Private companies, family-owned businesses and employee stock ownership plans (ESOPs) face unique challenges when conducting internal investigations. Unlike their public company counterparts, these types of businesses often lack robust, established investigative protocols. This absence of structured procedures can expose these entities to similar — if not greater — risks than public companies face, particularly when management and boards approach investigative inquiries without the benefit of well-established public company protections and oversight mechanisms.
Key Decision Points in Private Company Investigations
When should an investigation rise to board level? Board involvement becomes essential in several circumstances. For example, when allegations involve management or raise concerns about the integrity of individuals responsible for certifying or signing financial statements, board oversight is critical. Potential legal violations also demand board attention to ensure appropriate handling and compliance. Additionally, issues affecting the company’s reputation or significant financial matters that could impact financial statements require board engagement to preserve stakeholder confidence and meet regulatory requirements. Routine investigations that do not pertain to management’s integrity can often be handled by the management team itself.
Defining board involvement. When it has been determined that board involvement is needed, the audit committee chair typically leads the investigation. He or she may then choose to engage external legal counsel, forensic accounting firms or both. If the audit committee or independent directors lack investigative experience, establishing a special committee with a nominated board member to oversee the investigation can provide the necessary expertise and independence to ensure that key issues are addressed in both an appropriate and timely manner.
Balancing investigation scope. Determining the appropriate scope of an investigation presents both an initial and ongoing challenge, particularly for private companies with less regulatory oversight. External auditors often provide guidance on scope adequacy. The key principle is to address allegations methodically with a focus on what has been alleged, neither more nor less. A common best practice employed by many boards is to begin with the review of a defined time period — typically one year — and to focus on the specific issues raised in the complaint rather than expanding beyond the original concerns.
Understanding investigation stakeholders. Investigations primarily serve two critical groups: auditors, who require assurance to sign off on financial statements, and shareholders, who depend on accurate financial reporting and corporate governance. Understanding these stakeholders’ needs helps shape the appropriate investigation scope and methodology.
Determining when to engage external advisors. External counsel or forensic accountants become necessary when allegations involve potential legal violations or questions about management integrity. The decision should consider who might later scrutinize the investigation results and what evidence or processes they would expect to see. When engaging outside counsel, attorney-client privilege will protect the confidentiality of communications and work product.
Common Pitfalls in Private Company Investigations
Reputation-based dismissal of allegations. One of the most dangerous mistakes involves dismissing allegations based on personal relationships or reputation. All allegations deserve objective evaluation regardless of the accused party’s reputation . Comments, like “We all know John, the CFO — he would never do such a thing,” or conversely, “Everyone knows Bob was a bad apple,” represent dangerous biases that can undermine the investigation’s credibility.
Inappropriate scope limitation. Private companies frequently limit investigation scope inappropriately, often citing budget constraints or using phrases like “Let’s only look at XYZ subsidiary.” While boards need not “boil the ocean,” investigations must be reasonable in scope and performance. The key is proportionality: Investigations need not be perfect, but they must be adequately scoped to address the allegations properly.
Failing to identify the key stakeholders. Successful investigations require early identification of who will review and rely on the results. Potential audiences include the board, management, compliance officers, employees monitoring the company’s response, regulators, law enforcement and investors. Understanding audience expectations drives appropriate questioning and evidence gathering.
Time pressure and rushed investigations. Private companies often face pressure to expedite investigations with justifications such as “We must deliver audited financials to our lender” or “Private company investigations should be shorter than public company investigations.” This latter assumption is false. Allegations should receive the same thorough treatment regardless of company type.
Independence, objectivity and training. Investigations lose credibility when conducted by individuals within the same group, division or reporting structure as those being investigated . External forensic accounting firms or law firms often become necessary when management is named in complaints. The investigative team and process must withstand scrutiny from identified users of the findings. Various forms of bias can compromise investigation quality. Here are just a few:
• Confirmation bias. Hearing only what supports preconceived notions.
• Misinformation bias. Operating on false assumptions about facts or expected outcomes.
• Halo effect. Believing certain individuals incapable of wrongdoing.
• Economic self-interest. External providers expanding scope unnecessarily for financial gain .
One of the most significant mistakes occurs when management conducts informal inquiries while formal investigations proceed elsewhere in the organization. These “parallel investigations” create multiple problems: They can compromise the formal investigation’s integrity, alert potential wrongdoers and undermine the investigation’s credibility with stakeholders. Finally, it may threaten the company’s legal privileges.
Using untrained investigative teams represents a fundamental error that auditors particularly scrutinize. Auditors must assess the technical proficiency of investigative teams to rely on findings for financial statement purposes. Proper training and experience must match the investigation type and complexity.
Employee Stock Option Plans
ESOPs will have slightly enhanced procedures than a traditional private company, yet still do not have all the requirements of a public company. An ESOP must follow the fiduciary duties imposed by the Employee Retirement Income Security Act (ERISA). The plan’s ESOP trustee, not the audit committee chair, who is the legal owner of the ESOP’s shares, must initiate the process by adhering to the “prudent expert” and “exclusive purpose” rules.
Core ESOP rules for board investigations include:
- The prudent expert rule. Under ERISA, ESOP fiduciaries, including the trustee, are held to the “prudent expert” standard. This standard is a higher bar than that applied to corporate directors, requiring a fiduciary to act with the care, skill and diligence of a person familiar with such matters. For investigations, a prudent fiduciary must conduct a thorough, factual investigation before making a decision. Simply relying on the advice of legal or investment counsel is not sufficient and is sometimes referred to as acting “with a pure heart and an empty head”.
- Documentation. All aspects of the investigation, including the rationale for any decisions, must be clearly and meticulously documented.
- The exclusive purpose rule. This rule requires that ESOP fiduciaries act solely in the financial interest of the plan participants and beneficiaries.
- Conflict of interest. The ESOP trustee and other fiduciaries must avoid conflicts of interest with the company’s management and board.
- If a conflict exists, a trustee must take one of three actions to avoid violating the exclusive purpose rule:
- Resign until the conflict is resolved.
- Appoint independent legal or investment counsel.
- Conduct a scrupulous, intensive investigation of the facts.
The ERISA and state guidelines apply another level of protection for the shareholders, but still not at the level of a public company.
Building Investigation Resilience
Board-directed investigations often give rise to unplanned expenses and organizational disruption. They also often require personnel changes, the implementation of new processes and procedures, and, in some cases, the restructuring of departments or operations. However, companies that successfully navigate these types of investigations emerge stronger, with improved controls and a better understanding of their risk profile.
Public companies operate under established rules and best practices that provide an excellent road map for private companies. By adopting similar protocols — emphasizing independence, appropriate scope, trained personnel and objective evaluation — private companies can manage investigative challenges more effectively while protecting stakeholder interests and maintaining organizational integrity.
The investment in proper investigation protocols pays dividends beyond immediate compliance needs. It builds stakeholder confidence, strengthens internal controls, and demonstrates the organization’s commitment to transparency and accountability — values that serve companies well in both crisis and normal operations.