Why did the SEC begin this investigation?
There are many reasons why the SEC Staff
might begin an investigation.
The SEC Staff conducts surveillance activities
with respect to the stock market and the Internet and reviews
news stories in the media. The Staff obtains referrals from
other divisions, other government agencies, and from self-regulatory
organizations such as the National Association of Securities
Dealers, Inc. and the New York Stock Exchange .
They also receive communications from
disappointed investors, disgruntled employees, and short sellers.
It usually is more important to identify and address the Staff's
substantive concerns than to worry about the source of the
concerns.
What should
a company do if the SEC Enforcement Staff telephones management
and asks questions?
The company should listen to the Staff's
questions and promise to cooperate.
In this circumstance, it is important
to learn what the Staff's concerns are and communicate that
the company will be responsive. The company should promptly
collect the information the Staff requested. However, before
providing the requested information, the company should carefully
test its accuracy by interviewing individuals with relevant
knowledge and reviewing relevant documents.
What type
of SEC investigation is this?
Broadly speaking, the SEC conducts two
types of investigations. In informal investigations, the SEC
Staff does not have the power to subpoena person to produce
documents or provide testimony and relies primarily on voluntary
cooperation of witnesses. In formal investigations, the Commissioners
have issued an order, known as a "Formal Order,"
authorizing the SEC Staff to issue subpoenas requiring the
production of documents and the provision of testimony. Once
the Commission has issued a Formal Order, the Staff does not
need to obtain further authorization from the Commission before
issuing subpoenas.
It is not difficult for the Staff to obtain
a Formal Order from the Commissioners. The Formal Orders are
not available to the general public. However, any person asked
to testify before the Commission or to produce documents to
the Commission can request and obtain a copy of the Formal
Order from the SEC. This Formal Order will generally provide
limited information regarding the direction of the SEC investigation.
Both informal investigations and formal
investigations can adversely impact a company and its officers.
Both should be taken seriously.
Are we a target
of the SEC investigation?
Unlike the Department of Justice, the SEC does
not identify its targets and subjects. Accordingly, the Staff
will not formally disclose to a company whether it is a target
of the SEC investigation. Historically, it was often possible
to assess the direction of the SEC investigation based on
the Formal Order (if any), the circumstances surrounding the
investigation, the caption on correspondence from the SEC,
the nature of the questions posed by the SEC, and conversations
with the SEC Staff. For example, if the investigation was
directed at the financial statements of a public company,
only the public company, its personnel, and its auditors were
likely to have much exposure. In recent years, however, the
SEC has demonstrated an increased interest in bringing enforcement
actions against third parties (both companies and individuals)
who assist public companies in issuing misleading financial
statements.
Does the existence of the investigation mean that the SEC
Staff expects the Commission to bring an enforcement proceeding?
The fact that the SEC Staff is conducting
an investigation does not mean that the SEC Staff expects
to recommend an enforcement action; it simply means that the
Staff has identified an issue that, in its opinion, warrants
investigation. The SEC closes many investigations without
any enforcement action.
What type of
team should the company consider assembling in response to
the SEC investigation?
The company should consider assembling
a multi-disciplinary team consisting of its general counsel,
the chief financial officer, the chief accounting officer,
public relations advisers, outside counsel representing the
company in the SEC investigation, an accounting expert retained
by outside counsel, a securities law disclosure adviser, and
the officer responsible for investor relations. (If the public
relations advisers are outside professionals, care should
be taken to preserve the attorney-client and work product
privileges.) The company should consider assigning to one
person responsibility for coordinating the efforts of the
team.
In addition, the audit committee should
consider retaining separate outside counsel to assist the
committee in meeting its obligations. This counsel would gather
information on behalf of the committee and advise the committee.
We have
done nothing wrong and believe there is no probable cause.
Can we challenge the Formal Order?
In general, the issuance of a Formal
Order is not subject to judicial view.
The Commission does not need "probable"
or even "reasonable" cause to suspect a violation
of the federal securities laws in order to conduct an investigation.
It is rarely possible to halt an investigation on the ground
that the SEC has exceeded its statutory powers.
Is the SEC
going to disclose the existence of this investigation to the
public?
The SEC rarely announces the existence
of an investigation (e.g., the September 11 investigation
and the Enron investigation). Usually, the SEC conducts its
investigations on a non-public basis and refuses to confirm
or deny publicly that it is investigating a specific company
or individual. In the course of conducting its investigation,
however, the Staff might contact individuals and companies
who have relevant information, and the persons contacted might
discuss the investigation with others, including the media.
If the investigation results in an enforcement
action, the SEC will make that action public. Securities enforcement
actions often receive substantial press coverage.
Does
the company have to disclose the existence of the SEC investigation
to the investing public?
There is no specific requirement that
an issuer disclose the existence of an SEC investigation.
The question of whether a company is legally
obligated to disclose the existence of an SEC investigation
turns primarily on whether the existence of such an investigation
is material information. This determination depends on a number
of factors including: (1) whether the investigation will materially
affect the company's performance and prospects; (2) the likelihood
that the investigation will result in an enforcement action;
and (3) the impact the potential enforcement action would
likely have on the company.
Historically, many companies did not disclose
the existence of an SEC investigation at least until the Staff
has formally notified the company that the SEC Staff has tentatively
decided to recommend that the Commission authorize an enforcement
action against the company and/or its officers. This notification
is commonly referred to as a "Wells" notice. Companies
hesitate to disclose the investigation earlier than necessary
for several reasons. The announcement of an SEC investigation
likely will generate considerable adverse publicity. This
publicity often causes and attracts the attention of the plaintiffs'
bar (resulting in a shareholders class action or a derivative
action). In addition, some SEC defense lawyers fear that the
disclosure of the SEC investigation might make the SEC more
reluctant to terminate its investigation without an enforcement
action.
It is important, however, that company officials
not falsely deny the existence of an SEC investigation. Accordingly,
senior management should contact the individuals authorized
to deal with the press and media on behalf of the company
and ensure that they do not deny the existence of the SEC
investigation.
Even if the investigation is material, the company
typically is not required to make disclosure unless it is
filing a periodic report or the company is selling securities.
A company might make earlier disclosure if, among other things,
it appears likely that the existence of the investigation
could not be kept confidential.
If the company decides to disclose the existence
of the investigation, counsel should work with company officers
to help prepare them to respond to questions posed by the
media, analysts, and shareholders. The analysts, shareholders,
and the media will press company officials for details. The
company will have to balance competing demands. There will
be a public relations desire to make extensive disclosure,
but there also will be a desire to limit disclosures because
of the potential liabilities if released information proves
arguably inaccurate. There is also a risk that the company
might have to update its response if it turns out that, unbeknownst
to senior management, the initial response was inaccurate
or materially misleading, and the danger that any public disclosure
could waive privileges that might otherwise apply. Company
officials will have to set the company's priorities.
The company should consider consulting
with public relations advisers. All public statements relating
to the investigation should be reviewed by counsel. In addition,
the company should be cognizant of Regulation
FD.
What else
should I brace the company for?
As set forth above, disclosure of an
SEC investigation is likely to trigger an onslaught of questions
from analysts, shareholders, customers, suppliers, creditors
and the media, and the company should carefully prepare a
response to all these inquiries.
In addition, SEC investigations often result
in restatements. Given the pressure that the Enforcement Division
asserts on companies and their auditors, even companies that
firmly believe in the accuracy of their financial statements
often end up restating them. Accordingly, you should prepare
your company for the possibility that it will ultimately restate
its financial statements.
An SEC investigation can cause a liquidity crisis.
For example, a restatement or failure to obtain a timely SAS
71 or audit report might result in a violation of a debt covenant.
Even if the investigation does not result in a violation of
a debt covenant, the uncertainty associated with an SEC investigation
could impair the company’s ability to raise or borrow
capital, lead a rating agency to downgrade your company's
credit rating, or prompt vendors to tighten their credit terms.
Thus, you should consider whether to begin preparing your
company for a possible liquidity crisis.
Should we retain outside counsel to
assist us in this matter?
Companies often hire outside counsel to assist
in responding to SEC investigations. The company should consult
outside counsel immediately if it appears that the company
is a target of the investigation, particularly if the investigation
might involve the company's disclosures or other conduct.
Even if the investigation does not appear to be focused on
the company, it is often prudent to consult with outside counsel
experienced in dealing with SEC investigations.
A number of law firms have substantial experience
representing companies and their employees in SEC investigations.
These law firms offer a number of advantages. They are alert
to the issues that are of interest to the SEC and are experienced
in quickly gathering information in response to an SEC investigation.
They know SEC procedures and are sensitive to the important
respects in which responding to an SEC investigation differs
from litigation. They have experience with issues that recur
in defending SEC investigations. They are experienced in dealing
with the SEC Staff. They can assist management in developing
the strategy that best fits the circumstances.
Should management notify the Board of Directors regarding
the SEC investigation?
In general, management should notify
the Board of Directors if it appears likely that the company
or a senior officer is a target of the investigation or the
company otherwise has significant potential exposure.
Should the company refrain from taking
remedial action for fear that it will be construed as an admission
of wrongdoing?
In general, the company should take remedial
action if such steps are appropriate in light of the circumstances.
Commencing remedial action addresses the obligations of the
Board and senior management to shareholders. In addition,
remedial action enables the Board and senior management to
demonstrate to the public and to the SEC that the company
takes seriously the matter under investigation and that even
if the company arguably engaged in violative conduct in the
past, there is little likelihood of future violations. Moreover,
to the extent that prior disclosures were materially false
or misleading when made, books and records were inaccurate,
or internal controls were deficient, failure to take corrective
action could expose the company, senior management, and the
Board to further liability.
Accordingly, throughout an investigation, the company should
periodically consider whether remedial action is appropriate.
At the onset of the investigation, the company should consider
implementing increased oversight or restrictions on certain
activities or personnel until additional information has been
gathered and reviewed. The Audit Committee should consider
an internal investigation or a special review of the company's
internal controls and books and records. Senior management
and the Board should consider whether prior disclosures should
be corrected or supplemented, whether internal controls and
training should be enhanced, whether books and records should
be corrected or supplemented, and whether personnel should
be disciplined and/or reassigned.
Our CEO is well-connected to an influential senator. Should
he contact the senator and seek relief?
Such contacts are usually counterproductive.
In the current environment, political figures are reluctant
to interfere with law enforcement investigations. In addition,
the SEC Staff is proud of its political independence and would
likely redouble its efforts in response to any political pressure.
Should the company notify the auditor?
In almost all circumstances, promptly
upon learning that it is the subject of an SEC investigation,
the company should notify its auditor. The information could
be relevant to the auditor in connection with an ongoing or
upcoming audit of annual financial statements or review of
quarterly financial statements. The assistance of the auditors
is often crucial to developing an informed response to the
SEC investigation. In addition, failure to inform the auditors
can adversely impact the company's relationship with the auditors
and could be viewed as a violation of law or as evidence of
fraudulent intent.
The company should, however, be prepared for
the auditor to take strong action upon learning of an SEC
investigation. The auditor is likely to be concerned that
it is a potential target of the SEC investigation, and the
national office of the auditor is likely either to review
the audit workpapers or have them reviewed by respected auditors
not previously associated with the audit. If the national
office decides that the financial statements are materially
misstated, the auditor will likely withdraw its opinion, with
serious consequences for the company's stock price, stock
listing, and liquidity. The auditor might view the SEC investigation
and the associated facts as triggering obligations under Section
10A of the Exchange Act. If the SEC investigation involves
issues that implicate the company's current financial statements,
the auditor is likely to be skittish about completing quarterly
reviews and annual audits.
Which employees should be notified of an SEC investigation?
Even if the company decides not to disclose
the investigation publicly, the company should notify employees
who interact with analysts and the media so that they do not
inadvertently deny the existence of the investigation.
The company should consider also notifying company employees
who are potential witnesses and might therefore be contacted
by government investigators. Because the company does not
want to be accused of obstructing justice, the company should
refrain from instructing employees not to talk to government
investigators. The company may, however, inform these employees
that they are not obligated to talk to government investigators
and have a right to consult with counsel. Unless and until
the company announces the existence of the SEC investigation,
all employees notified of the existence of the investigation
should be told to keep that information confidential.
Should the company notify anyone else of the investigation?
While the SEC does not publicly disclose the
existence of investigations, in the course of an investigation,
the Staff might contact the company's customers or other persons
who do business with the company. Such contacts can have an
adverse impact on the company's business relationships. If
it appears likely that the SEC Staff will contact customers
or other persons who do business with the company, the company
should consider taking proactive steps to mitigate the impact
of these contacts.
The cost of defending an SEC investigation
often is not covered by insurance unless that defense assists
in the defense of a claim that is covered by insurance. Nevertheless,
an SEC investigation might constitute a circumstance giving
rise to a claim. Accordingly, the company should consider
providing prompt notice to the appropriate insurance carrier(s).
When might the SEC contact the company's
independent auditors?
The Staff could contact the company's auditors
at any time and without prior notice to the company.
If the investigation involves the company's
financial statements, the SEC likely will request that the
auditors produce workpapers and other materials. If the SEC
investigation is informal, the ethical rules governing auditors
call upon them to obtain the consent of the company before
voluntarily producing workpapers to the SEC. Companies ordinarily
provide such consent, in part because the Staff is virtually
certain to obtain a Formal Order if the auditor does not voluntarily
produce the workpapers.
Will the pendency of the SEC enforcement action prevent the
company from proceeding with the sale of securities to the
public?
The SEC Division of Corporation Finance may
permit a registration statement to go effective even though
the Enforcement Division is conducting an investigation. Before
taking affirmative action (such as accelerating the effective
date of a registration statement) the Division of Corporation
Finance will ask a company to provide a so-called Tandy letter.
In the Tandy letter, a company will represent that
- the disclosure in the filing is the company's
responsibility;
- the SEC's action (declaring a registration
statement effective) does not relieve the company from its
responsibility for the disclosure in the filing; and
- if the SEC takes action, the company
will not assert this action as a defense in any proceeding
initiated by the SEC or any person under the federal securities
laws.
If, however, the SEC believes that the registration
statement is materially misleading, the Commission can institute
administrative proceedings to issue a stop order suspending
the effectiveness of the registration statement.
Companies should hesitate to proceed with
a securities offering in the midst of an SEC investigation
regarding the company's accounting or other disclosures. If
the investigation results in an enforcement action or restatement,
there will likely be litigation pursuant to Sections
11 and 23
of the Securities Act if the price of the securities declined
compared to the offering price. In addition, as a practical
matter, underwriters sometimes hesitate to proceed with a
public offering if the Enforcement Division is actively conducting
an investigation.
How long does an SEC investigation typically last?
An SEC investigation can take less than two
months or two or more years.
An SEC investigation that results in an enforcement
action involving financial disclosures typically takes at
least one year and often two or more years. However, the Commission
has recently emphasized the importance of "real time"
enforcement. Accordingly, it is possible that the average
duration of an investigation will become shorter. In addition,
a company might be able to expedite the resolution of an SEC
investigation by responding proactively.
How does an SEC investigation typically proceed?
The SEC gathers information primarily by obtaining
and reviewing documents and questioning witnesses. Counsel
can supplement the information the Staff obtains from these
sources with other information that defuses the Staff's concerns
and places troubling evidence in context or assists the Staff
in conducting the investigation more efficiently.
The Staff sometimes issues document requests
that are extremely broad and have unrealistic deadlines. Accordingly,
the Staff is usually receptive to efforts to negotiate the
scope and timing of the production. The Staff will often agree
to extend deadlines or to accept a rolling production as the
company locates and reviews documents. The Staff is less likely
to be receptive if the company waits until after the deadline
to seek an extension.
The process of collecting, reviewing and producing
documents is inherently time-consuming. The company and counsel
should strive to produce documents in a timely fashion. Counsel
should keep the Staff informed regarding the status and expected
timing of the production.
Great care should be taken to search thoroughly
for responsive documents. The credibility of the company can
be impaired if subsequent discovery reveals that the company
did not timely produce significant responsive documents.
The testimony of key witnesses is among the
most crucial events in an SEC investigation. In order to prepare
a witness properly, counsel should attempt to learn about
the events underlying the investigation and the Staff’s
concerns and should become familiar with the relevant documents.
In preparing a witness, counsel helps a witness to testify
accurately and effectively. The Staff sometimes asks questions
that are confusing or that address facts out of context. Counsel
teaches the witness how to handle such questions. In complex
matters, the preparation of a witness often requires several
sessions.
Under the SEC rules, a witness has the
right to be accompanied by counsel during testimony. The role
of counsel during testimony is largely to assist the witness
in testifying accurately and to defuse potentially tense situations.
Counsel also asks questions that clarify testimony, place
purportedly harmful facts into an exculpatory context, and
present exculpatory information to the Staff. During breaks,
counsel confers with the witness and the Staff. In general,
counsel experienced in defending SEC investigations will tend
to be less aggressive during testimony than litigators are
during depositions.
The SEC sometimes asks companies to provide
information in response to questions that resemble interrogatories.
Historically, SEC requests for information were largely limited
to chronologies. Recently, the SEC began promulgating questions
pursuant to Section
21(a) of the Exchange Act , which authorizes the Commission
to require “any person to file with it a statement in
writing, under oath or otherwise as the Commission shall determine,
as to all the facts and circumstances concerning the matter
to be investigated.” Although it is not clear that this
provision authorizes the Commission to require a person to
answer detailed interrogatories as part of an investigation,
companies have been reluctant to challenge the Commission’s
authority.
In addition, the Staff sometimes asks
a company to respond to detailed questions on a voluntary
basis. Although it is clear that the Staff does not have the
power to compel answers to such questions, companies often
want to demonstrate cooperation and therefore voluntarily
provide answers.
What is
a Wells Call?
The Staff does not have authority to institute
an enforcement proceeding. If the Staff tentatively decides
to recommend that the Commissioners authorize the institution
of an enforcement proceeding, the Staff usually will notify
counsel to the prospective defendant. This notification is
referred to as a "Wells Call."
Upon receiving a Wells Call, counsel should
meet with the Staff to learn the basis for the Staff's tentative
decision. Counsel can then prepare a document, referred to
as a "Wells Submission," to persuade the Staff not
to recommend the action or to recommend a less severe action.
In addition, counsel can meet with the Staff and attempt to
dissuade the Staff from proceeding with the proposed recommendation.
If the Staff decides to proceed with the
recommendation, the Staff submits to the Commission a memorandum
setting forth its recommendation and the basis for its recommendation.
Defense counsel does not have an opportunity to see this recommendation
memorandum. At a meeting that is open to the Staff but closed
to the public (including the proposed defendants and their
counsel), the Commission decides whether to authorize the
institution of the enforcement action based on the recommendation
of the Enforcement Staff, the Wells Submissions filed by proposed
defendants, and input from other interested Divisions (e.g.,
the Office of the Chief Accountant, the Division of Corporation
Finance, and the Office of General Counsel).
The investigation appears to be focused on insider trading,
and not on the timeliness or accuracy of the company's disclosure.
What exposure does the company have?
The company has little direct exposure
as long as the investigation remains focused on insider trading
and the company had previously instituted and maintained a
reasonable set of procedures to address the danger of insider
trading. The investigation could, however, extend to encompass
the timeliness and accuracy of disclosures.
How does the SEC investigate suspected
insider trading?
Investigations into possible insider
trading are launched in a number of ways.
Often, an investigation will be triggered
when the SEC, NASD or NYSE identifies market activity that
is suspicious in light of subsequent events (e.g., the price
of a company's stock increases dramatically in advance of
a positive announcement). The investigators (sometimes at
the SEC, sometimes at the NASD or NYSE) will then ask each
relevant company for a chronology of events leading to the
announcement and a list of individuals (both company personnel
and others) who knew the critical information before it was
announced. The investigators will also ask broker dealers
to identify the customers who made timely trades in the securities.
Often, the investigators will ask if anyone with advance knowledge
of the critical information knows any of the individuals who
made timely trades. The SEC will then proceed by questioning
witnesses (sometimes through telephone interviews, sometimes
by taking testimony) and obtaining documents (including telephone
and bank records). The SEC looks for circumstances that indicate
that a trade was suspicious, evidence linking the trader to
persons with advance knowledge, and evidence linking an individual
who made timely trades to other individuals who made timely
trades. In trades involving foreign accounts the SEC often
will seek a court order freezing funds.
Do many SEC actions result in settlements?
Most enforcement actions are settled before
they are filed.
Notwithstanding SEC rules suggesting that the
Staff can negotiate settlements only if the Commission has
authorized such negotiations, if the target initiates settlement
discussions earlier, the Staff often will respond. Settlements
are sometimes negotiated before or during the Wells process.
Sometimes, the proposed defendant does not negotiate a settlement
until the Commission has authorized the action. All settlements
must be approved by the Commissioners.
Counsel should negotiate the remedy (e.g.,
cease-and-desist order v. injunction), the language of the
charging document, the amount of any disgorgement or penalty,
and (if appropriate) exemptions from certain collateral consequences
of the settlement. In almost all cases, the settlement documents
will specify that the defendant neither admits nor denies
the substantive allegations in the complaint. The SEC does,
however, take the position that the findings in an SEC settlement
are binding on the settling defendant/respondent in the event
the SEC brings another enforcement action against the settling
defendant/respondent in connection with another matter. See
In re Marshall E. Melton, IA Release No. 2151 (July 25, 2003).
What defense strategy should the company adopt?
The development of a defense strategy requires
delicate judgments based on numerous factors. A protracted
SEC investigation is costly and disruptive. Accordingly, there
are a number of proactive measures that a company should consider
taking in response to an SEC investigation.
At the onset of the investigation, the company
should take steps to preserve relevant documents, including
computer documents. These steps should include suspension
of document destruction routines.
Counsel often arranges to meet with the Staff
early in the investigation. Through these meetings and subsequent
communications, counsel can attempt to gain a better understanding
regarding the Staff's view of the case and to provide information
that might help defuse those concerns or put troubling evidence
into context.
It sometimes is in a company's interest to respond
to an SEC investigation by instituting an internal investigation,
asking the Staff to defer its investigation pending the completion
of the internal investigation, and promising to provide to
the Staff the results of the investigation. There can be a
number of benefits to this approach, especially if the company
is prepared to take strong remedial measures. An internal
investigation can expedite the resolution of the SEC investigation.
This is beneficial to the company both because shorter SEC
investigations are, in general, less disruptive and less costly
than long internal investigations and because the Staff is
more likely to close a matter without recommending an enforcement
action if the Staff has only invested limited time and resources
in the investigation.
In structuring an internal investigation, consideration
should be given to the
SEC Standards of Professional Conduct for attorneys who
appear and practice before the Commission. If the internal
investigation is being conducted in response to a report made
under the SEC Standards or if the attorneys conducting the
internal investigation provide securities law advice regarding
an SEC filing, then the attorneys conducting the investigation
are “appearing and practicing before the Commission”
and may have up-the-ladder reporting obligations under unless
the engagement is structured to avoid those obligations. Moreover,
if information uncovered by the internal investigation constitutes
“evidence of a material violation” within the
meaning of the SEC Standards, then the reporting of that information
to attorneys who appear and practice before the Commission
in the representation of an issuer could trigger reporting
obligations for them.
The SEC sometimes gives credit for cooperation.
The fact that the company undertook the internal investigation
and provided the results to the SEC is a factor that the Commission
and the Staff will consider in determining what remedy, if
any, to impose. Indeed, under the Commission's Rule 21(a)
report regarding Seaboard
Corporation , such extraordinary cooperation, in conjunction
with other factors such as the remedial measures taken and
the size of the loss to the investing public, might cause
the Commission to refrain from an enforcement action against
the company. More likely, the Commission will simply bring
an enforcement action that arguably is less onerous than the
action the Commission might otherwise have brought. For example,
the Commission might bring a cease-and-desist proceeding instead
of an injunctive action and might include exculpatory language
in the order.
The courts have not agreed on a standard for
determining the extent, if any, to which disclosure of privileged
information to the SEC should waive the protection of attorney-client
privilege and the work product doctrine. In considering the
extent and nature of cooperation that it is appropriate for
a company to provide to the Commission, counsel should consider
the resulting uncertainty and the implications that a general
waiver may have.
More often, the company and its counsel will
make presentations addressing specific topics, such as the
company's system of internal controls, the lack of materiality
of the disclosure at issue, the accounting principles at issue,
how that particular industry operates, and remedial measures
taken by the company. In addition, the company and its counsel
can attempt to assist the Staff in efficiently locating the
sources of the information the Staff desires. For example,
if the Staff is interested in learning how and when certain
software was designed and written, the company might identify
the witnesses who could provide the most information on that
topic or offer to provide a chronology on that topic.
The vast majority of SEC enforcement actions
are settled simultaneously with being filed. Often, company
counsel will attempt to negotiate a settlement upon receiving
a Wells Call. Sometimes, company counsel
will wait to see if the Commission has authorized an enforcement
action before attempting to negotiate a settlement. Deciding
when to initiate settlement discussions is a matter of delicate
judgment. In appropriate circumstances, the company can consider
making an early settlement proposal. The Staff will often
be reluctant to accept an early settlement proposal without
at least conducting confirmatory discovery. An early settlement
proposal might, nevertheless, prompt the Staff to focus and
therefore expedite the resolution of the investigation, at
least as to the company and the company personnel, if any,
who are participating in the offer. Even after the settlement
has been accepted, the investigation might continue in order
to develop evidence with respect to the auditors or other
potential defendants who are not covered by the settlement
offer.
Does
the representation of a public company in an SEC investigation
qualify as appearing and practicing before the Commission
for the purpose of the SEC Standards of Professional Conduct?
Yes. The SEC
Standards define “appearing and practicing before
the Commission” to include “[r]presenting an
issuer in a Commission administrative proceeding or in connection
with any Commission investigation, inquiry, information request,
or subpoena.” The SEC Standards provide, however, that
an attorney shall not have any obligation to report evidence
of a material violation if the attorney was retained or directed
by the chief legal officer (or the equivalent thereof) to
assert, consistent with his or her professional obligations,
a colorable defense on behalf of the issuer in any investigation
or judicial or administrative proceeding relating to such
evidence of a material violation, and the chief legal officer
(or the equivalent thereof) provides reasonable and timely
reports on the progress and outcome of such proceeding to
the issuer's board of directors, or a qualified legal compliance
committee, or another committee of independent directors.
Can the law firm representing the
company also defend the testimonies of each of the company
employees called to testify in the investigation?
The Staff will usually not permit company counsel
to attend the testimony of a company employee unless the company
counsel also represents the individual employee.
There are often substantial benefits to the
company and the individual employees if company counsel can
represent both. Often, company counsel will be able to represent
the company and one or more employees simultaneously if counsel
obtains their informed consent after full disclosure. Ethical
rules may limit the ability of company counsel to represent
individual employees if the interests of the employees are
adverse, or potentially adverse, to the company. In assessing
whether multiple representation is appropriate, counsel should
consider the SEC
Standards of Professional Conduct. It may be difficult
for counsel to simultaneously represent both a company and
an individual if counsel must assess whether (1)whether the
company has made a timely and appropriate response to such
a report or(2) the SEC Standards require counsel to report
to the company’s CLO or CEO evidence of a material violation
by the individual.
When company counsel also represents individual
employees, the company should ensure that the engagement letters
contain appropriate provisions. The letters should address
how the simultaneous representation will work and what will
happen if a conflict arises or counsel otherwise ceases to
represent one of the clients.
Sometimes company counsel will be able to represent
the individual employee if the employee is also represented
by separate counsel. Separate counsel can advise the employee
on those issues where the employee and the company are potentially
adverse and mitigate the adverse consequences of company counsel
later withdrawing from representation of the individual if
a conflict arises.
In situations where the ethical rules appear
to preclude company counsel from simultaneously representing
one or more of the company employees called to testify, the
company can still obtain some of the efficiencies of simultaneous
representation by having the company counsel perform a major
coordinating role. In many circumstances, for example, it
will be appropriate for company counsel to participate in
one or more preparation sessions with the individual employee.
Can the company pay the reasonable
cost of counsel representing company personnel?
The company should review the indemnification
provisions in the company's charter and by-laws and in employment
contracts.
Generally, companies may indemnify corporate
officers who satisfy a specified standard of care. For example,
Delaware corporations may indemnify someone who "acted
in good faith, in a manner he reasonably believed to be in
or not opposed to the best interests of the corporation and,
with respect to a criminal action or proceeding, had no reason
to believe his conduct was unlawful." Some companies
have charters or by-laws that specifically provide for mandatory
advancement of legal fees and expenses. Other companies leave
the advancement of fees and expenses to the discretion of
the Board of Directors. If the company advances fees and expenses
on behalf of an individual, the company usually should obtain
an undertaking from the individual that the funds will be
repaid if it is determined that indemnification was inappropriate.
Although some questions have been raised as to whether such
an indemnification arrangement constitutes an employee loan
prohibited by Section
402 of the Sarbanes-Oxley Act, a memorandum
that 25 law firms prepared on the Section 402 prohibition
sets forth three strong arguments that the prohibition does
not apply to such arrangements.
What type of enforcement action can
the SEC bring?
The SEC has the ability to bring a wide variety
of enforcement actions.
The SEC's fundamental enforcement tool is a
civil action in federal court seeking an injunction against
future violations of certain provisions of the federal securities
laws. The SEC brings these actions against both companies
and individuals.
The SEC can also ask a court to order defendants
to disgorge unjust enrichment and to impose monetary penalties
on defendants. In addition, the SEC has become more aggressive
in seeking to bar individuals from serving as officers or
directors of public companies. Furthermore, with respect to
officers of a corporate issuer, the Commission may seek disgorgement
of bonuses and other employment compensation that arguably
were earned as a result of the misstatement of financials,
as well as any proceeds from stock sales that arguably occurred
as a result of sales at prices that were inflated because
of a misstatement. The Commission has also become more aggressive
in seeking monetary penalties. The Sarbanes-Oxley
Act enhanced the Commission’s authority in all of
these areas.
The SEC can also bring an enforcement proceeding
before an administrative law judge. In such proceedings, the
SEC can seek an order that the respondent cease and desist
from certain violations of the federal securities laws and
take corrective action. With respect to an accountant, a lawyer,
or other professional, the SEC can seek an order limiting
the ability of the professional to practice before the Commission.
If the company is selling securities pursuant to a registration
statement, the SEC can seek an order suspending the effectiveness
of the registration statement. The SEC also has the ability
to obtain orders suspending for ten days trading in the securities
of a public traded company.
An SEC enforcement action often has substantial
collateral consequences for a company, including adverse publicity,
private damage actions by shareholders, loss of certain safe
harbors, and exemptions provided under the federal securities
laws. An enforcement action against an individual can, as
a practical matter, severely impair the ability of an individual
(especially a corporate financial or accounting official,
a lawyer, an auditor, or a securities professional) to earn
a living in his or her chosen profession.
Can the SEC criminally prosecute the company or its officers?
The SEC does not have the power to bring criminal
actions.
The SEC refers appropriate cases to the Department
of Justice or to state and local authorities for prosecution.
The SEC considers a number of factors in deciding
whether to make a criminal referral, including its view on:
(1) the quality of the evidence; (2) whether the witness lied
during testimony, destroyed documents or otherwise obstructed
justice; (3) the perceived egregiousness of the defendant's
conduct; (4) whether the prospective defendant has previously
violated the federal securities laws; and (5) the loss to
the investing public and the profits reaped by the prospective
defendant.
Each year, criminal prosecutors obtain convictions
in matters initially investigated by the SEC. Since the collapse
of Enron, both the Department of Justice and the States have
substantially increased the number and scope of criminal investigations
and prosecutions relating to financial accounting and disclosures.
What can I do to make an SEC investigation less likely?
Most SEC investigations involve revenue recognition.
You should take steps to ensure that: (1) your company's revenue
recognition clearly complies with GAAP; (2) your company has
instituted and maintains a strong system of internal controls
governing the recognition of revenue; (3) your company discloses
business actions that will have the effect of accelerating
into the current period revenue that, under your company's
historic practices, would otherwise likely not have been recognized
until a later period; and (4) your company is not engaging
in swaps that lack a business purpose but result in additional
revenue being reported. You should take measures to confirm
that your company's sales force has not backdated sales contracts,
engaged in bill-and-hold practices or entered into side agreements.
The SEC continues to be very concerned about
"earnings management." Accordingly, your company
should refrain from accounting actions designed to smooth
earning or achieve analyst expectations. To the extent that
accounting actions have such effects they should be disclosed.
For example, if a company's true operating performance is
obscured by a change in estimate (e.g., increasing the depreciable
life of an asset) the SEC will expect the change in estimate
to be disclosed.
The Commission takes the position that even
a de minimis departure from GAAP is material if management
intentionally departed from GAAP in order to manage earnings.
Accordingly, your company should take steps to ensure that
neither its accounting staff nor the accounting staff at the
company's divisions or subsidiaries intentionally departs
from GAAP to manage earnings.
The SEC is also very concerned about "cookie
jar" reserves. Your company should take steps to ensure
that: (1) it does not establish reserves in excess of the
levels permitted by GAAP, and (2) reserves and other estimates
are not manipulated to manage earnings. To the extent a refinement
in the estimation process has an arguable material impact
on your company's financial statements, your company should
consider disclosing that impact.
The SEC increasingly is focusing on quarterly
disclosures, even where the issues were resolved by year-end.
Accordingly, your company should redouble your efforts to
get quarterly financial statements "right."
Perhaps most importantly, you can help establish
a "tone at the top" that communicates to the company
personnel that your company values accurate and full disclosure
and that employees are expected to support those values.
What else can I do to protect my company and myself in the
event that there is an SEC investigation?
You should ensure that your senior finance
and accounting executives and audit committee members understand
that the SEC is showing less and less deference to accounting
judgments made by company accountants and their auditors.
It used to be that the SEC recognized the ambiguities inherent
in GAAP and demonstrated considerable deference to the judgment
of a company and its auditors that a company's accounting
policy was aggressive, but compliant with GAAP. Increasingly,
the SEC is likely to reach its own conclusion and view any
contrary conclusion as a reckless or intentional violation
of GAAP. As one senior SEC official has stated, the Staff
thinks it is a good thing if companies are deterred from adopting
applications of GAAP that, while aggressive, are arguably
compliant with GAAP. Accordingly, the fact that your company
and its auditors have concurred in good faith that a company
accounting policy, while aggressive, is GAAP compliant will
provide only limited protection if the SEC Staff reaches a
contrary conclusion. Indeed, even if the company's financial
statements comply with GAAP, the SEC might take the position
that the company's disclosures, including the CEO and CFO
certifications, are misleading because they do not fairly
present the financial condition and results of the company.
Your company therefore should hesitate to adopt policies that
it recognizes as aggressive.
You should also ensure that company personnel are sensitive
to language used in written materials, especially emails.
People tend to use imprecise and casual language in emails.
Taken out of context, such language can energize an SEC investigation.
Accordingly, you should encourage company personnel to use
temperate, business-like language in emails and other documents.
Should my company document our reasoning
when we make a difficult accounting decision?
Documentation serves two salutary purposes.
First, the documentation process often introduces a degree
of rigor that improves the quality of the decision-making
process. Second, in the event that the SEC initiates an investigation,
the company may be able to defuse the Commission's concerns
if the company can provide documentation prepared at the time
of the decision that details the company's reasoning and demonstrates
the care that went into the decision. Accordingly, such documentation
can greatly reduce the scope and intrusiveness of an SEC investigation.
It is, however, important that the documentation
carefully reflect the best reasoning of the company. The documentation
can make the defense of an SEC investigation more challenging
if the decision is not carefully reasoned. Our experience
is that when accountants document their reasoning, the documentation
often does not accurately reflect the analysis that took place.
This discrepancy is particularly likely when senior accounting
personnel do not have the time to review the documentation
carefully.
What else can I do to prepare my company for an SEC investigation?
You should also prepare your senior officers
and members of your financial and accounting staff for the
possibility of an SEC inquiry. Normally, you will learn that
your company is the subject of an SEC investigation through
a letter or subpoena from the SEC seeking documents or information.
Less often, you will learn of an SEC investigation when the
SEC telephones a company officer and begins asking questions.
If an SEC Staffperson contacts your company, he or she will
always identify him or herself. The optimal response is to
listen carefully, take careful notes, promise prompt cooperation,
and provide information to the Staff only after the information
has been thoroughly vetted to confirm that it is accurate
and has been framed in the most effective manner.
It is dangerous for a company to instruct its
personnel not to cooperate if contacted by law enforcement
personnel; such instructions could expose the company to criminal
charges of obstruction of justice or witness tampering. A
company can, however, educate its officers regarding their
rights if contacted by a government investigator who seeks
to interview or otherwise question an employee. The employee
has the right to decline to cooperate, to consult with an
attorney before cooperating, and to set the time, place and
conditions for any interview (e.g., the employee's counsel
will be present). The company can explain that the employee
should not necessarily treat such contacts as "routine"
and that anything the employee says to the government could
later be used against the employee, other employees, or the
company. The company should explain that while it is within
an employee's discretion to agree to answer voluntarily questions
posed by a government investigator, the employee should not
testify regarding the content of any communications with company
counsel that are protected by the attorney-client privilege.
The company should stress that if the employee provides information
to a government investigator, it is imperative that this information
be accurate. The company can also direct its employees to
notify the company promptly after the employee is contacted
by a government investigator. If an employee is questioned
by a government investigator, company counsel should immediately
debrief the employee carefully and thoroughly.
As discussed earlier in response to the question
“Does the company have to disclose the existence of
the SEC investigation to the investing public? “, one
important decision that a company has to make early in an
investigation is whether to disclose publicly that the company
is the subject of an SEC investigation. Especially for smaller
companies, one factor that sometimes requires disclosure of
the investigation is the likelihood that defense costs will
be material to the company's performance results. Although
many D&O policies do not cover the cost of defending an
SEC investigation, some policies do provide such coverage.
While D&O coverage is increasingly expensive and difficult
to obtain, you should consider whether the coverage might
enable your company to avoid disclosing the existence of an
investigation.
I have just received information indicating that my company's
financial reporting and disclosures may be misleading. What
should I do?
You should respond forcefully to allegations
of possible misconduct. If you receive an allegation that
your company's financial reporting and disclosures may be
materially misleading, the company's CEO and the CFO should
be notified. Management should also seriously consider notifying
the audit committee. It is appropriate to notify the audit
committee of an allegation if the allegation appears to be
credible (based, for example, on the source, specificity and
reasoning of the allegation) and the allegation implicates
senior financial or accounting personnel or is not clearly
immaterial.
The company should look into the allegation.
Under many circumstances, this can appropriately be done under
the direction of management by company personnel (e.g., internal
auditors or company counsel). Under some circumstances, it
is appropriate for the investigation to be conducted by independent
counsel under the direction of the audit committee. In determining
the appropriate response to the allegation, consideration
should be given to the nature of the allegation (including
its source, specificity, and reasoning), whether the allegation
implicates senior financial or accounting personnel, and the
potential materiality of the misstatement.
Taking this proactive approach offers a number
of advantages to you and your company. By responding forcefully,
you might be able to address a potential problem before it
materializes. You demonstrate that you are part of the solution,
not part of the problem. In addition, you protect yourself
from later criticisms that you were attempting to cover up
the alleged misconduct.
My company has launched an internal
investigation relating to its financial reporting and disclosures.
What should I do?
If your company launches an internal
review or investigation into possible violations of the federal
securities laws, you should prepare carefully before you provide
information or submit to an interview. While you will want
to be forthcoming to demonstrate that you have nothing to
hide, you should appreciate the importance of providing accurate
and effective answers. You should be aware that company counsel
represents the company, not you. You should also be aware
that the SEC views skeptically any internal investigation
that does not identify at least one member of senior management
as having engaged in wrongdoing. Accordingly, you should,
at a minimum, carefully review your files before providing
information. Often, you would be well served by retaining
as personal counsel an attorney experienced in accounting
matters and SEC investigations.
Am I a target of the investigation?
The SEC is intent on pursuing senior
management of companies that made false or misleading disclosures.
Accordingly, if the investigation involves your company's
disclosures and you were involved in drafting those disclosures,
you should assume that you are a target of the investigation.
Should I retain separate counsel for the SEC investigation?
There are advantages to being represented
by company counsel. Company counsel is likely to gain an unparalleled
mastery of the evidence. In addition, while your company will
likely advance the reasonable fees and costs associated with
your retaining separate counsel, the retention of separate
counsel can impose a substantial financial burden on your
company. Nevertheless, it often is in the interest of a senior
executive to retain separate counsel to ensure that the interests
of the executive are being fully protected.
Content is based on Kenneth B. Winer &
Samuel J .Winer, SEC Enforcement: Counseling and Defense, a
book to be published by LEXIS/NEXIS in the first quarter of
2004 and on an article by Kenneth B. Winer and Samuel J. Winer
that was originally published by the Corporate Counsel Weekly.
It is being reproduced with permission from BNA's Corporate
Counsel Weekly, Vol. 16, No. 33. Pp. 264 et seq. (Aug. 22, 2001).
Copyright 2001 by the Bureau of National Affairs, Inc. (800-372-1033)
http://www.bna.com. This paper is for general informational
purposes only and should not be used as a substitute for legal
consultation on a specific matter. |
