Defending Against SEC Restatement Investigations.

1. Preservation

Upon receiving the SEC request, the recipient should immediately suspend any routine document deletion practices to preserve all evidence that may be subject to the SEC’s request. This includes electronically stored information, emails, and other internal electronic files and records.

2. Conflict Management

Company counsel will be unavailable to represent individual officers, employees, and customers. As a result, it is important to identify and manage these conflicts promptly and to appoint each individual’s independent counsel.

3. Independent Factual Analysis

Conducting an independent factual analysis is necessary to understand your company’s and individual officers’ and employees’ exposure. A financial restatement does not automatically establish securities fraud; it simply serves as the starting point for assessing the risk for individual officers and the company.

4. Disclosure Decisions

Quick and informed disclosure decisions are necessary when a restatement is underway. For example, pursuant to Form 8-K Item 4.02, companies must disclose nonreliance determinations within four business days. Determining whether to make supplemental disclosures is also critical.

5. Cooperation Decisions

The SEC is a civil enforcement agency, meaning it cannot prosecute criminal offenses. However, the SEC frequently refers suspected criminal conduct to the Justice Department. In deciding to what extent a company and its officers and employees should cooperate with the SEC, it is critical to assess both the likelihood and the risk of such a referral and the Justice Department’s potential likelihood of pursuing criminal charges based on the underlying conduct.

6. Remediation Decisions

The remediation decisions will include corporate reform and clawback provisions under the Sarbanes-Oxley Act.

7. Coordinating Decisions Among Agencies

FINRA, PCAOB, CFTC, and state regulators often launch investigations based on the same or overlapping conduct. In these cases, it is essential to coordinate the company’s response to the SEC with its response to these agencies to avoid inconsistent disclosures, admissions, or statements.

Together, this comprehensive and coordinated approach offers the best defense against SEC restatement investigations.

What happens after the SEC requests records or testimony?

Voluntary Requests vs. Formal Investigations

While SEC requests may seem to be “voluntary,” both voluntary requests and formal investigations may have significant legal and strategic consequences. While the SEC’s formal investigation authority enables designated staff to issue subpoenas for documents and sworn testimony, the investigation may begin with an informal request. This informal request can trigger mandatory preservation obligations and other risks, and an effective defense strategy needs to address all aspects of the investigation from its very beginning.

What information can the SEC request?

With a formal or informal request, the SEC can demand a wide range of information. This includes company records and documents, emails and other electronic communications, and personal cell phone records (including both business and personal communications). With this in mind, individuals should not assume their personal cell phones or other personal devices or accounts are outside the reach of the SEC.

What should I do if the SEC requests records or testimony?

If the SEC requests records or testimony, you must take steps to preserve all relevant data. In today’s world, this often requires preserving emails, text messages, and messages created on messaging applications like WhatsApp. If there are any concerns regarding the integrity of the relevant records, you must promptly determine whether altering or fabricating documents (or concealment in all cases) will lead to additional legal exposure beyond the underlying securities issues. If required, you will need to work with outside counsel to promptly issue preservation notices to all relevant record holders.

How can I defend against an SEC subpoena?

If the SEC issues a subpoena, your defense will start by assessing the subpoena’s scope and negotiating appropriate production deadlines with the SEC. Your counsel will determine what information the SEC has the legal authority to request and will work to resolve any challenges on the merits in a way that makes sense in view of the other facts and circumstances.

How do I defend against a document production demand?

Our firm’s approach to defending document production demands is focused on compliance that protects the client. While you will be entitled to withdraw documents to which you are entitled to assert privilege, you will need to establish that all such documents are indeed privileged. Simultaneously, you will need to establish the legal grounds for withholding all documents not produced. Finally, you will need to comply with the SEC’s production requirements to avoid the potential for accusations of non-compliance.

How do I defend against a testimony demand?

Our firm’s approach to defending testimony demands is focused on informed, non-prejudicial disclosures. In general, this means ensuring that you do not disclose information that is either not within your personal knowledge or is not subject to a waiver of privilege. When appropriate, we work with our clients to reconstruct the relevant facts as accurately as possible, while identifying a range of credible alternative explanations and avoiding any admissions that are not necessary.

Does a financial restatement prove securities fraud?

Rule 10b-5 Fraud Requires Proof of Scienter

Under Rule 10b-5 (17 C.F.R. § 240.10b-5), investors must establish that a person committed fraud by proving the underlying scienter; in other words, that the person acted with the intent to mislead, manipulate, or defraud. If you committed an accounting mistake, you did not act with scienter. If you did not act with scienter, you could not have committed a Rule 10b-5 violation.

Securities Act Violations Do Not Require Proof of Scienter

However, Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 allow the SEC to bring negligence-based claims. These are common in securities fraud cases, and a viable defense will often require rebutting a negligence-based claim as well. Also, the SEC may charge reporting violations, controls violations, and other violations that do not require a showing of Rule 10b-5 scienter.

Materiality Considerations

Materiality is another important factor when defending against securities fraud allegations. Under the “materiality” standard defined in TSC Industries, Inc. v. Northway, Inc., a fact or omitted fact is material if there is a substantial likelihood that a reasonable investor would have viewed its disclosure as having significantly altered the “total mix” of information made available. At a single point in time, this means the fact or omission must have had a material effect on the reasonable investor’s view of the company based on a reasonable investor’s knowledge of other available information.

As noted in SEC Staff Accounting Bulletin No. 99, “Materiality Considerations for Financial Statement Disclosures,” these materiality considerations, “are not numeric. Rather, they are both quantitative and qualitative in nature.” Here, SAB 99 rejected the idea that “materiality” can be established (or defeated) through a “quantitative analysis” or other numeric-based approach. While it acknowledged that a “percentage-based approach” can be a starting point, it made clear that “qualitative factors” must also be considered.

For contingent events, in Basic Inc. v. Levinson, the U.S. Supreme Court described materiality as being contingent upon both “probability” and “anticipated magnitude.” Specifically, the Court adopted the standard that materiality “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.”

Financial Restatements and SEC Scrutiny

For public companies, financial restatements can trigger the attention of the SEC’s Enforcement Division. However, the Division’s initiation of an investigation does not establish that any securities violations occurred. Rather, it is simply the first step toward making the informed, factual, and legal determinations that will define the defense against the SEC.

Todd Spodek is the managing partner of Spodek Law Group, a second generation criminal defense firm that has been practicing since 1976.

Who should control the company’s independent restatement investigation?

Attorney-Client Privilege Is a Corporate Right

When a company retains outside counsel to conduct an independent restatement investigation, the corporate attorney-client privilege belongs to the company, not to the company’s executives, employees, or other representatives. This distinction is important when conducting interviews, taking testimony, and making other informed and strategic decisions in the interest of both the company and the individual officers, employees, and representatives involved.

Exchange Act Rule 10A-3

Under Exchange Act Rule 10A-3, the company’s audit committee is responsible for overseeing the appointment, compensation, and conditions of engagement of the independent auditor as well as providing a means for the independent auditor to report matters directly to the audit committee. The rule also specifically authorizes the audit committee to retain independent counsel, advisers, and other professionals.

The Corporate Attorney’s Duty to Advise

For corporate attorneys, ABA Model Rule 1.7 (or the comparable state rule) identifies certain scenarios in which it will be imperative for a corporate attorney to advise the company to retain separate outside counsel to conduct the restatement investigation. Specifically, a lawyer may not represent a client if there is a known conflict of interest that materially limits the lawyer’s ability to provide representation without bias, or if the lawyer’s representation is materially limited by the lawyer’s responsibilities to another client, a former client, or a third party. Here, Rule 1.7 applies to the corporate attorney’s representation of the company itself in the restatement investigation, as well as to the corporate attorney’s individual representation of the company’s executive officers.

Employee Interview Warnings

When conducting an internal investigation, the corporate attorney has a duty to warn the employee about the corporate attorney-client privilege. For example, in Upjohn Co. v. United States, 449 U.S. 383 (1981), the Supreme Court held that communications between corporate counsel and a company’s employees can be privileged and that the privilege belongs to the corporation; the warnings that grew out of that decision tell the employee that the company, and not the employee, controls whether those communications are disclosed.

Sharing In-House Legal Advice with Independent Auditors

When the auditor conducts an independent restatement investigation, the company will likely share in-house legal advice (or in-house legal advice shared with outside counsel) with the independent auditor. Sharing this information is important for the purposes of effectively conducting an independent restatement investigation; however, it can also potentially lead to a waiver of the company’s attorney-client privilege.

Attorney Work-Product Protection

While disclosing in-house legal advice to independent auditors can lead to a waiver of the attorney-client privilege, doing so does not waive the attorney work-product protection. As the court noted in United States v. Deloitte & Touche, the auditor’s disclosure of a document that contained the law firm’s preliminary work product was “not a waiver of the law firm’s work-product protection.”

Company Waivers of the Attorney-Client Privilege

A company is free to waive its attorney-client privilege by authorizing the disclosure of communications with its counsel to the SEC or other relevant authorities. In this case, the company will need to clearly and unambiguously waive the privilege, while also maintaining the privilege with respect to other communications.

What must the company disclose and remediate after restatement?

1. Influence of Cooperation on SEC Enforcement

2. Impact of Cooperation on SEC Enforcement

Cooperation can lead to significant reductions in the company’s and individual officers’ and employees’ civil monetary penalties and may also contribute to an enforcement declination.

For example, when determining the penalty to impose in an enforcement action, the SEC “will consider a company’s willingness to cooperatively participate in the investigation and its willingness to correct the conduct and conduct suitable remediation.” This is similar to DOJ practice under the Justice Manual.

3. Recovery of Executive Officers’ Incentive Compensation

A. Recovery of Listed Issuers’ Incentive Compensation

Under the newly-effective Exchange Act Rule 10D-1, listed issuers must maintain a restatement clawback policy. Recovery under Rule 10D-1 is required whenever there is an accounting restatement, and it cannot depend on whether there was misconduct or whether executive officers were at fault.

The recovery requirements apply to all executive officers of listed companies who received erroneously awarded incentive-based compensation within the relevant applicable period. This includes former executive officers as well.

B. Recovery of CEOs’ and CFOs’ Incentive Compensation

In addition to Rule 10D-1, Sarbanes-Oxley Act Section 304 separately authorizes the SEC to seek reimbursement from CEOs and CFOs when a restatement results from “material noncompliance, misconduct, or a fraud.” Here, reimbursement is only authorized when the restatement results from “misconduct,” as determined by the SEC or in civil or criminal proceedings.

4. Necessary Supplemental Disclosures

While companies have a duty to disclose necessary information promptly, they also have an obligation to maintain a sufficient level of information that “prevents [the] required information from being misleading.” This is important because, while the “materiality” standard does not apply to these disclosures, the “accuracy” standard still applies.

5. Individual Liability for Insider Trading

The risk of insider trading is present for individuals who trade while aware of material nonpublic information (i.e., information that is both material and not publicly available). While the “materiality” standard only applies to public disclosures, the standard used to determine whether an individual is subject to insider trading is whether the information at hand is likely to affect the stock price.

Will insurance and advancement cover SEC defense costs?

1. Claims-Made D&O Policies

Claims-made directors and officers (D&O) policies often contain a limitation on when a “claim” can be made. In the case of an SEC investigation, this can present a problem, as an SEC investigation may not become public until after the limitation on claims expires.

2. SEC Subpoenas as “Claims”

Whether an SEC subpoena for records and testimony constitutes a “claim” under a D&O insurance policy depends on the terms and conditions of the policy, specifically the policy’s definition of what is considered a “claim.”

3. Advancement of Costs

Advancement is a contractual and statutory right that enables a company’s individual officers and employees to receive advance payment for defense expenses while their ultimate right to indemnification is determined. Under Delaware General Corporation Law (DGCL) Section 145(e) (and the comparable statute adopted in the majority of other states), public companies can advance legal expenses, provided the individual signs a written undertaking promising to repay any costs advanced that he or she is ultimately determined not to be entitled to receive as indemnification.

4. Coverage for Penalties and Settlements

Whether an individual is entitled to insurance coverage for the amount of an SEC penalty or other reimbursement award depends on the terms and conditions of the applicable D&O insurance policy and the relevant applicable law. However, with the SEC’s civil enforcement authority, the civil penalties that result from civil enforcement actions are typically covered under D&O insurance policies unless these policies contain a specific exclusion (as opposed to the penalties that may be imposed in the event the DOJ pursues criminal charges).

Contact a Federal Criminal Defense Attorney

Nothing here is legal advice, and the details of your case matter. Todd Spodek and Spodek Law Group take federal criminal and white collar cases nationwide, from offices in New York, Brooklyn, Queens and Los Angeles. You can reach the firm at 212-300-5196.