Increased SEC Aggressiveness In Investigations And Enforcement Actions: New Initiatives, Tougher Stances, Wider Exposure And Stiffer Penalties For Non-Cooperation

In recent months, the Securities and Exchange Commission has become increasingly tougher on targets and third-party witnesses both in conducting its investigations and in bringing enforcement actions against issuers, their management and third parties.

The SEC is engaging in more aggressive, proactive measures in investigating potential securities law violations. It is spending less time investigating and negotiating, whether formally or informally, before bringing enforcement actions. It is likely to name more defendants or respondents than in the past. And the SEC is litigating cases with greater zeal, frequency and speed. One of the mainstays of SEC enforcement practice – the ability to settle a matter without admitting or denying the SEC’s allegations – is reportedly under critical review by the SEC’s Staff.

The SEC is also imposing substantial penalties on companies, individuals and third-parties who fail to comply promptly or completely with subpoenas or fail to cooperate in investigations. To be considered cooperative, companies must not only produce documents and information quickly and completely, but may also be pressured by the Staff to waive the attorney/client and work product privileges and produce internal investigation reports to the SEC, take decisive action to punish wrongdoers and deny any indemnification for defense costs to its employees when indemnification is not mandatory.

Immediate decisions must be made at the first indication of a corporate crisis. These early decisions will have ramifications with the SEC, in the reaction of the securities market and in any potential future shareholder litigation. While cooperation with the SEC may reduce exposure to regulatory sanctions, cooperative conduct may have dire consequences with respect to preserving attorney/client and work product privileges in shareholder litigation, protecting the rights of individual officers and directors, and maintaining the company’s director and officer insurance coverage. What do you need to know as a public company, as an officer or director, as an individual or company doing business with a public company, or as counsel or auditors of a public company?

1. Wildcatting:

The SEC is taking a more proactive approach to enforcement. Instead of responding to the discovery of misconduct, the SEC is engaging in systemic looks at potential issues and industrywide "sweeps." After learning of potential misconduct at one company in an industry, the SEC may make inquiries of other companies in the industry. An example would be an examination of revenue recognition practices within an entire industry, as prompted by the results of an SEC investigation of a particular industry member. The SEC is making efforts to "see around the corner" to discover trends, practices, and risks that may cause harm to investors instead of waiting to learn of specific problems at specific companies.¹ The SEC, which is already hiring hundreds of additional staff, is specifically seeking candidates with industry expertise in key areas (software, transportation, retail and manufacturing have been specifically mentioned). This means that even a wholly innocent company - otherwise off the SEC’s radar screen - can unexpectedly receive inquiries from the SEC.

2."Real-Time Enforcement":

The SEC is also trying to learn of violations more quickly, take immediate action to stop the misconduct and force immediate corrective action, instead of taking months or even years to conclude an investigation. "Real-Time Enforcement" refers to an effort by the SEC Chairman to substantially decrease the time spent from the start of an investigation to the bringing of an enforcement action. Because of the SEC’s desire to bring quick action, it is spending much less time in negotiations before taking legal action. The SEC is bringing suit almost immediately after discovering violations in order to cause immediate correction of the violations by obtaining emergency relief from the courts. The SEC Staff is now more likely to bring multiple actions, staged over time, if waiting to complete the investigation as to all defendants would unduly delay obtaining relief the SEC considers necessary. While the Staff has always been able to proceed on an emergency basis, greater resources and a new sense of urgency indicate that Real-Time Enforcement will be more the norm.

• For example, the SEC brought action against HealthSouth Corp. within seven days after the SEC’s investigation began.²

• The assets of WorldCom, Inc. were frozen within 72 hours of the company’s restatement announcement.³

• The SEC obtained a cease and desist order against Edison Schools, Inc. alleging that even though GAAP was followed the company committed securities law violations by failing to make adequate disclosures regarding its revenues.⁴

• The SEC obtained emergency relief freezing the assets of C-Tech, LLP within four days after it learned of a scheme to misappropriate offering proceeds.⁵

The SEC is also using "Real-Time Enforcement" to force subpoena recipients to comply fully and in a timely manner:

• In the last 3 years, the SEC has brought over 45 subpoena enforcement actions to enforce compliance with subpoenas^.6

• In September 2003, the Commission obtained a $2 million payment from a law firm for violating a court order to produce documents in a pending SEC civil lawsuit against one of the law firm’s former clients. The law firm failed to produce 27 boxes of records until 18 months after the entry of the court order requiring production.⁷

• The Staff may now demand a written verification by the producing parties of the completeness of their production of documents to the Staff, along with affirmative representations confirming the preservation of evidence.

• It is reasonable to expect more subpoena enforcement, contempt, perjury charges or monetary penalties in such situations. The SEC is also quickly bringing actions against companies and third parties who fail to preserve documents:

• In December 2002, the SEC jointly filed actions against five major broker-dealers for violations of record-keeping requirements; each firm agreed to pay fines of $1.65 million during the investigation phase for failure to preserve documents before resolution of the investigation into the underlying conduct.⁸

• The SEC has recently brought several proceedings against individual auditors at large accounting firms for altering and destroying work papers.⁹

Officer and Director Bars:

The SEC is more frequently barring individual wrongdoers from serving as officers and directors of public companies, either permanently or for a specified time period. The Sarbanes-Oxley Act lowered the standard for imposing the bars. In 2003, the SEC sought 170 Officer and Director bars, compared to only 38 in 2000.¹⁰

• In the Lucent Technologies, Inc. proceeding, SEC penalties for individuals included officer and director bars ranging from a 5-year bar to a permanent bar from serving as an officer or director of a public company.¹¹

Indemnification:

The SEC is beginning to insist that individual officers and directors settling with the SEC forgo their rights to be indemnified by their companies for the defense costs paid in connection with an investigation, making it difficult to ensure that they are adequately and competently represented. It is also demanding that companies and securities industry firms forgo paying any indemnification that is not mandatory. (See further discussion below.)

Third-Party Liability:

The SEC is also actively pursuing third-parties who participate or assist public companies in committing securities law violations. The SEC is charging suppliers and customers who help issuers book and fabricate documentation of fictitious transactions, use side agreements to conceal secret terms or lend assistance to other fraudulent methods to inflate earnings.

• The SEC charged an individual at a third-party company with aiding and abetting Lucent’s securities laws violations by signing side agreements and post-dated letters to hide the existence of agreements that would substantially reduce the amount of current period revenue that Lucent could recognize.¹²

• The SEC is also investigating allegations that several third-party companies signed documents for Kmart Corp., acknowledging receipt of payments that had not been received and thereby assisting Kmart in misrepresenting its financial statements. Also, in every single enforcement case the Staff is questioning the role played by professionals in the alleged violations.

• Attorneys and accountants, for instance, can be denied the privilege of practicing before the Commission and working for public companies, and may also face sanctions by licensing authorities.

• A section 102(e) administrative action by the SEC against an auditor or transaction lawyer requires only a negligence standard, but can have serious consequences for the professional. �� These inquiries can create serious conflicts of interest and ethical dilemmas for legal and accounting professionals to whom the issuer would ordinarily be able to look for representation and support in the investigation and enforcement proceedings.

The SEC is placing increasingly greater weight on cooperation, rewarding companies that cooperate and substantially penalizing those that it regards as uncooperative. However, the definition of cooperation has changed. It is no longer sufficient to merely comply with legal obligations. In order to be deemed cooperative, companies and individuals need to act quickly and go beyond what is required by law. According to the SEC, factors that may be considered in assessing a company’s level of cooperation include: quickly and completely producing documents and information, conducting internal investigations, waiving applicable attorney/client and work-product privileges and producing the reports of the internal investigations to the SEC, and taking decisive action to correct violations and punish wrongdoers. Simply defending oneself and properly asserting privileges may now be viewed as a lack of cooperation by the SEC.

The SEC rewards companies that "cooperate" in addressing "problems" in financial reporting and disclosure. In 2001 the SEC announced in connection with the Seaboard Corp. investigation that it will look for the following conduct in evaluating "cooperation":¹³

Self-Policing:

• Implementing effective legal compliance programs at companies to ensure compliance with legal obligations

• Setting an appropriate tone by management that the company will follow the law ("tone at the top") Self-Reporting:

• Conducting a thorough review of any alleged accounting improprieties or other misconduct 
• Promptly and completely disclosing improprieties to the SEC

• Disclosing the misconduct to the public and regulators

Remediation:

• Dismissing and disciplining wrongdoers

• Improving internal controls and procedures

• Compensating victims

Cooperation with law enforcement authorities upon investigation:

• Providing the SEC with all information relating to the violations and remedial efforts

• Disclosing results of internal investigations, including waiver of the attorney/client privilege

Seaboard: Company cooperation can result in no action against a company that takes quick action. After learning of the alleged misconduct, Seaboard Corporation’s internal auditors conducted a preliminary review and advised management of their findings within one week. Management then reported the results of the preliminary review to the audit committee and thereafter, the full board hired a law firm to conduct a thorough inquiry. Four days after hiring the law firm to conduct an investigation, three employees were dismissed, and the next day Seaboard advised the SEC and the public that its financial statements had to be restated. Seaboard also provided the SEC Staff with all information relevant to the underlying violations, it produced the details of its internal investigation, including notes and transcripts of interviews of the principal wrongdoer and others, and the company did not invoke the attorney-client privilege, work product protection or other privileges or protections with respect to any facts uncovered in the investigation.¹⁴

Homestore: In a more recent case, the SEC imposed no monetary or other penalties on Homestore, Inc. because of the company’s aggressive internal policing and "swift and extensive extraordinary cooperation" including self-reporting, initiating an accounting inquiry, providing privileged internal investigation reports to the SEC without asserting the attorney/client or work product privileges, terminating wrongdoers and implementing remedial actions.¹⁵

A lack of cooperation will result in stiff penalties by the SEC. In recent cases, the SEC has found a lack of cooperation with respect to the following:

1. Failure to Preserve and Produce Documents:

Failing to preserve documents, failing to produce requested documents, and delaying production of documents, including failing to produce key documents until after the testimony of relevant witnesses, are viewed as a lack of cooperation.

• $25 million civil penalty and $1 million in disgorgement was paid by Lucent for noncooperation, including incomplete document productions.¹⁶

• $10 million civil penalty was paid by Banc of America Securities, LLC for violations of the recordkeeping and access requirements during an SEC investigation for improper trading; the penalty imposed was just for the lack of cooperation in failing to promptly furnish documents, misinforming the SEC regarding the availability and production status of documents and other dilatory tactics in the investigation.¹⁷

2. Incomplete Disclosure:

Failing to provide full and timely disclosure of information to the SEC, including withholding documents protected by the attorney/client privilege, may be deemed a lack of cooperation.¹⁸

3. Indemnification of Officers, Directors and Employees:

Agreeing to indemnify officers, directors and employees for legal defense costs when not required under the company’s by-laws or state law may be deemed uncooperative.¹⁹

4. Denial of Allegations to the Press or Public After Settlement with the SEC:

Denying the SEC’s allegations can be viewed as a lack of cooperation. In one matter, after agreeing in a settlement neither to admit nor deny the SEC’s allegations, the former chairman and CEO of the company and outside counsel stated in a magazine interview that the alleged accounting fraud resulted from a "lack of communication," which the SEC viewed as a denial that the fraud occurred and an act of bad faith.²⁰ The SEC now routinely reserves the right to reopen the case if a party settles "without admitting or denying" the violation and subsequently denies that it occurred. This raises concerns regarding issuer press releases and financial footnote disclosures as to shareholder litigation based on the same alleged violations.

• $3 million penalty was imposed by the SEC because of Dynegy, Inc.’s lack of full cooperation in the early stages of the investigation. However, the SEC noted that this penalty was lower than it could have been because the company cooperated later in the investigation and took steps to ensure compliance with new policies and procedures.²¹ Notably, the company had to pay an additional $5 million penalty for the underlying violations.²²

• Oxford Health Plans, Inc. had to pay a $250,000 penalty because although it produced documents and witnesses in response to subpoenas, it did not go beyond its legal obligations to cooperate.²³

Critical decisions must be made in the first hours and days after learning of corporate misconduct or irregularities in financial reporting or after receiving an unexpected SEC inquiry or subpoena. These often involve irrevocable decisions regarding document preservation, commencement of internal investigations, the need for personal counsel by corporate officers, issues of privilege, as well as assessment of the need for corrective action and often difficult disclosure questions. Denials of wrongdoing and assertion of defenses, once considered routine, now must be carefully considered. All these decisions have "cooperation" implications in an ensuing SEC investigation and enforcement context. Notably, the SEC has pointedly sanctioned several companies for their failures to cooperate early in the investigation.

There are, however, potentially serious, negative implications of cooperating with the SEC, especially the consequences of waiving privileges, the denial or relinquishment of indemnification rights, and the possible loss of director and officer liability insurance coverage.

1. Waiver of the attorney/client and work product privileges:

Disclosure of reports of internal investigations to the SEC and the accompanying waiver of privileges has been held by most courts to result in a complete privilege waiver for all purposes and makes the report and possibly the investigation materials discoverable in shareholder litigation.²⁴ These reports and other materials can give the shareholders a roadmap to prove liability. (Federal legislation is being proposed that would allow companies to disclose privileged matters to governmental authorities without waiving the privilege,²⁵ but its passage is not imminent.)

2. Loss of Indemnification:

As discussed above, in settling with the SEC, the Staff may insist that companies not indemnify individuals unless legally required to do so (permissive as opposed to mandatory indemnification) and to demand that certain individuals agree to relinquish their rights to indemnification. As a matter of policy, the Staff can be expected to object to an issuer’s providing any indemnification for an officer’s or director’s civil and criminal penalties or fines. The Staff is now focusing on indemnification and advancement of defense costs. Individuals who forgo or are denied funding of defense costs may not have the financial means to defend themselves against the SEC’s charges, may effectively lose their right to counsel, may not be adequately prepared for their testimony and may be forced to settle even if they have valid defenses to the SEC’s charges. Many targeted individuals have sued their employers to enforce their indemnification rights, often prevailing despite counter-arguments that they acted in bad faith or are subject to offsetting liabilities to the employer.²⁶ Recent public comments by senior SEC Staff indicate that this is an area of continuing policy examination. The due process elements of this debate will likely be tested in future litigation.

3. Loss of Insurance coverage:

Director and Officer liability insurance policies often cover SEC enforcement proceedings and some cover regulatory investigations. D&O insurance is, of course, of critical importance in the shareholder litigation that typically accompanies SEC investigations. However, companies that admit that their financial statements were incorrect and issue restatements may provide their D&O liability insurers, who request those financial statements when underwriting coverage, the basis for attempting to rescind the policies. For example, the very corrective statements that led the SEC to consider Homestore, Inc. "cooperative" also prompted the company’s D&O carriers to sue for and obtain rescission of their policies.²⁷ (The trial court’s decision rescinding the policy is on appeal in the Ninth Circuit Court of Appeals). Also, D&O policies typically contain  "cooperation clauses" which often contractually prohibit or require insurer consent to any admissions of liability, as well as to selection of counsel and any settlements negotiated. At the first sign of an investigation, it is essential to review D&O policies immediately, notify D&O insurers early, assess the coverage implications of every action and obtain all necessary consents.

The SEC’s new aggressive approach to investigations and enforcement has significantly raised the stakes for public companies in crisis, their officers and directors, and third-parties who do business with them. It has also radically altered and complicated the matrix for corporate decision-making upon discovery of misconduct or improprieties in financial reporting. Early decisions must be informed and well thought-out despite the urgency, because they will likely affect the SEC’s view of the company’s cooperation and affect whether the SEC imposes penalties. These decisions may also adversely affect the course of future litigation against the company.

A company crisis is a minefield. There is no question that the SEC perceives itself as the "new sheriff in town" but that does not necessarily mean that an aggressive defense, if justified, should not be pursued. The significant, long-term, often countervailing consequences of the decisions and actions required to address the crisis make it imperative from the outset to have the advice of experienced counsel who know where the mines are likely to be buried.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.