Imagine that you are the CEO or CFO of a public company. You are at your desk one day when the director of credit and collections comes into your office. She closes the door and says: “I think we have a problem. We’ve been trying to collect a $1.5 million receivable from customer Doe Corp. for 5 months. Today, when we told them we would have to put them on credit hold, they faxed us this.” She hands you a copy of a letter, signed by your VP of North American Sales, which purports to amend the license agreement with Doe. The amendment provides that Doe need not pay the $1.5 million until it resells the product to an end-user. “We never saw this in Finance before today,” she informs you. “What should we do?”


This article attempts to answer that question. It sets forth a model – not necessarily the only model – for responding to evidence of accounting fraud at a public company. It is based on my experience with, and observation of, many accounting restatements. Some of those restatements resulted in the death of the company involved. Others did not. How you respond will influence the outcome for your company.


The Wall Street Journal Test

Before diving into specific action items, allow me to suggest a framework for how you should approach the crisis -- what I call “The Wall Street Journal test.” Throughout your handling of the investigation, ask yourself: if everything I did from now forward were recorded accurately and in detail, and then published on the front page of The Wall Street Journal, would I be proud of it? Would a fair observer conclude that I had acted ethically and honorably? Or would people conclude that, even though I was not responsible for the original wrongdoing, I had participated in covering it up?


As students of Watergate learned decades ago, the cover-up is usually worse than the crime. If you uncover an impropriety at your company and remedy it, things will probably turn out all right; in any event, you will not be tainted by it. By contrast, if you join in a cover-up of the problem, then you make it your own problem. In cases of accounting fraud, executives who help cover it up are treated at least as harshly as those who engineered the fraud in the first place.


With the appropriate ethical mooring in place, let’s turn to specific tasks. These are not listed in sequential order: many of them must take place simultaneously, often in the first few hours or day.


Who’s in Charge?

A threshold issue is establishing the chain of command. This will vary depending on initial indications as to who may have been involved in the misconduct. In most cases, the General Counsel will be in charge of the process. She will report to the Audit Committee of the Board of Directors. Absent any indication that the CEO and CFO participated in the wrongdoing, they will be closely involved in the investigation as well. But, in my opinion, the Audit Committee (or a lead director on that committee) must be looped in immediately. At every significant stage, management must keep the Audit Committee informed. It is the Audit Committee that must make the key decisions with respect to involving the outside auditors, restating prior financials, and issuing public disclosures. The CEO, CFO, and General Counsel will be involved in those decisions, provided that they clearly played no role in the fraud.


The other end of the spectrum is equally clear. If the General Counsel has reason to believe that the CEO or CFO may have participated in the violations, then (with the Audit Committee’s assent) she should exclude them from the investigatory process, at least until they have been exonerated. Obviously, this places the General Counsel in a difficult position and is a decision that must be made by the Audit Committee. If the Audit Committee has any reason to believe that the General Counsel may have acted improperly, then it should exclude her from the process, relying instead on outside counsel to spearhead the investigation.


In some instances, the facts will lie somewhere in-between: there will be uncertainty as to the culpability of senior management. In that situation, the Audit Committee should err on the side of excluding potentially implicated executives from the process until they have been cleared, while expediting the fact-finding with respect to them.


Representation and Conflict Issues

A threshold issue for the General Counsel and the Audit Committee is: which lawyers should conduct the investigation? Accounting-fraud investigations are complex, and prior experience in conducting them is essential. If the company’s outside counsel is experienced in accounting investigations -- and clearly understands that it owes its duties to the corporation, in the form of the Audit Committee, not to individual members of management -- then that firm may assume the role. On the other hand, if the Audit Committee has reason to believe that outside counsel may be beholden to management and protect them in the course of the investigation, then the Committee should select another law firm as special counsel to the Board.


Those conducting the investigation must make clear to persons they interview that the lawyers are not acting as counsel for the individuals. The lawyers should disclose at the beginning of every interview that: they are representing the company, not the person being interviewed; that the privileges surrounding the interview belong solely to the company and may be waived by the company, in its discretion; that the information obtained may be provided to regulatory authorities, in the company’s discretion; and that the person being interviewed is free to consult with his own counsel before proceeding. This is not to suggest that an employee has the right to refuse to answer questions at the interview: I believe that she does not, and that failure to cooperate can provide a basis for termination. Nevertheless, it is important that the investigators make clear to the employee what the process is about and the potential ramifications of her answers.


Securing Evidence

From the moment the General Counsel learns of the potential accounting violations, she must move aggressively to secure potential evidence. She should meet immediately with personnel in the information technology department to preserve any backup tapes of electronic data. As soon as she has identified potential participants in the wrongdoing, she should copy their files on the network and on their local computers. Depending on the strength of the evidence against them, she may also want to lock them out of the computers. The General Counsel also needs to secure relevant paper files in the finance department and sales organization. She should also secure files located in the offices of those apparently involved in the fraud.


I cannot overemphasize the urgency with which these steps must be taken. When a financial fraud starts to unravel, the perpetrators sometimes destroy evidence. Better to lock-out someone from her files and office unnecessarily, then to arrive a few hours after she has shredded the documents and reformatted the hard drive.


Engaging Forensic Accountants

An early branch in the road involves who will do the legwork: internal staff; forensic accounting consultants; or the company’s outside auditors. The answer depends in part on the nature of the potential accounting problem. In general, I am reluctant to have internal finance department staff perform the accounting aspects of the investigation. They either missed the problem to begin with or may otherwise be tainted by relationships with the perpetrators. If the company has a capable, adequately staffed internal-audit group, it may be capable of conducting the investigation, at least during the initial stages of sizing up the problem.


If the problem is at all significant, the company should turn to outsiders for help. My preference, in most circumstances, is to retain forensic accounting consultants, instead of using the company’s outside auditing firm. Independent consultants have only one objective: to ascertain the facts and help the Audit Committee come to the right accounting decision. With the company’s outside auditors, there is a danger that they may be influenced by personal relationships with those involved in the misconduct, as well as by a desire to minimize their firm’s own liability exposure.


Some believe that using forensic accountants from a firm other than the auditors unduly delays the process, because the auditors will redo the investigation once the forensic accountants present their report. This concern has some validity. On the other hand, I have seen many instances in which outside auditors have conducted an expedited review, based on information presented to them by the consultants.


Conducting the Investigation

It is difficult to generalize about which documents to review and which persons to interview. These will vary greatly depending on the nature of the apparent accounting violation. Your outside counsel and forensic accountants will guide you on these matters. But a few generalizations are appropriate.


First, rarely is there just one side letter or improper transaction. Treat with great skepticism assurances from the malefactor that “it only happened once.” Occasionally, that is true. Often, however, meeting the financial targets required more than one improper transaction. Sometimes, having borrowed revenue from future periods to make the initial quarter, the employee later had to book additional improper transactions in order to avoid detection. For this reason, your investigation should examine the bona fides of many transactions beyond the one as to which you uncovered the first side letter.


Second, it is unusual that only one person knew about the fraud. In some restatements, the fraud involved only one or two transactions, and was committed by one or two persons. Such situations present much less of a danger of a meltdown to the company. On the other hand, more serious restatements – involving substantial portions of revenue and income, over multiple accounting periods – rarely are limited to one perpetrator. Your investigators will need to probe aggressively to determine whether those who turned a blind eye to the transactions may be culpable.


Third, don’t assume that customers will blow the whistle. In some situations, an employee at the customer may have facilitated the improper transaction, perhaps as an accommodation to the sales rep who asked for a favor. You should be prepared for some customers to refuse to assist you in the investigation. Often, the only way to learn the true state of events from the customer (or to obtain the actual transaction documents) is through an SEC subpoena.


Fourth, restatements are seldom small. One reason is that, as indicated above, the employee who booked one improper transaction often will have booked others. Another reason is that, in the ordinary course, a company makes judgment calls on accounting issues that could go either way; the outside auditors accept them as within the zone of reasonableness. But once the company has detected a fraud and reopened its books for prior periods, auditors will often revisit those prior judgment calls and require the most conservative treatment. In situations in which the outside auditors may share some culpability for the improper accounting, they may search out other problems, not attributable to them, in order to reduce their share of the blame.


Documenting the Investigation

Practices regarding creation of a paper-trail vary greatly by lawyer. Here is one approach. As set forth repeatedly in this article, it is imperative that your investigation be thorough and genuine. That does not necessarily mean that it has to generate mounds of paper. In my opinion, creation of too many documents can present difficulties for the company down the road.


In all likelihood, your company will face an SEC and/or DOJ investigation into the restatement. As a condition of cooperation by the company, the government often will require some portion (or all) of the investigatory work-product to be turned over. Plaintiffs in private securities actions will try to obtain those documents, either from the government or from the company, asserting waiver of any privileges. Your company may be in a more difficult position defending itself in the private litigation if plaintiffs can obtain a roadmap from the investigation.


If you do create documents during the course of the investigation, you should not discard them, even prior to announcement of the restatement. The risk of being found to have engaged in spoliation of evidence is significant.


Confidentiality and Disclosure

Preventing leaks during the investigation is challenging. The deeper you probe into the sales and finance organizations, the greater the risk that rumors about an accounting problem will spread within, and potential outside, the company. For that reason, you should bring as few people within the tent as you need to and should emphasize to them the importance of confidentiality.


When to go public with the potential restatement is a judgment call. Some lawyers advise putting out a press release as soon as the company realizes it is likely to restate, even if it has not determined the scope of the restatement. In general, I dissent from that view. Absent a triggering event – discussed below – a company has some reasonable period of time (measured in days or weeks, not months) to get its arms around the problem. If you must restate, the worst possible release says: “We have discovered a side letter. We may have to restate. We don’t know what the magnitude will be.” The best possible release provides the precise financial impact, indicates that the investigation has been completed, and states that the company does not believe there are any other accounting problems.


Several factors can trigger early disclosure, even before the investigation is completed. One is the pendency of a corporate transaction, such as a securities offering or an acquisition. You obviously cannot sell stock or acquire a company if you know that you may have to restate. Another trigger is the need to issue an earnings release or make a periodic filing with the SEC. In many circumstances, the timing of such releases or filings will compel you to disclose the likelihood of a restatement even before the final details are nailed down. In some instances, rumors and press inquiries may force the company’s hand. Finally, if the restatement appears likely to be large, or to reflect widespread fraud at the company, your outside auditors may require an immediate press release by threatening to withdraw their opinion as to previously audited financials.


Assuming that those triggering events are absent, and that you do not need to issue a release immediately, you must restrain your company’s normal marketing and PR efforts during the period when you are sizing up the problem. You will lose additional credibility in the market (and potentially exacerbate your liability) by saying things that drive your stock price up while you plan to announce a restatement.


When you do issue the announcement about the restatement, avoid “spinning” it too much. Your company will be in the credibility doghouse with the Street for some time. Don’t make things worse by downplaying the significance of what has happened.


Involving The Outside Auditors

If you have chosen to have separate forensic accountants conduct the investigation, then you need to be sensitive to the timing of bringing the auditors inside the tent. There are two basic approaches; which is right will depend on your company’s relationship with its auditors.


One approach is to give the auditors a heads-up at the start of the investigation. Explain how you and your consultants are going to conduct the investigation. Assure the auditors that you will provide a complete transfer of information at the completion of the investigation. The auditors may agree to stand back and await the results of your investigation. The risk is that they will insist on sending in their own team immediately, before you have time to complete your work.


The alternative approach (which I generally prefer) is to complete your own investigation before notifying the auditors. You and your forensic accounting team then meet with the auditors to present the information you uncovered and the conclusions you reached. In many situations, the auditors will review the materials and accept them, without redoing the entire investigation. The risk is that the auditors will start from scratch, consuming additional time at a point when you may feel great pressure to issue a release.


Terminations and Payments

In general, you will terminate those who were involved in the accounting fraud. There may be exceptions at lower levels, where the Board concludes that certain employees were following orders and not personally culpable.


Do not act hastily in granting severance payments, or promising indemnification, to terminated employees. The Board may later decide that, in light of their involvement in the fraud, certain employees should not receive payments to which they would otherwise contractually be entitled. It is prudent to hold back the payment until doubts have been resolved, rather than trying to recoup payments later.


Note that, if the Board has doubts as to a particular executive’s culpability, it can insist that she submit to an interview by the company’s investigators before agreeing to make any payment. In my opinion, refusal to submit to such an interview justifies rejecting a request for severance payment or indemnification.


Cooperation with the Government

If your company restates, an SEC investigation almost certainly will ensue. Your Board will want to cooperate in order to minimize any penalty levied against the company.


You may want to give the regional SEC office in your area advance notice immediately before issuing the press release about the restatement. My experience has been that the regional offices tend to be less adversarial than the Washington office in dealing with companies trying to correct accounting violations.   Moreover, your employees will then have their depositions taken locally, instead of in D.C.


If you provide the government with meaningful cooperation, your company is not likely to be punished for the accounting fraud. It may have to enter into a consent decree, committing not to engage in accounting violations in the future. But it probably will not have to pay any penalty or fine.


Preparing for the Lawsuits

When you announce the restatement, your company will be sued early and often. It likely will face shareholder class actions, as well as derivative suits naming the entire Board. Every time you type the company’s ticker into a search engine, you will pull up scores of press releases from lawyers trolling for plaintiffs. Try to keep these suits in perspective. Over the long run, the lawsuits will be less important to the company’s recovery than market credibility and operational fundamentals. Don’t let your business strategy, or investor relations strategy, be skewed by preoccupation with the lawsuits.



The situation in which you find yourself when confronted with a potential restatement is not one that you created. Now, however, you are in a position to make it better or to make it worse. If you approach the investigation with ethics and integrity, and with experienced assistance, you can ensure that the situation does not get worse than it already is, and can start a process that will enable your company to move beyond it.



Copyright 2001, Boris Feldman