October 4, 2013, 2:14 PM ET

Amid Corporate Crime Crackdown, Expectations for Board Rise

CHRISTOPHER M. MATTHEWS

A growing expectation among U.S. enforcement agencies that companies investigate themselves when allegations of corporate misconduct arise and turn over the results means the consequences of mishandling the probe have never been larger. Amid the heightened risks, prosecutors increasingly prefer an even higher standard of review. They want internal probes to be led by the board of directors to ensure independence from management interference, according to current and former officials at the Department of Justice.“Internal investigations these days are effectively an extension of government investigations,” said Joe Whitley, a former acting associate attorney general and now a partner at Greenberg Traurig LLP. “A growing number of investigations are handled by the board once the government is involved.”

The officials said there are no hard and fast rules for when the board of directors should step in, but if there is any indication that a company’s senior management is involved in the wrongdoing, the board should conduct its own investigation. Even if senior executives are not involved, there are instances in which the conduct is so egregious that the board should be involved, one current Justice Department official said.

“At the end of the day, when we decide the resolution, to the extent there’s been a tainted process and management tried to sweep it under the rug, the company’s not going to get near the same credit,” the official said.

Indeed, should authorities question the legitimacy of an internal probe, the consequences can be dire. Take, for example, the case of China North East Petroleum Holdings Limited, or CNEP.

In early 2010 CNEP, a reverse-merger, Chinese oil exploration firm that was registered in Nevada, had been a trendy stock pick. But by April of that year, the company disclosed material weaknesses in its internal controls and said financial statements for the past few years weren’t reliable. By May, the New York Stock Exchange halted trading of the company’s stock after it failed to file annual and quarterly reports.

The trouble appears to have begun in April 2010 when Robert Bruce, founder and president of Oakmont Advisory Group, a director at CNEP and the chair of the audit committee, discovered a line item in the company’s draft 2009 financial statements that hadn’t previously been disclosed to the board. Mr. Bruce noticed a $3.89 million debt that was allegedly due to CNEP from a shareholder, according to a Securities and Exchange Commission lawsuit filed against the company. When he asked about the debt, he received “varying explanations” according to court documents filed by the SEC.

At the request of the audit committee, the company and the board hired John Lees Associates, a Hong Kong accounting firm, to look into the matter. A July report by JLA found a large number of unauthorized transfers of company funds between certain company directors, including board president and chief executive Hongjun Wang, and the company’s Chinese subsidiaries, but said there was no evidence to suggest the funds were stolen or misused, according to the court documents.

But Mr. Bruce was not satisfied. He wrote his fellow directors and senior CNEP executives, including Mr. Wang, on July 22 and asked the company to authorize the audit committee to “undertake a thorough and independent review of the company’s prior financial statements, associated SEC filings, and cash payments to persons who may be deemed “government officials” under the [Foreign Corrupt Practices Act], over the past five years.” The rift became public when Mr. Bruce’s letters to the board and its responses were filed publicly with the SEC in August 2010.

Mr. Bruce suggested independent law and accounting firms be put at the board’s disposal. “[F]ailure by the Company to undertake what I believe are necessary additional investigative efforts as outlined above will, in my opinion, lead to an end result that is likely worse for shareholders, company management and directors,” he wrote in a letter.

Edward Rule, the chairman of the board, wrote Mr. Bruce on Aug. 5, 2010, and denied his request, citing the cost and length of such an investigation and the possibility that the company’s stock could be de-listed. On Aug. 8, Mr. Bruce tendered his resignation.

Mr. Bruce declined to comment, citing pending shareholder litigation against him, the board and company management accusing them of breaching their fiduciary duties. Bruce and the others have denied the claims. Mr. Rule could not be reached for comment.

The public spat didn’t go unnoticed. On or about Aug. 16, 2010, the SEC issued a formal order of investigation, according to court documents. By November, the SEC had sued CNEP, Mr. Wang and Chao Jiang, CNEP’s former vice president of corporate finance, over claims that some $59 million in offering proceeds were fraudulently diverted to insiders’ personal accounts. The SEC also charged Ju Guizhi, Mr. Wang’s mother and a company founder. The case is still pending.

Ms. Ju couldn’t be reached for comment.

The SEC lawsuit detailed Mr. Bruce’s initial inquiries into the $3.89 million line item and also called into question the extent of the of the JLA report. “There are numerous other examples of questions unresolved by the JLA Report,” SEC lawyers wrote in a May 2013 court filing in federal court in Manhattan. “Ultimately, there exists a factual dispute as to the scope of JLA’s investigation and the reliability and interpretation of JLA’s ‘conclusions….’”

Michael Coffino, a lawyer for the company, said the JLA investigation was “forensic and independent” and turned up no evidence of wrongdoing. The SEC’s case lacks any specificity of evidence, Mr. Coffino said.

John Lees, JLA’s managing director, said in an email the firm’s instructions were to investigate the $3.89 million transfer and it had limited authority to investigate other payments or access to the underlying records.

“It would appear that there is a dispute between the SEC and the directors of CNEP in respect of the scope of our engagement,” Mr. Lees said.

An SEC spokeswoman declined to comment.

In May, the Justice Department charged Mr. Wang and Mr. Jiang with defrauding investors in connection with the public offerings of stock. Mr. Jiang was also charged with making false statements to SEC lawyers. The pair face both face more than 25 years in prison if convicted.

They have both denied the allegations and the criminal case is pending in federal court in Washington, D.C., A lawyer for Mr. Wang declined to comment. A lawyer for Mr. Chao, Michael Li-Ming Wong, said he looked forward to the entire record getting out in open court and expected his client to be vindicated.

“The United states government has unleashed its full force and might against our client including two teams of government lawyers who have brought court actions against our client in two different venues, but our client is unbowed and will stand up to the government,” said Mr. Wong, who is a partner at Gibson Dunn & Crutcher LLP.

A Justice Department spokesman declined to comment.

CNEP has de-listed its stock and is de-registered in the U.S.

Bradley Bondi,  a partner at Cadwalader Wickersham & Taft LLP, said that as allegations climb the corporate ladder, the need for board involvement becomes more acute. The risk is that management could interfere to protect themselves, he said. Mr. Bondi was speaking generally and not about CNEP.

The Justice Department will rarely demand board involvement, one current official said, but prosecutors may question the reliability of an investigation if senior management is implicated and is involved in directing the investigation.

But, an independent board-led investigation can create tension between the board and management, as probes can be costly, time consuming and distracting.

“They may have to ask tough questions of management, and that can be hard when they’re writing the check,” Mr. Bondi said.

Still, they are usually worth the trouble, according to Mr. Bondi. Companies can also feel the sting of failing to conduct an independent investigation at the settlement stage. Both the SEC and the Justice Department reward full cooperation and independent reviews, Mr. Bondi said, and punish companies that don’t get it right.