SEC enforcement activity with respect to hedge funds increased significantly in 2005 and is almost certain to increase again in 2006. The outcome of an SEC investigation may involve disgorgement of profits, civil monetary penalties, suspensions or bars from the securities industry, or even criminal prosecution. In the best interest of the fund and its managers, an appropriate pro-active response to an SEC inquiry is often the best way to react to a call from the Enforcement Division. This article addresses the first steps to take, "when the sheriff comes calling."
First, contact experienced counsel. SEC Enforcement contacts are not random. The initial response can be very important. Experienced counsel can help management evaluate the scope and magnitude of the SEC Staff’s concern and begin to formulate an appropriate response. Experienced counsel will also help set the appropriate tone from the beginning.
Second, consider notification. Management will need to consider, with the advice of counsel, who should be advised of the inquiry. For example, management needs to evaluate whether there is a business or legal reason to notify auditors, investors, or others.
Third, preserve documents. As soon as the government has made an inquiry, management has the responsibility to assure that all relevant documents, including e-mails, be preserved, even before an actual subpoena is issued. Failure to do so may not only have a negative impact on the outcome of the SEC’s investigation, but it could also result in criminal obstruction of justice charges.
Fourth, gather information. If the SEC Staff is acting pursuant to a Formal Order of Investigation (which gives the Staff subpoena power), a copy should be obtained by counsel. In addition, experienced counsel will initiate a dialogue with the SEC Staff to help identify the areas of concern. While the Staff is typically reticent to discuss the scope of an investigation, experienced counsel can often create an environment that will, over time, provide counsel with more information from the Staff about its concerns. Counsel may also choose to pursue discussions with attorneys representing other parties who may be involved in the SEC investigation. Hedge fund managers should generally avoid any direct efforts to initiate conversations with others involved in an SEC investigation as this may be viewed as improperly trying to influence testimony, or, at a minimum, could become the subject of uncomfortable questions at a later date. Depending on the circumstances, it may be necessary to do a full-scale review of all documents. Initially, a more limited review may be sufficient. Ultimately, all available material documents about which the client may be questioned should be reviewed by counsel. Counsel will also interview the key witnesses who are available.
Fifth, make a preliminary assessment of the matters at issue in the SEC inquiry. While a full investigation may take months, or conceivably longer, key managerial personnel and counsel should meet after initial information gathering is conducted to make a preliminary assessment of the scope of the matters at issue and to begin to formulate a strategy for duly responding to the SEC’s concerns.
Sixth, consider the need for multiple representation. Counsel and fund management must consider whether it is appropriate to have separate counsel represent individuals, any management entity, and/or the fund. Counsel and the potential clients need to consider not only whether there are there actual differing interests among applicable entities and individuals, but what conflicts may develop later (e.g., in a potential settlement, civil actions, or criminal proceedings). Multiple representation by a single law firm may give rise to future disqualification of counsel. As part of the evaluation of whether separate counsel should be engaged to represent different person or entities, consideration should be given to whether an individual may need to give serious consideration to assertion of a Fifth Amendment privilege. Thought should also be given to confidentiality Issues. Multiple representation, even of the closest friends or an entity fully owned by a single individual, may involve future waivers of the privilege. For example, the government might ultimately seek and obtain the imposition of a receiver for an entity who may, in turn, waive privilege with respect to communication with an attorney who represented both the entity and its management and/or owners, even when the entity is owned by a single person! Experienced counsel will also advise individual clients of privilege limitations. In this regard, the fund’s interest in disclosure to minimize liability may entail disclosure of actions implicating individuals in management.
Seventh, immediately consider insurance coverage and indemnification issues. Inquiry should be made with respect to whether there is insurance coverage that may be implicated by the SEC inquiry and/or indemnification agreements that provide for advancing costs of defense. The obligation, if any, for an insurance carrier will generally only commence upon notification. To the extent that employees are the subject of an SEC inquiry, a review of any applicable contract or other potential source for defense costs should be analyzed as well as possible state law obligations. A determination should be made early on as to whether management and/or the fund should voluntarily pay for separate representation for individuals who may be questioned by the SEC. There may be obligations, or limitations, imposed by statute or otherwise about which the individual needs to be advised.
Eighth, decide whether to cooperate with the SEC’s investigation. Cooperation with the SEC is a factor that the SEC Staff weighs heavily in making its enforcement recommendations to the SEC Commissioners. While often cooperation with the SEC Staff is the best course, there are exceptions. Moreover, there are, of course, levels of cooperation. One issue that has invoked considerable, heated debate is whether cooperation should include a waiver of attorney-client privilege.
Ninth, determine whether to conduct an internal investigation. It has become commonplace for public companies to retain separate counsel to conduct an internal investigation of the facts underlying an SEC inquiry. Internal investigations raise numerous strategic questions. Should they be conducted at all? If so, what is the appropriate scope? Should conclusions be reduced to writing? What privilege issues arise for the individual being questioned as part of an internal investigation and for the entity conducting the investigation? The limits of the attorney-client privilege, e.g., the crime-fraud exception, which will require disclosures of certain communications with counsel, may not be fully understood by witnesses or even some attorneys. Also, while communications by witnesses with counsel during the internal investigation may be technically privileged, at least to some extent, the privilege is often waived at the end of an internal investigation. This fact alone, may make separate representation for individuals the most prudent course.
In short, when the "sheriff comes calling," fund managers need to evaluate the appropriate response with a full appreciation of the complexities involved.
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.