Pomerantz LLP

When Corporate Internal Investigations Become Part of the Problem

Pomerantz Monitor, March/April 2014 

When a company uncovers evidence of accounting improprieties or executive misconduct, or when the government does it for them, a common step is for the company to conduct an “independent” internal investigation. The American Institute of Certified Public Accountants has gone so far as to say that an audit committee must initiate an internal investigation when fraud is detected. A proper investigation, followed by a candid report of findings to investors, can play a critical role in rebuilding investor confidence. However, all too frequently internal investigations are used to hide the truth and protect those responsible. For example, the Office of the Comptroller of Currency (OCC) recently charged that a JP Morgan internal investigation into the bank’s handling of Madoff funds was designed to conceal the knowledge of key witnesses. After spending time with JP Morgan’s lawyers, the government said that the witnesses demonstrated “a pattern of forgetfulness.” 

Even worse, because the investigation had been conducted by lawyers, JP Morgan claimed that the details of the investigation were protected by attorney-client privilege. On that basis, JP Morgan refused to produce the notes from interviews of 90 bank employees following Madoff’s arrest. OCC lawyers argued that the privilege did not apply because it was being used to perpetuate a fraud. However, the argument failed because the OCC could not establish what the newly-forgetful witnesses told their lawyers, or what the lawyers told them to say to investigators. 

In December, 2013, the OCC dropped its attempt to discover details regarding JP Morgan’s internal investigation. A month later, JP Morgan agreed to pay a civil penalty of $350 million to the OCC. The deal represented the largest fine ever paid to the OCC, but it also ensured that the facts surrounding the internal investigation would forever remain private. Where the investigators’ report cannot be manipulated from the outset, companies sometimes contrive to conceal the results. In the AgFeed Industries, Inc. securities litigation, for example, Pomerantz uncovered evidence of an attempt to bury the findings of an internal investigation. In that case, the chairman of the committee investigating rampant fraud at the company testified that investigative committee lawyers and other committee members refused to produce a report to investors because the lawyers – who also represented management at the time – believed that the findings would expose management to litigation. As a result, the full breadth of the fraud was concealed for years. 

In a recent editorial in the Financial Times, short seller Carson Block questioned why these independent investigations so routinely failed to identify even blatant cases of fraud: “Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?” On his website, Block named names. Concentrating on U.S.-listed Chinese firms, Block identified seven independent investigations that purported to clear management despite obvious signs of fraud that caused investors to lose most of their investment: China Agritech, ChinaCast Education, China Integrated Energy, China Medical Technologies, Duoyuan Global Water, Sino Clean Energy, and Silvercorp. 

The OCC’s charges in the JP Morgan case and the list of improper independent investigations published by Carson Block both confirm a disturbing trend. One possible reason for the trend: outside law firms, which often turn internal investigations into a lucrative practice area. Shielding management is the safe play for the investigating law firms. If they candidly exposed wrongdoing to investors, what company is going to hire them the next time around?