the issue with the company’s lawyers and demonstrate the compelling need.

Similarly, the question of “who got fired” frequently poised by government investigators is little more than overreaching. Whether the company has taken steps to prevent a reoccurrence is the key. The retention or termination of employees is a matter between the company and the employee; and more important is a state law question reserved for the states under the savings clauses in the federal securities laws. Congress and the courts have given the SEC very limited authority in this area in the form of requesting an officer/director bar under limited circumstances. To the extent the government believes an employee is guilty, simply put they should institute whatever law enforcement action they deem appropriate and afford the employee proper due process.

Finally, the government has no business inquiring about the payment of legal fees. Again, this is a traditional state law issue typically covered in state corporation codes and company by laws. It has nothing to do with the federal securities laws. While it may be tempting for government investigators to try and ease their burden in any subsequent enforcement action by cutting off the ability of persons to fight the case, such conduct is clearly inappropriate.

In sum, the government should reassess its practices in implementing its standards for corporation cooperation. New standards should focus on what government needs to effectively enforce the law, which fall within two distinct categories: obtaining the pertinent facts and prevention of future violations

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The SEC and the U.S. Attorney for the Northern District of California held a joint news conference today to announce the filing of the first enforcement actions based on the back dating of stock options. Following a year long investigation, the SEC filed civil fraud charges against three former officers of Brocade Communications – the former CEO, CFO and vice president of human resources. The U.S. Attorney’s office filed a single count criminal complaint alleging securities fraud against the former Brocade CEO and vice president of human resources.


Both cases are based several instances of backdating options and the claimed falsification of company records to conceal those actions from auditors, shareholders and the public. These actions turned the financial reporting of the company into “hash” according to SEC Chairman Cox. As a result Brocade has been required to restate its financial statements.


Criminal and civil investigations relating to the practice of backdating stock options are continuing. The SEC’s enforcement director noted that the agency has dozens of open investigations looking into the issue.

The backdating of stock options raises a number of complex issues as previously discussed in this blog. While not all such action violates the law as SEC Commissioner Paul Atkins made clear in his speech on July 6, 2006, the actions filed today, coupled with the complexity of the issues, makes it clear that every issuer should carefully review its practices surrounding the issuance of options.

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