How Does The SEC Handle Complaints? | Hacker Noon

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Even public companies with a strong code of conduct, an exemplary tone at the top, robust internal controls, and a culture of compliance may face allegations of misconduct that can lead to an investigation by the Division of Enforcement of the US Securities and Exchange Commission (the SEC or the Commission).

A company may learn of an SEC investigation from a phone call to in-house counsel from Division of Enforcement staff notifying the company that the SEC has opened an investigation.

Alternatively, a document preservation notice, voluntary request, or subpoena may arrive without warning. At other times, a public company may learn about the investigation from a third party, such as its auditors, a vendor, or a customer that receives a subpoena or request for information.

Public companies should be prepared to respond to the investigation swiftly and with strategic foresight. The decisions made at the outset are frequently critical, will impact how the investigation unfolds and can shape the investigation’s ultimate outcome. The SEC begins investigations for a variety of reasons.

The Enforcement Staff regularly monitors the financial markets, the internet, company filings, and news stories for information indicating that a violation of the federal securities laws may have occurred. Public company reporting and disclosure has always been an area of focus for the SEC, but in 2013, the SEC announced the formation of the Financial Reporting and Audit Task Force dedicated specifically to detecting fraudulent or improper financial reporting.

As part of that effort, the SEC has made a significant investment in tools and personnel to engage in data analysis to identify potential fraudulent activity. One example of that effort is the Corporate Issuer Risk Assessment Program, also known as CIRA. Public companies should be alert to the existence of putative whistleblowers.

Particularly since the passage of the Dodd-Frank Act — which added strong financial incentives and anti-retaliation protections for putative whistleblowers to the Exchange Act — the staff receives communications from employees, investors, short-sellers, and other members of the public. Section 21F provides for a whistleblower program offering financial incentives for a person to voluntarily provide to the Commission non-public information which results in an enforcement action. Specifically, any resulting enforcement action that results in monetary sanctions in excess of US$1 million makes the whistleblower eligible for an award of between 10–30% of the aggregate monies any US regulator receives. The SEC maintains extensive information about its whistleblower program at https://www.sec.gov/whistleblower.

In addition, Section 21F includes an anti-retaliation provision, which establishes a private cause of action for a whistleblower to sue his or her employer in federal court for any form of harassment the employee’s whistleblowing activity causes. The Commission can also take legal action against retaliating employers. As of the end of Fiscal Year 2017, the SEC had paid more than US$160 million to 46 whistleblowers since whistleblower rules went into effect in August 2011. Even if they are not formal whistleblowers under the processes created pursuant to Dodd-Frank, these putative whistleblowers may bring tips and complaints to the SEC. The SEC maintains an internal database, known as the TCR System, which includes information received through its website, from more traditional sources like phone calls and letters, and from referrals from other agencies. Any such information, regardless of its source, can be grounds for an investigation. The Division does not need probable or reasonable cause to launch an investigation, public companies do not have judicial remedies for challenging the Enforcement staff’s decision to open an investigation, and Enforcement staff has broad discretion in the conduct of an investigation.

SEC investigations are authorized by various federal securities statutes and are governed by the rules provided in 17 C.F.R. § 202.5, Enforcement Activities, the Division’s Enforcement Manual, and other Commission guidance. Investigations may be either formal or informal. In a preliminary inquiry, also known as a Matter Under Inquiry (MUI), or in an informal investigation, the staff does not have the power to subpoena companies or individuals, and relies on the voluntary cooperation of those from whom information is sought. In a formal investigation, the staff obtains a formal order of investigation, authorizing them to issue subpoenas that could require the recipient to produce documents or provide testimony. The formal order is not publicly available, but persons asked to produce documents or testify before the Commission can request it. The Enforcement staff states consistently that SEC investigations are for the purpose of determining whether securities law violations occurred. In correspondence related to the investigation (e.g., document requests and subpoenas), the staff frequently notes that the fact of the investigation should not be “construed as an indication that the Commission or its staff have a negative view of any entity, individual or security” or words to that effect. The existence of an investigation does not mean that the staff will necessarily recommend enforcement action to the Commission. Instead, the investigation means that the staff has identified an issue that it believes warrants investigative resources. The staff can and does close investigations without enforcement action at any stage of the investigation. With limited exceptions, the SEC conducts investigations without publicly disclosing their existence, and generally does not confirm or deny publicly that it is investigating a specific company. That said, the staff may contact other individuals and companies who have relevant information about the matter, and these individuals, like the company itself, do not have a duty to keep the matter confidential. These individuals may discuss the investigation with others, including the press. If an investigation results in an enforcement action, however, the SEC will make the matter public. The SEC will publicly file pleadings and orders related to the enforcement action and, generally, the SEC will publicize the enforcement action with press releases and litigation filings published directly on the SEC’s website. These press releases and filings could receive substantial media coverage. The duration of an SEC investigation can be difficult to predict. Typical investigations related to financial disclosures (to the extent such generalizations can be made) frequently take at least one year and often take two or more years. Investigations lasting five years or even longer are not unheard of. A company can attempt to expedite this timeline by responding to investigation demands promptly and proactively, as well as by crafting a strategy involving internal fact-gathering and legal argument to respond to the staff’s concerns.

Numerous federal statutes may be at issue in an SEC investigation. The principle federal securities statutes likely to be involved in an investigation involving public company accounting and disclosures are discussed below:

  • The Anti-Fraud Provisions
  • Reporting, Books and Records, and Internal Controls

When a company learns of a potential SEC investigation, the company should consider retaining outside counsel with experience in SEC investigations. A company faces a multitude of complex issues and strategic decisions, and outside counsel’s experience in dealing with the Enforcement staff is important. A company should consider several strategic factors when determining whether and when to disclose publicly an SEC investigation. There is no specific line-item disclosure requirement, meaning a company must assess the materiality of the investigation, underlying conduct, and potential outcomes, before deciding whether a disclosure is required. As a result, a company should carefully analyze the facts and circumstances developed during an investigation, determine how those facts affect the company’s previous disclosures and make materiality assessments. A company may choose to disclose earlier based on a variety of strategic considerations, including whether earlier disclosure will preserve credibility with investors and analysts (and whether that credibility may be harmed by delayed disclosure), the risk of leaks, and whether the SEC may contact customers or other third parties about the investigation. Taking into account these strategic considerations — particularly if a company fully understands the scope of the potential misconduct — it may choose to disclose the existence of an investigation when the Enforcement staff first notifies the company of the investigation. Alternatively, a company may choose not to publicly disclose an SEC investigation until disclosure is required pursuant to a specific requirement (such as Regulation S-K), or the company learns that the staff has decided to recommend that the Commission authorize an enforcement action against the company or its officers. In any event, a company under investigation must not falsely deny the existence of an SEC investigation. However, a company may wish to consider a policy of not commenting on the existence of a SEC investigation. Of course, the disclosure of an investigation (as well as any evidence of possible misconduct or other negative facts) likely will result in adverse publicity and possible private litigation, such as shareholder class actions or derivative actions. Therefore, a company should instruct all employees who deal with the media about how to respond to questions from the press, analysts, and shareholders about a disclosed investigation. Any communications related to the investigation should take into account public relations considerations; concerns about releasing inaccurate or misleading statements; waivers of privilege; and Regulation Fair Disclosure (Reg FD). A company and its counsel should also consider whether the company should inform third parties of the investigation, including, for example, insurance carriers, lenders, customers, and other business partners.

During an investigation, the SEC often gathers information through document requests. At the beginning of any investigation, the company should take proactive steps to preserve relevant documents, which may include paper records, electronic files, and other materials. These steps should include the suspension of document destruction routines or procedures. Improper document destruction or alteration — even if inadvertent — is always a serious matter and can carry significant penalties, including fines and prison sentences. Document collection, processing, and review can be both time-consuming and expensive. Moreover, SEC document requests and subpoenas are often very broad and have unrealistic deadlines. As a result, the Enforcement staff is usually receptive to negotiating both the scope and timing of document productions. Through these negotiations, counsel may be able to extend the amount of time given for a production, limit the date range or subject matter for document requests, or even eliminate certain requests altogether. The staff may also agree to accept production of documents on a rolling basis. Also, in the event of production delays, counsel should contact the staff immediately with a status update to assure them of a client’s continued cooperation. If the SEC requests or subpoenas witness testimony, counsel will need to prepare witnesses to testify accurately and effectively.

Witnesses have a right to be accompanied by counsel during testimony, and only counsel who represents the witness can attend investigative testimony. Witness preparation requires time and an understanding of key documents about which the SEC may ask a witness to testify. The Fifth Amendment privilege against self-incrimination is available to individuals throughout an SEC investigation and civil enforcement action. Whether an individual asserts the privilege will be the decision of the individual with advice from her or his counsel, but this can have significant ramifications for the company in both the SEC investigation and in related civil litigation — particularly if a senior executive makes the assertion. Since 2001, when the SEC released its Seaboard Report outlining considerations for the SEC in evaluating whether a public company would receive credit in the form of reduced charges or sanctions for “self-policing, self-reporting, remediation and cooperation,” the SEC has emphasized the importance of a public company’s cooperation in an SEC investigation. The SEC website highlights the Enforcement Cooperation Program and the benefits of cooperation. Depending on the level of cooperation, the benefits may be significant. The SEC has been willing to agree to cease-and-desist orders, deferred prosecution agreements, non-prosecution agreements, and even “full passes” if the respondent substantially cooperated with the investigation. In most instances though, to the extent the Commission rewards cooperation, it is through the reduction of charges, penalties, or other sanctions which the staff would otherwise have pursued. Whether — and how — to cooperate is a judgment each company must make. The Seaboard Report includes the following questions, among others, relating to these considerations:

  • How did the company cooperate with the staff’s investigation?
  • What compliance procedures were in place to prevent the misconduct now uncovered?
  • How was the misconduct detected and who uncovered it? Did the company report the misconduct to the SEC, or did the SEC know about the problem before hearing from the company?
  • What steps did the company take upon learning of the misconduct?
  • What assurances are there that the conduct is unlikely to recur?

In the Seaboard Report, the Commission identified voluntary disclosure of investigative findings as a factor to consider in determining a company’s cooperation credit, but acknowledged that public companies need not waive the attorney-client privilege, work-product protection, or other privileges in order to receive credit. Deciding to share privileged materials with the SEC is a significant decision with serious potential consequences. Voluntary disclosure to an independent third party that lacks a common legal interest generally waives the attorney-client privilege, even if the third party agrees not to disclose the communications to anyone else. Most courts have held that a company’s disclosure of privileged materials to the SEC waives the attorney-client privilege. And if the attorney-client privilege is waived to the SEC, that waiver would generally include a waiver as to other third parties, including potential civil litigants or the Department of Justice (DOJ). A waiver with respect to specific documents or information would also likely extend to all other communications related to the same subject matter as the disclosed communications. When the SEC is investigating, keeping the company’s independent auditors in the dark is almost never advisable. In an SEC accounting investigation, the independent auditors will be concerned about a number of issues, including the accuracy of the company’s financial statements (and whether a restatement may be necessary), whether they can continue to rely on representations received from management, and whether their prior audits may become a subject of the investigation. Indeed, to the extent the SEC’s investigation is accounting related, the independent auditors likely will receive a request for documents and possibly investigative testimony. Keeping the auditors informed and up-to-date will help facilitate the investigation and ensure, to the extent practicable, that the company is able to continue to issue audited financial statements. To the extent, a company is also conducting an internal investigation, auditors often make substantive suggestions regarding the scope of document collection, search terms, investigative interviews, and fact-finding. In an investigation, independent auditors may also request:

  • Details of the document collection and data processing
  • Search terms for identifying relevant documents
  • Interview lists
  • Key documents
  • Detailed briefing on facts from the document review and investigative interviews a company has conducted
  • In certain cases, to conduct their own interviews

A company can minimize the risk of delay in the investigation by finding a way to provide such information to the company’s independent auditors to ensure their comfort with the investigation process while being mindful of the privilege and workproduct risks.

When a company learns of potentially problematic conduct, the company should take immediate steps to ensure that no improper or illegal conduct is ongoing and to remedy any mistakes in financial statements. The SEC considers appropriate remediation to be a key element of cooperation, and prompt and meaningful remediation can impact both whether there is an enforcement action and the scope of the sanctions. Any remediation plan should be robust and demonstrate to the SEC the company’s desire to fix any problems that occurred. Remediation can include personnel actions, and often does if there has been some wrongdoing. Remediation may also include management’s assessment of any internal control deficiencies, and management’s and the board’s plans to remedy any deficiencies to prevent the issues from repeating. Favorable resolutions come in many forms. Closing an investigation quickly without any charges, and with minimal disruption to a company’s business, is the most desirable outcome — and that does occur. Even if an investigation is extended, an SEC staff decision to close the investigation without action is still a good outcome. Defending and cooperating with an SEC investigation is costly, and leaving an investigation unresolved prolongs uncertainty in the capital markets, — which is especially costly for a company that issues securities. A lengthy investigation can also cause broader reputational harm. If a company believes that a response to a Wells notice will not be persuasive or that an enforcement action is inevitable, the company should consider an attempt to resolve the SEC matter as quickly as possible, assuming a reasonable settlement can be reached. Even if a company seeks to settle, the staff might refuse to enter into serious settlement negotiations prior to investigating the conduct of senior officers or potentially implicated board members, because determining the level of individuals’ culpability may impact the level of a company’s culpability.

Public companies often opt to settle rather than litigate SEC cases involving allegations that the company misstated their financial condition for a number of reasons beyond the costs of litigation, including:

  • Adverse findings in litigated proceedings are generally binding in private shareholder litigation.
  • The SEC permits parties to settle without admitting the Commission’s allegations or findings of wrongdoing (so long as the parties also do not deny the allegations or findings), although, as discussed below, in some instances the SEC may insist on an admission.
  • Settling parties can often influence the way the SEC describes the alleged misconduct. In cases of good cooperation and remediation, settling parties can sometimes arrange for positive mention in the Commission’s public releases of a company’s cooperation with the SEC’s investigation and of remedial measures a company has undertaken. By contrast, individuals tend to have a different calculus and litigate more frequently against the SEC.

Types of Enforcement Actions possible:

  • Civil Injunctive Action
  • Administrative proceedings before the SEC’s own administrative law judges
  • Parallel Criminal Investigations
  • Monetary Sanctions

Generally, the securities laws set forth two alternative methods for calculating the maximum penalty. The first method, which is applicable in both administrative and civil actions, permits a “per violation” calculation, the amount of which increases by tier based on the seriousness of the violation. The second method, which is applicable only in civil actions, allows for the imposition of a penalty equal to the “gross amount of pecuniary gain” to the defendant as a result of the violation(s). The penalty amounts available still permit the SEC significant flexibility in tailoring a sanction. First, the SEC can usually find as many violations as it needs to — for example, the SEC can charge each allegedly misstated entry in the books and records of a company as a separate violation. Second, if there is a sufficiently large pecuniary gain, the per violation amounts become

irrelevant in civil actions. The statutes are not particularly limiting in practice, and the SEC is often subject to public clamor and pressure to impose high penalties for violations of federal securities laws. Historically, in SEC settlements, parties would neither admit nor deny the Commission’s allegations, findings, or conclusions. In recent years, however, the SEC has twice amended its longstanding policy permitting a company to settle without admitting or denying the allegations in the complaint. First, in early 2012, the SEC announced that it would eliminate the “neither admit nor deny” language in cases where there had already been admissions or adjudications of fact in criminal cases. Thus, in cases involving a parallel criminal conviction, or a non-prosecution or deferred-prosecution agreement including admissions or acknowledgement of criminal conduct, the SEC will delete the standard neither admit nor deny language from the settlement documents, and recite the fact and nature of the criminal conviction or non-prosecution or deferred prosecution agreement in the settlement documents. This policy change would not require admissions beyond those already included in the criminal proceedings, and thus should not have independent effect in other litigation.

SEC resolutions can trigger a variety of collateral consequences. Each case is unique and the nature and extent of any collateral consequences will depend on the particular facts and resolution. Some of the potential collateral consequences public companies may face are set forth below:

  • Impact on Other Litigation
  • Public Company Disclosure Obligations
  • Ineligibility to File Automatic Shelf Registration Statements
  • Disqualification From Certain Offerings
  • Loss of Safe Harbor for Forward Looking Statements

As noted above, historically, public companies settling with the SEC were able to resolve matters without admitting or denying the Commission’s allegations, findings, or conclusions. In addition, in a settled enforcement action, there is no adjudication on the merits of the Commission’s allegations. Accordingly, SEC settlements without any admission have no preclusive effect — meaning the fact of a settlement does not preclude litigating the underlying facts in another proceeding like a securities class action. Some recent cases, however, have explored whether any part of the settlement is admissible in subsequent litigation. To the extent a company is required to make an admission to settle with the SEC, however, that admission would be admissible and could have a preclusive effect in other litigation. This means that the company would be unable to argue a contrary position, thereby affecting the ability to prevail and the settlement value of any other litigation. SEC investigations can be complex, costly, and time-consuming. But understanding the process and pitfalls can help public company executives and in-house counsel navigate the process while avoiding unnecessary distraction from business operations. Understanding the process, risks, and strategic issues a company will face can help avoid missteps and move the investigation toward resolution as quickly as possible with the least disruption to the company, its executives, and employees.

Sergey Golubev (Сергей Голубев)

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