SEC enforcement actions are growing at record pace
In September, when Senator John McCain declared that his presidential response to the country’s economic woes would be to fire the head of the SEC, the statement drew widespread criticism. It may have been one of those empty election campaign promises that all candidates make but it is highly unlikely he could have done so even if he wanted to (a Supreme Court ruling suggests that presidents don’t have the authority to fire SEC commissioners). McCain’s statement did, however, signal a major shift in the zeitgeist: After years of placing corporations in the hot seat, the SEC now finds itself in the hot seat too.
‘There’s an enormous spotlight on the SEC right now,’ says Bruce Carton, a former attorney in the SEC’s enforcement division and editor of Securities Docket. ‘People are critical of the SEC’s actions and inactions over the past several years and are trying to figure out what, in fact, contributed to the current crisis.’ He continues, ‘The scrutiny will lead to the SEC being as vigilant as it can. It’s certainly no time to relax right now.’
A record few years
In the midst of the nation’s financial turmoil, the SEC published its financial year (FY) 2008 enforcement statistics. The SEC brought 671 enforcement actions in 2008, the second-largest number in the Commission’s history. In FY 2007 and 2006, when the SEC was also under chairman Christopher Cox’s stewardship, the Commission brought 655 and 574 enforcement actions, respectively, a big jump from the 490 actions averaged under Chairman Arthur Levitt’s stewardship from July 1993 until February 2001.
Philip Khinda, a partner in the securities and enforcement practice at Steptoe & Johnson in Washington, DC, predicts that the number of both SEC and corporate internal investigations will continue to rise.
Khinda is not alone in his ominous view. Michael Rivera, a partner in the securities enforcement and regulation department of Fried Frank in Washington, DC, believes, ‘With the current financial crisis, there’s going to be pressure on the SEC to be tough. I don’t see the enforcement program ratcheting down at all.’
A resurgence of insider trading prosecutions
As shareholder activism has grown over the past few years so too has the SEC’s and Department of Justice’s (DoJ) scrutiny of public corporations. Enforcement activity is up across the board but there are some areas that are attracting particular attention and that are likely to do so going forward.
Insider trading and market manipulation cases have recently assumed center stage in SEC enforcement actions. In FY 2008, the number of insider trading and market manipulation cases rose more than 25 percent and 45 percent, respectively, against the previous year. ‘The enforcement division has really seen a lot of insider trading activity that needs to be pursued. It’s commented that this is as bad as the days of Ivan Boesky,’ says Carton.
‘Insider trading has clearly reared its head again, and in ways the SEC finds more troubling than usual,’ observes Rivera. ‘The SEC has expressed surprise and dismay at the type of people involved in recent insider trading scandals. Increasingly, the insider traders have not been people on the periphery, but rather securities professionals and lawyers, or ‘gatekeepers’ as the SEC likes to call them, as well as corporate officials.’
Among its high-profile insider trading cases of 2008, the SEC charged former Dow Jones board member David Li and three other Hong Kong residents in a $24 million insider trading enforcement action. It also charged the former chairman and CEO of a division of Enron with illegally selling hundreds of thousands of shares of Enron stock based on non-public information.
When insider trading is alleged at the highest reaches of an organization, companies usually feel they need to take action. Typically, they conduct their own investigations, run by outside counsel with no affiliations to the company.
How these investigations are conducted often determines the amount of credence they’re given. ‘The government generally puts more credibility in an internal investigation if it’s done by a law firm that has no prior allegiances to management,’ says Russ Ryan, a partner in the government investigations group at King & Spalding in Washington, DC. ‘An external investigation should be designed to convince the government that we’ve looked under every rock and this is what we’ve seen.’
Whether management or the board conducts the investigation is an important opening question. ‘If there are any issues regarding the sitting CEO, for example, then the board and its independent directors have to take the lead,’ says Khinda.
Khinda cautions that SEC insider trading investigations can be ‘particularly invasive’ for many reasons, among them that the SEC often seeks personal credit card and cell phone records from personnel.
Here, the quality of a company’s corporate policies and procedures come under a microscope. Because enforcement actions often catch executives and boards by surprise, Khinda advises making sure that meaningful trading policies are widely known and enforced before trouble hits. ‘Make the rules clear, post all the speed limits and be out there watching,’ he says.
Boom generation for subprime and FCPA actions
William McLucas, a partner at WilmerHale in Washington, DC who chairs its securities department, notes that subprime issues are a relatively new priority for the SEC. There are currently over 50 ongoing investigations relating to the subprime market, according to the SEC tally.
Such information suggests the size of the subprime net may be larger than previously expected. ‘I understand that subprime lending investigations could involve not only the lenders themselves but also all manner of companies involved in creating, selling, rating or securitizing credit derivative products,’ says Rivera. This means that investment banks, credit rating agencies, insurers, investment advisers and even homebuilders may wind up targeted by the subprime working group formed by the SEC’s enforcement division to conduct subprime investigations.
Fraud and illegal stock option backdating cases remain a strong focus and the SEC launched a number of major cases during 2008. Another growth area, according to the SEC and lawyers specializing in enforcement, is in Foreign Corrupt Practices Act (FCPA) cases. See ‘FCPA over the years’, page 17.
‘The government is trying to send a message that we need to compete responsibly in other countries,’ says Ryan. ‘Every time you think the FCPA trend is leveling off, it doubles in size.’
Although the direction of earlier investigations is clear, the SEC’s priorities will almost certainly be shaped by the incoming administration of President Elect Barack Obama. Ken Rosen, associate professor at the University of Alabama School of Law, points out that ‘the prioritization of enforcement actions may change as new commissioners come in, particularly a new chairman.’ However, Rosen also notes that any change in course may be mitigated by the fact that the director of enforcement at the SEC, Linda Thomsen, is not a political appointee. ‘Subject to any personal plans she may have, there should be some continuity in terms of the permanent staff of the Commission,’ says Rosen.
With enforcement action clearly on the rise, and with scrutiny likely to increase even more as the global financial crisis continues to unfold, many people are trying to identify what government regulators will focus on in the years ahead. For those companies trying to read the enforcement tea leaves, clues can be found in the SEC’s playbook, which was published for the first time ever in early October. Gibson, Dunn & Crutcher described the SEC’s reference for its enforcement division staff as ‘an essential guide for anyone with a matter before the division of enforcement,’ available at: www.sec.gov/divisions/enforce/enforcementmanual.pdf.
SEC on the losing end
The increasingly aggressive moves made by the SEC and the DoJ are in turn causing companies to retaliate by taking a more active stance; instead of their customary habit of rushing to settlement, companies are taking litigation to trial. And those that have the stomach for a fight are enjoying some success. In recent months, individuals and companies prevailed against the SEC in a handful of enforcement cases.
‘The SEC has had a few losses of late – more than usual – but no one thinks that the SEC is going easier,’ contends Ryan. He notes that the losses have occurred in smaller, lower profile cases. On September 30, for instance, plaintiffs Adeline Coffman and Richard Sellers, whom the government has accused of fraud in SEC v Stansbury Holdings, not only prevailed against the SEC but a judge awarded them court expenses.
When you’re right, you’re right
Fighting the SEC isn’t easy, warns Ryan. ‘If you’re a public company, you need to be careful about your public image and you can rarely afford to be anything other than cooperative with an SEC inquiry.’ On the other hand, he advises companies that truly believe an enforcement action has no merit to consider fighting. ‘If you have a genuinely good legal argument as to why something is not illegal, you can and should push those things.’
Khinda agrees. ‘Cooperation is always the starting proposition, but if the government is misinterpreting the law or the facts, you have to push back. Whether you’re the government or you’re advising a company or board committee, the mission is to get to the truth and the goal is to be fair. The trick is getting there as quickly and quietly as you can.’
The high percentage of enforcement cases that are being settled is a direct result of the SEC’s diligent process, says SEC spokesman John Nester. He points out that before the enforcement division can bring an action, ‘it has to gather enough evidence to convince a jury or a court.’ For this reason, he says, SEC enforcement lawyers must do a very thorough job: ‘You see the settlements because of the strength of the case that’s been developed.’
In the end, though, pragmatism is what likely drives many companies to settle rather than fight. ‘Very few large public companies can afford to litigate with the SEC when their financial statements are at issue,’ opines McLucas. ‘They need to put the problem behind them, come to closure and get on with their business.’
To disclose or not to disclose
In addition to legal and possible settlement costs of an SEC action, companies also run serious risks related to reputation damage. This is because most companies feel compelled to disclose the information to shareholders even though they may not be legally obligated to do so. Because the SEC does not make its enforcement investigations public, executives and counsel often debate whether to announce the bad news in a press release and Form 8K.
‘There’s really no hard and fast rule on disclosure for an SEC investigation,’ says Timothy Smith, director of socially responsible investment at Walden Asset Management in Boston.
Nester says that the decision to disclose boils down to whether or not the investigation is material. ‘Companies are required to disclose material events to investors,’ he says. ‘So if it’s something a reasonable person would want to know before buying, selling or holding a security, then you need to disclose.’
Khinda concurs and points out that ‘the disclosure question should turn on the materiality of the facts underlying the SEC investigation, rather than the mere existence of the investigation itself.’
That said, some argue that materiality isn’t the only issue. Being transparent, they say, trumps the discomfort of announcing bad news that may eventually be revealed anyway. ‘Sometimes you’re better off getting the information out yourself rather than disclosing down the line,’ says McLucas. ‘While there’s no absolute rule, many people believe that disclosing more and disclosing earlier are wise things to do.’
How a company chooses to disclose an SEC investigation also matters. Khinda suggests that blanket assertions denying culpability from the outset are a mistake and may create a ‘duty to update’, a potential quagmire for companies that may not yet fully understand all that’s transpired.
What lies ahead
As the country attempts to restore investor confidence and repair its financial woes, it’s not clear whether the SEC, banking regulators or an agency that has yet to be created will assume the lion’s share of responsibility for investigating the mistakes of the past. With a change in administrations looming and the scope of the financial crisis only now being understood, it’s very difficult to predict what types of enforcement actions the SEC will pursue in the future, asserts McLucas.
Smith agrees, although he’s also convinced that fairly seismic changes in enforcement and oversight lie ahead. ‘Because of the economic crisis, the financial architecture of the US is going to be rejiggered,’ he says. ‘It’s not a left or right issue, but an issue of needing checks and balances to protect investors and consumers. ... We’ll definitely see investors standing up for their rights.’
