1. law, govt and politics
2. law enforcement

Chapter 15
SEC Investigations and
Enforcement Actions
John H. Sturc, Jonathan C. Dickey,
Barry R. Goldsmith & Mark K. Schonfeld
§ 15:1 Introduction
§ 15:2 SEC Investigations
§ 15:2.1 Triggering Events
§ 15:2.2 Types of SEC Enforcement Activities
[A] Informal Investigations
[B] Formal Investigations
[C] “Wells” Notices
[D] Closing Investigations
§ 15:2.3 SEC Enforcement Trends
§ 15:3 SEC Enforcement Actions
§ 15:3.1 The Role of Cooperation
[A] The Seaboard Report
[B] 2006 Statement on Penalties
[C] Privilege Waivers As an Element of Cooperation
§ 15:3.2 Civil Remedies
[A] Civil Injunctions
[B] Ancillary Relief
[B][1] Disgorgement
[B][2] Clawback of Executive Compensation
[B][3] Corrective Disclosure
[B][4] Corporate Governance Changes
[B][5] Civil Money Penalties
[B][6] “Improper Influence”
[C] Bar Upon Service As Officer or Director
(Securities Litig., Rel. #6, 10/12)
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§ 15:1
SECURITIES LITIGATION
§ 15:3.3
Administrative Remedies
[A] Cease-and-Desist Orders
[B] Suspension and Deregistration
[C] Professional Discipline
§ 15:3.4 Parallel Criminal Cases
[A] Common Grounds for Prosecution
[B] Cooperation Between SEC and DOJ
[C] Parallel Proceedings by the SEC and Private Entities
§ 15:4 Insider Trading Cases
§ 15:4.1 “Classical Theory” of Insider Trading
§ 15:4.2 “Misappropriation Theory” of Insider Trading
§ 15:4.3 “Use” Versus “Possession”
§ 15:5 Role of Directors
§ 15:5.1 Corporate Codes of Conduct and Compliance Policies
§ 15:5.2 Internal Controls
§ 15:5.3 Dealing with Potential Illegal Acts
§ 15:5.4 Supervising Internal Investigations and the Corporation’s
Response to the SEC
§ 15:5.5 Audit Committee Oversight
§ 15:6 Role of Counsel
§ 15:7 Role of Auditors
Appendix 15A
Recent SEC Enforcement Actions Against Audit Firms and
Audit Partners
§ 15:1
Introduction
The U.S. Securities and Exchange Commission (SEC) is the federal
government’s principal investigative and enforcement arm with respect to the securities activities of corporate America. This chapter
provides an overview of SEC investigative and enforcement authority
as commonly applied to public companies, regulated entities (such as
brokerage firms and investment advisors), and their officers, directors,
and employees, and suggests how these entities and affiliated persons
may most effectively deal with SEC investigations and enforcement
actions.1
Investigations by the SEC are both a major cause and a symptom of a
corporate crisis. SEC investigations frequently raise questions about the
performance or integrity of corporate management, the integrity of a
corporation’s financial reporting specifically, and corporate stewardship
generally. Even if the investigation is concluded without an enforcement
action, the pendency of an investigation places a cloud over
1.
For an excellent overview of the SEC from the standpoint of a former
Commissioner, see P. Atkins & B. Bondi, Evaluating the Mission: A Critical
Review of the History and Evolution of the SEC Enforcement Program,
13 FORDHAM J. CORP. & FIN. L. 367 (2008).
15–2
SEC Investigations and Enforcement Actions
§ 15:1
the corporation that may inhibit its access to capital markets, chill
relationships with vendors and customers, and distract and demoralize
management. With respect to individuals, an SEC investigation may
result in termination or resignation from one’s current position and
may effectively preclude an individual from being hired elsewhere.
An enforcement action by the SEC may also have significant
collateral effects. It may cast doubt on the reputation of the corporation; it may lead to lawsuits by shareholders or other persons; and it
may ultimately require significant changes in key management, not to
mention that it raises the spectre of individual liability for the
corporation’s officers, directors, or employees.
How a corporation responds to an indication of misconduct is often
as important to the future of the corporation as remediating the underlying conduct itself. Any business enterprise may have a rogue employee
or officer who engages in misconduct either for personal benefit or
because of a misguided belief that it will assist the corporation. In the
eyes of the SEC and, in many instances, the Department of
Justice (DOJ), such conduct may not be attributed to the corporation,
as the conduct may be inconsistent with the policies, values, and
interests of the corporation. On the other hand, the failure to detect
the misconduct may reflect upon the quality of the company’s internal
accounting and other controls. More important, the manner in which
the company responds to indications of misconduct or to a government
investigation will directly affect the SEC’s views of the integrity of the
company and may have a significant impact on the outcome of an
investigation.2
Nearly two decades ago, the SEC stated that it “considers it
essential for board members to move aggressively to fulfill their
responsibilities to oversee the conduct and performance of management.”3 The Cooper case arose out of three alleged schemes, involving
2.
3.
The Federal Sentencing Guidelines for Organizations consider the presence of effective programs to prevent and detect violations, and acts of selfreporting and cooperation with the government, as mitigating factors in
determining the sentence to be imposed on a corporation found guilty of a
violation of law. In practice, such measures may even prevent a corporation from being charged in the first place. Although the Sentencing
Guidelines are not binding on the SEC in connection with its civil
enforcement efforts, they are consistent with the SEC’s own views.
Report of Investigation in the Matter of the Cooper Companies, Inc., as it
Relates to the Conduct of Cooper ’s Board of Directors, Exchange Act Rel.
No. 35,082, [1994–1995 Transfer Binder] Fed. Sec. L. Rep. (CCH)
¶ 85,472, at 86,065 (1994). The SEC has encouraged corporations to
cooperate in the form of deferred prosecution agreements (DPAs) and nonprosecution agreements (NPAs), tools typically used by the DOJ to resolve
alleged corporate wrongdoing. After entering into its first-ever NPA in
December 2010, the SEC announced the agency ’s first-ever DPA in May
(Securities Litig., Rel. #6, 10/12)
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§ 15:1
SECURITIES LITIGATION
the company’s CEO and co-chairman, to engage in frontrunning,
insider dealings of corporate assets, and securities manipulation. The
allegations ultimately led to criminal convictions of the CEO and the
company. The SEC asserted that the company ’s board was aware of an
initial investigation by the SEC, a subsequent parallel investigation by
the DOJ, and then undisclosed affiliated transactions between the
company and its CEO that resulted in a transfer of $560,000 in
potential profits from the company to the CEO and his family.
Since Cooper, the SEC has continued to bring enforcement actions in
which the Staff has questioned the adequacy of a corporation’s response
to suspected wrongdoing. In February 2011, the SEC brought charges
against a large government supplier, alleging in part that certain executives systematically and repeatedly failed to investigate red flags,
enabling the company to engage in numerous securities law violations.4
In particular, the complaint alleged that the willful blindness of three
former board members allowed senior management to file materially
false and misleading periodic reports with the Commission and use
corporate funds to pay for personal expenses. The SEC also alleged that
their actions allowed the company’s then-CEO to divert corporate funds
to a personally controlled entity. The three directors allegedly lacked
independence because of their business relationships and decades-long
social relationships with the CEO. In the press release announcing the
complaint, Enforcement Director Robert Khuzami stated, “We
will not second-guess the good-faith efforts of directors. But in stark
contrast . . . [these] were directors and audit committee members who
repeatedly turned a blind eye to warning signs of fraud and other
misconduct by company officers.”5 This recent complaint evidences
the SEC’s continued interest in bringing enforcement actions against
4.
5.
2011. See Press Release No. 2011-112, U.S. Sec. & Exch. Comm’n,
Tenaris to Pay $5.4 Million in SEC’s First-Ever Deferred Prosecution
Agreement (May 17, 2011), available at www.sec.gov/news/press/2011/
2011-112.htm. Enforcement Director Robert Khuzami announced that
the “company’s immediate self-reporting, thorough internal investigation,
full cooperation with SEC staff, enhanced anti-corruption procedures, and
enhanced training made it an appropriate candidate for the Enforcement
Division’s first Deferred Prosecution Agreement.”
SEC Litigation Rel. No. 21,867, SEC v. DHB Industries, Inc. n/k/a Point
Blank Solutions, Inc., Civil Action No. 0:11-cv-60431-JIC (S.D. Fla.
Feb. 28, 2011), available at www.sec.gov/litigation/litreleases/2011/
lr21867.htm.
Press Release No. 2011-52, U.S. Sec. & Exch. Comm’n, SEC Charges
Military Body Armor Supplier and Former Outside Directors with Accounting Fraud (Feb. 28, 2011), available at http://sec.gov/news/press/
2011/2011-52.htm.
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SEC Investigations and Enforcement Actions
§ 15:2.1
directors of publicly traded companies when they personally violate laws
or willfully disregard their responsibilities.
In recent years, the SEC has imposed harsh penalties in cases where
it believed that a company ’s self-policing efforts were less than
thorough, or lacking in independence. In addition, the Staff has
publicly stated that it views the board and in-house counsel as critical
gatekeepers charged with responsibility to monitor and oversee the
company’s securities law compliance. The Staff also has declared that
it will bring enforcement action against such gatekeepers in appropriate circumstances.
The overall question of how to coordinate the defense and resolution of parallel civil and regulatory proceedings is beyond the scope of
this treatise and indeed may require a treatise itself. That said, it is
critical that defense counsel be familiar with the general approaches
that the SEC takes in investigating possible securities law violations,
how it expects companies to behave in connection with an investigation, and some of the potential pitfalls in dealing with the Staff. 6 In
2008, the SEC provided written guidance in all of these areas in its
Enforcement Manual.7
§ 15:2
SEC Investigations
SEC investigations are conducted by the Division of Enforcement
(or “Enforcement Division”). Enforcement Division Staff are located at
the SEC’s headquarters in Washington, D.C., as well as around the
country in eleven regional offices. The Enforcement Division conducts
investigations, recommends enforcement actions to the Commission,
and negotiates settlements (subject to the Commission’s approval).
The Enforcement Division also litigates before SEC Administrative
Law Judges and in federal court.
§ 15:2.1
Triggering Events
Nothing more than official curiosity is required for the SEC to start
an investigation. This is not to say, however, the investigations are
6.
7.
Gibson, Dunn & Crutcher LLP on a semi-annual basis publishes an
update on recent developments in securities enforcement, which is available to its clients and the public. See, e.g., 2011 Year-End Securities
Enforcement Update, Publications, GIBSON DUNN (Jan. 10, 2012), http://
gibsondunn.com/publications/Pages/2011YearEndSecuritiesEnforcement
Update.aspx; see also 2011 Mid-Year Securities Enforcement Update,
Publications, GIBSON DUNN (July 18, 2011), http://gibsondunn.com/
publications/Pages/2011Mid-YearSecuritiesEnforcementUpdate.aspx.
SEC, Division of Enforcement, Enforcement Manual (Feb. 8, 2011) [hereinafter SEC Enforcement Manual], available at www.sec.gov/divisions/
enforce/enforcementmanual.pdf.
(Securities Litig., Rel. #6, 10/12)
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§ 15:2.1
SECURITIES LITIGATION
started for no reason. Usually some event or market activity prompts
the SEC to begin an inquiry. Examples include the following:
1.
Review of periodic filings and registration statements by the
Division of Corporation Finance.
2.
Review of Forms 8-K. The SEC reviews every Form 8-K dealing
with adverse events and with changes in auditors.
3.
Review of trading data and market surveillance reviews.
4.
Referrals, particularly in the insider trading context, from selfregulatory organizations such as the Financial Industry Regulatory Authority (FINRA).
5.
DOJ referrals under the Foreign Corrupt Practices Act (FCPA).
6.
Newspaper and other media reports.
7.
Complaints from disgruntled investors. Investors frequently
complain to the SEC. Sometimes these complaints come from
professional short-sellers.
8.
Complaints from issuers that believe their stock is subject to
illegal short selling or manipulation.
9.
Tips from whistleblowers—frequently an employee of the
company who is dissatisfied with the manner in which
management is accounting for its assets or conducting itself
domestically or abroad. As discussed below, whistleblowers
now have significant incentives to report tips to the government and substantial protections against alleged retaliation.
10. Complaints from competitors. On occasion, corporations
believe that they are competing against a company that has
been falsely stating its performance.
11. Complaints from plaintiffs and their lawyers. It is not unusual
for the plaintiffs in private civil actions to assert that the SEC
should get involved in the same matters that are the subject of
the private lawsuits.
While the SEC Staff has endeavored to evaluate such complaints
with a critical eye, some complaints have proven to be well founded,
and the Staff has taken appropriate action. Some complaints, however,
may not have received appropriate attention. In early 2009, the SEC
received a torrent of criticism when it was disclosed to the public that
Harry Markopolous, an independent financial fraud investigator and
former securities industry executive, for nine years had attempted
repeatedly, in vain, to persuade the SEC to investigate Bernard Madoff.
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SEC Investigations and Enforcement Actions
§ 15:2.1
Since becoming Chairman of the SEC, Mary Schapiro has worked
to address the “important questions” raised by the Markopolous affair
concerning the SEC’s handling of tips and whistleblower information.8 As part of an ongoing initiative to review and improve the SEC’s
internal procedures in evaluating tips, complaints, and referrals, the
Enforcement Division established the Office of Market Intelligence,
which serves as a central office for handling all such information. 9 In
addition, the SEC has established the Office of the Whistleblower,
which administers the whistleblower rules and provides substantial
monetary awards to eligible individuals who come forward with
information that assists the Commission in identifying potential
fraud and other violations.10
The provision for compensating whistleblowers is included in the
Dodd-Frank financial reform bill, enacted in 2010, and in implementing rules adopted by the SEC in 2011.11 The legislation and rules
reward whistleblowers who voluntarily provide original information
that leads to a successful enforcement action and imposition of
monetary sanctions of over $1 million. The whistleblower in such
cases is entitled to between 10% and 30% of the total monetary
sanctions imposed.12 The whistleblower program went into effect on
August 12, 2011. According to the Commission’s 2011 Annual
Report, during the first seven weeks of the program, the SEC received
334 whistleblower tips.13 The most common complaint categories
included tips regarding market manipulation, corporate disclosures
and financial statements, and offering fraud.14 Since the passage of
Dodd-Frank, the SEC has reported an increase in the quality of tips it
receives.15 On August 21, 2012, the SEC reported its first payout as a
8.
9.
10.
11.
12.
13.
14.
15.
Mary L. Schapiro, Chairman, SEC, Testimony Before the Subcommittee on
Financial Services and General Government, U.S. Senate Committee on
Appropriations (Apr. 28, 2010), available at www.sec.gov/news/testimony/
2010/ts042810mls.htm.
Id.
See Office of the Whistleblower, SEC, www.sec.gov/whistleblower.
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No.
111-203 (H.R. 4173), 124 Stat. 1376 (July 21, 2010) [hereinafter DoddFrank]; see also Press Release No. 2011-116, SEC, SEC Adopts Rules to
Establish Whistleblower Program (May 25, 2011), available at sec.gov/
news/press/2011/2011-116.htm.
Id. § 922.
U.S. SEC. & EXCH. COMM’N, ANNUAL REPORT ON THE DODD -FRANK
WHISTLEBLOWER PROGRAM, FISCAL YEAR 2011 (Nov. 2011), available at
www.sec.gov/about/offices/owb/whistleblower-annual-report-2011.pdf.
Id.
See Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm’n, Opening
Statement at SEC Open Meeting Item 2—Whistleblower Program
(May 25, 2011), available at www.sec.gov/news/speech/2011/spch
052511mls-item2.htm.
(Securities Litig., Rel. #6, 10/12)
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§ 15:2.1
SECURITIES LITIGATION
result of the whistleblower program, awarding $50,000 to a whistleblower who helped stop a multi-million-dollar fraud. 16 The payout
represented 30% of the total monetary amount collected by the SEC in
the enforcement action, the maximum percentage permitted under the
whistleblower law.
A controversial aspect of the SEC’s whistleblower rules is the extent
to which the financial incentives could undermine corporate compliance programs by leading employees to bypass internal reporting
mechanisms in favor of reporting to the SEC in the first instance.
The rules do not require an employee to report a complaint to the
company first in order to be eligible for a reward, but rather provide
that the amount of the reward may be higher if the employee reports
the complaint internally and permit the employee complaint to the
SEC to relate back up to ninety days to the date of the report to the
company. The rules also permit principals, compliance personnel,
accountants, and individuals retained to conduct an inquiry to qualify
for a reward if they report the alleged violation to their compliance
program and the company proceeds in “bad faith” or does not
disclose the information to the SEC “within a reasonable time.”17
In order to more effectively identify and assess complex financial
industry practices and products, the SEC has also established the
Industry and Markets Fellows Program.18 The Fellows Program recruits industry experts to the agency’s Office of Risk Assessment, in
order to strengthen the Staff ’s oversight of securities markets by
providing new information and seasoned perspectives. Additionally,
the Division of Enforcement has formed five specialized units, each
with a specific enforcement focus, in order to increase enforcement
efficiency. These five units address high-priority areas of enforcement,
specifically: Asset Management, Market Abuse, Structured and New
Products, the Foreign Corrupt Practices Act, and Municipal Securities
and Public Pensions. The Division of Enforcement has additionally
made efforts to streamline internal operations by reducing the number
of managers, reassigning those individuals to the front lines of
investigations, and delegating authority to start formal investigations
16.
17.
18.
See Press Release No. 2012-162, U.S. Sec. & Exch. Comm’n, SEC Issues
First Whistleblower Program Award (Aug. 21, 2012), available at http://sec.
gov/news/press/2012/2012-162.htm.
See Implementation of the Whistleblower Provisions of Section 21F of the
Securities Exchange Act of 1934, 17 C.F.R. § 240, 249, available at www.
sec.gov/rules/final/2011/34-64545.pdf.
Press Release No. 2009-98, U.S. Sec. & Exch. Comm’n, SEC Announces
New Initiative to Identify and Assess Risks in Financial Markets (Apr. 30,
2009), available at www.sec.gov/news/press/2009/2009-98.htm.
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SEC Investigations and Enforcement Actions
§ 15:2.2
and issue subpoenas to senior officers in the Division of
Enforcement.19
§ 15:2.2
Types of SEC Enforcement Activities
[A] Informal Investigations
Frequently, SEC investigations begin with a request for the corporation’s voluntary cooperation in providing information to the SEC Staff.
While a corporation and its employees are under no obligation to comply
with such a request, it is usually in the company’s interest to do so. First,
voluntary cooperation will put the company in a more positive light in
the Staff ’s consideration of the issues posed by the investigation.
Second, voluntary cooperation may encourage the SEC Staff not to issue
a formal order of private investigation and may possibly reduce the
company’s requirement to disclose the informal inquiry in its periodic
filings. Third, voluntary cooperation gives the company some greater
degree of control over the scope of the investigation and the amount and
type of information that must be produced.
In any event, whether the company chooses to cooperate or not, once
it is advised of an informal inquiry, it should preserve relevant documents. The destruction of relevant documents in these circumstances
could lead to charges of obstruction of justice.20 In determining which
materials it is obliged to preserve or disclose in an informal inquiry, the
company should consider the potential relevance of the materials to the
matters under inquiry, not the informal or formal nature of the inquiry.21
[B] Formal Investigations
The federal securities laws permit the SEC to issue subpoenas to
compel the production of documents by company or by individuals
and to compel witnesses to appear and to testify under oath in
connection with investigations of possible violations of the securities
laws. The commissioners do not, of course, conduct these investigations themselves. They delegate their authority to members of the
19.
20.
21.
Robert Khuzami, Director, Division of Enforcement, U.S. Sec. & Exch.
Comm’n, Speech by SEC Staff: Speech to the Society of American Business
Editors and Writers (SABEW) (Mar. 19, 2010), www.sec.gov/news/speech/
2010/spch031910rsk.htm.
See, e.g., United States v. Fruchtman, 421 F.2d 1019, 1021 (6th Cir. 1970)
(holding that the obstruction of justice statute applies to an FTC inquiry
and is not limited to matters “before a federal agency which are juridical or
administrative in nature”; a “proceeding” within the meaning of the
obstruction of justice statute “is a term of broad scope, encompassing
both the investigative and adjudicative functions of a department or
agency”).
For a more detailed discussion of the benefits of cooperation, see section
15:3.1, infra.
(Securities Litig., Rel. #6, 10/12)
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§ 15:2.2
SECURITIES LITIGATION
Staff. This delegation is accomplished by the issuance of a “formal
order of private investigation,” which recites the factual predicate for
issuing the order and the statutory sections that may have been
violated, and which authorizes designated Commission employees
to issue subpoenas and compel witnesses to appear under oath. The
SEC Enforcement Manual states that as a general matter, informal
investigations should be closed or converted to an investigation within
sixty days.22
A formal order is not a finding of a fact or a form of adjudication. It
is akin to a corporate board resolution. Nevertheless, it asserts the
possibility of a violation of law by the company, and it may include
within its scope a wide variety of persons.23
In an effort to bolster the SEC’s enforcement program, SEC Chairman Mary Schapiro provided for a more rapid initiation of investigation.24 Formal orders had previously been subject to full review at a
meeting of all the Commissioners.25 This required several weeks
advance notice in order to have the formal order request placed on
the Commission’s meeting agenda.26 Under Chairman Schapiro, the
SEC has delegated the authority to issue subpoenas directly to
senior staff of the Enforcement Division “so investigations can be
launched without the prior—and time-consuming—approval of the
Commission.”27
Typically, SEC investigations commence with a broad request to the
company for the production of documents covering a specified time
period, as well as possible subpoenas. Such document requests and
subpoenas can be narrowed by negotiation in order to prevent an
undue burden and the production of irrelevant documents.
Once documents are collected, if the SEC Staff continues to have
questions, it will frequently call witnesses to testify regarding the
matter. The SEC may also opt to enter into proffer agreements in order
to obtain information and initiate a discussion with witnesses,
22.
23.
24.
25.
26.
27.
SEC Enforcement Manual § 2.3.2.
See SEC Enforcement Manual § 2.3.3.
Mary L. Schapiro, Chairman, SEC, Testimony Before the Subcommittee
on Financial Services and General Government, U.S. Senate Committee
on Appropriations (Apr. 28, 2010), www.sec.gov/news/testimony/2010/
ts042810mls.htm.
Mary L. Schapiro, Chairman, SEC, Speech by SEC Chairman: Address to
Practising Law Institute’s “SEC Speaks in 2009” Program (Feb. 6, 2009),
www.sec.gov/news/speech/2009/spch020609mls.htm.
Id.
Mary L. Schapiro, Chairman, SEC, Testimony Before the Subcommittee
on Financial Services and General Government, U.S. Senate Committee
on Appropriations (Apr. 28, 2010), www.sec.gov/news/testimony/2010/
ts042810mls.htm. See also SEC Delegation of Authority to Director of
Division of Enforcement, 17 C.F.R. § 200.30-4 (2009).
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SEC Investigations and Enforcement Actions
§ 15:2.2
including potential cooperating witnesses.28 With respect to neutral
witnesses, the SEC Staff is now often interviewing witnesses without a
court reporter. In a financial disclosure case, witnesses from the
company usually include its controller, its chief financial officer, and
other accounting and finance personnel.
Because financial disclosure investigations frequently turn on the
treatment of transactions between the company and third parties, the
SEC may issue subpoenas for testimony to other relevant persons.
Depending upon the nature of the case, these may include
(1)
the company’s independent auditors;
(2)
counterparts, such as customers, vendors, lenders, and banks;
and
(3)
business partners.
The SEC takes the position that it is not required to give the
company notice of the persons to whom the subpoenas are issued.
Thus, one of the frequent side effects of an SEC investigation is the
fact that it will cause persons with whom the company does business
to receive a subpoena in the investigation, with concomitant effects
upon the company’s reputation and business relationships.
[C] “Wells” Notices
After gathering documents and taking testimony, the Staff typically
makes a collaborative decision as to whether it will recommend that a
particular company or individual should be charged with a violation of
the federal securities laws, which laws are believed to have been
violated, and the nature of the relief to be sought. In virtually every
case other than those requiring emergency relief, the Staff will contact
counsel for the prospective defendant, state its conclusion, and summarize the basis for that conclusion. This is known as a “Wells”
notice. Counsel then has a time-limited opportunity to make a Wells
submission—essentially a brief setting forth factual and legal arguments why an enforcement action may not be appropriate. Before
making the Wells submission, the prospective defendant and counsel
have an opportunity to meet with the Staff to discuss the basis for its
28.
See SEC Enforcement Manual § 3.3.7 (“A proffer agreement is a written
agreement providing that any statements made by a person, on a specific
date, may not be used against that individual in subsequent proceedings,
except that the Commission may use statements made during the proffer
session as a source of leads to discover additional evidence and for
impeachment or rebuttal purposes if the person testifies or argues inconsistently in a subsequent proceeding.”).
(Securities Litig., Rel. #6, 10/12)
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§ 15:2.2
SECURITIES LITIGATION
conclusion. Such a meeting can be a helpful means to obtain greater
insight into the evidence the Staff believes supports its theories.
The Staff has the discretion, upon request, to allow the prospective
defendant and counsel to review non-privileged portions of the
investigative file.29 Viewing such information may allow counsel to
more intelligently assess the risks of possible enforcement action.
The ultimate decision whether to institute an enforcement proceeding is the Commission’s, based upon the Staff ’s recommendation. That recommendation usually is a collaborative one. Thus, in a
financial disclosure case, attorneys from the SEC ’s Division of
Enforcement typically solicit the views of the Office of the Chief
Accountant and the Division of Corporation Finance, and all recommendations are reviewed for consistency and for compliance
with Commission policy and statute by the Office of the General
Counsel.
Meetings with and Wells submissions to the Staff sometimes are
fruitful. Often counsel or the company can inform the Staff of
significant facts that may change its recommendation. Moreover,
even if the recommendation itself is not ultimately changed, counsel
and the company may be successful in persuading the Staff that some
defendants should be excluded altogether or that the severity of
charges should be reduced.
Although there are substantial benefits that may result from a Wells
submission, there are also possible tactical disadvantages to submitting one. To begin with, Wells submissions are commonly sought, and
sometimes considered discoverable, in private civil litigation. 30 In
addition, the SEC considers Wells submissions to be party admissions,
which may be used by the SEC in any future litigation it brings against
the person making the submission (and, in appropriate circumstances,
perhaps the corporation for whom the person was or is employed). 31
A Wells submission may also provide the SEC with a “roadmap” to the
defense in the event of litigation. In addition, federal prosecutors may
obtain Wells submissions pursuant to an information request from the
SEC and, in turn, make use of the Wells submission in a parallel
29.
30.
31.
See SEC Enforcement Manual § 2.4.
See, e.g., In re Initial Pub. Offering Sec. Litig., 2004 WL 60290 (S.D.N.Y.
Jan. 12, 2004).
See SEC Enforcement Manual § 2.4 (written Wells notice or written
confirmation of an oral Wells notice should, among other things, “inform
the recipient that any Wells submission may be used by the Commission
in any action or proceeding that it brings,” and attach a copy of SEC Form
1662); see also id. at 25 (the Staff may reject a submission if the person
making the submission “limits its admissibility under Federal Rule of
Evidence 408 or otherwise limits the Commission’s ability to use the
submission pursuant to Form 1662”).
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SEC Investigations and Enforcement Actions
§ 15:2.2
criminal proceeding. Thus, counsel must weigh carefully the benefits
and pitfalls of making a Wells submission and, if one is made, give
careful consideration to the content of the submission.
If the prospective defendant is unsuccessful in persuading the Staff,
the Staff sends its recommendation in the form of a memorandum
together with the Wells submission, to the Commissioners. In a
meeting open to the Staff but not to the public or to the prospective
defendants, the Commissioners decide whether an enforcement action
should be commenced. Once that decision is made, counsel is usually
advised of it and afforded a brief opportunity to determine whether to
negotiate a resolution of the case or to contest it.
The receipt of a Wells notice may create disclosure obligations. For
example, the associated firm of a registered broker who receives a Wells
notice is required to report that event on broker ’s Form U4.32 In
addition, the receipt of a Wells notice may trigger reporting obligations
for a public company. Failing to make the requisite disclosures can
result in significant penalties for regulated entities.33 Wells notices are
also commonly sought in discovery in private civil litigation discovery.
Under Dodd-Frank, the Commission must also comply with certain obligations if it chooses to issue a Wells notice. The Commission
Staff, within 180 days of issuing a Wells notice against a person, is
required to either bring action against that person or notify the
Division of Enforcement of its intent not to do so.34
In some cases, it is possible to engage with the Staff in a “pre-Wells”
process in which counsel may make a submission akin to a Wells
submission and engage in a dialogue with the Staff, but without the
receipt of a formal Wells notice. This can alleviate the various
32.
33.
34.
See, e.g., FINRA Provides Guidance on Its Enforcement Process, NASD
Regulatory Notice 09-17 (Mar. 18, 2009).
See News Release, FINRA, Goldman Sachs to Pay $650,000 for Failing to
Disclose Wells Notices (Nov. 9, 2010), available at www.finra.org/Newsroom/NewsReleases/2010/P122416 (announcing fine against broker-dealer
for failure to report, pursuant to FINRA rules, that two registered representatives had received Wells notices). However, in a separate shareholder
action against the broker-dealer based on the firm’s failure to disclose its
receipt of a Wells notice, the district court held that the failure to disclose a
Wells notice was not materially misleading. See Richman v. Goldman
Sachs Grp., Inc., No. 10 Civ. 3461 (PAC), 2012 WL 2362539, at *6
(S.D.N.Y. June 21, 2012) (finding “Plaintiffs have not shown that Defendants’ nondisclosure of their receipt of Wells Notices made their prior
disclosures about ongoing governmental investigations materially misleading; or that Defendants breached their duty to be accurate and complete in
making their disclosures”).
Dodd-Frank § 929U(a).
(Securities Litig., Rel. #6, 10/12)
15–13
§ 15:2.3
SECURITIES LITIGATION
discovery issues and disclosure obligations.35 In addition, since the
passage of Dodd-Frank, a “pre-Wells” process also alleviates for the
Staff the time constraints imposed by Dodd-Frank.
[D]
Closing Investigations
In 2007, the Government Accountability Office issued a report
criticizing the SEC for failing to close investigations in a timely
manner.36 The SEC responded to that criticism by encouraging the
Staff to close an investigation as soon as it becomes apparent that no
enforcement action will be recommended so that resources can be
directed to investigations that will be more productive. 37 The SEC
closed 628 cases in fiscal year 2011, compared to 975 in fiscal year
2007—a 64% decrease.38
The SEC also has made it its policy to send termination letters to the
individuals, entities, or their counsel “at the earliest opportunity” when
the Staff has determined not to recommend an enforcement action
against them.39 The SEC’s policy is to send termination letters regardless of whether the investigation was pursuant to a formal order.40 The
SEC Enforcement Manual provides that a termination letter
must in no way be construed as indicating that the party has been
exonerated or that no action may ultimately result from the staff ’s
investigation of that particular matter. All that such a communication means is that the staff has completed its investigation
and that at that time no enforcement action has been recom41
mended to the Commission.
§ 15:2.3
SEC Enforcement Trends
During the last few years, the turmoil in the economy and in the
financial markets has underscored the importance of SEC enforcement
and spurred a period of significant review and change in its enforcement program. In January 2009, Mary Schapiro became the twentyninth Chairman of the SEC. Schapiro has stated that she intends to
35.
36.
37.
38.
39.
40.
41.
See SEC Enforcement Manual § 2.4 (“If the staff intends to provide a
written Wells notice, the staff may give advance notice of the intention to
the recipient or his counsel.”).
SEC Report, Additional Action Needed to Ensure Planned Improvements
Address Limitations in Enforcement Division Operations, GAO-07-830
(Aug. 2007), available at www.gao.gov/new.items/d07830.pdf.
See SEC Enforcement Manual § 2.6.1.
SEC Report, Greater Attention Needed to Enhance Communication and
Utilization of Resources in the Division of Enforcement, GAO-09-358
(Mar. 2009), available at www.gao.gov/new.items/d09358.pdf.
See SEC Enforcement Manual § 2.6.2.
Id.
Id. at 35.
15–14
SEC Investigations and Enforcement Actions
§ 15:2.3
reinvigorate the SEC’s enforcement program and protect investors
through a variety of new measures and proposals to bring transparency
and accountability to the marketplace. The implications are likely to
be significant for companies facing SEC investigations in the coming
months.
Over the last few years, the SEC Enforcement Division has brought
hundreds of enforcement actions annually, ranging from 484 actions
in 2001 to a record high 735 actions in 2011.42 The number of insider
trading cases increased 8% from 2010 to 2011, while the number of
market manipulation cases remained relatively unchanged. The
dramatic increase in actions brought against broker-dealers and investment advisers accounts for much of the enforcement growth in
2011. There was a 30% increase in actions against investment advisers
and a 60% increase in actions against broker-dealers, as compared to
2010. The SEC filed nearly 8% more actions overall and continued its
trend upwards with respect to the number of formal orders of investigation opened, up from 531 in 2010 to 578 in 2011. In 2011, the
number of temporary restraining orders sought by the SEC increased
by 5%, while the number of asset freezes declined by 26%.
In 2011, the SEC obtained roughly $1.88 billion in disgorgement
orders, representing only a slight increase from $1.82 billion in 2010.
Penalty orders remained high in 2011, amounting to $928 million,
though slightly down from the record-high $1.030 billion in 2010. 43
One of Ms. Schapiro’s first acts as Chairman was to end the SEC’s
“penalty-pilot” program, which required approvals from the Commissioners before seeking monetary penalties against public companies in
civil fraud actions. That policy was heavily criticized for discouraging the
Staff from either seeking a penalty or seeking what was considered to be
a disproportionately high penalty.44
In most years, until recently, financial reporting and disclosure
cases represented the single biggest percentage of the Enforcement
Division’s caseload. Indeed, in every year between 2001 and 2007, the
Enforcement Division brought at least one hundred such cases. 45
This trend somewhat paralleled the trend in restatements by public
42.
43.
44.
45.
SEC, SELECT SEC AND MARKET DATA FISCAL 2011, available at www.sec.
gov/about/secstats2011.pdf.
SEC, SELECT SEC AND MARKET DATA FISCAL 2010, at 2, available at www.
sec.gov/about/secstats2010.pdf.
Luis A. Aguilar, SEC Commissioner, Speech at Third Annual Fraud and
Forensic Accounting Education Conference, Atlanta, Georgia, “Combating
Securities Fraud at Home and Abroad” (May 28, 2009), available at www.
sec.gov/news/speech/2009/spch052809laa.htm.
The year 2010 bucked this trend as securities offering cases exceeded
reporting and disclosure cases 144 to 126, respectively. SEC Select Data,
at 3.
(Securities Litig., Rel. #6, 10/12)
15–15
§ 15:3
SECURITIES LITIGATION
companies, which reached record levels during this same time period,
spurred in part by the reforms adopted by many companies as a result
of the passage of the Sarbanes-Oxley Act. More recently, the statistics
above reflect a significant increase in the number of actions against
SEC registered firms and their associated persons.
The Enforcement Division has also dramatically increased the
number of actions brought under the FCPA. For decades, the SEC
seldom used its authority, shared with the DOJ, to enforce this thirtyyear-old statute. But in recent years the number of FCPA cases—which
are very often very large and can involve fines in the hundreds of
millions—has increased dramatically, rising from zero cases in 2003
to twenty cases in 2011.46 In December 2008, the SEC reached a
$350 million settlement with Siemens AG in an FCPA case, the largest
FCPA settlement in the SEC’s history. Two months later, the SEC
concluded a $177 million settlement with Halliburton Co. and its
former subsidiary, KBR, Inc. In March 2010, Daimler AG agreed to pay
$91.4 million to settle SEC charges for FCPA violations. In July 2010,
Snamprogetti Netherlands, B.V. and ENI, S.p.A. settled FCPA violations for $125 million jointly. In September 2010, ABB Ltd. agreed to
pay more than $39.3 million and Alcatel-Lucent, S.A. settled FCPA
charges for $137 million in December 2010.
§ 15:3
SEC Enforcement Actions
§ 15:3.1
The Role of Cooperation
[A] The Seaboard Report
In the past decade, the SEC has become increasingly vocal about the
role of cooperation in deciding the severity of punishment it will seek
against a corporation whose employees are believed to have been
involved in violations of the federal securities laws. The trend began
in 2001 with the so-called Seaboard Report,47 in which the SEC laid
out the factors that are considered in determining whether a company
should receive credit for good cooperation. The release stressed four key
concepts—self-policing, self-reporting, cooperation, and remediation—
and listed a detailed set of factors the SEC may consider when bringing
an enforcement action. The Seaboard Report notes that public companies should institute effective compliance procedures before the
46.
47.
Speech by SEC Staff: Remarks at News Conference Announcing New SEC
Leaders in Enforcement Division (Jan. 13, 2010), www.sec.gov/news/
speech/2010/spch011310newsconf.htm.
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 Rel. No.
44,969 (Oct. 23, 2001).
15–16
SEC Investigations and Enforcement Actions
§ 15:3.1
discovery of alleged wrongdoing—and be prepared to answer questions
such as “What compliance procedures were in place to prevent the
misconduct now uncovered?” and “Why did these procedures fail to
stop or inhibit the wrongful conduct?” Companies need to be aware of
these concerns and should probe their own compliance structure and
conduct with these questions in mind.
While an effective compliance program and self-policing are important factors, the Seaboard Report also devoted considerable time to
a discussion of the role of cooperation. In the Seaboard investigation
itself, the Staff noted that the company had provided the SEC with all
information relevant to the alleged misconduct, including the details
of its internal investigation. That included notes and transcripts of
interviews of the former controller and others. Also, the company “did
not invoke the attorney-client privilege, work product protection or
other privileges or protections with respect to any facts uncovered in
the investigation.”
The Seaboard Report concerned credit for cooperation by corporations, not individuals. In January 2010, the Enforcement Division
amended its Enforcement Manual to add new provisions designed to
foster cooperation by individuals. The new provisions offer guidance
for evaluating an individual’s cooperation and authorize new cooperation tools, including cooperation agreements, deferred prosecution
agreements, and non-prosecution agreements.48
In evaluating an individual’s cooperation, the Enforcement Division will consider:
(a)
assistance provided by the individual;
(b)
importance of the underlying matter;
(c)
interest in holding the individual accountable; and
(d)
profile of the individual.
The standards track the typical DOJ considerations for evaluating
cooperation.
Once the Enforcement Division determines that an individual
should be given credit for cooperation, the new enforcement manual
provides the Division and the Commission with a nonexclusive list of
tools to encourage and facilitate such cooperation.
(1)
48.
Cooperation agreements: The Enforcement Division may
agree to recommend to the Commission that the individual
or company receives credit for giving substantial assistance.
The Division may also make specific enforcement recommendations to the Commission where appropriate. In return, the
SEC Enforcement Manual § 6.
(Securities Litig., Rel. #6, 10/12)
15–17
§ 15:3.1
SECURITIES LITIGATION
individual or company agrees, among other things, to cooperate fully and truthfully, and waive applicable statutes of
limitations.
(2)
Deferred prosecution agreements: The Commission may
forego an enforcement action against an individual if the
individual agrees to cooperate fully and truthfully, to waive
applicable statutes of limitations, to comply with prohibitions
and undertakings, to pay any agreed disgorgement or
penalty amounts, and to admit or agree not to contest the
relevant facts underlying the alleged offenses. Deferred prosecution agreements are for a set amount of time that cannot
exceed five years, after which the Commission may agree not
to pursue any further enforcement action if the individual
adheres to the terms of the agreement.
(3)
Non-prosecution agreements: The Commission may agree not
to pursue an enforcement action if the individual agrees to
cooperate fully and truthfully, comply with express undertakings, and pay any agreed disgorgement or penalty amounts.
The guidelines make clear that these should generally be used
in limited circumstances and that other forms of obtaining
cooperation should be considered first.
(4)
Expedited immunity requests: The Director of Enforcement
may now submit expedited immunity requests to the DOJ in
to provide a cooperator with protection against criminal
prosecution. Approval of the Commission is no longer required for such requests.
(5)
Proffer agreements: Statements made by an individual in an
investigation may not be used against that individual in
subsequent proceedings except as a source of investigative
leads or for impeachment or rebuttal if the person testifies
inconsistently in a subsequent proceeding.
(6)
Oral assurances: Assistant directors may give assurances to
individuals that based on currently available evidence the
Division does not currently anticipate recommending an enforcement action against an individual or a company.
It remains to be seen whether these initiatives will result in meaningful credit for cooperation by individuals. Thus far, the Staff has
stated that it has entered into cooperation agreements with a number
of individuals. However, there is a sparse public record identifying an
individual as a cooperator or reflecting the credit that individual
received in return for their cooperation.
15–18
SEC Investigations and Enforcement Actions
§ 15:3.1
In 2012, the SEC announced for the first time publicly that it
credited the substantial cooperation of a former senior executive of an
investment adviser by declining to take enforcement action against
him.49 The executive’s cooperation assisted in the settled enforcement
action against institutional money manager AXA Rosenberg, where,
without admitting or denying wrongdoing, the firm agreed to pay
$217 million to clients plus a $25 million penalty.50 The Commission
issued a corresponding litigation release where it analyzed the former
executive’s cooperation by applying it to the four factors outlined in
the Commission’s Cooperation Policy Statement:
(1)
Assistance Provided. The executive possessed intimate knowledge relating to the investment adviser and provided his
assistance to the SEC without conditions, which bolstered
his credibility.
(2)
Importance of the Underlying Matter. The SEC was able to
return to clients their alleged losses, and AXA Rosenberg
agreed to pay a penalty totaling $25 million.
(3)
Interest in Holding the Senior Executive Accountable. The
cooperating executive played a limited role in the alleged
conduct at issue, and his cooperation maximized the SEC’s
law enforcement interests by efficiently and successfully resolving the issues against the firm.
(4)
The Executive’s Profile. The executive, who had no prior
disciplinary history, was not an associated person of any
regulated entity, a fiduciary for other individuals or entities
regarding financial matters, or an officer or director of a public
company.51
The SEC’s announcement represents an initial step in the direction
of creating a public record of the potential rewards for cooperation.
While this announcement provides much-needed insight into the
potential benefits of cooperation, because the nature of this case is
highly fact-specific, there still remains a relative scarcity of guidance in
this area.
49.
50.
51.
SEC Litigation Rel. No. 22,298, SEC Credits Former AXA Rosenberg
Executive for Substantial Cooperation During Investigation (Mar. 19,
2012), available at www.sec.gov/litigation/litreleases/2012/lr22298.htm.
See Press Release No. 2011-37, U.S. Sec. & Exch. Comm’n, SEC Charges
AXA Rosenberg Entities for Concealing Error in Quantitative Investment
Model (Feb. 3, 2011), available at www.sec.gov/news/press/2011/2011-37.
htm.
SEC Litigation Rel. No. 22,298, SEC Credits Former AXA Rosenberg
Executive for Substantial Cooperation during Investigation (Mar. 19,
2012), available at www.sec.gov/litigation/litreleases/2012/lr22298.htm.
(Securities Litig., Rel. #6, 10/12)
15–19
§ 15:3.1
SECURITIES LITIGATION
With respect to corporations, the SEC has made public use of two of
its new cooperation tools. In 2010, the SEC entered into its first nonprosecution agreement.52 In resolving the alleged accounting fraud,
the corporate defendant did not have to pay a monetary penalty, but
agreed to cooperate in the SEC’s investigation for an unlimited period
of time and to forego raising a statute-of-limitations defense if it were
to violate the agreement. In 2011, the SEC entered into its first
deferred prosecution agreement.53 To resolve alleged FCPA violations,
the three-year agreement required the corporate defendant to pay
disgorgement and to toll the statute of limitations during the threeyear agreement period.
[B]
2006 Statement on Penalties
Following criticism from the issuer community about the Enforcement Division’s pattern of imposing ever-increasing civil penalties
against corporations for alleged noncooperation, and in light of the
lack of definitive guidance as to the circumstances under which the
SEC would impose penalties against a corporate issuer, the SEC issued
important guidance in 2006, setting forth specific criteria that the Staff
will utilize in evaluating the question of civil penalties. Specifically,
the SEC issued its “Statement Concerning Financial Penalties” on
January 4, 2006, in which it said that the appropriateness of penalties
on a corporation in a particular case turns principally on two factors:
(1) the presence or absence of a direct benefit to the corporation as a
result of the violation and (2) the degree to which the penalty will
recompense or further harm the injured shareholders. In addition, the
SEC noted other subsidiary factors, which included the extent of
cooperation exhibited by the company in connection with any SEC
investigation. On that issue, the Statement said that “the degree to
which a corporation has self reported an offense, or otherwise cooperated with the investigation and remediation of the offense, is a factor
that the Commission will consider.” The stated purpose of the guidelines was to provide “clarity, consistency, and predictability.”54 Upon
recommendation by the Government Accountability Office, current
52.
53.
54.
Non-Prosecution Agreement Between Carter ’s, Inc. and the Securities
and Exchange Commission (Dec. 17, 2010), available at www.sec.gov/
litigation/cooperation/2010/carters1210.pdf.
Deferred Prosecution Agreement Between Tenaris S.A. and the Securities
and Exchange Commission (May 17, 2011), available at www.sec.gov/
news/press/2011/2011-112-dpa.pdf.
Robert Khuzami, SEC Director, Testimony Concerning Strengthening the
SEC’s Vital Enforcement Responsibilities, Before the U.S. Senate Banking,
Housing, and Urban Affairs Subcommittee on Securities, Insurance, and
Investment (May 7, 2009), available at www.sec.gov/news/testimony/
2009/ts050709rsk.htm.
15–20
SEC Investigations and Enforcement Actions
§ 15:3.1
Enforcement Director Robert Khuzami stated in 2009 that the Division would undertake an examination to see whether the 2006
corporate penalty policy is actually achieving its intended goals. 55 As
stated by Mr. Khuzami, the “focus of any penalty policy should be
assurance that malefactors get appropriately severe sanctions to sufficiently deter them and others from engaging in similar misconduct in
the future.”56
Nevertheless, the SEC continues to struggle with the issue of
corporate penalties, as illustrated by the SEC’s settlement with Bank
of America57 over its failure to disclose an agreement to pay $5.8 million
in bonuses to Merrill Lynch executives prior to Bank of America’s
acquisition of Merrill. After rejecting the SEC’s initial proposed fine of
$33 million, Judge Rakoff reluctantly approved a $150 million settlement with Bank of America. Judge Rakoff noted that the fine penalized
shareholders without holding individual executives accountable, and
suggested that sanctions against the culpable employees would have
been more appropriate.58
The SEC has also recently faced a challenge, also from Judge Rakoff,
to its traditional policy to enter into settlements by permitting
defendants to neither admit nor deny the allegations of the complaint
or findings in the administrative order. In November 2011, Judge
Rakoff rejected a proposed $285 million settlement between the SEC
and Citigroup.59 Judge Rakoff explained that
the S.E.C.’s long-standing policy—hallowed by history, but not by
reason—of allowing defendants to enter into Consent Judgments
without admitting or denying the underlying allegations, deprives
the Court of even the most minimal assurance that the substantial
60
injunctive relief it is being asked to impose has any basis in fact.
55.
56.
57.
58.
59.
60.
Id.
Id.
SEC v. Bank of Am. Corp., 2010 WL 624581 (S.D.N.Y Feb. 22, 2010)
(Rakoff, J.).
Id. at *5 (“Where management deceives its own shareholders, a fine most
directly serves its deterrent purposes if it is assessed against the persons
responsible for the deception.”). In August 2010, Judge Huvelle refused to
approve a settlement between Citigroup and the SEC over allegations that
Citigroup mislead investors regarding its exposure to the subprime mortgage crisis. SEC v. Citigroup, Inc., No. 10-cv-1277 (D.D.C. Aug. 17, 2010).
She issued eight questions to the SEC, among them why negligence was
charged and why it was fair for Citigroup’s shareholders to pay the
proposed $75 million settlement. In October Judge Huvelle approved the
settlement after ordering that the settlement make clear that the $75 million
will be used to compensate shareholders.
See SEC v. Citigroup Global Mkts., Inc., 827 F. Supp. 2d 328 (S.D.N.Y.
2011).
Id. at 332.
(Securities Litig., Rel. #6, 10/12)
15–21
§ 15:3.1
SECURITIES LITIGATION
Both Citigroup and the SEC moved for interlocutory appeal, and a
three-judge motions panel of the Second Circuit, per curiam, disagreed
with Judge Rakoff, staying the District Court proceedings and writing
that the petitioners had a substantial likelihood of prevailing on
appeal.61 In granting the stay, the Second Circuit noted that “the
[district] court does not appear to have given deference to the SEC’s
judgment on wholly discretionary matters of policy . . . [i]t is not,
however, the proper function of federal courts to dictate policy to
executive administrative agencies.”62 At the time of this publication, a
full appeal on the merits of this case remains pending, but in a public
statement at the beginning of 2012, Enforcement Director Robert
Khuzami made clear that the SEC stands by its traditional “neither
admit nor deny” approach in cases such as this.63
[C]
Privilege Waivers As an Element of Cooperation
In light of the Seaboard Report and subsequent SEC enforcement
actions in which large penalties have been imposed for alleged noncooperation, a particular concern has arisen over the question of
whether companies must waive their attorney-client privileges in order
to garner greater credit for cooperation. In the wake of Seaboard,
although the Enforcement Staff publicly stated that it did not require
companies to waive privilege, the Staff has consistently asked companies to produce their privileged materials. As a result, companies
raised concerns that a new “culture of waiver” had arisen that
threatened the very fabric of the attorney-client privilege. Moreover,
companies that waived their privileges in connection with an SEC
investigation have been exposed to the additional risk that such
privileges also were deemed waived in connection with any parallel
private class action litigation. Indeed, in a number of prominent cases,
district courts ordered companies to produce otherwise privileged
documents to the civil class action plaintiffs’ lawyers, based upon
the fact that the companies previously had produced those same
documents to the SEC or other government agencies.64
61.
62.
63.
64.
SEC v. Citigroup Global Mkts., Inc., 673 F.3d 158 (2d Cir. 2012).
Id. at 163.
Robert Khuzami, Enforcement Director, U.S. Sec. & Exch. Comm’n,
Public Statement by SEC Staff: Recent Policy Change (Jan. 7, 2012),
available at www.sec.gov/news/speech/2012/spch010712rsk.htm (noting
that the SEC made a recent policy change in its “admit or deny” approach
as applied specifically to criminal convictions, but this “policy change does
not affect [the] traditional ‘neither admit nor deny’ approach in settlements” and, in particular, “it is separate from and unrelated to the recent
ruling in the Citigroup case”).
See In re Qwest Sec. Litig., 450 F.3d 1179 (10th Cir.), cert. denied, 549
U.S. 1031 (2006).
15–22
SEC Investigations and Enforcement Actions
§ 15:3.1
This practice met with considerable criticism from a wide range of
commentators and practitioners, including one SEC Commissioner.
In one article, former Commissioner Paul Atkins and a co-author
wrote that “the Enforcement Division and the Commission . . . often
have misinterpreted the Seaboard Report as a basis for rewarding
companies for waiving privilege.”65 The authors noted that, “[a]s
a practical matter, rewarding companies for cooperating by waiving
privilege has the same effect as punishing them for not waiving
privilege—both effectively strip the attorney-client privilege, which is
a fundamental component of our legal system.”66
Widespread concerns over the “culture of waiver” led to congressional inquiries and proposed legislation to forestall future efforts by
the SEC to penalize companies that refuse to waive attorney-client
privileges in connection with SEC investigations. The DOJ addressed
the issue head-on in the McNulty Memorandum, issued in December
2006.67 The McNulty Memorandum stated that “waiver of attorneyclient and work product protections is not a prerequisite to a finding
that the company has cooperated in the government’s investigation.”
The McNulty Memorandum went on to recite, however, that prosecutors may legitimately request waivers when in their view there is a
“legitimate need for the privileged information to fulfill their law
enforcement duties.” If those conditions exist and a request for waiver
is made, “a corporation’s response to the government’s request for
waiver of privilege [of purely factual information relating to the
underlying misconduct] may be considered in determining whether a
corporation has cooperated in the government’s investigation.” By
contrast, a prosecutor ’s request for privileged information that
may include overt attorney-client communications or non-factual
attorney work product, if refused, may not be considered against the
corporation in making a charging decision.68
In August 2008, in the face of the many challenges to the McNulty
Memorandum’s position on privilege waivers in connection with DOJ
criminal investigations, the DOJ announced that it was once again
65.
66.
67.
68.
Paul S. Atkins & Bradley J. Bondi, Evaluating the Mission: A Critical
Review of the History and Evolution of the SEC Enforcement Program, 13
FORDHAM J. CORP. & FIN. L. 367, 404 (2008).
Id. at 404–05.
See Principles of Federal Prosecution of Business Organizations, a memorandum from Deputy Attorney General Paul J. McNulty to all United
States Attorneys [hereinafter McNulty Memorandum].
The McNulty Memorandum also sets forth various other factors that may
influence the charging decision, including whether the company may be
viewed as trying to protect culpable employees from the government. This
factor in turn may implicate such common practices as the advancement
of defense costs, indemnification policies and practices, and the like. For a
discussion of this aspect of the McNulty Memorandum, see section 14:1.6.
(Securities Litig., Rel. #6, 10/12)
15–23
§ 15:3.2
SECURITIES LITIGATION
revising its guidelines, effectively superseding the McNulty Memorandum. In the revised guidelines, known as the Filip Memorandum,
the DOJ made clear that credit for cooperation in a criminal investigation cannot be tied to an agreement by the company to waive attorneyclient or work-product protections. Rather, credit for cooperation will
be based on disclosure of relevant facts not necessarily embodied in
privileged communications. The Filip Memorandum also has been the
target of criticism for not going far enough to protect the attorneyclient privilege. As former Deputy Attorney General McNulty stated,
“there is still a pressure to waive attorney-client privilege if you have
‘relevant factual information’ covered by attorney-client privilege . . .
and quite a bit of ‘relevant factual information’ is subject to privilege
claims.”69
In November 2008, the Enforcement Division issued its first-ever
Enforcement Manual, which sets forth the SEC’s approach to privilege
waivers. Like the Filip Memorandum, the manual provides that the
Staff should not ask a party to waive the attorney-client or workproduct privilege, and it is not directed to do so. 70 The manual
further provides that voluntary disclosure need not include a waiver
of privilege to be an effective form of cooperation, as long as all
relevant facts are disclosed.71
§ 15:3.2
Civil Remedies
[A] Civil Injunctions
The SEC may obtain a civil injunction prohibiting any person or
corporation from future violations of the federal securities laws based
upon a showing that the person or enterprise has violated or is about
to violate the federal securities laws. Injunctions are issued by a federal
district judge after commencement of a lawsuit by the SEC and a trial
pursuant to the Federal Rules of Civil Procedure. 72 The standard for
issuing an injunction requires that the SEC show a reasonable likelihood of future violations. Courts usually look to four factors:
69.
70.
71.
72.
Brian Baxter, With Thompson Trashed & McNulty Moot, Filip Memo’s Time
Has Come, AM. LAW. DAILY, Aug. 28, 2008, http://amlawdaily.typepad.com/
amlawdaily/2008/08/with-thompson-t.html.
See SEC Enforcement Manual § 4.3.
Id.
In a recent decision, the Eleventh Circuit ruled that injunctive orders for
Rule 10b-5 violations must be written with particularity. The court held
that such an order is an impermissible “obey the law” command “if an
injunction simply used the language of § 10(b) of the Exchange Act or Rule
10b-5” because “a defendant reading the injunction would have little
guidance on how to conform his conduct to the terms of the injunction.”
SEC v. Goble, D.C. Docket No. 6:08-cv-00829-MSS-KRS, 2012 WL
1918819, at *11 (11th Cir. May 29, 2012).
15–24
SEC Investigations and Enforcement Actions
§ 15:3.2
(1)
The nature of the conduct;
(2)
The degree of scienter (bad intent) involved;
(3)
The defendant’s ability to violate the law in the future; and
(4)
The degree to which the defendant has recognized the wrongfulness of his conduct.
The SEC is also able to obtain temporary equitable relief—such as
an asset freeze or receivership—under emergency circumstances. The
SEC generally seeks such relief when there is significant reason to
believe that a defendant might destroy evidence or move assets outside
the SEC’s jurisdiction. In a case in 2008, the SEC even went so far as
to obtain an asset freeze in the United Kingdom, which required
convincing the High Court of Justice in London that the SEC
constituted a public law enforcement agency for the purposes of
U.K. law.73
[B] Ancillary Relief
Even if a court does not issue an injunction prohibiting future
violations of the law, it may award the SEC ancillary relief. Common
forms include the following.
[B][1] Disgorgement
The SEC will frequently seek to have the defendant “disgorge” or
repay money obtained as a result of alleged violations of the federal
securities laws. Such improper gains may include, for example, profits
from insider trading; proceeds obtained from illegal securities distributions; bonuses based upon improperly recognized revenues; and
assets that were misappropriated. The SEC will seek prejudgment
interest on these sums.
In addition to traditional disgorgement remedies, the SEC also was
granted new authority by the Sarbanes-Oxley Act of 2002, permitting
it to add the amount of any civil penalties it recovers to any disgorgement fund established for the benefit of victims of the securities law
violation. This “fair funds” provision in section 308 arguably increases
the SEC’s ability to make victims whole when the amount of disgorgement otherwise obtainable from wrongdoing officers and directors is insufficient, whether due to the limited assets of the
individuals, or other factors mitigating against the imposition of a
more severe disgorgement amount. The SEC succeeded in distributing
approximately $2.2 billion to injured investors in 2010, bringing the
73.
See SEC Obtains Asset Freeze in the United Kingdom Against Hedge Fund
Principal (June 25, 2008), available at www.gibsondunn.com/Publications/
Pages/SECAssetFreezeInUKAgainstHedgeFundPrincipal.aspx.
(Securities Litig., Rel. #6, 10/12)
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SECURITIES LITIGATION
total distributions since the passage of Sarbanes-Oxley to over $4.6 billion.74 In 2007, the SEC created the Office of Collections, Distributions
and Financial Management to manage the collection of penalties and
disgorgements and speed the process of returning funds back to harmed
investors.75
Finally, section 1103 of the Sarbanes-Oxley Act authorizes the SEC
to obtain an order temporarily freezing assets of an individual accused
of a securities law violation. Specifically, section 1103 allows such an
asset freeze if it is “likely” that the issuer will make “extraordinary
payments” to an officer suspected of violating the federal securities
laws. The freeze order can extend to payments in the form of compensation “or otherwise,” and requires the issuer to escrow such funds
for a period of up to forty-five days, presumably to permit the SEC to
then seek additional relief to prohibit the movement of funds. In
practice, this statute would typically be used in the context of a severance
deal with a wrongdoing officer, particularly if there is a flight risk.
[B][2] Clawback of Executive Compensation
Section 304 of the Sarbanes-Oxley Act provides that, if an issuer “is
required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial
reporting requirement under the securities laws,” the CEO and CFO
shall reimburse the issuer for any bonus or other incentive-based or
equity-based compensation received, and any profits realized from the
sale of the securities of the issuer, during the year following issuance of
the original financial report.76 The statute does not specify whose
“misconduct” is required in order to trigger the remedy. Until recently,
the SEC only asserted section 304 claims against CEOs and CFOs who
were also alleged to have been personally involved in wrongdoing
leading to the restatement. For example, several early cases involved
CEOs or CFOs who participated in option backdating and received
backdated options.77 Another case involved an officer who allegedly
participated in a fraud and misappropriated company funds. 78
74.
75.
76.
77.
78.
SEC, FY 2010 Performance and Accountability Report, at 12, available at
www.sec.gov/about/secpar/secpar2010.pdf.
Luis A. Aguilar, SEC Commissioner, Introductory Remarks Before the
District of Columbia Bar, Reinvigorating the Enforcement Program to
Restore Investor Confidence (Mar. 18, 2009), available at www.sec.gov/
news/speech/2009/spch031809laa.htm.
Section 304 of the Sarbanes-Oxley Act is codified at 15 U.S.C. § 7243.
See, e.g., SEC v. McGuire, No. 07-CV-4779-JMR/FLN (D. Minn. 2007);
see also Litigation Rel. No. 20,387 (Dec. 6, 2007), available at www.sec.
gov/litigation/litreleases/2007/lr20387.htm.
SEC v. Brooks, No. 07-61526-CIV-Altonaga/Turnoff (S.D. Fla. 2007); see
also Litigation Rel. No. 20,345 (Oct. 25, 2007), available at www.sec.gov/
litigation/litreleases/2007/lr20345.htm.
15–26
SEC Investigations and Enforcement Actions
§ 15:3.2
In 2009, the SEC for the first time used section 304 in an action
seeking to “claw back” bonuses and proceeds of stock sales from a CEO
who was not accused of any securities law violation.79 The SEC’s
complaint based the claim on the company ’s misconduct.80 The
district court in the case denied the CEO’s motion to dismiss, finding
that section 304 does not require personal misconduct.81 The SEC
subsequently reached a settlement to claw back $2.8 million in
compensation from the former chief executive and chairman, who
oversaw the company at the time of the scandal.82 In 2011, the SEC
settled another significant case with an executive not accused of
wrongdoing, recovering $1.4 million from the former CFO of a large
home builder.83 The SEC’s application of section 304 to executives not
accused of personally violating the securities laws or other misconduct
raises significant legal and policy questions that will continue to be
addressed in this litigation. In another matter, the SEC reached a
settlement with a CEO whereby the CEO consented to a final order for
him to reimburse cash bonuses, stock, and stock options, despite the
fact that the SEC did not allege the CEO was involved in the
corporation’s alleged fraud.84
[B][3] Corrective Disclosure
The SEC may also seek an order requiring that the issuer restate
previously issued annual or quarterly financial statements to correct
79.
80.
81.
82.
83.
84.
SEC v. Jenkins, Case 2:09-cv-01510-JWS (D. Ariz. July 23, 2009); see also
Litigation Rel. No. 21,149A (July 23, 2009), available at www.sec.gov/
litigation/litreleases/2009/lr21149a.htm.
The SEC had previously filed a settled enforcement action against the
company alleging improper accounting that led to financial restatements.
See In the Matter of CSK Auto Corp., Securities Act Rel. No. 9,032
(May 26, 2009), available at www.sec.gov/litigation/admin/2009/
33-9032.pdf. The SEC had also filed an unsettled enforcement action
against several former senior executives of the company, other than the
CEO, alleging violations of the federal securities laws. See SEC v. Fraser,
Case No. 2:09-cv-00442-LOA (D. Ariz.), Litigation Rel. No. 20,933
(Mar. 6, 2009), available at www.sec.gov/litigation/litreleases/2009/
lr20933.htm.
SEC v. Jenkins, 2010 WL 2347020 (D. Ariz. June 9, 2010).
See Dealbook, S.E.C. Claws Back $2.8 Million from CSK Executive, N.Y.
TIMES, Nov. 15, 2011, available at http://dealbook.nytimes.com/2011/11/
15/s-e-c-claws-back-2-8-million-from-csk-executive/.
Press Release No. 2011-172, U.S. Sec. & Exch. Comm’n, SEC Recovers
CFO’s Bonus and Stock Sale Profits Received During Beazer Homes
Accounting Fraud (Aug. 30, 2011), available at www.sec.gov/news/press/
2011/2011-172.htm.
SEC v. O’Dell, No. 1:10-CV-00909 (D.D.C. June 2, 2010); see also
Litigation Rel. No. 21,543 (June 2, 2010), available at www.sec.gov/
litigation/litreleases/2010/lr21543.htm.
(Securities Litig., Rel. #6, 10/12)
15–27
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SECURITIES LITIGATION
alleged accounting errors or to correct other previously filed 10Ks,
10Qs, or disclosure documents.
[B][4] Corporate Governance Changes
On occasion, the SEC will seek an order requiring a structural
change in a business, such as the adoption of internal controls, the
establishment of an audit committee or other committees, or,
in extreme cases, the appointment of a receiver to take control of
the enterprise.
[B][5] Civil Money Penalties
As a result of the Securities Enforcement Remedies and Penny Stock
Reform Act of 1990 (Remedies Act), the SEC also has the authority to
obtain civil money penalties from issuers of securities, and persons
associated with issuers. The amounts of such penalties are based upon
the nature of the violation and whether the defendant is an individual
or an organization.
[B][6] “Improper Influence”
Section 303 of the Sarbanes-Oxley Act of 2002 added a new
potential cause of action, giving the SEC exclusive authority to sue
an officer or director of a corporation who had taken any actions to
“fraudulently influence, coerce, manipulate or mislead” the company’s
outside auditors. As of the time this book went to press, no reported
decision has been found in which an enforcement action under
section 303 has been litigated.
[C]
Bar Upon Service As Officer or Director
The Remedies Act also authorized the SEC to obtain an order from
a district court prohibiting an individual from serving in the future as
an officer or director of a public company. Such orders require a
showing of a violation of a scienter-based anti-fraud provision applicable to public companies—section l0(b) of the Securities Exchange
Act or section 17(a)(1) of the Securities Act.85
In addition, the Sarbanes-Oxley Act of 2002 amended the standard
under which a court or administrative law judge can determine
whether an officer or director meets the test of “unfitness” that would
support the imposition of a bar order. Specifically, section 305(a)
modified the existing standard that used the phrase “substantial
unfitness,” and substituted the less rigorous standard of mere “unfitness.” Commentators believe that the lower standard will enable the
85.
The Sarbanes-Oxley Act of 2002, section 1105, extended the SEC ’s
authority to obtain bar orders in administrative cease-and-desist proceedings as well as in district court actions.
15–28
SEC Investigations and Enforcement Actions
§ 15:3.3
SEC to obtain bar orders based on a single act or transgression of a
director or officer.
§ 15:3.3
Administrative Remedies
[A] Cease-and-Desist Orders
Before 1990, the SEC had relatively little jurisdiction in administrative proceedings over public companies and their officers. In 1990,
as part of the Remedies Act, Congress gave the SEC the authority to
seek cease-and-desist orders against public companies and their officers. The Remedies Act authorizes the SEC to issue its own orders
against persons who have directly violated the securities laws or who
are found to be “a cause” of another person’s violation. For example, a
cease-and-desist order may compel an issuer to state its financial
reports in accordance with GAAP and forbid the CFO from being a
“cause” of the issuer ’s violation.
Since 1990, hundreds of cease-and-desist orders have been issued.
The SEC contends that it may obtain an order upon a lesser showing
than a “reasonable likelihood of future violation” as is required for civil
injunctions. In KPMG, LLP v. SEC, the District of Columbia Circuit
Court of Appeals held that the SEC could use a negligence standard as
the basis for issuing a cease-and-desist order.86
Cease-and-desist proceedings are tried before an administrative law
judge, a full-time Commission employee, with a right of appeal to the
Commission and from there to a U.S. court of appeals. Thus, the trial
is entirely an in-house proceeding with far more restricted rights of
discovery and of appeal than in a standard civil trial.
The SEC may also issue orders compelling disgorgement of illgotten gains and ancillary relief in administrative proceedings. As a
result of Dodd-Frank, the SEC may now also order the payment of a
civil money penalty ranging from $7,500 to $150,000 for individuals,
and $75,000 to $725,000 for companies and other entities. 87 Prior to
Dodd-Frank’s passage, in an administrative proceeding the SEC could
impose a penalty only against a respondent who was associated with
regulated entities, such as brokerage firms, investment advisers,
investment companies, and other registered entities. To extract a
penalty from others, the SEC had to obtain an order from a federal
district court in a civil action, triable by jury.
In a recent case, a respondent in an administrative proceeding
has already challenged the SEC’s new authority. In response to an
administrative proceeding88 arising out of the Galleon insider trading
86.
87.
88.
KPMG, LLP v. SEC, 289 F.3d 109, 118–20 (D.C. Cir. 2002).
Dodd-Frank § 929P.
In re Rajat K. Gupta, Exchange Act Rel. No. 63,995 (Mar. 1, 2011).
(Securities Litig., Rel. #6, 10/12)
15–29
§ 15:3.3
SECURITIES LITIGATION
investigation,89 the defendant filed a request for an injunction in the
Southern District of New York, arguing that the SEC had unfavorably
singled him out for an administrative proceeding without discovery or
a jury, compared to all the other Galleon-related defendants whose
cases were filed in district court, in violation of his equal protection
rights.90 He also argued in part that the SEC could not use an
administrative proceeding to seek civil penalties for conduct that
occurred prior to Dodd-Frank granting the SEC the power to impose
such penalties. The SEC challenged jurisdiction and argued that the
claims were not ripe for review. Presiding over the suit, Judge Rakoff
found that, with the passage of Dodd-Frank, the law now provides the
SEC with more flexibility in its choice of forum and the ability to seek
civil monetary penalties in administrative proceedings against all
individuals, not just registered persons.91 However, Judge Rakoff ruled
that the defendant could proceed with his equal protection claim
against the Commission under the relatively unique circumstances
presented.92 The SEC elected to dismiss the administrative proceeding, thus averting full discovery on the issue and litigation on the
merits of the respondent’s equal protection claim.
[B]
Suspension and Deregistration
Under section 15(b) of the Exchange Act, the SEC can suspend or
revoke the registration of any individual or entity that willfully violates
or aids and abets a violation of any of the federal securities laws.
Because issuers, broker-dealers, investment advisers must be registered
with the SEC in order to do business, revoking the registration of such
an entity has been referred to as the “death penalty” of the securities
laws.
[C]
Professional Discipline
In addition to injunctive actions and administrative proceedings
seeking a cease-and-desist order, the SEC may also take action against
professionals. These actions traditionally have arisen under Rule 102(e)
of the SEC’s Rules of Practice, which permits the Commission to limit
the ability of a professional who has engaged in improper professional
conduct or who has violated the federal securities laws to practice and
appear before the Commission. Rule 102(e) proceedings are brought
before an administrative law judge. Section 602 of the Sarbanes-Oxley
89.
90.
91.
92.
See section 15:4, infra.
Complaint for Declaratory and Injunctive Relief and Demand for Jury
Trial, Gupta v. SEC, 2011 WL 923951 (S.D.N.Y. Mar. 18, 2011) (No. 11cv-1900-JSR).
See Gupta v. SEC, 796 F. Supp. 2d 503 (S.D.N.Y. 2011).
Id.
15–30
SEC Investigations and Enforcement Actions
§ 15:3.3
amendments to the Exchange Act codified Rule 102(e) of the SEC’s
Rules of Practice.93
Rule 102(e) proceedings clearly extend to outside professionals,
such as accountants and lawyers. Rule 102(e) proceedings in this
context commonly consider whether previously issued financial statements were audited in accordance with generally accepted auditing
standards or whether professionals, such as lawyers, violated the
federal securities laws in connection with the preparation of prospectuses, registration statements, or other disclosure documents.
The Commission takes the position that practice before the Commission includes advice by a lawyer on the application of the federal
securities laws.
The Commission also has taken the position that Rule 102(e)
extends to management professionals within a corporation, such as
chief financial officers, controllers, and in-house counsel. Thus, an
order prohibiting a professional from practicing and appearing before
the SEC may preclude a professional from assisting in the preparation
of financial statements to be filed with the SEC, even if the professional is not associated with an outside firm.
The Sarbanes-Oxley Act added provisions specifically regulating
the practice of attorneys before the Commission. In section 307,
Congress reacted to the widespread perception that in scandals such
as Enron and WorldCom, lawyers had failed in their role as gatekeepers, and otherwise permitted unlawful conduct to take place.94
Accordingly, Congress imposed a “reporting up” provision, requiring
that if a lawyer becomes aware of evidence of a “material violation of
securities law, or breach of fiduciary duty or similar violation,” the
lawyer must report it to the chief legal officer or chief executive officer.
Second, if the lawyer is not satisfied that an appropriate response to
the evidence has been made, the lawyer must escalate his or her
concerns to the audit committee or other committee of the board. In
2003, the Commission adopted detailed rules implementing section 307.95 The SEC’s rules under section 307 empower the SEC to
bar an attorney from practicing before the Commission in the event
of a section 307 violation.96
93.
94.
95.
96.
See 15 U.S.C. § 78d-3.
Section 307 of the Sarbanes-Oxley Act is codified at 15 U.S.C. § 7245
(2002).
17 C.F.R. § 205 et seq.
Acting under authority granted by section 307 of the Sarbanes-Oxley Act,
the Commission promulgated rules setting forth minimum standards for
attorneys appearing before the Commission on behalf of issuers. See 17
C.F.R. §§ 205.1–205.7 (2003).
(Securities Litig., Rel. #6, 10/12)
15–31
§ 15:3.4
SECURITIES LITIGATION
§ 15:3.4
Parallel Criminal Cases
The SEC does not have independent authority to prosecute criminal cases. On the other hand, any willful violation of the federal
securities laws can be prosecuted as a crime. Because of the large
amounts of money often involved, securities offenses are popular
among federal criminal prosecutors. Thus, the SEC has a close working relationship with federal prosecutors and frequently refers more
egregious violations of the federal securities laws to them.
[A] Common Grounds for Prosecution
The securities laws violations most commonly prosecuted are
insider trading, financial fraud, and unregistered securities offerings.
While not always pursued for garden-variety financial disclosure cases,
criminal prosecutions are frequent where there has been widespread
misappropriation of assets or the sale of stock by insiders who know
that the financial statements are false.
In addition to securities law offenses, prosecutors frequently will
charge the following:
(1)
mail and wire fraud;
(2)
false statements to the government, such as those contained
in SEC filings, under 18 U.S.C. § 1001;
(3)
money laundering; and
(4)
RICO violations.
The Sarbanes-Oxley Act added a number of new sanctions to the
criminal enforcement arsenal, including:
•
Section 802, prohibiting the alteration or destruction of documents in connection with a federal investigation, and section
1102, prohibiting such conduct in connection with any “official
proceeding.” Both statutes authorize fines and prison terms of
up to twenty years.
•
Section 807, authorizing a prison term of up to twenty-five years
for criminal securities fraud.
•
Section 902, expanding the criminal remedies for persons found
guilty of an “attempt” to commit a securities law violation, and
now subjects persons guilty of an “attempt” to the same
penalties as those prescribed for the offense that was the object
of the attempt.
•
Sections 903 and 904, authorizing greater prison time—twenty
years instead of five—for acts of mail fraud and wire fraud, and
15–32
SEC Investigations and Enforcement Actions
§ 15:3.4
increasing the fines for violations of the Employee Retirement
Income Security Act (ERISA).
•
Section 906(c), authorizing fines and prison terms for the filing
of false certifications by the company’s CEO and CFO that the
company’s financial statements are sound. Fines for “willfully”
false certifications may be as high as $5 million, and the prison
term as high as twenty years.
•
Finally, section 1106, amending the criminal sanctions under
section 32(a) of the Exchange Act, increasing the fines from
$1 million to $5 million, and increasing the prison time from
ten years to twenty years.
[B] Cooperation Between SEC and DOJ
Testifying before the Senate Banking, Housing, and Urban Affairs
Subcommittee on Securities, Insurance, and Investment, Robert
Khuzami, the SEC’s Director of the Division of Enforcement, identified “cooperation and coordination with criminal and other authorities” as vital for “yield[ing] even better results.”97 Director Khuzami’s
testimony underscores a strategy that has now become commonplace.
In recent years, the SEC and the DOJ have organized joint task forces
that allow for more robust investigations into alleged misconduct,
including the use of expanded investigatory tools and resources. The
Corporate Fraud Task Force98 and the Subprime Working Group99 are
two such examples. Often, witnesses are interviewed jointly by SEC
and DOJ attorneys.
Coordinated law enforcement efforts have not gone unchallenged,
however. In a 2008 challenge to a joint investigation by the DOJ and
SEC, United States v. Stringer,100 the Ninth Circuit rejected claims of
due process violations stemming from the joint investigation. The
defendant in Stringer claimed that after the SEC commenced an
investigation of FLIR Systems, Inc., the SEC did not tell Stringer (a
former officer of FLIR) that it was meeting with and sharing information
with the FBI and the DOJ. The facts showed, however, that Stringer had
been supplied with a form when he was subpoenaed disclosing that the
SEC “often makes its files available to other government agencies,
97.
98.
99.
100.
Robert Khuzami, SEC Dir. of Enforcement, Testimony Before the United
States Senate Banking, Housing, and Urban Affairs Subcommittee on
Securities, Insurance, and Investment (May 7, 2009), available at www.
sec.gov/news/testimony/2009/ts050709rsk.htm.
See Exec. Order No. 13271, 67 Fed. Reg. 46,091 (July 11, 2002).
Elisse B. Walter, SEC Commissioner, Testimony Before the United States
House of Representatives Committee on Financial Services Concerning
Securities Law Enforcement in the Current Financial Crisis (Mar. 20,
2009), available at www.sec.gov/news/testimony/2009/ts032009ebw.htm.
United States v. Stringer, 535 F.3d 929 (9th Cir. 2008).
(Securities Litig., Rel. #6, 10/12)
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§ 15:3.4
SECURITIES LITIGATION
particularly the United States Attorneys and state prosecutors.” Placing
significant weight upon the form notice provided with the subpoena to
Stringer, the Ninth Circuit rejected the district court’s finding that
nondisclosure of the criminal investigation violated Stringer ’s due
process rights. According to the Ninth Circuit, the SEC has no legal
duty to otherwise disclose the existence of a criminal investigation.
The SEC Enforcement Manual provides direct guidance to the Staff
in the area of parallel proceedings, which largely follows the prescription for proper coordinated law enforcement investigations set forth by
the courts. First, the manual provides that a civil investigation should
have “its own independent civil investigative purpose” and should not
be initiated solely for the benefit of or to obtain evidence for a criminal
investigation.101 Second, the Staff should make its own independent
decisions regarding investigative strategy, such as what documents to
request, what testimony to take, what questions to ask, and where
testimony should be taken.102 Third, if asked by individuals or their
counsel whether there is a parallel criminal investigation, the manual
advises the Staff to direct the individual or their counsel to a section
in SEC Form 1662 that provides that the “Commission often makes
its files available to other government agencies, particularly the
United States Attorneys and state prosecutors.”103 Fourth, the Staff
is directed to have supervisors involved “in all significant discussions
and written communications with criminal authorities.” 104 In addition, the manual provides that sharing information with criminal
prosecutors is generally permissible to assist a criminal prosecution,
and in certain circumstances, it is permissible for the Staff and
criminal prosecutors to advise each other to refrain from taking certain
actions that may harm their respective investigations. 105
[C]
Parallel Proceedings by the SEC and Private
Entities
The manual also provides guidance for parallel investigations by the
SEC and private entities.106 Under the “state actor doctrine,” an action
by a private party may be attributed to a government entity “if there is
a sufficiently close nexus between the state, or government entity, and
the challenged action of a private entity.” 107 Thus, the manual
provides that, when the Staff is aware that a private entity is investigating conduct that is also the focus of an investigation by the Staff, “the
101.
102.
103.
104.
105.
106.
107.
SEC Enforcement Manual § 5.2.1.
Id.
Id., n.2.
Id. § 5.2.1.
Id.
Id. § 3.1.4.
Id.
15–34
SEC Investigations and Enforcement Actions
§ 15:4
SEC and the private entity’s investigations should be parallel and should
not be conducted jointly.”108 To this end, the manual directs the Staff to:
(1)
make independent investigative decisions;
(2)
not take investigative steps principally for the benefit of a
private entity’s investigation;
(3)
not suggest investigative steps to a private entity; and
(4)
where a witness in an SEC investigation has indicated an
intention to assert his or her Fifth Amendment right not to
testify, not suggest to the private entity any line of questioning,
nor to provide “any document or other evidence . . . other than
pursuant to an approved access request.”109
§ 15:4
Insider Trading Cases
“[I]nsider trading has a unique hold on the American popular
imagination.” 110 And recent trends suggest that insider trading
enforcement remains a priority among the regulatory authorities. In
2010, the SEC stepped up its investigatory efforts by creating the
Market Abuse Unit to target large-scale insider trading matters. 111 In
2011, the SEC brought 57 insider trading cases,112 and the DOJ has
similarly ramped up its criminal prosecutions of insider trading and
Ponzi schemes. With an increased focus on this issue, the SEC and
DOJ have begun to work more closely in prosecuting insider trading
cases.113
Recently, the SEC filed what it described as the largest hedge fund
insider trading case it had ever brought, SEC v. Galleon Management.114 The DOJ brought a parallel criminal case against the
108.
109.
110.
111.
112.
113.
114.
Id.
Id.
Linda Chatman Thomsen, SEC Dir. of Enforcement, Remarks Before the
Australian Securities and Investments Commission 2008 Summer School:
U.S. Experience of Insider Trading Enforcement (Feb. 19, 2008), available
at http://sec.gov/news/speech/2008/spch0219081ct.htm.
2010 Performance and Accountability Report, at 13.
SEC, SELECT SEC AND MARKET DATA FISCAL 2011, available at www.sec.
gov/about/secstats2011.pdf.
See John H. Sturc & Adam Chen, Insider Trading: New Developments and
How to Deal with Them, PRACTICAL COMPLIANCE & RISK MGMT. FOR SEC.
INDUS. (Nov.–Dec. 2011), available at www.gibsondunn.com/publications/
Documents/SturcChen-InsiderTrading-NewDevelopments-Practical
Compliance.pdf.
See Amended Complaint, SEC v. Galleon Mgmt., LP, 2009 WL 3664677
(S.D.N.Y Nov. 5, 2009) (No. 098811, JSR); see also Litigation Rel. No.
21,284 (Nov. 5, 2009), available at www.sec.gov/litigation/litreleases/2009/
lr21284.htm.
(Securities Litig., Rel. #6, 10/12)
15–35
§ 15:4
SECURITIES LITIGATION
defendants including Galleon founder Raj Rajaratnam.115 The insider
trading scheme alleged in the case is estimated to have generated
approximately $45 million in profits. The Galleon case is the first
time, in the parallel criminal investigation, that the government used
wiretaps to collect evidence. The propriety of the wiretaps to collect
evidence, as well as the SEC’s access to such evidence, was initially
upheld by the district court as the SEC, in its civil action, sought
discovery of wiretaps defendants obtained from prosecutors in the
parallel criminal proceeding.116 On appeal, the Second Circuit found
that the wiretapped conversations could be disclosed to the SEC
but that a district court must balance the SEC’s right of access to
these materials in civil discovery against the privacy interests at
stake.117 Following the Second Circuit’s decision, the district court
found the SEC’s right of access outweighed any remaining privacy
interests and ordered the production of the wiretaps. 118 The criminal
case culminated in May 2011 when Rajaratnam was found guilty of all
fourteen conspiracy and securities fraud charges brought against
him.119
Wiretaps played key roles in other recent insider trading cases.
In another case in 2009, the SEC and DOJ charged a number of
individuals involved in an insider trading ring that obtained inside
information from an associate at a law firm on upcoming
deals involving the firm’s clients.120 Recently, the SEC and DOJ
have also focused on expert network firms, industry consultants and
traders and analysts that use these services as a source of information.
Over the last year, the SEC and DOJ have charged several individuals,
including employees of a research network firm, employees of public
companies who acted as consultants through the networks, and
analysts at hedge funds who utilized their services. The cases charged
that the consultants provided material nonpublic information in
return for payments through the networks.121 Similarly, in November
115.
116.
117.
118.
119.
120.
121.
See Indictment, United States v. Rajaratnam, 2009 WL 7698507 (S.D.N.Y.
Dec. 15, 2009) (No. 09CR01184).
See SEC v. Rajaratnam, 683 F. Supp. 2d 316 (S.D.N.Y. 2010).
See SEC v. Rajaratnam, 622 F.3d 159 (2d Cir. 2010).
SEC v. Galleon Mgmt., LP, 2011 WL 1770631 (S.D.N.Y. May 10, 2011).
See Dealbook, The Verdict on Raj Rajaratnam, N.Y. TIMES, May 11, 2011,
available at dealbook.nytimes.com/2011/05/11/the-verdict-on-raj-rajaratnam/.
See SEC v. Cutillo, Civil Action No. 09-09208 (LAK) (S.D.N.Y. Nov. 5,
2009); Litigation Rel. No. 21,283 (Nov. 5, 2009), available at www.sec.gov/
litigation/litreleases/2009/lr21283.htm.
See SEC v. Longoria, Civil Action No. 11-CV-0753 (S.D.N.Y. Feb. 8, 2011);
United States v. Dung Ching Trang Chu, No. 1:10mj2625, (S.D.N.Y.
Nov. 23, 2010); United States v. Shimmon, No. 1:10mj2823, (S.D.N.Y.
Dec. 15, 2010); United States v. Jiau, No. 10-mj-02900 (S.D.N.Y. Dec. 23,
2010).
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SEC Investigations and Enforcement Actions
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2010, the SEC brought insider trading charges against Dr. Yves
Benhamou for passing material, nonpublic information on a clinical
drug trial to a hedge fund.122 Recently, in 2012, the government’s
expansive investigation of insider trading related to Galleon culminated in the conviction of Rajat Gupta, the former chairman of
McKinsey and a former director of several public companies, for
tipping Rajaratnam with material nonpublic information regarding
those companies.
The SEC has extended its jurisdiction to reach insider trading
in credit default swaps.123 In SEC v. Rorech, the court held that credit
default swaps are subject to section 10(b) of the Securities Exchange
Act of 1934 as “securities-based swap agreements” under the GrammLeach-Bliley Act. However, the court ruled against the SEC on whether
the defendants had committed insider trading.124
§ 15:4.1
“Classical Theory” of Insider Trading
Insider trading is prohibited by SEC Rules 10b-5 and 14e-3.
Rule 10b-5, promulgated under section 10(b) of the Securities Exchange Act of 1934, provides that “[i]t shall be unlawful for any
person . . . [t]o employ any device, scheme, or artifice to defraud [or] . . .
[t]o engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person in connection with
the purchase or sale of any security.” Rule 14e-3 prohibits similar
activities in connection with a tender offer.
Insider trading liability under Rule 10b-5 originally required a
fiduciary relationship between the insider and the person with
whom the insider traded. This is because the fraud occurs not by
virtue of the possession of material, nonpublic information alone, but
rather by the trader ’s failure to disclose such information where the
trader has a duty to do so. Typically, a trader has no duty to disclose the
information upon which he or she bases his or her stock transactions,
and it is expected that investors trade on the basis of unequal
(although equally available) information.
Instead, under the “classical theory” of insider trading, only certain
persons—corporate executives and directors, as well as other persons
associated with the corporation who have access to material, nonpublic information, such as certain key employees and the corporation’s accountants, lawyers, and investment bankers (and individuals
who obtain information from any of these persons)—can be held liable
122.
123.
124.
See SEC v. Benhamou, 10-CV-8266 (S.D.N.Y. Nov. 2, 2010).
See Complaint, SEC v. Rorech, No. 09-CV-4329 (S.D.N.Y. May 5, 2009);
see also Litigation Rel. No. 21,023 (May 5, 2009), available at www.sec.
gov/litigation/litreleases/2009/lr21023.htm.
SEC v. Rorech, 2010 WL 2595111 (S.D.N.Y. June 25, 2010).
(Securities Litig., Rel. #6, 10/12)
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SECURITIES LITIGATION
for insider trading. It is the relationship of trust and confidence
between the shareholders of a corporation and those insiders who
have obtained confidential information by reason of their relation to
that corporation (or to a person who has such a relation) that gives
rise to the duty to disclose the confidential information at the time of
the trade or to abstain from trading. In short, the classical theory of
insider trading holds that a corporate insider should not use corporate
information to take unfair advantage of the corporation’s own shareholders in the securities markets.
§ 15:4.2
“Misappropriation Theory” of Insider Trading
In 1997, the U.S. Supreme Court, in United States v. O’Hagan,125
adopted the “misappropriation theory” of insider trading. Although
the misappropriation theory had been adopted by five of the eleven
U.S. courts of appeals its validity had come into doubt because two
other courts of appeals—the Fourth and the Eighth Circuits—had
rejected misappropriation of material nonpublic information as a basis
for insider trading liability.
In contrast to the classical theory of insider trading, the misappropriation theory holds that a person commits fraud “in connection
with” a securities transaction for purposes of Rule 10b-5 when he
misappropriates and trades on the basis of confidential information in
a breach of a duty owed to the source of the information. As stated by
the Supreme Court, “[i]n lieu of premising liability on a fiduciary
relationship between company insider and purchaser or seller of
the company’s stock, the misappropriation theory premises liability
on a fiduciary-turned-trader ’s deception of those who entrusted
him with access to confidential information.”126 Thus, according to
the Supreme Court, “[t]he two theories are complimentary” in that
the original theory “targets a corporate insider ’s breach of duty to
shareholders with whom the insider transacts,” and the misappropriation theory “outlaws trading on the basis of nonpublic information by
a corporate ‘outsider ’ in breach of a duty owed not to a trading party,
but to the source of the information.”127
In practice, the O’Hagan case is used in training and educating
company employees not to divulge sensitive information to third
parties. Corporate compliance policies also should be clear that
employees are prohibited from trading on the basis of material,
nonpublic information obtained in the course of their duties as
employees, including information concerning companies with which
125.
126.
127.
United States v. O’Hagan, 521 U.S. 642 (1997).
Id. at 652.
Id. at 652–53.
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SEC Investigations and Enforcement Actions
§ 15:5
the employer conducts business or from which the company otherwise
receives confidential information.
One district court case has moved in the direction of limiting the
reach of the misappropriation theory of insider training, although it
was overruled on appeal.128 In July 2009, a district court granted a
defendant’s motion to dismiss allegations of insider trading on the
grounds that, absent a fiduciary relationship, an agreement to keep
information confidential did not itself create an obligation not to trade
based upon that information. In the case, the SEC’s complaint alleged
that the CEO of a corporation reached a verbal agreement with the
defendant that the defendant would keep the divulged information
confidential. The defendant thereafter used the information to sell
his stock in advance of the public announcement of the information.
On appeal, the Fifth Circuit held that the district court erred in that
the pleaded misappropriation theory was sufficient to survive the
motion to dismiss and reinstated the charges against defendant.
§ 15:4.3
“Use” Versus “Possession”
For many years, debate raged over whether an insider trading claim
could be based upon the fact that a person merely was in possession of
material nonpublic information at the time of a trade, regardless of
whether the person actually used such information as the basis for the
decision to trade. To provide the Enforcement Division with a
more liberal standard upon which to base future insider trading cases,
the SEC promulgated SEC Rule 10b5-1, which expressly states that a
person trades “on the basis of” material nonpublic information when
the person “was aware of” the material nonpublic information
when the person made the purchase or sale. In other words, mere
possession of the information, not just use of the information,
suffices. The same rule, however, permits individuals to create
so-called 10b5-1 plans that allow the person to buy or sell on a
preestablished basis, pursuant to a written plan for the trading of
such securities. The contract instruction or plan must specify the
amount of securities to be sold, the formula for any such sales, or other
indicia that the person has been divested of discretion to exercise any
subsequent influence over how, when, or whether any securities were
to be purchased or sold.
§ 15:5
Role of Directors
Outside directors have a critical role to play in preventing the
adverse events that may lead to SEC investigations, mitigating the
128.
See SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009), vacated and
remanded by 620 F.3d 551 (5th Cir. 2010).
(Securities Litig., Rel. #6, 10/12)
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§ 15:5.1
SECURITIES LITIGATION
effects of any wrongdoing, and managing a company ’s response to an
SEC investigation to prevent it from going out of control. Plainly,
outside directors cannot and should not try to micromanage an
enterprise. On the other hand, by setting standards for corporate
behavior, they may help a corporation prevent or ameliorate the effects
of a government investigation. Several beneficial measures are discussed below.
§ 15:5.1
Corporate Codes of Conduct and Compliance
Policies
Many corporations now have codes of conduct and compliance
policies and procedures that set forth legal and ethical standards for
officers and employees. Codes of conduct establish the corporation’s
values and put employees on notice of behavior that may result in
termination of employment even prior to the commencement of
regulatory action. Codes of conduct enable a corporation to demonstrate to the government that misconduct by an employee was contrary to the interest of the corporation and may also provide a basis for
terminating an errant employee who refuses to cooperate with an
internal investigation.
Similarly, properly done compliance policies should help to prevent
violations. Even when they are not fully effective, compliance policies
demonstrate the corporation’s good faith.
§ 15:5.2
Internal Controls
Probably the most effective measure to prevent employee or officer
misconduct is the presence of strong internal accounting and operational controls. Several recent debacles, such as the collapse of Enron,
WorldCom, Adelphia, and HealthSouth, have been attributed in part
to the lack of strong internal controls. Thus, outside directors can play
a critical role in reviewing existing controls and insisting that they be
enhanced where appropriate.
§ 15:5.3
Dealing with Potential Illegal Acts
Section 10A of the Private Securities Litigation Reform Act of 1995
requires that the auditor of a company whose stock is registered
pursuant to section 12 of the Exchange Act include in its annual audit,
among other things, procedures regarding the detection of illegal acts.
Where material illegal acts are detected, section 10A requires the auditor
to report its finding directly to the SEC if the issuer fails to do so.
Nothing in section 10A or the regulations promulgated pursuant to
it requires a company’s management or audit committee to undertake
any additional duties or responsibilities to implement section 10A’s
fraud detection and disclosure standards. But the potential for an
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SEC Investigations and Enforcement Actions
§ 15:5.4
auditor’s whistleblowing to the SEC in connection with the reporting
of suspected illegal acts should provide added incentive for the audit
committee and the board to strengthen their oversight of the company’s compliance programs, and to take appropriate remedial steps
when illegal acts are suspected. Indeed, section 10A requires the
auditor to seek to have appropriate remedial measures taken by the
audit committee and the board, and to report violations to the SEC
only when the auditor is not satisfied with the remedial actions taken.
As well, the audit committee may be called upon to engage in more
extensive oversight depending on the existence of fraud “risk factors”
as specified in Statement of Auditing Standards No. 82.
In light of these standards, and as a minimum step towards
monitoring accounting controls, the audit committee should consider
the following:
•
Evaluate, in conjunction with management, each of the risk
factors identified in SAS 82 in order to judge whether any
particular risk factors, alone or in combination with others,
indicate that the company’s current environment may foster
fraud. The audit committee should recommend that appropriate actions be taken to mitigate these perceived risks, and
expand the scope of the internal audit function to better detect
fraud.
•
Familiarize itself with the audit procedures to be implemented
by the outside auditors, and understand to what extent the
outside auditors believe that material fraud risk factors exist
within the company.
•
Consider, or reconsider, how the audit committee monitors
corporate activities and what company-wide information and
reporting systems exist for the detection of fraud and illegal acts.
Moreover, where fraud or other illegal acts are suspected, the audit
committee’s counsel could independently investigate the suspected
wrongdoing and advise the committee as to its obligations.
§ 15:5.4
Supervising Internal Investigations and the
Corporation’s Response to the SEC
Outside directors also should play a useful role in supervising
internal investigations of potential misconduct and overseeing a
corporation’s response to the government. Supervision of an internal
investigation is helpful because it provides the corporation and third
parties the assurance that evaluations of employee conduct have been
independently made by persons who do not have as vested an interest
in the outcome as does management. This independence is essential if
the investigation implicates senior management, or if the effects of the
(Securities Litig., Rel. #6, 10/12)
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§ 15:5.5
SECURITIES LITIGATION
misconduct are so severe as to warrant changes in senior management. Independence is just as important even if management changes
are not warranted, as the independent determination by outside
directors provides managers with the assurance that they will continue
to be supported by the board during the investigation and may also
enable the corporation to remove a political cloud over the managers at
an early stage.
The board also should monitor pending government inquiries.
Wishful thinking is an all too common human trait. Thus, management may not fully appreciate the significance of a government
investigation. The independent assessment that a board can provide
allows a corporation to take appropriate remedial measures before it is
too late.
§ 15:5.5
Audit Committee Oversight
Partly due to the enhanced duties imposed on audit committees
under the Sarbanes-Oxley Act, the SEC has focused particular attention in recent years on the oversight responsibilities of audit committees, and in some cases the Enforcement Staff has targeted audit
committee members. In February 2011, the SEC filed a complaint
against three former independent directors and audit committee
members of DHB Industries, Inc.129 According to the SEC, from
2003 to 2006 the directors permitted the company to report falsely
its financials, allowed the CEO to divert $10 million from the
company, and oversaw the payment of the CEO’s personal expenses
including luxury cars, art, vacations, and prostitution services. The
SEC alleged that the directors “willfully ignored significant red flags”
while “fraud swirled around them.” The alleged red flags included
material weakness letters from the company’s auditors, two of which
resigned; concerns raised by the company’s controller; the resignation
of outside counsel hired to investigate the related transactions with the
CEO; and the CEO’s insistence that he oversee the replacement
investigation firm, which he later fired when it raised concerns over
company payment of his personal expenses. The SEC alleged that the
directors not only were not independent due to their business and
decades-long personal relationships with the CEO, but also “made
little or no effort even to understand their Audit Committee
responsibilities.”
Another example is the 2006 enforcement action against the former
chair of the audit committee of Spiegel, Inc.,130 in which the Staff
129.
130.
SEC v. Krantz, No. 11-cv-60432 (S.D. Fla. Feb. 28, 2011).
In re Horst Hansen, Proc. No. 3-12470, 2006 SEC WL 3095646 (Nov.
2006).
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SEC Investigations and Enforcement Actions
§ 15:6
initiated a cease-and-desist proceeding where it is alleged that Hansen,
through his position as audit committee chair, recommended that the
Spiegel board withhold filing the company ’s financial statements until
the auditor provided an unqualified opinion after the audit firm first
threatened a “going concern” qualification.131 It is still relatively rare
for the SEC to pursue claims against audit committee members for a
breach of duty of oversight. Nevertheless, audit committee members
should be mindful that, unlike the private securities litigation arena,
where there is no private right of action for “aiding and abetting,” the
SEC has plenary powers to pursue enforcement actions against aiders
and abettors, including audit committee members. Underscoring the
point, in a 2006 speech former Commissioner Campos stated that
“directors cannot have a good-faith belief that an audit committee of
a multi-billion-dollar corporation that meets for an hour quarterly
(with some participating by phone) devoted enough time and attention
to oversight.”132 Thus, audit committee members should be mindful
that some of the same principles that apply to them under state
law fiduciary duty standards may apply to them under the federal
securities laws.
§ 15:6
Role of Counsel
In recent years, the SEC has frequently spoken of the role of counsel
in preventing fraud and has identified in-house and outside counsel as
among the most important “gatekeepers” who are expected to play a
role in guarding against misconduct.
In years past, it was infrequently the case that in-house counsel was
ever sued in an enforcement action. In several important cases beginning in Fall 2004, however, the SEC announced that it was taking a
harder look at the role of lawyers in alleged frauds, and it soon began
to assert claims against lawyers with greater frequency. Among the
higher-profile cases were the SEC’s actions against an in-house counsel
at Google133 and at an outside counsel for a Pennsylvania school
131.
132.
133.
Other recent SEC cases against audit committee members have involved
more traditional antifraud issues such as insider trading, rather than any
violation based on a breach of a duty of oversight. See, e.g., SEC v.
Erickson, No. 3-07-CV-0254-N (N.D. Tex. Feb. 7, 2007) Litigation Rel.
No. 19,992 (Feb. 7, 2007); SEC v. Morris Gad & Nathan Rosenblatt,
07-CV-8385 (GEL) (S.D.N.Y. Sept. 27, 2007), Litigation Rel. No. 20,577
(May 15, 2008).
Remarks of Commissioner Roel Campos, How to Be an Effective Board
Member, HACR Program on Corporate Responsibility, Boston, Mass.
(Aug. 15, 2006).
In re Google, Inc. & David C. Drummond, Admin. Proc. Rel. No. 33-8523
(Jan. 13, 2005).
(Securities Litig., Rel. #6, 10/12)
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§ 15:6
SECURITIES LITIGATION
district.134 In the latter case, the SEC had found that the lawyer had been
“at least negligent” in his work as bond counsel for the school district
and had failed to exercise “reasonable prudence,” which to most
observers were indicative that the Staff was effectively suing the lawyer
for negligence under section 17(a) of the Securities Act—a concept that
immediately stirred controversy within the legal community. In 2006,
the SEC decision was affirmed by the court of appeals in language that
tended to describe the lawyer ’s conduct as “negligence plus.”135 The
SEC, however, does not use a professional conduct standard when
evaluating a claim against a lawyer. It will not take action against a
lawyer for “giving bad advice”136 or “negligent acts . . . they may have
committed in providing non-public legal advice to clients.”137 The
Commission instead looks to see if a lawyer engaged in conduct such
as intentional violation of securities laws, causing false statements to be
filed with the SEC, or conduct that would have made a non-lawyer liable
in similar circumstances.138
In a case involving outside counsel, Joseph Collins, a former
partner and head of a large law firm’s derivative practice, was charged
for his role in the financial demise of Refco, a now-defunct New York
financial services firm.139 As the long-time primary outside counsel for
Refco, Collins was alleged to have substantially assisted Refco in its
failure to disclose millions of dollars in related party transactions and
related party indebtedness.140 A district judge dismissed a shareholders’ suit against Collins and his law firm, citing the Supreme
Court’s decision in Stoneridge v. Scientific-Atlanta,141 which held that
third parties could not be liable to shareholders unless the shareholders directly relied on actions by the third parties in making
investment decisions.142 Stoneridge did not save Collins from criminal
liability, however, as the U.S. Attorney ’s Office for the Southern
134.
135.
136.
137.
138.
139.
140.
141.
142.
In re Ira Weiss, Securities Act Rel. No. 8641, Exchange Act Rel. No. 52,875
(Dec. 2, 2005).
Weiss v. SEC, 468 F.3d 849 (D.C. Cir. 2006).
Christopher Cox, Chairman, SEC, Address to the 2007 Corporate Counsel
Institute (Mar. 8, 2007).
In the Matter of Scott Monson, Litigation Rel. No. 28,323 (June 30, 2008);
cf. In re Steven Altman, Esq., SEC Litigation Rel. No. 63,306 (Nov. 10,
2010) (noting that “[a]lthough the Commission has cautioned against
bringing Rule 102(e) attorney disciplinary proceedings based on negligent
legal advice, it did so in dicta and the question was not squarely presented
in the case”).
Id.
See SEC v. Collins, SEC Litig. Rel. 20,402 (Dec. 18, 2007), available at
www.sec.gov/litigation/litreleases/2007/lr20402.htm.
Id.
Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148
(2008).
In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d 304 (S.D.N.Y. 2009) (Lynch, J.).
15–44
SEC Investigations and Enforcement Actions
§ 15:6
District of New York brought criminal charges against Collins for his
role in helping perpetrate the Refco fraud.143 In July 2009, following a
trial on the criminal charges, a jury found Collins guilty of securities
fraud, wire fraud, and conspiracy. He is currently serving a seven-year
prison sentence. Following his conviction, the SEC, which had charged
Collins with fraud stemming from his acts to aid and abet Refco file a
false IPO, reached a settlement with Collins enjoining him from future
violations of section 10(b) of the Securities Exchange Act.144
In another recent criminal case, attorney Phillip Offill was found
guilty of securities fraud for his role in advising several companies
on evading registration requirements under the securities laws as part
of a “pump-and-dump” share-price manipulation scheme.145 He was
sentenced to eight years imprisonment.
In the last several years, the Enforcement Division has also brought a
number of cases against in-house general counsel. Many of these cases
arose from the stock option backdating scandal and include enforcement
actions against in-house counsel of Symbol Technologies, Comverse
Technology, Apple Computer, McAfee, Mercury Interactive, CNET,
Monster Worldwide and Boston Communications, KLA-Tencor, and
Juniper Networks.146 In several of these cases, the DOJ also brought
parallel criminal actions. In general, these cases turn on specific allegations that the in-house lawyers were active participants in knowing
misconduct and, in most cases, are alleged to have personally benefited
from the alleged misconduct. In that respect, it can be concluded
that the SEC is not simply targeting in-house counsel who commit
negligent acts, but rather is targeting lawyers who allegedly engage in
deliberate and intentional acts. In a highly publicized case, the SEC
brought charges against the general counsel for a registered brokerage
firm claiming that he failed reasonably to supervise an individual stock
broker who allegedly manipulated a publicly traded stock and who also
allegedly engaged in sales practice violations with respect to the accounts
of several of his customers.147 After years of heavy litigation, Chief
Administrative Law Judge Brenda J. Murray issued an opinion recommending dismissal of the case, concluding that the general counsel acted
reasonably. The Division of Enforcement appealed. The Commission
143.
144.
145.
146.
147.
See SEC v. Collins, SEC Litigation Rel. No. 20,402 (Dec. 18, 2007),
available at www.sec.gov/litigation/litreleases/2007/lr20402.htm.
Id.
SEC v. Offill, SEC Litigation Rel. No. 21,508 (Apr. 28, 2010), available at
www.sec.gov/litigation/litreleases/2010/lr21508.htm.
An extensive review of these cases is found in Dickey, Litigation Against
Accountants and Lawyers: The Year of Living Dangerously, WEST LEGAL
WORKS (Nov. 2007).
See Initial Decision, In re Urban, Admin. Proc. File No. 3-13655 (Sept. 8,
2010), available at www.sec.gov/litigation/aljdec/2010/id402bpm.pdf.
(Securities Litig., Rel. #6, 10/12)
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§ 15:7
SECURITIES LITIGATION
dismissed the proceeding on a 1-1 vote (with other Commissioners
recusing themselves from the decision), leaving unresolved the legal
issues presented—namely, when, if ever, a general counsel is a supervisor, and what constitutes a reasonable response to indicia of misconduct.148 Nevertheless, the recent history of enforcement actions against
in-house counsel provides a sober reminder that counsel may be subject
to SEC scrutiny.
§ 15:7
Role of Auditors
The other significant gatekeepers about which the Enforcement
Division has frequently spoken in recent years are the outside audit
firms for public registrants. Over the past decade, a number of
enforcement actions have been brought against major accounting
firms and individual audit partners. In recent years, the SEC stepped
up its enforcement efforts against individual audit partners. In May
2012, the SEC brought its first-ever enforcement action against a
foreign audit firm for its refusal to provide the SEC with audit work
papers related to an investigation of another foreign-based company.149 In addition to cases brought by the Division of Enforcement,
proceedings may also be initiated by the Public Company Accounting
Oversight Board (PCAOB) (discussed below) pursuant to its own
independent enforcement powers over audit firms and audit partners.
A representative summary of recent SEC enforcement proceedings
against audit firms and audit partners is found in Appendix 15A at the
end of this chapter.
In addition to the SEC, audit firms also are subject to oversight and
enforcement from the PCAOB, established by Congress as part of the
Sarbanes-Oxley Act. In 2003, the PCAOB adopted rules that govern its
investigations and adjudications, and since then the PCAOB has
slowly built up its enforcement resources. Today the PCAOB is fully
staffed to conduct inspections of audit firms and, where appropriate,
initiate disciplinary proceedings.
With the combined oversight of the SEC and the PCAOB, auditors
are acutely aware of their roles and responsibilities as gatekeepers and
of their obligation to discharge their duties as independent auditors
with ever-increasing vigilance. Even before passage of Sarbanes-Oxley,
federal statutes imposed significant obligations on audit firms to take
148.
149.
See Order Dismissing Proceeding In re Urban, Admin. Proc. File No. 313655 (Jan. 26, 2012), available at www.sec.gov/litigation/admin/2012/3466259.pdf.
See Press Release No. 2012-87, U.S. Sec. & Exch. Comm’n, SEC Charges
Deloitte & Touche in Shanghai with Violating U.S. Securities Laws in
Refusal to Produce Documents (May 9, 20120), available at http://sec.gov/
news/press/2012/2012-87.htm.
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SEC Investigations and Enforcement Actions
§ 15:7
prompt remedial actions in the event of the detection of illegal acts.
For example, section 10A of the Securities Exchange Act sets forth
detailed statutory requirements that auditors must follow in the event
it detects an illegal act, including the ultimate obligation to report
to the SEC if, after detection of such an illegal act, the company ’s
management or board of directors fails to take “timely and appropriate
remedial actions with respect to the illegal act.” The obligation to
report to the SEC provides a powerful inducement to public
companies to respond promptly and substantively to the audit firm’s
concerns during the course of an audit. In practice, the duty to report
has resulted in significant cooperation between companies and auditors
to address suspected wrongdoing in a prompt and decisive fashion.
The Sarbanes-Oxley Act further enhanced the standards applicable
to audit firms in the performance of their audit duties, including new
independence standards, and new obligations imposed on public
companies with regard to their financial statements, including the
requirement that the chief executive officer and chief financial officer
sign “certifications” of the financial statements, that the company
certify as to the sufficiency of its internal controls, and that the
company’s management avoid any improper influence on the conduct
of the external audit. All of these provisions have caused audit firms to
perform more rigorous annual audit and quarterly reviews, and
management to implement more rigorous internal policies and practices associated with the preparation and disclosure of the company ’s
financial statements.
The auditor ’s role continues to be critical to the effective implementation of all these systems. While the fair presentation of the
company’s financial statements is the responsibility of management,
auditors nevertheless have generally taken proactive steps in recent
years in at least the following areas:
•
Insuring their own independence, consistent with independence
standards promulgated by the FASB, the PCAOB, and other
standards-setting organizations;
•
Designing audit procedures that are reasonably likely to detect
fraud;
•
Evaluating the company ’s business risks, credit risks, and
financial statement risks, and incorporating those risks into
the development of the audit plan;
•
Regularly and effectively communicating with the audit committee; and
•
Evaluating the integrity of management and the effectiveness of
the company’s system of internal controls.
(Securities Litig., Rel. #6, 10/12)
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§ 15:7
SECURITIES LITIGATION
These and other steps have become “best practice” for most public
company audits and are key areas that the SEC Enforcement Staff will
focus on in the event that it decides to investigate a possible fraud. The
SEC will expect to find documentation showing that the audit firm
carefully designed its audit and that, if a fraud occurred, it was not for
lack of audit procedures that were reasonably designed to detect fraud.
In that respect, and in light of the major financial frauds of the last
decade, more is expected of audit firms by the SEC than ever before. 150
Chairman Schapiro recently stressed that accounting standards and
practices are ever increasing, stating that they must “reflect the
ongoing changes in the financial world” as accounting, “like every
other tool of modern finance, progresses at a rapid pace.”151 Because
the “lingering results of the financial crises underscore the need to
protect investors,” auditors should perform their tasks “with increasingly informative accounting standards; with scrupulous application
of all standards, old and new; and with robust auditing that ensures
accuracy.”
150.
151.
Partly as a result of the heightened level of SEC enforcement activity, and
also the sheer magnitude of the damages exposures represented by parallel
private civil actions against accounting firms, the risk of catastrophic loss
to the remaining “Big Four” accounting firms has led to a number of recent
proposals to reform the liability standards applicable to auditors. For a
discussion of recent reform proposals, see J. Dickey, et al., 2008 Securities
Litigation Reform Forecast: Cloudy, Chance of Rain, 5 S EC. LITIG. REP. 2
(Feb. 2008).
Mary L. Schapiro, Chairman, SEC, Speech by SEC Chairman: Remarks
Before the Financial Accounting Foundation’s 2011 Annual Board of
Trustees Dinner (May 24, 2011), www.sec.gov/news/speech/2011/
spch052411mls.htm.
15–48