------Some Lessons from Internal Investigations

 

by Alan D. Strasser

 

When your company learns that its own employee has stolen a lot of money, what should it do? Once it investigates to learn what happened, where should it go with the answer? Should the answer be written or oral?

 

            Our recent experience illuminates some of the legal and practical problems that can arise during an internal investigation from the perspectives of inside counsel and outside counsel.1  Although many issues arose during this matter, this article focuses on three of them:  1) Discovery of the fraud occurs slowly, as company employees do not typically assume that irregular patterns mean that the company has been defrauded. 2) Having decided to investigate, the company must decide who will conduct the investigation and whether to create a written record of it. 3) The company must decide whether it will report the results to law enforcement and if so, to whom it should make the report.

 

            We investigated a scheme that cost the Corporation more than a million dollars. A long-time Employee enlisted an Outside Vendor(“Vendor”) to cheat the Corporation concerning the provision of certain computer services. The Employee, who had the authority to order certain outside work, allowed the Vendor to submit invoices for the preparation of Computer-Assisted Drawings (CAD). Although the Vendor prepared none of the drawings, he would invoice the Corporation weekly for $7500 worth of phantom drawings. The Employee would approve payment and hand-carry the check to the Vendor. The Corporation eventually discovered the scheme and reported it to the FBI. Both men were indicted, pled guilty in federal court to fraud charges and eventually were sentenced to prison.

 

No Clear Signal About Bringing In Outside Help

 

            No bell rang to announce that the Corporation had been defrauded. The slow unraveling of the fraud scheme came as a series of revelations to Corporate managers. A change in the accounting systems at the Corporation prompted one manager to ask questions about the size of his department’s annual costs from the Vendor. Those questions led to internal accounting inquiries that revealed that the Employee ordered the work, approved the work and approved payment for the work. No manager assumed that the Employee had done anything wrong, much less that he had concocted a fraudulent scheme, as he was a third generation employee of the Corporation and had worked there for twenty-eight years. The accounting inquiries led to the involvement of in-house counsel, who decided to bring in outside counsel with expertise in investigating frauds.

 

 

            Close questioning of the Employee produced some inconsistencies and gaps in his explanation of the services that the Corporation was receiving. He also falsely denied having any financial relationship with the Vendor. Although the Employee insisted that the Corporation had received every single CAD drawing it had paid for, he was unable to produce any of them. During an interview with outside counsel, the Employee identified several locations in the Corporation’s computer system where the CAD drawings could be found. The Corporation looked there and found none the drawings. Without any warning to the Corporation or co-workers, the Employee resigned the next day.

 

            Some Corporate managers were reluctant to believe that a long-time employee had stolen so much money. The managers believed that the Corporation had paid the Employee well and they had heard no major complaints from him. The Employee concealed most of the evidence of his new-found wealth for most of the duration of the scheme. The managers initially expressed skepticism about the need for investigating anything and wanted to gather as much information as possible before confronting the Employee. The Employee’s misleading answers during the interview and his precipitous resignation evaporated any doubt that the Corporation had been the victim of the crime.

 

            As no one had been caught red-handed in the act of defrauding the Corporation, the proof of the scheme required the patient assembly of circumstantial evidence to rebut the denials by Employee and Vendor of any problems.  Each new piece of evidence confirmed the conclusion that a fraud had been committed. When the internal audit was finally completed, the Corporation realized that it had been cheated on a broad scale.

 

Who Conducts the Investigation and Prepares the Report?

 

            When faced with a potential fraud, the company should choose someone with experience in conducting internal investigations to direct an investigation. The company also should anticipate the possibility that the investigator may become a witness in a criminal prosecution or the subsequent civil case brought either by the insurance company or the company. In our case, the U.S. Attorney planned that both inside and outside counsel would testify at the trial of Employee and Vendor about statements each of those men had made during the internal investigation.

 

            The investigation may require substantial accounting or technical expertise. In our case, the Corporation was able to call on an experienced internal auditor to conduct much of the internal accounting work.  Use of company employees to conduct the investigation may reduce the cost of the investigation. Given the multiple demands on the time of employees, though, it is important to build an internal constituency for the investigation. It is not unusual to find that some managers resist conducting a thorough investigation in the belief that it is not worth the money to hire outside investigators and not worth the other foregone work to use internal investigators. The resistance by other managers can become most apparent when counsel insists that the investigator perform follow-up work or pursue another line of inquiry to nail down a point of proof.

 

            It is possible to supplement the work of the internal auditor with outside experts where needed. Of course, the outside expert really must be an expert. In our case, the Corporation hired a partner in a national accounting firm who said he had experience in conducting investigations regarding computer files. The expert used a commercially available software product to search for the CAD drawing files that the outside vendor was supposed to provide. His search, he said, revealed that none of the files had been provided. Once the FBI interviewed him, though, he acknowledged that he could not say that the files had never been provided, but only that he was unable to find them at the time he searched. He explained to the FBI that he had only used the software on one previous investigation.

 

            The experience with the accounting software “expert” illustrates one enduring problem in investigations: the level of proof necessary to convince internal managers of what has happened often will not suffice for purposes of a criminal prosecution, which requires proof beyond a reasonable doubt. The internal investigators may have to gather evidence for a report to the government that will go far beyond what is necessary to convince internal managers. Additional evidence gathering often confronts internal managers with additional demands on the time and attention of company employees.

 

            Although the company can wait to make a decision whether to disclose the matter to law enforcement once the internal investigation is complete, the company must bear in mind the prospect of such disclosure from the beginning of the investigation. Once the company discloses the report of the internal investigation to the prosecutor, the company will have great difficulty preventing disclosure to third parties.

 

Will the company report the crime to a prosecutor?

 

            Once the company has completed an internal investigation, it can decide whether to make a disclosure to law enforcement.  Some companies do not as matters of policy inform law enforcement about internal thefts, because it is embarrassing. Some feel that it opens up the company to shareholder lawsuits because the loss suggests that the company lacked adequate internal controls. Many companies, though, realize that even the best systems cannot detect every possible fraud scheme, and so prefer to make an example of dishonest employees by referring the matter for prosecution.

 

            A company may report the crime to law enforcement to improve its chances of collecting restitution. Although federal law always permitted a judge to order that a convicted defendant pay restitution, Federal law now requires the court to order restitution as part of the sentence for any defendant convicted of “an offense against property...including any offense committed by fraud or deceit.”  18 U.S.C. §3663A(c)(1))A)(ii). Although many criminal defendants lack the resources to make substantial restitution, the court’s order makes it easier for the victim-even a corporate victim-to collect something from the wrongdoer. Of course, the company never can collect unless it reports the matter to law enforcement.

 

            In our case, the Corporation decided to report the matter to law enforcement to publicize that the Corporation would not tolerate this kind of conduct from its employees or outside vendors. The Corporation also reported the loss to its insurance company and obtained reimbursement for the loss.

 

            If the internal investigation results in a referral to law enforcement, the company’s investigative work probably will increase, rather than decrease. Often this will mean educating the managers, internal auditors and even senior management on the virtues of the referral and the potential benefits to the company. Counsel must explain to senior management that a referral may not bring a prompt resolution of the matter nor will it necessarily bring prompt restitution.

 

            In our case, senior management fully supported the referral to law enforcement and understood the logistical support it required. They proved instrumental in insuring that adequate corporate resources were devoted to the internal audit, the referral, and support of the prosecution. Even with this level of support and resources, a year passed between the referral to the FBI and the entry of guilty pleas on the eve of trial. It took eight months from the referral to an indictment, even though the Corporation’s internal auditors had prepared a detailed audit report and the Corporation had amassed thousands of pages of supporting documentation

 

Should the company prepare a written report?

 

            There is no simple automatic answer to the question whether a company should prepare a written report of its investigation.  Preparation of a written report imposes a discipline of clarity and thoroughness not required by an oral report. A written report can explain more systematically a complicated fraud scheme or a large web of circumstantial evidence. A written report makes it easier for others, especially senior management, to review the investigation and the analysis that is part of any internal investigation. The preparation of a written report makes it easier to communicate a concise account of the fraud and its detection to a prosecutor or other outside party. 

 

            A written report, however, means there is greater risk of disclosure to people who should not read the report. Given the ubiquity of photocopiers, scanners, and e-mail, it is easy to copy and transmit any written report. Furthermore, a written report commits the writer of it to particular version of the facts that may be contradicted by later discoveries. If the writer then testifies at a trial, he can be impeached with the prior written report.

 

            In our case, the Corporation chose to have internal auditors prepare a written report under the direction of counsel. The links among the pieces of circumstantial evidence in the scheme were too hard to follow without a systematic written description of the evidence and the various tests and searches that the auditors made.  Furthermore, counsel wanted senior management to be able to review the report if necessary to understand the origin and scope of the scheme so that the Corporation could implement corrective measures.  Finally, counsel wanted a compact summary of the scheme for communication to the prosecutor and insurance company.

 

Which law enforcement authority should receive the report?

           

            If the company decides to send the case to a prosecutor, which one should it choose?  Federal prosecutors typically have more substantial resources, including the FBI, available to them to investigate white-collar crimes.2  They also do not have to juggle the crushing caseloads that state or local prosecutors handle. Furthermore, the Federal Sentencing Guidelines require imprisonment in most cases for anyone who has stolen a substantial sum; state courts may not impose jail time for routine “white collar “ crimes.  On the other hand, state prosecutors almost always will have jurisdiction over the theft or embezzlement under state criminal laws.  Despite the impression created by recent national events, federal prosecutors lack the authority to investigate every imaginable crime.  Federal  prosecutors typically insist on identifying a specific federal statute that was violated before they will proceed.  Although the federal mail fraud and wire fraud statutes have broad reach, they do not cover everything.

 

            In our case, the Corporation preferred to have a federal prosecutor handle the matter. However, the Employee and Vendor did not use the mails or any interstate wires as part of their schemes, so neither the federal mail nor wire fraud statutes applied. The Vendor delivered the invoices by hand, and the Employee delivered the checks by hand.  Although we doubt that the Employee or Vendor planned to avoid the mail or wire fraud statutes, their conduct did so. Unfortunately for them, however, the Corporation’s checks were drawn on an out-of-state bank. The deposit of out-of-state bank checks, which traveled interstate as part of the checkclearing process, supported jurisdiction under 18 U.S.C. §  2314 (interstate transport of proceeds obtained by fraud) where the amount of the fraud exceeds $5,000. Pereira v United States, 347 U.S. 1,9 (1954); United States v Scarborough, 831 F. 2d 1244 (D.C. Cir. 1987);

 

            Even after the company has decided to report the crime to a prosecutor, it may have to persuade the prosecutor to investigate and prosecute. Prosecutors may be reluctant to investigate what seems to be an ordinary commercial dispute, because they reason that for-profit entities can protect themselves against theft or other crimes through civil litigation. Furthermore, prosecutors often suspect the thoroughness of any internal investigation, believing that the company may be more interested to find a scapegoat for a problem than to be scrupulous about identifying the true culprit.  The prosecutor may suspect that the internal investigation had an ulterior motive that has little to do with the prosecutor’s insistence on neutral and even-handed application of the criminal law. The company must convince the prosecutor that it actually seeks the truth rather than merely identifying a convenient target for blame because the ultimate decision to prosecute remains with the government.  The company can advocate prosecution and supply evidence to support it, but it must be careful not to appear heavy-handed about its approach.  It must allow the prosecutor to gather the evidence he needs, even if that means duplicating the investigative steps that the company already has taken.

 

            In most jurisdictions, including the Fourth Circuit, the disclosure of an internal investigative report to the government will waive whatever attorney-client privilege would have protected the report from outside parties. In re Martin Marietta ,856 F. 2d 619 (4th Cir. 1988), the Fourth Circuit held that a company’s disclosure to the government of materials from an internal investigation waived the attorney-client and nonopinion work-product privileges when a third party (in that case, an employee) sought to compel disclosure of the items for use in his defense in a related criminal case.3  Disclosure of the company’s internal report may mean that other parties, including potentially adverse civil litigants or the company employee (or in our case, the Vendor) can compel disclosure of the report and its underlying data. In Martin Marietta, the Fourth Circuit exempted only opinion work product from disclosure.

 

            Disclosure of the internal investigative report to the insurance company in support of the company’s claim often will have the same effect. As embezzlement and like schemes often are covered by a company’s insurance policy, the company must examine the question of whether to report the loss to the insurance company and try to recover under its policy. The insurance company typically will want to see evidence of the loss before it pays any money. Should the insurance company get the same report as the prosecutor?

 

            Disclosure to the insurance company almost certainly will bring about a waiver of whatever privileges would have attached to an internal investigative report. Thus, if the company knows that it will submit a copy of the report to the prosecutor, it can submit a copy to the insurance company because the privilege would have been waived in any event.  The company should provide the same version of the report to the insurance company as it did to the prosecutor to avoid the possibility of later impeachment with inconsistent statements between the two versions of the report or impeachment with omissions from one of the reports.

 

            Counsel then faces a few choices, none of them ideal. Counsel can try to prepare a report for law enforcement and/or insurance purposes. That report, once disclosed, will not be privileged, but counsel may be able to preserve the privilege for underlying discussions with the company. Counsel must take steps to try to preserve the privilege about any advice he has given the company’s senior management and for discussion with management about strategic choices the company might make in pursuing the investigation, or in fitting the investigation into any other company purpose.

 

Summary

 

            Internal investigations inevitably raise complicated issues of law and of internal management. We hope that this article has illustrated how these issues intersect generally and in the context of the Corporation’s  particular case. We hope that this discussion and the illustration will help others avoid potential pitfalls in these internal investigations. 

 

 

Endnotes

 

1          Even though the entire case appeared in court, the Corporation does not wish to be identified publicly.  In-house counsel played a substantial role in the internal investigation and in the writing of this article but asked not to be identified to preserve the Corporation’s privacy.

 

2          The Washington Post published a revealing article showing that embezzlers seldom receive jail time in the state courts in northern Virginia.  “A Crime with Little Punishment,” Page A1, October 1, 1998.

 

3          In one recent case, a federal judge upheld enforcement of a subpoena to a company in a civil case for copies of all the materials it had provided to the government in support of a prosecution.  The judge ruled that the disclosure to the government waived whatever privilege might have attached to the materials.  Resources Inc v Dun & Bradstreet Co, 96 Civ. 5716 (S.D.N.Y. 1998) (Stanton, J.)

 

 

About the Author

 

           

A litigation partner in the Washington, D.C. office of Kutak Rock since 1991, Mr. Strasser specializes in the defense of white-collar criminal cases, Congressional investigations, and associated regulatory and administrative investigations.   In recent years, his criminal practice has focused on the defense of allegations of health care fraud and  fraud against the government and on the implementation of corporate compliance programs.

 

Mr. Strasser graduated cum laude from Yale College (1974) and Harvard Law School (1977). From 1977 to 1991, he served as a Trial Attorney with the Civil Frauds Section of the Justice Department and as an Assistant U.S. Attorney for the District of Columbia.

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