SEC Investigations of Public Company Disclosures.

SEC public company disclosure investigations can be informal. If necessary, however, they can be conducted pursuant to formal orders issued by the SEC’s Division of Enforcement.

The investigation’s target can also vary, and public companies and executives can, and often will, face SEC investigative exposure at the same time.

Investigations under federal criminal law also have the potential to proceed along with SEC investigations. Public company disclosure investigations with the SEC frequently occur at the same time as investigations with the U.S. Department of Justice (DOJ).

As companies navigate these (and other) federal investigations, they need to make informed decisions about their disclosure obligations. However, simply being the subject of an SEC investigation does not, of course, create a federal disclosure obligation for public companies.

Many SEC public company disclosure investigations can (and do) resolve at the examination stage, without the need for enforcement proceedings.

If an SEC investigation doesn’t resolve during an SEC examination, public companies and executives need to prepare for SEC enforcement action.

A public company’s (and its executives’) best chance to avoid an SEC enforcement proceeding is during the SEC examination. If the investigation proceeds, this will present a second chance during the “Wells process” before any charges are filed.

If the SEC’s Division of Enforcement staff recommends initiating enforcement action, the staff will issue what is called a Wells Notice. Once public companies and executives receive a Wells Notice, they have the opportunity to submit a Wells submission.

While a Wells submission allows for advocacy before charges are filed, a successful Wells submission doesn’t always result in a closing letter from the SEC.

In some instances, however, the Division of Enforcement staff closes a public company’s investigation without recommending an enforcement action to the SEC.

What can trigger an SEC disclosure investigation?

Whistleblower reports from the SEC’s Office of the Whistleblower and the SEC’s Division of Enforcement can target accounting fraud, failure to maintain adequate internal controls, insider trading, the buying and selling of improperly acquired non-public information, offering and selling unregistered securities, and other violations of federal securities laws. This includes, but is not limited to, the SEC’s recent focus on public company disclosures related to environmental, social, and governance (ESG) factors.

While some SEC public company disclosure investigations can be triggered by whistleblower reports, this is not always the case. In many instances, public companies and executives can take the first step, and, through the timely engagement of experienced securities defense counsel, launch an internal investigation. This allows for a proactive and efficient defense that can, in many instances, head off regulatory scrutiny altogether.

In many instances, the SEC also triggers public company disclosure investigations itself. These types of investigations often start out as SEC examinations. If, in a particular SEC examination, the Division of Examinations decides to refer the matter for enforcement, this can lead to a formal SEC public company disclosure investigation.

In other cases, the SEC’s Division of Corporation Finance may refer matters to the SEC’s Division of Enforcement.

Financial restatements can also have the potential to trigger investigations from both the SEC and the Justice Department. If the SEC has concerns about financial reporting, an investigation by the SEC is a very real possibility.

What types of issues can trigger SEC public company disclosure investigations?

While public company disclosure investigations often target financial reporting issues (i.e., accounting fraud), the SEC also investigates failures to maintain adequate internal controls, insider trading, the offering and sale of unregistered securities, and numerous other potential violations of the federal securities laws.

The topics that recur most often in SEC public company disclosure investigations include:

• Revenue recognition, related-party transactions, and all aspects of accounting
• Investor disclosures, executive compensation, and corporate disclosures
• Asset valuation, impairment judgments, and other-related accounting concerns
• All other disclosures that are required for public companies to make under the federal securities laws

What powers does the SEC have during a public company disclosure investigation?

At the informal stage, the SEC doesn’t have the power to issue subpoenas, and public companies and executives can decline to respond to the SEC’s requests. However, if the SEC supports the voluntary request with a compulsory legal process, such as an administrative subpoena or a grand jury subpoena, then public companies and executives may be compelled to respond.

What is a formal order of investigation?

A formal order of investigation is an order issued by the SEC’s Commission (the SEC Commissioners) to conduct an enforcement-related investigation. When the Commission issues a formal order of investigation, it will also designate the SEC staff that is authorized to investigate and issue subpoenas.

Can the SEC issue a subpoena for records and testimony in SEC investigations?

Yes. In formal SEC investigations, the SEC can issue subpoenas for records and for testimony. However, an SEC subpoena does not override any legally-protected privilege.

Can the SEC enforce an SEC subpoena in federal court?

Yes. Under Section 21(c) of the Exchange Act, if a company does not comply with an SEC subpoena, the SEC can seek to enforce its subpoena in federal district court.

However, there is an exception. If the SEC Division of Enforcement decides to file a case, the SEC Commission must first authorize the enforcement recommendation made by the Division of Enforcement staff.

How long does an SEC investigation take?

The duration of SEC investigations can vary considerably. There is no federal statute that establishes a standard duration for SEC investigations, so they can be concluded in months, or they can take years.

What other powers does the SEC have in SEC public company disclosure investigations?

Along with the authority to investigate, the SEC also has the authority to seek temporary restraining orders, freeze assets, install receivers in receiverships, and seek other forms of relief.

Can corporations invoke the Fifth Amendment privilege against compelled disclosure of corporate records?

No. While individuals can invoke their Fifth Amendment privilege against compelled self-incrimination, corporations cannot. In other words, corporations cannot invoke the Fifth Amendment privilege against compelled disclosure of corporate records.

What should a public company do after the SEC initiates an investigation?

1. Preserving Documents

The legal obligation to preserve documents arises when a company can reasonably anticipate enforcement litigation. This can occur long before the SEC formally recommends any enforcement action against a company. Documents that must be preserved include company-owned devices, personal devices, messaging platforms and devices, and documents and records that are subject to automatic deletion.

2. Understanding Upjohn Warnings

When counsel represents a public company, a company executive, or a company employee, it can be necessary for counsel to explain the difference between the company’s representation and the company’s representation. This is known as an “Upjohn Warning.” In other words, the representation of the company is not the same as the representation of the employee and the company’s interests may diverge. An Upjohn warning explains:

• The company’s counsel is not representing the individual employee; the counsel is representing the company;
• The company’s counsel is under a legal duty of confidentiality to the company;
• The company is not under a legal duty of confidentiality to the employee;
• the employee’s statements may be disclosed to the SEC in the event the company decides to waive the attorney-client privilege.

3. Maintaining Attorney-Client Privilege

Attorneys should be careful not to inappropriately disclose communications that are protected by the attorney-client privilege. To qualify for the attorney-client privilege, a communication must be made in confidence and for the purpose of obtaining or providing legal advice. This is a factual determination that will be made on a case-by-case basis and it is not determined based on whether the communication is deemed part of an “investigation.”

4. Maintaining Attorney Work Product Protection

As a public company conducts an internal investigation, it will need to maintain attorney work product protection to the extent possible. Attorney work product refers to documents prepared by an attorney during, or in anticipation of, litigation or an enforcement proceeding. If a company produces any attorney work product to the SEC, it will need to carefully make decisions about how to do so in order to preserve work product protection during enforcement litigation in the future.

5. Seeking Extensions to SEC Subpoena Deadlines

Depending on the circumstances involved, companies may need to seek extensions to respond to SEC subpoenas and requests. In many cases, the SEC Enforcement staff will agree to extend a deadline if the company proactively reaches out.

6. Selecting Boards, Audit Committees, and Special Committees

Depending on the circumstances involved, companies will need to select appropriate boards, audit committees, and special committees to oversee internal investigations.

7. Assessing Investigative Witnesses and Subjects

As investigations proceed, companies’ directors, officers, employees, auditors, and counsel may become investigative witnesses and subjects as well. As a result, companies will need to determine how to protect their privilege while ensuring their investigation doesn’t obstruct a government investigation.

If you are facing this situation, Spodek Law Group handles federal criminal defense matters nationwide, from offices in New York and Los Angeles.

When must a company disclose an SEC investigation?

While public companies do not have a general duty to disclose an SEC investigation, this is not the case in some instances. Public companies must make appropriate disclosures:

• Under Rule 10b-5. If public companies have previously made an affirmative statement, they must make corrective and updating disclosures if an SEC investigation renders the previous affirmative statement materially misleading in light of all material circumstances.
• Under Item 103. In addition to disclosing pending material legal proceedings in which the company is a party, companies must disclose material proceedings that “they reasonably believe are likely to become material to the financial condition or operations of the registrant or any of its subsidiaries.” Companies must also disclose similar government proceedings if they “know that the government is contemplating such action.”
• Under ASC 450-20. According to FASB, if a public company “reasonably expects to incur a loss that is both probable and reasonably estimable,” then “it shall accrue the loss.” If an unaccrued loss is “reasonably possible,” the public company “discloses the nature of the loss contingency and estimates the amount or range of loss, if possible.”
• Under Item 105. Under Item 105, public companies are required to disclose “material risk factors.” While this can include the risk of federal securities enforcement proceedings, Item 105 requires companies to avoid “generic risk factors” that are not specific to the registrant.
• Under Form 8-K.
• Under Item 4.02. Item 4.02 generally requires a company to report a conclusion within four business days of a determination of nonreliance on financial statements.
• Under Item 4.01. Item 4.01 requires a company to disclose certain types of disagreements with its former accountants.
• Under Item 1.05. Item 1.05 requires a company to disclose a material cybersecurity incident within four business days of determining that the incident is material.

If the public company determines that an SEC investigation triggers a disclosure obligation under any of the above rules or regulations, it must promptly make the required disclosure.

Is there a duty to provide cooperation during a federal securities enforcement investigation?

Public companies and executives are not obligated to cooperate with the SEC in investigations unless they are served with a subpoena or another compelling legal process. However, cooperating can be beneficial. In many cases, cooperating can reduce the length and cost of the investigation, potentially mitigate the results of the investigation, and even result in no charges being filed against the company or the individuals.

Is it necessary to conduct an internal investigation during a federal securities enforcement investigation?

While it is not always necessary to conduct an internal investigation, it can help a public company make informed decisions about the best next steps to take.

What must the SEC prove in a disclosure case?

The SEC can bring disclosure-related cases with allegations that range from negligent oversight to intentional investor fraud.

While alleging a failure to maintain adequate internal accounting controls does not necessarily require proving investor fraud, alleging fraud under Rule 10b-5 triggers a requirement to prove scienter under the Supreme Court’s ruling in Ernst & Ernst v. Hochfelder.

On the other hand, liability under the Securities Act’s Sections 17(a)(2) and 17(a)(3) doesn’t require scienter. Instead, these sections permit negligence-based liability in federal courts.

Materiality in Disclosure-Related Cases

Materiality is another critical factor in disclosure-related cases. Materiality is a fact-intensive concept that has been developed in federal securities law case law rather than by a federal statute. While materiality often appears in allegations of investor fraud, a determination of materiality is also required in some cases involving allegations of deficient internal accounting controls.

Broadly speaking, information is material to a reasonable investor if its omission “significantly altered the total mix of information available.”

Disclosure Controls and Internal Control Over Financial Reporting (ICFR)

With respect to public company issuers, Rules 13a-15 and 15d-15 require maintaining effective “disclosure controls” and “internal control over financial reporting” (or “ICFR”). These rules impose requirements that include a range of internal policies and procedures that companies use to:

• Capture, process, and communicate information timely, accurately, and effectively, and
• Provide reasonable assurance of reliable financial statements and reports, including ones that are in compliance with generally accepted accounting principles (GAAP).

Generally speaking, “disclosure controls” are focused on a company’s ability to capture, process, and communicate information that is required for reporting under the Exchange Act, while “ICFR” provide reasonable assurance that financial statements are in compliance with GAAP. While both types of internal controls address companies’ disclosure and reporting obligations, this is not the end of the story.

In many instances, the SEC can still pursue enforcement proceedings even where a company is not alleged to have issued financial statements that are inconsistent with GAAP.

Control Person Liability

While some SEC public company disclosure investigations involve only companies, many of these cases target individual directors and officers as well. Under Section 20(a) of the Exchange Act, this allows the SEC to pursue control person liability without proving that the corporate executives and officers had the requisite mental state for primary liability. However, public company executives and officers and those who exercise control over their employers can raise a good-faith defense.

How can response decisions affect charges and parallel exposure?

1. Selection of Counsel

Public companies’ response decisions can affect not only the chances that the SEC will file charges against them, but their chances of facing charges in parallel investigations as well. In many cases, this means making informed decisions about selection of counsel.

As SEC public company disclosure investigations unfold, a public company’s interests may diverge from those of its directors and executives. When this happens, the public company and its executives may need to engage separate counsel.

2. Wells Submissions

As noted above, when the SEC’s Division of Enforcement staff recommends initiating an enforcement action against a company or individual, this triggers a “Wells process” under 17 C.F.R. § 202.5(c). While C.F.R. § 202.5(c) sets forth the circumstances under which a “Wells notice” may be sent, no statute guarantees a Wells notice prior to every SEC enforcement action. However, if a company or an individual receives a Wells notice, it will have the opportunity to submit a Wells submission to a company’s or an individual’s counsel’s liking.

Wait, what is a Wells notice? A Wells notice is a formal letter from the SEC Enforcement Division stating that the staff has concluded to recommend the initiation of an enforcement action. While it does not represent a finding of liability by the SEC Commission, it means the SEC Enforcement Division staff has made its recommendations based on their investigation.

3. Cooperation Credit

A company’s voluntary self-policing, self-reporting, remedial measures, and cooperation can each lead to a reduction in the chances of facing charges in an SEC public company disclosure investigation. The SEC’s “Seaboard Report” analyzes the importance of cooperation when pursuing enforcement actions. However, cooperation credit is discretionary, and it is the SEC Commissioners who determine what results public companies and executives can hope for.

4. Information Sharing with the Justice Department

When public companies provide information to the SEC voluntarily, this can also have implications for their exposure in parallel investigations. For example, under SEC Form 1662, “the Commission reserves the right to share information with other government agencies.” While this means, for example, information shared voluntarily with the SEC in a civil investigation may be shared with the DOJ in a parallel criminal investigation, it can also be an opportunity to reach a favorable outcome in both investigations.

5. Testimony Given at the SEC’s Request

Along with providing information and documents, public companies and executives have the opportunity to voluntarily testify during an SEC public company disclosure investigation as well. If an SEC investigation is conducted as a civil matter, statements made to the SEC, among other reasons, are generally not protected by the Fifth Amendment. Even when the U.S. Supreme Court has granted immunity in certain cases, this immunity does not, in some instances, extend to use of the testimony in criminal proceedings, and voluntary testimony can later be used as evidence.

Get Advice on Your Situation

If you want someone to look at the specifics of your case, Spodek Law Group handles federal criminal defense nationwide from New York and Los Angeles. The firm has been practicing since 1976 and its motto is simple: we owe loyalty to only you. Call 212-300-5196.