With the SEC’s enforcement of laws against fraud and other financial wrongdoing at its highest in recent memory, CPAs must be vigilant in defense of companies under investigation. This article describes the current enforcement climate and recommends the best strategies to adopt for a vigorous, successful defense in the face of an SEC investigation.
Over the past decade, the SEC has aggressively pursued investigations and prosecutions related to accounting and auditing liability. At the same time, the SEC’s standard operating procedures for conducting and prosecuting private, formal investigations have undergone drastic changes. Properly navigating SEC enforcement actions is more crucial than ever, necessitating the counsel and advice of experienced attorneys to develop winning strategies that put an issuer in the best position to successfully fend off or even defeat the action.
Background Primer on SEC Enforcement Actions
A private, formal SEC investigation begins with the full commission issuing a formal order of investigation, without dis-closing to the public that the investigation is under way. The order provides the staff assigned to the matter with full subpoena power throughout the United States. The staff subpoenas documents from the participant (or respondent) organization or individuals being investigated, as well as third parties with knowledge (e.g., accountants, auditors, customers). The staff also subpoenas witnesses to give sworn testimony, akin in many ways to a civil deposition. Similar to a criminal investigation, the SEC staff does not share its investigative file with counsel for the respondent; rather, counsel only has access to the materials and testimony in which it participates. Importantly, the SEC seeks only civil remedies and penalties; it does, however, always have the option of referring matters it thinks deserving to the Department of Justice for criminal investigation.
The white paper process is, generally speaking, voluntary. Agreeing to submit a white paper may be advantageous for some companies and not for others.
SEC investigations often take months or even years to complete. At the conclusion of its investigation, the staff often sends a Wells notice to the respondents notifying them that the SEC has concluded that they should be charged with violation of the securities laws. The Wells notice identifies the specific statutes or regulations allegedly violated and may offer some factual detail in support. The staff often has a Wells notice call with counsel, providing additional factual detail as necessary. Once the Wells notice is issued, respondents generally have 30 days to file a Wells submission—a legal brief setting forth legal and factual arguments as to why no charges should be brought. The full commission is presented with these materials and makes a determination as to 1) whether charges should be filed, 2) what specific charges should be filed, and 3) in which venue—federal district court or an administrative proceeding before an administrative law judge. Importantly, once a Wells notice is issued, there is an 80% chance that an enforcement action will be prosecuted (Jean Eaglesham, “SEC drops 20% of Probes After ‘Wells Notice,’” Wall Street Journal, October 9, 2013, http://on.wsj.com/1OyjPUD). Thus, the best course of action is to avoid a Wells notice completely.
Trends in SEC Enforcement Actions
Use of Pre–Wells Notice White Papers in SEC Investigations.
Generally speaking, a respondent has no formal opportunity to address the SEC staff’s legal and factual positions until a Wells notice is issued. The Wells notice, if disclosed voluntarily for business or legal reasons, may attract significant media attention and can spur immediate stock price and sales declines, as well as investor and consumer reaction. Over the past several years, the SEC has offered respondents the opportunity to be more active participants in the pre–Wells notice investigation process through the submission of white papers on issues or questions raised during the course of the investigation. It is not clear whether this shift is part of a formal mandate or simply favored by current senior officials. In any event, these white papers are written submissions on legal or factual issues raised by the staff and may contain factual and legal arguments, as well as supporting material such as relevant documents and expert reports.
The white paper process is, generally speaking, voluntary. Agreeing to submit a white paper may be advantageous for some companies and not for others. Experienced counsel should assess the pros and cons and provide a recommendation that fits the situation. Pros include: 1) the ability to explain complex facts, especially helpful in very complex or esoteric accounting or securities areas where the white paper allows the respondent to address the staff’s legal and factual positions head-on, allowing for market context and pragmatic flavor that could lead the staff to a different conclusion; 2) the opportunity to avoid adverse publicity, since no white papers have been disclosed to the public to date and there is little risk of adverse publicity by their submission; and 3) a better sense of the staff’s theories, giving the respondent a better grasp of the scope and direction of the investigation, as well as offering access (in some cases) to certain information in the staff’s investigative file that ordinarily is not made available until after a Wells notice is served.
The cons of submitting a white paper also need to be carefully evaluated. They include: 1) cost, as white papers can be lengthy and even involve expert reports, requiring time, legal fees, and human capital costs; 2) cooperation, as the white paper process places an increasing burden on the participant to be cooperative and forthcoming, which might not be ideal depending on the case; 3) moving target concerns, as the white paper process could lead to many follow-up questions, changing staff theories, and subsequent white paper submissions, as well as help the staff refine its legal and factual theories and potentially strengthen its position; 4) binding positions, meaning that unless otherwise agreed, the staff will likely take the position that any statements in the white paper are admissible as admissions against interest or for impeachment purposes in later proceedings (although the case law is still evolving on this point); 5) discoverability in third-party civil litigation, as any communications with the SEC, including white papers, are theoretically discoverable in such actions; and 6) parallel government investigations, since the white paper submission could potentially be used in a parallel investigation by the Department of Justice or other government agencies.
Overall, assuming a company has strong facts and legal positions on its side, a white paper can offer an opportunity to avoid a Wells notice. The above facts should be weighed on a case-by-case basis to determine the optimal path for best protecting the respondent’s interests.
SEC Settlements and Admission of Liability.
In SEC v. Citigroup Global Markets, Inc. [827 F. http://1.usa.gov/1n1ud0O).328 (S.D. N.Y. 2011)], the court refused to approve the settlement of an enforcement action where Citigroup settled “without admitting or denying liability.” Following this and other, similar decisions, it was not clear whether or under what circumstances the SEC would continue settling cases without admission of liability or wrongdoing. As a result, the SEC made an official pronouncement of its position, stating that, while settlements without admission of liability were still available, the SEC would no longer accept such settlements in cases where 1) a large number of investors have been harmed or the conduct was egregious, 2) the conduct posed a significant risk to the market or investors, 3) admissions would aid investors in deciding whether to deal with a particular party in the future, or 4) reciting unambiguous facts would send an important message to the market (see Mary Jo White, “Deploying the Full Enforcement Arsenal,” speech at Council of Institutional Investors Fall Conference, September 26, 2013,
While most cases continue to be settled without an admission of liability, respondents who choose to settle with such an admission should carefully consider the ramifications. These include the impact of admitting liability in the face of parallel government investigations and civil litigation on the same subject matter. In addition, an admission of liability could have an impact on the coverage positions taken by directors and officers (D&O) insurers, including the fraud exclusion generally included in such policies.
The SEC has focused its investigations over the past year on the twin pillars of auditor independence/conflicts of interest and deficient audits.
SEC Enforcement Actions Filed in Administrative Courts.
Prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), SEC administrative courts were limited to enforcement actions against persons registered with the SEC and affiliated with SEC-regulated industries. There are critical procedural safeguards available to respondents in federal court that are absent in administrative proceedings. First, the administrative law judge (ALJ) overseeing these proceedings is hired by the SEC staff and paid by the SEC. On top of that, the first-level appeal from an ALJ ruling is to the full commission—the same commission that authorized the formal order of investigation in the first place. Procedurally, there is no right to a jury trial, and there are time limits as to how long after the case is filed the ALJ decision must be issued, often putting a heavy burden on counsel to quickly prepare a defense. In addition, the federal rules of evidence do not apply, and the defense has no right to depose witnesses who have previously provided sworn testimony to the SEC.
Given the uneven playing field set forth above, and the expanded remedies available under Dodd-Frank, the SEC began filing more and more enforcement actions in administrative courts. In 2015, the SEC filed 76% of its enforcement actions against public company defendants as administrative proceedings (Cornerstone Research, “SEC Administrative Proceedings Increase as Constitutional Challenges Continue,” January 12, 2016, http://bit.ly/1OApxoW). Unsurprisingly, the SEC won more than 90% of its cases filed in administrative courts the previous year, as opposed to only 69% in federal district courts (Jean Eaglesham, “SEC Wins With In-house Judges,” Wall Street Journal, May 6, 2015, http://on.wsj.com/1AKOxEH). Respondents in these administrative actions are in an uproar, especially individuals not in the securities business or directly regulated by the SEC, such as alleged insider traders and public company executives. These respondents have filed suit in federal court seeking a ruling that the administrative actions are unconstitutional on two grounds: 1) the ALJs presiding over such actions were appointed in violation of Article II of the U.S. Constitution, since they are not appointed by the president or even the commission; and 2) the above-mentioned lack of procedural safeguards afforded to the respondents in defending these claims. The only two federal courts addressing these cases on the merits thus far have found that the ALJ appointments likely violate Article II and have enjoined the administrative proceedings [Hill v. SEC, 2015 WL 4307088 (N.D. Ga. June 8, 2015); SEC v. Duka, 1:15 Civ. 357 (RMB) (S.D. N.Y. August 3, 2015)]. The executive branch is currently examining the appointments issue as to the SEC, as well as other federal agencies. In the meantime, the SEC has proposed implementing some procedural safeguards to address, at least in part, respondents’ concerns (SEC Press Release 2015-209, “SEC Proposes to Amend Rules Governing Administrative Proceedings,” September 24, 2015, http://1.usa.gov/1LiiiXZ). These include a willingness to adjust the timing of proceedings in appropriate cases and to permit parties to depose witnesses as part of discovery.
The SEC’s Enforcement Focus for 2016
The SEC has established auditing and accounting liability as priority areas of enforcement for 2016, both by its words and its conduct; this tracks with its behavior in previous years. During the SEC’s 2014/15 fiscal year, it filed 507 independent actions for violations of the federal securities laws, an increase of 22% over 2013/14 (SEC Press Release 2015-245, “SEC Announces Enforcement Results for FY 2015,” October 22, 2015, http://1.usa.gov/24sZGLx). In fiscal year 2013/14, 14% of cases were filed against auditing firms, and 10% were filed against individual auditors (Brian Hoffman, “A Review of SEC’s Audit Fraud Enforcement Trends: Part 2,” Law360, September 25, 2015, http://bit.ly/1TbJ2fT). For the current fiscal year of 2015/16, the SEC’s Division of Enforcement has set a keen focus on accountants and auditors as gatekeepers in its quest to ensure fair markets and accurate financial disclosures, averring that auditors and accountants are the last line of defense for the investing public. Therefore, the SEC has focused its investigations over the past year on the twin pillars of auditor independence/conflicts of interest and deficient audits.
At least 12 enforcement actions filed in administrative courts, and related settlements, between July and December of 2015 confirm the Division of Enforcement’s continued focus on auditors as gatekeepers; these cases are in addition to numerous other actions filed against issuers for improper accounting. They are instructive as to the types of cases currently being investigated and filed against auditors:
- ▪ SEC v. Deloitte & Touche—charged with violation of auditor independence rules when Deloitte Consulting had a business relationship with a trustee serving on the boards of three funds that Deloitte audited; settled for $1 million;
- ▪ SEC v. BDO Seidman—charged with a deficient audit (dismissing red flags) and misleading audit opinions in connection with the audit of General Employment Enterprises; settled for disgorgement of $600,000 in audit fees and interest and a $1.5M penalty;
- ▪ SEC v. Grant Thornton—charged along with two partners for ignoring red flags while conducting deficient audits of two publicly traded companies that wound up facing SEC enforcement actions for improper accounting; settled for disgorgement of $1.5M in audit fees and interest as well as a $3M penalty; the individual partners paid small monetary penalties and were suspended from practicing before the SEC for several years.
The SEC’s focus on investigating and prosecuting actions against auditing firms and individual auditors is not likely to change anytime soon. The SEC is going after entities and individuals they deem to be gatekeepers to the financial markets, including auditors and attorneys. Given the robust changes regularly taking place in the financial marketplace, the SEC has made it known that those entities and individuals have a duty to protect the investing public.
The need for experienced legal counsel when navigating an SEC investigation cannot be overstated. Based on this author’s experience, there are several strategies, almost uniformly accepted by attorneys representing clients in SEC investigations, that should be considered to help ensure the best possible outcome. These include the following:
- ▪ Develop mutual respect with the SEC staff from the outset—this places the client in the best light;
- ▪ Create and maintain an open dialogue with the staff throughout investigation;
- ▪ Use or develop expertise at the outset of complex cases to properly position the case;
- ▪ Always address the staff’s legal theories in a non-threatening way, and always demonstrate the client’s compliant legal position; and
- ▪ Avoid a Wells notice if possible.
While each situation must be evaluated on an individual basis, using the above strategies as a guideline, and with proper guidance and counsel, CPAs can successfully steer their clients through the dangerous waters of an SEC investigation.