Investigating the Investigators
In the forensic accounting world, there’s a little-known area commonly referred to as “shadow investigations”. A shadow investigation is when accounting firms oversee internal investigations being performed by outside counsel and their forensic investigations counterparts. The primary objective is to ensure that the investigative scope is likely to provide sufficient information for the audit partner to comfortably sign off on the audited financial statements. In an episode of the Fraud Eats Strategy podcast, I spoke with two experts on the subject: Cleary Gottlieb litigation partner Lisa Vicens and FTI Consulting Senior Managing Director Mark Grover both of whom have worked on investigations that have been shadowed by accounting firms.
Since the passage of Sarbanes-Oxley 19 years ago, shadow investigations have been running in parallel to many internal investigations involving publicly traded companies. Most often they take place when an internal investigation has the potential to impact the company’s audited financial statements. Typically the audit firm will involve their forensic practice and ask them to shadow the forensic accounting and investigative procedures to make sure they’re scoped properly and will likely yield enough information for the audit partner to sign off on the financial statements.
It’s not always clear when an accounting firm finds it necessary to perform a shadow investigation. Often, there are different levels of depth depending on the issues at hand. Audit firms will typically perform a threshold assessment of whether a shadow investigation is warranted. This is done within the context of the audit firm’s responsibilities under Section 10 of the Securities Exchange Act parts A and B which require that auditing firms have procedures to detect illegal acts. Further required under the Act is when audit firms become aware of a potential illegal act, they must ensure that the company has taken appropriate remedial measures. Part of how audit firms operate in compliance with the Securities Exchange Act is to perform shadow investigations whenever an auditee has determined that it’s necessary to engage outside counsel and forensic accountants to investigate potential accounting or financial reporting improprieties. The extent of the shadow investigation procedures depends on the facts and circumstances of the situation. Those factors include whether there is potential fraud, if the potential fraud is critical to financial reporting, how widespread the issues are, and the professional judgment of the audit firm executives involved.
Regardless of the depth of the investigation, audit firms will typically assign two or more forensic accountants to the matter to make sure that the nature and scope of the investigative procedures are sufficient. They may also supplement the team with technical accounting subject matter expertise as needed.
There are two distinct categories of shadow investigations, soft touch and comprehensive. Soft touch shadow investigations are when the audit engagement team wants to understand the methodology underlying the investigation and the potential impact on the financial statements without getting into the weeds. In contrast, comprehensive shadow investigations require a sophisticated audit of the various investigative steps, such that they are more process focused, as opposed to just focusing on the methodology and the outcome.
Comprehensive shadow investigations are inherently more complex and can raise issues around the attorney-client privilege that must be managed while still providing the audit teams with enough comfort that they are willing to sign off on the financials. The goal of a comprehensive shadow investigation is to conduct an audit of the company’s investigation at every stage. It is a comprehensive review that examines the investigative procedures throughs a critical lens. Shadow procedures should audit and raise questions about the investigation scope, its work plan and seek confirmation of the steps that the investigation team took to collect the relevant information. Shadow investigative team members may wish to have input on the selection of which email custodians should be in scope and the search terms that are used to review key emails, who should be interviewed and receive regular updates on the progress and the findings of the investigation.
Another important purpose of a shadow investigation is to be on the alert for any indication that the findings could impact the financial statements or raise questions about the integrity of the members of management.
Investigations are performed under the auspices of the attorney-client privilege. When you have a shadow team involved in every step of an investigation, that can raise a number of privilege concerns. There can be concerns about inadvertent waiver of the privilege which would be a welcome roadmap to any prospective litigants who are looking to make a claim against the company based on the conduct giving rise to the investigation. There are a number of steps that can be taken to mitigate this privilege concern while still providing the auditors with information that they need in order to feel comfortable with the investigation and its independence. One way to mitigate this risk is to focus on sharing the factual and process-related parts of the investigation and not the actual underlying legal advice. It is also prudent to limit the amount of documents that are actually turned over and incorporated in the auditor’s work papers and instead providing oral updates and reports on progress. Lastly and most importantly, there needs to be open and candid conversation between the audit team and the investigative teams so that there is a clear understanding of the importance of confidentiality over the investigation.
This makes certain that the primary investigative team provides the shadow team with the level of information that they need to be comfortable with the investigation and its findings while still taking care, to make sure that they understand the importance of privilege over the investigation.
Shadow investigations are necessary and every bit as important to the client as the investigation itself. Shadow investigators and outside investigative teams of attorneys and forensic accountants each play an equally important role. Investigations must be independent, thorough and scoped in proportion to the allegations at hand. The investigation needs to expose all the evidence needed by management, regulators and law enforcement. At the same time, auditors must have confidence that the investigation was appropriate, sufficient and likely to uncover the relevant facts. They also need to have a clear understanding of any impact the investigation may have on the financial statements and whether the integrity of management is at issue. Investigations happen. Shadow investigations enable them to happen in full view of the auditors and ultimately the investing public.
To hear the full Fraud Eats Strategy podcast episode with Lisa Vicens and Mark Grover, click here.
Note: The postings on this site are my own and do not necessarily represent White Collar Forensic’s positions, strategies or opinions