The U.S. Securities and Exchange Commission (SEC) investigates companies, brokerage firms, and individuals for a broad range of statutory and regulatory violations. These investigations can lead to civil or administrative enforcement action by the SEC—or potentially referral to the U.S. Department of Justice (DOJ) for criminal prosecution. In any case, the costs of an unfavorable outcome can be substantial. Thus, when an investigation arises, asserting an effective defense needs to be the target’s top priority.
So, how do you defend against an SEC investigation? This starts with understanding the process – or rather processes – the SEC uses to gather information in support of its enforcement efforts. With a clear understanding of what to expect, targets and their defense counsel can executive tailored defense strategies focused on avoiding litigation.
“SEC investigations can present significant risks for targets, but targets that take a proactive approach can achieve favorable outcomes in many cases. The key is to quickly gain a clear understanding of the issues at hand, evaluate all potential risks and defenses, and execute an effective defense strategy while working with SEC Enforcement Division staff.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
The SEC conducts two types of investigations: informal and formal. In the substantial majority of cases, investigations are informal, or at least begin informal, in nature.
As the SEC explains, “Facts are developed to the fullest extent possible through informal inquiry, interviewing witnesses, examining brokerage records, reviewing trading data, and other methods.” Following an informal investigation, SEC Enforcement Division staff may either elect to terminate the inquiry, enter into settlement negotiations with the target, or pursue a formal investigation.
Initiating a formal investigation triggers the SEC’s subpoena authority. Generally speaking, the SEC reserves formal investigations for more-serious matters involving large amounts of money or affecting a large number of investors. However, this is not always the case, and SEC Enforcement Division staff may choose to pursue a formal investigation in any matter in which it appears that administrative, civil, or criminal penalties may be warranted. If a target is unwilling to consider reasonable settlement options during an informal investigation, this can lead to a formal inquiry as well.
Issues that Can Trigger SEC Investigations
SEC investigations can target a variety of issues. With jurisdiction over public companies, private companies, brokerage and advisory firms, and individuals both affiliated and unaffiliated with these entities, the SEC enforces an extremely broad range of requirements and prohibitions.
This includes requirements and prohibitions established under the SEC’s Rules and Regulations, the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940, among many other sources of federal authority.
Under these rules, regulations, and statutes, the SEC targets issues such as:
- Account churning and other fraudulent practices
- Blackout trading restriction violations
- Fraudulent initial public offerings (IPOs) and initial coin offerings (ICOs)
- Insider trading violations
- Misappropriation of investors’ funds or securities
- Misrepresentations and omissions by companies, firms, and individuals
- Pay-to-play violations
- Regulation FD violations
- Securities market manipulation (including manipulation through social media)
- Selling unregistered securities
The SEC can learn of alleged violations through various means. While the SEC conducts its own market surveillance and reviews companies’ public filings, it relies on a number of external sources as well. Complaints from investors, whistleblower claims, media reports, and information circulated on social media can all trigger scrutiny from the SEC’s Enforcement Division.
Informal SEC Investigations
As mentioned above, once the SEC learns of a potential violation, it will typically begin its enforcement efforts with an informal investigation. Broadly speaking, an informal SEC investigation involves:
Reviewing Available Data
The SEC’s Enforcement Division typically begins an informal investigation by reviewing the data it can access without contacting the target or any potential witnesses. Enforcement Division staff will review public filings, public statements, and information submitted by investors or whistleblowers in order to determine whether further action is warranted.
If Enforcement Division staff determine that further action is warranted, then they will begin interviewing witnesses. These may include the target himself or herself, or individuals within or outside of the target entity. When conducting an informal investigation, SEC Enforcement Division staff do not have subpoena power. Thus, all interviews are voluntary at this stage.
Requesting and Reviewing Additional Data and Documentation
In addition to requesting interviews, Enforcement Division staff will also request additional data and documentation that are not publicly available. While targets’ EDGAR filings, press releases, media quotes, and social media posts will be enough to substantiate allegations on their own in some cases, in many cases additional evidence will be required.
Compliance with these requests is voluntary, and targets and witnesses alike will need to carefully consider whether (and to what extent) it is in their best interests to cooperate during an informal SEC investigation.
Evaluating Potential Allegations
After reviewing all witness testimony, data, and documentation obtained, SEC Enforcement Division staff will evaluate potential allegations against the target. They may also consider whether to expand the scope of their investigation at this stage. If the investigation does not uncover evidence that is sufficient to support charges, then this could be the end of the inquiry.
Negotiating with the Target’s Defense Counsel
If it appears that enforcement action may be warranted, at this stage SEC Enforcement Division personnel will often seek to enter into negotiations with the target’s defense counsel. It then becomes incumbent upon defense counsel to determine whether it is in the target’s best interests to negotiate or to dispute the allegations at issue.
Determining Next Steps
Finally, based on the events that transpire during the investigative process, SEC Enforcement Division staff will make a determination regarding next steps. Principally, they must decide whether to drop the inquiry or move forward with a formal investigation focused on substantiating administrative, civil, or criminal charges.
Formal SEC Investigations
Formal SEC investigations are distinguished from informal investigations in a number of ways. However, perhaps the most-significant distinguishing factor is the availability of the SEC’s subpoena power. The SEC is able to issue administrative subpoenas during formal investigations; and, while these subpoenas do not require judicial approval, the SEC can seek judicial enforcement when necessary.
Issuance of SEC Subpoenas
The SEC can issue subpoenas requiring testimony (subpoenas ad testificandum) and subpoenas requiring the production of documents (subpoenas duces tecum). Testimony is taken under oath; and, when producing documents in response to an SEC subpoena, targets and witnesses must be careful to produce all responsive documents—with only limited exceptions for those that are privileged. While it is possible to challenge an SEC subpoena on limited grounds, federal judges will generally defer to the agency’s investigative expertise, and thus they will rarely quash SEC subpoenas in their entirety.
Issuance of a Wells Notice
After considering the available evidence during a formal investigation, the SEC’s Enforcement Division may (or may not) choose to issue a Wells Notice. This is a formal letter that summarizes the Enforcement Division’s findings and indicates the SEC’s intent to pursue charges. Responding to a Wells Notice is optional, and deciding whether to respond requires a thorough evaluation of all pertinent factors on a case-by-case basis.
Presentation to the SEC for Review
If SEC Enforcement Division staff believe that charges are warranted, the final stage in the investigative process is for staff members to present their findings to the SEC for review. Upon reviewing the findings, the SEC can authorize the Enforcement Division to initiate administrative or civil proceedings.
What Happens After an SEC Investigation?
As touched on above, SEC investigations can have a number of potential outcomes. Of course, the best-case scenario (once the SEC has initiated an investigation) is to resolve the investigation without any findings of wrongdoing. However, if the SEC’s Enforcement Division pursues substantiated allegations, then the focus of the target’s defense strategy may need to shift to minimizing its liability via settlement. Administrative and civil SEC enforcement actions are possibilities as well; and, if an investigation unveils evidence of criminal misconduct, Enforcement Division staff may engage the DOJ to pursue an indictment and prosecution in federal district court.
What Can (and Should) Targets Do During SEC Investigations?
Given the various paths SEC investigations can take and the various outcomes they can produce, what can (and should) targets do during SEC investigations?
As with all federal law enforcement matters, a proactive response is critical. Rather than waiting to see what evidence the Enforcement Division is able to collect and what charges the agency chooses to pursue, targets should work to minimize any potential exposure and secure a favorable pre-charge resolution.
What does this entail? First, a target should engage defense counsel to intervene in the investigation. The target should then work with its defense counsel to conduct an internal (attorney-client privileged) audit and evaluate possible charges and defenses.
Then, based on the facts at hand and the evidence that is available to the SEC’s Enforcement Division, the target’s defense counsel will need to formulate and execute a tailored defense strategy focused on efficiently – and quietly – achieving a positive outcome.