Responding to an SEC investigation: two attorneys review the dangers posed by an SEC probe, and the ways in which public companies could and should react to minimize the potential damage, including possible litigation.

Public companies need only to read the daily headlines to know that recent corporate scandals have triggered a dramatic increase in the enforcement efforts of the Securities and Exchange Commission (SEC)--and that corporations and corporate officers face an increased risk of being involved in an SEC investigation.

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Statistics bear that out. In 2003, the agency hit companies with 679 enforcement actions, a record, and a recent hiring binge has given it unprecedeted manpower.

The SEC conducts both formal and informal investigations of possible securities law violations. Informal investigations generally seek to determine on a preliminary level whether a more extensive probe is required. These investigations can be initiated at a low level within the SEC without the approval from Washington that is required for formal investigations.

While SEC requests for testimony and information in informal investigations are "voluntary," failure to comply with such requests can result in the opening of a formal investigation in which subpoenas can be issued. Tactically, in cases where there are no securities violations, a corporation should attempt to avoid taking any action that transforms an informal investigation into a formal one. The reason is simple: an informal investigation can be closed by the SEC staff without the extensive review necessary to close a formal one.

Formal investigations are conducted pursuant to "formal orders of investigation" issued by the commission in Washington. Under these orders, the SEC staff is authorized to issue subpoenas for witness testimony and document production. Once a formal investigation is initiated, it can be terminated if no violations are found; however, the internal SEC review required for such termination needs the approval of senior SEC personnel in Washington. In today's environment, "closing" a formal investigation is no simple task.

Steps to take when faced with an informal or formal investigation.

The process a company follows at the outset in responding to either type of SEC investigation may be crucial in determining the ultimate outcome. In cases where there is no wrongdoing by the corporation, a prompt response to the SEC may result in an early termination of an investigation that could otherwise drag on for months or years. In addition, the SEC has taken the position that early cooperation may result in dramatically lower sanctions if wrongdoing is uncovered.

Because the initial response to an SEC investigation is crucial, a corporation that receives an SEC voluntary information request or a subpoena should immediately attempt to determine the following:

1. Is the corporation the target? In its investigations, the SEC seeks information from the targets of investigations as well as from third parties. While the SEC staff, as a matter of practice, never identifies the "targets" of an investigation, every effort should be made to determine the investigation's nature and the corporation's role in it. The SEC staff handling the investigation should be asked to provide whatever information they are willing to share. Because a formal order of investigation describes an investigation in general terms, a copy of this order should be obtained as soon as possible.

The SEC staff is authorized to provide copies of the formal order in response to written requests that specify that the order will be used in connection with the representation of a specific client and will not be disseminated to other individuals or entities.

2. Is the corporation required to disclose the investigation in its public filings? Public disclosure of an SEC investigation can cause an immediate drop in a company's share price. In addition, disclosure of an investigation can prompt the filing of securities class-action lawsuits.

There is no controlling legal authority on whether a corporation is required to disclose the existence of an investigation, but a corporation should consult with counsel about whether disclosure is advisable. That may be the case in a number of circumstances, including: a) when the corporation and/or employees with knowledge of the investigation intend to buy or sell company stock; b) when the fact of the investigation becomes broadly known to third parties as a result of the SEC subpoenas; and c) when the existence of the investigation makes any previous company disclosures materially misleading.

If a corporation does not initially disclose the existence of an investigation, it should continue to review this issue as the investigation progresses.

3. Should corporate officials being scrutinized in the investigation obtain separate counsel? SEC investigations routinely involve a determination of the role that corporate officials played in any corporate securities violations. To make that determination, the SEC takes testimony from individuals throughout the course of an investigation.

Because potential conflicts can exist if the attorneys for the corporation also represent individual witnesses in an investigation, a company should assess whether individuals need separate counsel. This is especially important today, when an organization may want to cooperate even if that isn't in the best interests of certain corporate officials.

The decision on whether corporate employees should be separately represented is a fact-specific one involving a determination of whether a given individual has "exposure" in the SEC inquiry. Because costs are often an issue in these decisions, a company should consider whether some individuals require completely separate counsel and whether other less-involved employees can be jointly represented by one attorney or a firm acting as "pool" counsel for a large group of witnesses. Whatever the decision, the corporation needs to deal with this issue early in an investigation.

4. Should a corporation conduct an internal investigation? This is one of the most difficult decisions that must be made in an SEC investigation. An internal probe has a number of potential benefits. For example, if the corporation decides to conduct one and disclose the fact of the investigation to the SEC, it may be able to persuade the SEC to delay its investigation until the corporation's own investigation is complete.

In addition, such an internal probe allows a corporation to assess whether it has committed securities violations, and whether it should actively defend itself in the SEC investigation or, instead, fully cooperate with the SEC by providing information about the violations.

While an internal investigation has certain benefits, it also has potential pitfalls. Once a corporation informs the SEC that it is conducting an internal investigation, the commission will expect to be given the results of the probe. To the extent that an organization refuses to disclose an investigation's results, the SEC may conclude that the probe has uncovered serious securities violations--and that the corporation's silence is evidence that it is not cooperating. The result may be harsher sanctions if the SEC ultimately decides to bring an action.

In addition, and perhaps just as ominous, if the internal investigation is disclosed to the SEC, it may also be available to plaintiffs in class-action litigation. Courts have generally held that the disclosure of an otherwise privileged internal investigation to the SEC waives the privilege as to all other parties. That means that the disclosure of the results of an internal investigation to class-action plaintiffs may provide a "road map" for their claims.

While the decision on whether to conduct an internal investigation is often difficult, it is generally advisable to make that decision as early as possible. This choice sets the tone of whether the corporation is going to be proactive or reactive to the SEC investigation. Failure to make a decision leaves the company with no choice but to react to the SEC's investigative plan.

Best-Case and Worst-Case Scenarios In an SEC Investigations

The SEC can bring a civil administrative action or a federal court injunctive action against a corporation. In these actions, the SEC can seek "disgorgement" of wrongfully obtained funds and monetary fines, running as high as $500,000 per violation, or the gross amount of pecuniary gain stemming from the violation.

For example, in a case where a corporation raised millions of dollars through the use of false financial statements, it could be required to disgorge the wrongfully obtained funds and fined an equal, additional amount.

The SEC can also bring similar actions against any involved individuals and seek to bar them from serving as officers and directors of public companies. In the worst-case scenarios, the commission can elect to provide the results of its investigation to the Department of Justice for criminal prosecution.

For a corporation, the filing of an SEC action can be devastating. It not only subjects the corporation to adverse publicity and substantial monetary penalties, but it also can impair the company's ongoing activities. For example, a corporation subject to an injunction is disqualified from certain private placements and is not eligible for the safe harbor for "forward-looking statements" contained in the Private Securities Litigation Reform Act--protective language found in most public announcements.

In sum, every responsible public company these days recognizes that an SEC investigation can have a devastating impact on its continued viability. With this reality in mind, knowing the basics of how the SEC conducts its investigations and giving thought to possible responses is an absolute must.

RELATED ARTICLE: The Key Elements of Cooperation

According to recent pronouncements and written policies, a company can substantially reduce or even eliminate the sanctions that the SEC will seek against it. The SEC has identified the following four broad measures of a company's cooperation:

* Self-policing prior to the discovery of the misconduct, including the establishment of effective compliance procedures and an appropriate tone at the top.

* Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely and effectively disclosing the misconduct to the public, regulators and self-regulators.

* Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct and appropriately compensating those harmed.

* Cooperation with law enforcement authorities, including providing the SEC staff with all information relevant to the underlying violations and the company's remedial efforts.

Source: McDermott, Will & Emery 

James L. Sanders ([e-mail]) and Gordon Greenberg ([e-mail]), both former federal prosecutors, are Partners in the Los Angeles office of law firm McDermott, Will & Emery.