You said what to the SEC?

– Stanley C. Morris

YOU SAID WHAT TO THE SEC?!

Don’t get caught in a Securities and Exchange Commission (“SEC”) amubush. If you receive a SEC enforcement ambush call, you may face catastrophic admissions that cannot be cured. That is why every organization or individual that may be subject to such a call must develop an effective plan of action before the SEC or some other regulatory or enforcement agency calls.

THE AMBUSH

In the early stages of an investigation, the SEC enforcement staff and other securities regulatory bodies frequently employ an investigative technique called the “ambush.” The “ambush” is the first phone call made to the subject of an investigation. It is made without warning. During the call, the SEC staff attorney interrogates an individual or representative of an entity with the goal of obtaining critical admissions and/or catching the subject lying about facts already known to the SEC.

The enforcement staff is attempting to lock the subject into a particular story from which he or she cannot be extricated. Often, the subject mistakenly believes that he or she can talk their way out of the problem. He or she blabs every detail to the interrogator in an effort to “make friends” with the interviewer. This can lead to more serious and penetrating investigations.

How do you prepare for this call? Prepare your responsive strategy with the advice of an experienced SEC enforcement defense attorney in advance and make sure all your employees know the proper response policy. Most importantly, make sure everyone representing you complies with that policy.

In short, you and your staff should be courteous to the SEC attorney, but never answer any questions until after you have discussed the matter with experienced SEC enforcement defense counsel.

Politely explain to the SEC attorney calling that it is your policy to cooperate fully with all governmental authorities, but that you must consult with an attorney before answering any questions. Refuse to engage in any further conversation, other than to get the caller’s name and telephone number. Immediately call an attorney experienced in dealing with SEC enforcement matters. Have that attorney call the SEC enforcement attorney on your behalf. Once the SEC attorney knows that you and/or your company are represented by an attorney, the SEC will not contact you and/or any of your employees directly without including your attorney.

THE COME HITHER LETTER

The “ambush” call usually is followed by a letter, known by the SEC staff as the “come hither” letter. The “come hither” letter requests the subject voluntarily to appear at the SEC to testify under oath and to produce an exhaustive list of documents. A “come hither” letter will not, however, provide you with any information about who the targets of the investigation are or what violations the SEC suspects may have occurred.

The document request included as part of the SEC’s “come hither” letter casts a broad net as part of the SEC attorney’s “fishing expedition.” Fortunately, unless you are a registered broker-dealer, documents produced or testimony provided pursuant to a “come hither” letter is voluntary. This puts you in a relatively good position to negotiate with the SEC regarding the amount and type of documents will produce. You must use this negotiating power skillfully to narrow the scope of the documents requested. Many unwary targets initially provide too much information in an effort to befriend the SEC staff member. This usually exposes the subject to broader inquiries into areas about which the SEC previously was unaware.

Based on the SEC attorney’s agreement to narrow the scope of the document production, your counsel may be able to detect what type of investigation the SEC is conducting and what violations the SEC suspects may have occurred. The bulk of SEC investigations can be lumped into one of the following types of actions: (i) Offering fraudulent unregistered securities; (ii) accounting deficiencies; (ii) insider trading; (iv) broker-dealer sales practices; (v) failure to supervise; (vi) “soft dollar” practices and (vi) disclosure problems. Your lawyer should be able to limit the documents produced to those that are relevant to the suspected violations.

Once the SEC has been forced to reveal some of its cards, your lawyer can help you make an informed judgment on the extent to which voluntary cooperation with the SEC is in your best interest. In most types of investigations the SEC moves very slowly and conducts a protracted investigation. But, if the violation is ongoing, the SEC can move quickly for a stop trading order or an emergency injunctive action with a complete asset freeze. Accordingly, it is at this time that you will want to weigh the costs and benefits of taking immediate remedial action to correct any problems that exist and prevent the SEC from obtaining emergency relief. Regardless of the type of violation, it is essential that you call an experienced SEC enforcement attorney at the latest upon receipt of upon receipt of a “come hither” letter.

INFORMAL / FORMAL INVESTIGATIONS

The SEC has two categories of non-public investigations. The first and generally less serious type is the informal investigation, sometimes referred to as a “Matter Under Inquiry” or “MUI.” The second, and generally more serious is the formal investigation.

A. The Informal Investigation.

The informal investigation is commenced at the sole discretion of a staff attorney by simply completing a one-page SEC form. Often the informal investigation is commenced with little information.

Virtually all investigations, regardless of how serious they may be, are initiated as a nonpublic informal “Matter Under Inquiry” or “MUI.” Both in oral statements made at the beginning of an “ambush” call and in the “come hither” letter, the SEC attorney will tell you that the investigation is an “informal fact finding” investigation. Don’t be mislead by the description “informal fact finding.” If handled inappropriately, informal investigations can quickly blossom into formal investigations or directly into enforcement actions. Your admissions in the informal stage of the investigation are binding in a formal proceeding and may lead directly to an enforcement action resulting in a seven-figure judgment, an asset freeze, criminal charges, an officer and director bar or a bar from the securities industry.

Notwithstanding the seriousness of an informal investigation, every effort should be made to keep the investigation from escalating to a formal proceeding. At the informal stage, the staff attorney does not have authority to issue subpoenas for documents and testimony of witnesses. Instead, except in the case of regulated entities such as broker-dealers, the staff attorney must rely on voluntary cooperation. This gives the defense attorney much more room to negotiate than in the case of a subpoena.

A less obvious, but important reasons to keep the investigation at the informal stage is that the informal investigation is much more likely to be terminated quickly and without any adverse consequences than a formal investigations. SEC procedures make it much easier to terminate an informal investigation than a formal investigation. At the informal stage, the SEC staff attorney has not invested a lot of time and resources and can make a decision to terminate a case based on his own discretion or after consultation with just one supervisor. This underscores the importance of having an experienced SEC defense counsel involved in your matter early to persuade the SEC staff attorney through factual, legal and policy arguments to simply drop the matter without any further action.

But sometimes it is impossible to prevent the matter from escalating to a formal investigation. Even if your defense attorney did everything exactly right, the SEC attorney may decide that he or she needs subpoena authority because an unrelated witness is not cooperating on a voluntary bases or the SEC attorney needs subpoena authority to obtain bank or phone records to proceed with the investigation. Under those circumstances, the SEC attorney will escalate the investigation to the formal stage to obtain authority to issue subpoenas.

B. The Formal Investigation

To escalate the investigation from informal to formal the SEC staff attorney must submit to the SEC Commissioners a written request that a Formal Order of Investigation be entered in the matter. That memo will detail the SEC attorney’s belief about the facts and possible securities law violations that have occurred. If the SEC Commissioners approve the staff attorney’s recommendation, and it is virtually certain they will, the Commissioners enter a Formal Order of Investigation.

After the Formal Order is entered, the burden on the subject of an investigation increases precipitously. The SEC attorney will makes broad use of his or her subpoena authority to compel the appearance of witnesses at the SEC and the production of documents. Responding to subpoenas can be onerous and is at the least very damaging to your reputation regardless of the outcome.

Although it is possible to challenge SEC subpoenas, rarely are such challenges successful or advisable. Congress granted the SEC broad investigative authority. In addition, a challenge to a subpoena must be made in federal court, which is a public forum and would cause your previously nonpublic investigation to become public.

Another consequence of a formal investigation is that the case takes on a higher profile at the SEC and the staff attorney loses some of his discretion to direct the outcome of a case. Not surprisingly, fewer formal investigations are terminated without adverse action being taken than informal investigations. Once a formal investigation is commenced, several layers of supervisors and the commissioners must approve the staff attorney’s recommendation to terminate. Unlike the informal investigation, at the formal investigative stage, your defense attorney does not have an opportunity to speak to all the necessary decisions makers. Instead, your counsel must convince the SEC staff attorney to terminate and then rely on the SEC attorney to persuade his supervisors and the Commissioners to terminate based on all the factual, legal and policy arguments presented by way of a written submission to the Commissioners.

EARLY WARNING RADAR

In the case of broker-dealers, it is often easy to spot the onset of an investigation very quickly. Early signs of danger include the presence of an enforcement attorney, more than two examiners or a branch chief at a “routine” exam. If you see one of those early danger signs, you should immediately contact experienced SEC enforcement defense counsel. Get prepared for a possible “ambush” of one or more of your employees.

In non broker-dealer cases the early warning signs are less obvious. But, if you receive any adverse media attention or are named in a shareholder lawsuit, you should make sure all your employees are prepared for a possible enforcement investigation. Accordingly, you should also take seriously any threats by individuals to make a report to the SEC. Experienced counsel should review all advertisements or press releases to ensure that they are not overly optimistic. The SEC regularly reviews press releases and advertisements that look suspicious.

Insider trading cases frequently commence with the SEC or a self-regulatory agency circulating a list of names of all the individuals who traded in a security shortly before an announcement to the company officials for identification. If you believe you may be on such a list, prepare for the “ambush.”

THE CONSEQUENCES

Depending on the circumstances, the consequences of SEC investigations run from a slap on the wrist to business crippling asset freezes, substantial fines and criminal referrals of matters to the United States Attorney’s Office and/or other criminal law enforcement agencies.

Civil lawsuits brought by the SEC generally seek injunctive relief against further violations of the federal securities laws, an asset freeze, an order for disgorgement of ill-gotten gains and large civil fines. In insider trading cases, the usual remedy is a civil injunctive action in federal court and a money judgment for three times the profits made or losses avoided.

The SEC also can bar you permanently from acting as an officer or director of a public company or registered entity, such as a broker-dealer, investment company and investment adviser.

Finally, even if exhonorated, the mere fact that SEC is investigating, can damage the reputation of even the best companies and prompt shareholder lawsuits.

THE IMPORTANCE OF EXPERIENCED COUNSEL

Unlike the Department of Justice, which openly identifies its targets, the SEC staff follows a long-standing policy against providing any information to its targets. If a witness or target asks about the focus, status or target of an investigation, the SEC staff is instructed to disclose only that the investigation is a non-public fact finding investigation and that the staff is prohibited from discussing the status or any potential targets.

This secrecy makes it all the more important that you have experienced counsel who is able to indirectly gain valuable information through informal meetings and conversations with the staff. An experienced SEC defense attorney will be able to find clues about the nature of your investigation and gage the intensity and disposition of the staff member investigating the matter. With that information, experienced SEC defense counsel may be able to direct the investigation in such a way that the SEC attorney misses the mark.

Another important element is the importance of the SEC defense attorney’s prior relationship and dealings with the staff member conducting the investigation. Although the rules governing SEC investigations are set forth at 17 CFR 203, much of the success or failure of handling your SEC defense cannot be found in a book, but comes from an unwritten understanding of the SEC play book and the constraints under which its attorneys must operate.

CONCLUSION

The best defense is innocence. You should attempt to comply with the SEC, NASD laws, rules and regulations. But mistakes can happen. If it’s too late for compliance, then you must have effective crisis management in place. Developing and implementing an effective plan of action before the SEC calls could save your career and economic life.