The Importance of Independent Internal Investigations

Internal investigations have become a necessity in today’s increasingly complex legal environment. They are now considered standard practice for businesses responding to serious allegations of financial misconduct and, when properly conducted, play a critical role in determining the credibility of the allegations, the identity of the responsible parties, and the impact of the fraud on the company’s financial statements. Many have argued that internal investigations will minimize the risk of regulatory enforcement after financial misconduct. This presumption is not just wishful thinking on the part of business leaders or attorneys, as regulators themselves promote internal investigations as a means through which firms can receive enforcement leniency. For instance, in 2001, the Securities and Exchange Commission (SEC) established a cooperation program by issuing what is commonly referred to as the Seaboard Report, which lists internal investigations as an important factor in determining whether or not to punish a firm. However, prior academic research has uncovered a surprising result: The initiation of an internal investigation actually increases the chance of being punished by the SEC or Department of Justice (DOJ) for financial misconduct (Files 2012; Leone et al. 2021).

Do these results suggest that internal investigations are attracting attention to a case that would have otherwise gone unnoticed by regulators? Should internal and external decision-makers stop lauding internal investigations as a way to limit regulatory intervention?

We argue that more exploration is needed before answering these questions, because simply conducting an internal investigation may not be enough to earn regulatory leniency.  Instead, regulators have clarified that “the independence of the investigation [is] crucial to its credibility” (Thomsen 2007, para. 20), and there is “no bright line that says you cannot use internal staff to conduct the investigation, but the devil is in the details. Typically, we prefer to see someone brought in who [is] independent [and] not employed by the company or its counsel” (McTague 2007, para. 4). In a 2015 speech, Leslie Caldwell, assistant attorney general of the DOJ, acknowledged that “there is no ‘off the rack’ internal investigation that can be applied to every situation at every company” (Caldwell 2015, para. 11), but she warned that regulators will “pressure test a company’s internal investigation… and will consider the adequacy of an internal investigation when evaluating a company’s claim of cooperation” (Caldwell 2015, para. 14). It appears that not all internal investigations are created equal and, to regulators, the independence of the investigation is a first-order concern.

To better understand the variation that may exist in internal investigations, we compile a novel dataset that contains details on the internal investigations conducted by 526 firms with major accounting restatements issued between 1997 and 2017. This information is hand collected from corporate press releases and SEC filings in the months surrounding the restatement announcement date. We explicitly identify the participants who manage and conduct the investigation (as well as their level of independence) and then explore whether variation in the composition of this investigation team affects two key outcomes of financial misconduct: chief executive officer (CEO) turnover and SEC enforcement.

We document that slightly over half (n = 272, 52 percent) of the restatement firms in our sample heed the advice of the SEC and DOJ and appoint an independent team, such as the audit committee or a special committee of independent directors to spearhead their internal investigation. These independent leaders are more likely assigned when the audit committee has prior accounting or finance work experience, the CEO is a certified public accountant (CPA), or the misconduct is more severe. The remaining 48 percent (n = 254) of the firms in our sample use non-independent leaders for their internal investigation, such as managers or internal counsel. These non-independent leaders are chosen more frequently when the CEO holds greater power in the organization or the firm employs a Big Five auditor (namely, KPMG, Deloitte and Touche, Pricewaterhouse Coopers, Ernst & Young, or Arthur Andersen).

Once chosen, the investigation leader must decide whether to hire an external advisory firm to assist with the investigation; these external advisers are considered independent because they are outside of the firm. We find that 35 percent (n = 184) of the firms in our sample hire at least one external adviser, such as a law firm or forensic accounting firm, to aid with the investigation. This incidence is significantly higher when the investigation is led by an independent team (e.g., the audit committee or a special committee of independent directors). Law firms are the only outside adviser hired by 95 firms (18 percent), whereas 84 firms (16 percent) hire both a law firm and forensic accounting firm to help conduct the internal investigation. We see that it is rare for firms to hire only accounting advisors (n = 5, 1 percent), consistent with attorney-client privilege being more difficult to maintain without external law advisers.

Using this novel dataset as the starting point, we next evaluate the association between the investigation participants (leader and external adviser) and two common consequences of financial misconduct: CEO turnover and SEC sanctions. We first examine whether the board holds the CEO responsible for the restatement by examining turnover rates. We find that the likelihood of CEO turnover after an accounting restatement is almost 50 percent higher when the internal investigation leader is independent, which is consistent with independent leaders being more willing to clean house. We also present evidence that independent leaders have an indirect effect on CEO turnover through their decision to hire law advisers. The presence of law advisers in the investigation increases CEO turnover likelihood by 6 percent.

Next, we examine how the independence of an internal investigation is related to SEC enforcement. We see that the likelihood of the firm being sanctioned by the SEC following an accounting restatement is 36 percent lower when the firm uses an independent investigation leader compared rather than a non-independent leader. We find no association between SEC enforcement likelihood and the involvement of external law or accounting advisers.

Taken together, our evidence suggests that, in their role as investigators of accounting misconduct, independent board members protect the firm (through regulatory leniency) at the expense of executives (through CEO turnover). These findings have at least two implications for boards as they consider how to respond to financial misconduct, as well as for future researchers exploring this topic. First, we caution that the typical CEO faces the risk of being fired at the end of independent investigations. Knowing this, boards should take care to remove the CEO from any involvement in the investigation process and to be aware that incoming CEOs may demand more compensation to bear this potential employment risk. Second, the involvement of independent investigation leaders lowers the chance of SEC punishment, even in cases where the existing CEO has been fired. This evidence suggests that independent boards are capable of successfully remediating financial misconduct, even without consistent CEO leadership. Ultimately, our results build upon the findings of prior research by showing that regulators grant enforcement leniency to firms that exhibit the “hallmarks of [a] good investigation” (Caldwell 2015, para. 11).


Caldwell, L.R. 2015. Assistant Attorney General Leslie R. Caldwell delivers remarks at New York University Law School’s program on corporate compliance and enforcement. Speech presented at New York University Law School, April 17.

Files, R. 2012. SEC Enforcement: Does forthright disclosure and cooperation really matter? Journal of Accounting and Economics 53:353-74.

Leone, A., E. Li, and M. Liu. 2021. On the SEC’s enforcement cooperation program. Journal of Accounting and Economics 71(1): 1-22.

McTague, R. 2007. Enforcement has strong interest in monitoring internal probes, official says. The Bureau of National Affairs, Inc. (now Bloomberg BNA) Corporate Law and Business 39 (19), May 14.

Thomsen, L. C. 2007. Speech by SEC Staff: Remarks before the Stanford Law School Director’s College. Speech presented at Stanford Law School Directors’ College, Stanford, CA, June 26.

This post comes to us from professors Rebecca Files at the University of Texas at Dallas and Michelle Liu at CUNY Hunter College. It is based on their recent article, “Unraveling Financial Fraud: The Role of the Board of Directors and External Advisors in Conducting Independent Internal Investigations,” available here.