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Volume 15, Number1 September/October 2005
When the SEC comes knocking
What to expect in an investigation
By Kevin J. Harnisch and Natasha Colton
It seems hardly a day goes by without word of a new SEC investigation
concerning a well-known company or industry. You know — Enron, WorldCom,
AIG, Wall Street research analysts as well as mutual funds. The commission's
increased enforcement activities make it important for lawyers to have at least a
basic understanding of their investigative process.
The staff of the commission's Division of Enforcement (the enforcement staff)
conducts two types of investigations: informal investigations and formal ones.
Both types are conducted in a nonpublic manner unless the commission takes
them public. Only in rare circumstances does the commission pass down that
order.
Generally, investigations begin as "informal" investigations. An investigation's
designation as "informal" does not mean that the matter is not serious. In fact,
the commission can opt to take enforcement action without an informal
investigation ever becoming "formal." The "informal" designation simply means
that the enforcement staff cannot issue subpoenas to compel the production of
documents or investigative testimony, which is an on-the-record question-andanswer session similar to a deposition.
An investigation becomes "formal" when the SEC issues a formal order of
investigation (formal order). Such an order empowers the enforcement staff to
issue subpoenas compelling investigative testimony and the production of
documents. The formal order describes the nature of the investigation in very
general terms and identifies the provisions of the federal securities laws that
CALENDAR
might have been violated.
The commission issues a formal order on a recommendation from the enforcement
staff in which the staff explains why it believes there may have been or may be
continuing violations of the federal securities laws. The staff also notes how the
ability to issue subpoenas would further its investigative efforts. The threshold for
issuing a formal order is very low and the staff's requests are almost always
granted.
The scope of the investigation is not necessarily limited by the contents of the
formal order. While some defense counsel may raise objections if the investigation
stretches beyond the order, the enforcement staff typically ignores such
objections. Also, as a practical matter, such objections are rarely effective because
the staff can rather easily obtain an amended order.
In informal investigations, because it cannot issue subpoenas for evidence, the
enforcement staff instead asks persons and groups to provide information
voluntarily. Care must still be taken when giving information to the staff because
knowingly providing false or misleading information to them is a criminal offense.
There are also certain mandatory document production requirements for various
commission-registered groups, such as the requirements imposed on brokerdealers under 15 U.S.C. § 78q and investment advisers under 15 U.S.C. § 80b-4.
In practice, the scope of document requests and the types of questions posed
during testimony do not depend on whether the investigation is formal or
informal. Instead, the distinction typically provides the recipient of a voluntary
request with more options on how to respond — that is, the recipient can opt not
to provide the requested information or may have more leverage in negotiating
modifications to the scope of the requests.
However, not responding fully to the enforcement staff's voluntary requests
generally raises staff suspicions and may prompt the staff to seek a formal order.
From a defense counsel standpoint, it is important that once an investigation
becomes formal, the enforcement staff is often less willing to terminate the probe.
Prior to providing information in a formal investigation, a witness has a right to
review the formal order, although a witness is not permitted to see the
enforcement staff's recommendation that resulted in the order being issued. A
witness may also obtain a copy of the order by making a written request to the
staff and representing that he or she will maintain the confidentiality of the
document.
Although violations of the federal securities laws can be criminal offenses, the SEC
does not have the ability to bring criminal charges. The U.S. Department of
Justice and the U. S. attorneys' offices criminally prosecute federal securities
cases. The enforcement staff, however, can suggest that a criminal investigation
be conducted. Such criminal referrals are becoming increasingly common as
prosecutors have become more willing to pursue complex securities and whitecollar cases.
Investigative testimony is one of the primary methods the enforcement staff uses
to get information. This testimony is similar to a civil deposition in that the
witness is asked a series of questions and is often shown exhibits and asked
about them. Like a deposition, a court reporter records the questions and answers
and a transcript is generated. Unlike a civil deposition, however, the Federal Rules
of Civil Procedure are inapplicable. Thus, there are no limitations on the number of
witnesses that can be subpoenaed, and there are no time limits on the length of
the testimony sessions. Also, sessions are not subject to judicial oversight.
The witness may order a copy of the testimony transcript, but the enforcement
staff must approve the order. As a practical matter, the staff routinely permits
witnesses to purchase copies of their transcripts. In any event, a witness has a
right to inspect an official copy of the transcript at the SEC. Witnesses are not
permitted to purchase or inspect the testimony transcripts of other witnesses.
Witnesses have the right to be accompanied, represented and advised by their
counsel during their testimony. In addition to the witness, the court reporter and
the enforcement staff, the only other people permitted to attend are the witness'
lawyers. Other interested persons or counsel for such persons are not permitted.
Each lawyer who attends will be asked to confirm on the record that he or she
represents the witness. If the witness is a company employee, company counsel
can attend the testimony by stating that he or she represents the witness in the
witness' capacity as an employee.
In a formal investigation, only enforcement staff members identified in the formal
order are permitted to ask questions. Therefore, defense counsel should always
determine whether the staff members present are included in the formal order.
During testimony, the witness is permitted to assert any applicable privileges,
such as the attorney-client privilege or the Fifth Amendment right against selfincrimination. Unlike in criminal proceedings, adverse inferences may be drawn
against a witness who refuses to answer questions by invoking the Fifth
Amendment.
In instances where a witness is unwilling to answer questions without some form
of protection, the enforcement staff may be willing to enter into a so-called
"queen-for-a-day" agreement or seek immunity for the witness. "Queen-for-aday" agreements prevent the staff from using a witness' statements against him
or her, although the staff is permitted to use the statements to develop other
evidence against the witness.
Immunity, which is granted by the Department of Justice at the enforcement
staff's request, precludes using the witness' statements and information derived
from those statements in a criminal proceeding against the witness; it does not
preclude the staff from using the statements or information derived from them
against the witness. The staff may enter into a queen-for-a-day agreement or
seek immunity when the witness has valuable information that is difficult to
obtain from other sources and the witness would otherwise assert his or her right
against self-incrimination absent such protections.
Document requests — either voluntary or following a subpoena — are another one
of the enforcement staff's information-gathering tools. The staff often issues
broad requests to the persons and groups it believes have information pertinent
to the investigation.
By beginning with a broad request, the enforcement staff places the recipient in
the position of not being able to discard documents (including e-mail and server
back-up tapes), even following an established document-retention policy, without
being exposed to prosecution for obstruction of justice. The staff has been making
increased use of sending broad document-preservation requests either in advance
of or contemporaneous with document requests.
While the enforcement staff often is willing to engage in some negotiation on the
scope of what must be produced and the timing of the production, any limitations
on the scope typically come with the caveat that the staff reserves the right to
change its mind and to require production of all responsive documents.
Because the Federal Rules of Civil Procedure do not apply to these investigations,
there are no express provisions for recipients of subpoenas to challenge the scope
of the subpoena as being overly broad, burdensome or vague. Therefore, while
defense counsel may raise practical reasons for modifying the scope of a
subpoena, whether to accept defense counsel's suggestions lies within the sole
discretion of the enforcement staff.
In order to obtain judicial review of an investigative subpoena, the recipient must
refuse to comply with the subpoena's requirements. In such a situation, the
director of enforcement has the ability to authorize the enforcement staff to make
a filing in federal district court for an order compelling compliance with the
subpoena. Because such filings are publicly available, and the commission
generally issues a corresponding press release, the existence of the otherwise
nonpublic investigation becomes a matter of public record.
If the staff is successful in obtaining a court order enforcing the subpoena and the
witness nevertheless refuses to comply, the staff can seek to have the witness
held in contempt of court.
Although enforcement investigations generally are conducted in a nonpublic
manner, people may file Freedom of Information Act (FOIA) requests with the
commission for copies of documents pertaining to investigations. FOIA requests
may be denied if the producing party claimed at the time of production to the
enforcement staff that the documents are subject to various exemptions from
disclosure.
There is an exemption for investigatory records obtained in connection with law
enforcement proceedings. There are also exemptions for information that contains
trade secrets or confidential business information. Therefore, in order to protect
the confidentiality of information provided during an investigation, the producing
party should claim at the time the information is submitted that the information is
exempt from FOIA production requests.
In order to further minimize the risk of production in response to FOIA requests,
the producing party should also request that the enforcement staff return the
documents at the conclusion of the investigation. Irrespective of exemptions from
production under the FOIA, the staff may share information provided to it with
other federal, state or foreign government agencies, including the U.S.
Department
regulators.
of
Justice,
self-regulatory
organizations
and
state
securities
The SEC often says that it weighs cooperation during the investigation when
deciding whether or what charges to file. Some of the factors the commission
uses to evaluate cooperation are:
how quickly the corporation responded to the reported misconduct;
remedial measures taken, including compensation of injured persons;
the nature of the internal review, including the involvement of the audit
committee and board of directors;
the sharing of information with the commission, including a thorough and probing
written investigative report; and
encouraging employees to cooperate with the commission. Report of
Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934
and Commission Statement on the Relationship of Cooperation to Agency
Enforcement Decisions, Exchange Act Release No. 44,969, 76 SEC Docket 220-18
(Oct. 23, 2001).
In addition to sometimes rewarding cooperation, the commission may seek to
impose stiff sanctions for not cooperating. See, for example, SEC v.
Halliburton Co., Litigation Release No. 18817 (Aug. 3, 2004); SEC v. Lucent,
Litigation Release No. 18715 (May 17, 2004); SEC v. Brightpoint Inc.,
Litigation Release No. 18340 (Sept. 11, 2003); SEC v. Dynegy, Inc.,
Litigation Release No. 17744 (Sept. 25, 2002); SEC v. Xerox Corp., Litigation
Release No. 17465 (Apr. 11, 2002).
Cooperation with the enforcement staff is not without risks. The staff often
views full cooperation as sharing information otherwise protected by the
attorney-client privilege and work-product doctrine. Before sharing any such
information with the staff, defense counsel should require a confidentiality
agreement. However, providing privileged information or work product to the
staff according to a confidentiality agreement is no guarantee that a court will
agree that the attorney-client privilege and work-product protections have not
been waived with respect to third parties, such as class action plaintiffs.
At the conclusion of an investigation, the enforcement staff determines
whether to recommend that the SEC authorize an enforcement action. The
commission must authorize an enforcement action before the staff can file
one. Enforcement actions are filed in federal district court or before an
administrative law judge. Federal district court actions are generally perceived
as more severe than administrative proceedings. Therefore, whether to file an
administrative proceeding or a federal district court action is often a point of
negotiation between defense counsel and the enforcement staff.
When the commission initiates litigation in federal district court, the Federal
Rules of Civil Procedure and the local rules of the particular court govern the
litigation. When the commission initiates litigation before an administrative
law judge, the commission's rules of practice apply.
The enforcement staff generally notifies a person or entity of its intention to
recommend the authorization of an enforcement action. This notification is
referred to as a Wells notice. The staff, however, might not provide a Wells
notice in an emergency situation, such as in situations requiring the filing of a
temporary restraining order. In the Wells notice, which often is in the form of
a phone call followed by a letter, the staff describes the general nature of the
alleged violations of the federal securities laws and the evidence supporting
those allegations.
The enforcement staff then invites the proposed defendant or respondent to
make a Wells submission. A Wells submission is a document in which the
proposed defendant or respondent explains why an enforcement action is not
warranted. It is often effective to have a meeting with the staff before
making a Wells submission. Having a dialogue helps defense counsel to
understand better the staff's areas of concern. It also helps defense counsel
to develop a sense of areas of potential compromise.
If the Wells submission does not persuade the enforcement staff to refrain
from recommending an enforcement action, the Wells submission is
presented to the commission in conjunction with the staff's recommendation.
Even if the staff recommends an enforcement action, the commission might
decline to authorize one.
Making a Wells submission is not mandatory. Before deciding to make a
submission, it is important to realize that the enforcement staff may try to
use statements in the Wells submission as admissions by the proposed
defendant or respondent. Wells submissions may also be discoverable in
related private litigation.
At the conclusion of an investigation, the enforcement staff might determine
not to recommend the authorization of an enforcement action against the
subjects of the investigation. The staff is not required to inform the subjects
of an investigation that no action will be taken against them. As a matter of
practice, however, the staff sends "closing letters" to recipients of Wells
notices and persons or entities whose names appear in the caption of the
formal order to inform them that no enforcement action will be taken against
them.
A closing letter simply means that the enforcement staff does not
contemplate any enforcement action against the recipient as of the date of
the letter — it does not preclude an enforcement action if new evidence is
obtained. Similarly, a closing letter is not an admission by the SEC or the
staff that the recipient did not violate the federal securities laws. Instead, it is
an acknowledgement that, for reasons not articulated in the closing letter
(which could include a conclusion that the recipient did not violate the federal
securities laws), an enforcement action will not be filed.
The commission can seek a variety of sanctions in an enforcement action. It
generally seeks:
an injunction (in a federal court action) or a cease-and-desist order (in an
administrative proceeding) prohibiting current and future violations of the
provisions of the federal securities laws at issue in the case;
disgorgement of any ill-gotten gains; and
monetary penalties.
The commission attempts to distribute disgorged funds to harmed investors.
If a defendant pays both disgorgement and a penalty, the commission can
seek to have the penalty also distributed to harmed investors. Otherwise,
penalties are paid to the U.S. Treasury. The commission can also seek
suspensions or restrictions of the activities of securities professionals, such as
broker-dealers and investment advisers.
Similarly, the commission may seek to restrict the ability of certain
professionals, such as accountants and lawyers, to appear and practice before
the commission if it is determined that such persons engaged in improper
professional conduct. Likewise, the commission has the power to seek to have
persons prohibited from serving as officers or directors of public companies if
it is determined that such persons are unfit to serve in those capacities.
Settlement offers can be made at any point between the receipt of a Wells
notice and the issuance of a decision in contested litigation. The enforcement
staff typically takes the position that it will not make settlement offers and
instead only receives and evaluates settlement offers. In practice, however,
by having a dialogue with the staff, defense counsel can generally develop a
sense of what is likely to be considered a reasonable settlement offer.
The enforcement staff is supposed to present reasonable settlement offers to
the commission, which ultimately decides whether to accept the offers. If the
commission accepts an offer, the staff files the settlement papers with the
court or the administrative law judge, thereby making the settlement papers
public documents. If a settlement is reached prior to the filing of an
enforcement action, the staff simultaneously files the settlement papers with
the complaint or order instituting proceedings.
In the settlement papers, the defendant or respondent neither admits nor
denies the SEC's allegations. Allegations in settled administrative proceedings,
although they are neither admitted nor denied, are set forth as "findings" of
the commission. These "findings" can raise concerns about collateral estoppel
in other related investigations or litigation.
According to § 307 of the Sarbanes-Oxley Act, the commission adopted rules
"setting forth minimum standards of professional conduct for attorneys
appearing and practicing before the commission in any way in the
representation of issuers." The definition of "appearing and practicing before
the commission" is very broad, and it certainly encompasses representing a
client in an enforcement investigation. Among other things, these rules
require lawyers to report evidence of material violations of U.S. federal or
state securities laws or a breach of fiduciary duty by an issuer or its agent to
the issuer's chief legal officer or qualified legal compliance committee.
If the lawyer does not receive an appropriate response after making a report
to the chief legal officer, the lawyer must report the evidence "up-the-ladder"
to:
the audit committee;
another committee of the board of directors comprised of directors not employed
by the issuer; or
the board of directors.
Given the breadth and stringent requirements of these lawyer-conduct rules,
lawyers should become familiar with them.
The ever increasing number of SEC enforcement investigations has created an
expanded need for subjects of those investigations, their employees and
parties with which they do business to seek advice in connection with these
investigations. Having a general understanding of the commission's
investigative process can be valuable given the increased likelihood that a
lawyer will encounter a client who is in some way involved in one of these
investigations.
Harnisch is a partner at Fried, Frank, Harris, Shriver & Jacobson LLP in
Washington. His e-mail is [email protected]. Colton is an
associate at O'Melveny & Myers LLP in Washington. Her e-mail is
[email protected].
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