Handling Communications Amid SEC Investigations

The Division of Enforcement at the Securities and Exchange Commission has been initiating both informal and formal investigations at a record pace over the past two years. In addition, companies in a variety of industries—including oil companies and telecommunications firms—are increasingly receiving information requests from the Commission; in July, the SEC asked 20 telecommunications companies for specific information about how they count their subscribers.

And though the letters are not to be construed as an indication of any wrongdoing, the sensitivity of the public markets can often misconstrue the most innocuous of regulatory inquiries.

As a result, it's critical that companies prepare strategies for reacting to investigations; those that fail to anticipate and plan for such event can caught like a deer in headlights.

Life Cycle Of A Probe

In order to lay the groundwork for a communications strategy, it’s important to understand the life cycle of a typical SEC investigation and what the SEC staff can and may publicly disclose throughout this process. It is equally important to know your company’s mandatory disclosure obligations, including the timing of mandatory disclosures.

Generally, investigations start out informally as what the SEC staff internally refers to as a “matter under inquiry,” or MUI (pronounced mYOU-ee). It takes little more than an idea for an SEC staffer in the Division of Enforcement to open a MUI; in fact, it is a routine practice to lay claim to a potential investigation by opening a MUI with the staffer’s name on it. Many MUIs can and do remain open for extended periods of time without the staff moving forward on them. Many others are actively worked as informal investigations.

The SEC is actually quite sensitive to the reputational harms that companies and individuals can experience when news of investigations is released to the public. After all, investigations—both formal and informal—are not legal actions, and many investigations are closed without the staff bringing formal charges.

The database at the SEC that stores information on all investigations is off-limits to the majority of SEC staff. It takes a special log-on for an SEC staffer outside the Division of Enforcement to access this information, and such access is often followed by a phone call from the Division of Enforcement asking the reason for the access. Also, because many—and arguably the majority of—MUIs do not progress to formal investigations, the staff as a matter of practice does not publicly disclose information on informal investigations. In addition, the Commission meetings at which the staff requests permission to upgrade a MUI to a formal investigation are closed-door sessions, meaning they cannot be attended by the public or by any staff member who does not have a legitimate role in the investigation.

Avoidable Disclosures

Surprisingly, there appears to be a growing practice by companies to disclose when the SEC has notified them of an informal investigation. Perhaps in an effort to introduce the possibility of a formal investigation to the market or to blunt potential criticism by shareholder activists for not immediately disclosing news of an investigation, these companies are choosing to disclose SEC inquiries in their most preliminary state.

Clearly, no mandatory disclosure obligation attaches here. And, arguably, voluntarily disclosing news of an informal investigation creates potential share-price volatility and reputational damage that is legally avoidable.

Even the SEC staff would acknowledge that, at preliminary stages, the vast majority of informal investigations are not material. Moreover, the decision by the staff to notify a company of an informal investigation does not carry with it an obligation for the staff to notify the company of a subsequent decision to put the investigation on hold or an election not to pursue the investigation altogether, thus exacerbating the market’s uncertainty surrounding the voluntary disclosure.

The Decision

Given that a company’s primary objective is to create value for its shareholders, the decision to disclose an informal investigation should be based on reasons that are more compelling than wanting to disclose the possibility of a formal investigation that, statistically speaking, could easily never happen.

If companies are thinking it’s best to disclose an informal investigation so that those with knowledge of it can buy or sell company stock without risking an insider-trading action, well, this approach is a dangerous slippery slope.

First, when the company discloses the informal investigation, the company itself attaches a certain amount of materiality to it that may not otherwise exist. Second, this voluntary disclosure arguably carries with it a duty to update in order to ensure that insiders and the public continue to trade on the same information. Exactly what event would trigger the duty to update? When the SEC staff requests copies of the sales records for the company’s top 20 customers for the past five fiscal years? When the staff asks to see the auditors’ work papers for the past two fiscal years? Clearly, the class action securities bar will have its own opinion as to what triggers the duty to update.

Obviously, a company that receives notice of an informal investigation should consult with outside counsel, preferably with one who has meaningful experience working directly with the Division of Enforcement, not other divisions at the SEC. That's because the Division of Enforcement’s activities are quite separate from those in other divisions at the SEC and, candidly, could be considered more closely aligned with the Department of Justice; the SEC enforcement staff frequently works more closely with DoJ staff—not other SEC staff—on investigations.

Based on the information the SEC staff is requesting, your counsel can identify the types of wrongdoing that the Commission is looking for, and—after conducting their own review—can assess the plausibility of the investigation.

In cases where—in outside counsel’s opinion—the informal investigation may have merit, a mandatory disclosure obligation still does not attach, and the biggest risk of voluntary disclosure at this point is that the SEC will delay moving it forward. Such a delay creates meaningful uncertainty for the company in the capital markets and, depending on the length of the delay, can lead to an erroneous assumption that the matter has been closed.

Disclosure Strategy

Once counsel has determined that the informal investigation may have merit, the company should immediately start developing its disclosure strategy and preparing the materials necessary to make accurate and clear public statements regarding the investigation when the appropriate time comes.

Communications tailored to address the needs of company employees and other stakeholders should be developed along with the public disclosures, and should never contain more information about the investigation than the public disclosures. In fact, it is a prudent practice to ensure that all material and non-public information about the investigation is limited to the core team assigned to the investigation, and to relevant members of the C-suite only. Disclosing non-public information to other employees in the company should be done on a strict, need-to-know basis. Burdening employees who are not central to the investigation with non-public information greatly increases the risks of inadvertent disclosures outside the company and places unnecessary stress and pressure on these employees.

Counsel should also be able to gauge with some certainty when the SEC's enforcement staff is likely to ask the Commission to approve a request for a formal investigation. If the company fully cooperated with the staff’s requests during the informal phase, progression to a formal investigation strongly suggests the staff has found enough evidence of wrongdoing (or not enough exculpatory evidence) to warrant bringing the investigation to the next phase. SEC staff can announce when they have opened a formal investigation, but typically they refrain from such an announcement unless they need to make a public filing with a court or approach a judge for some matter that will result in a public record. In those matters they typically feel a need to make a statement.

Companies are not legally required to disclose formal investigations, as their disclosure obligation attaches to legal proceedings and—as mentioned earlier—investigations are not legal proceedings.

That said, companies must disclose formal investigations when necessary to keep other publicly disclosed statements from being misleading. Accordingly, in-house and outside counsel should carefully review recent disclosures and coordinate future public statements with the investor relations and corporate communications officers to avoid violating this disclosure obligation.

Conventional Wisdom

Mandatory disclosure obligations aside, the conventional wisdom today is for companies to disclose that the SEC has notified them of a formal investigation. For the company, the timing of this disclosure is critical and—absent a legal requirement as described above—need not immediately follow the SEC’s notification. Clearly, it’s to the company’s advantage—and hence to the shareholders’ advantage—for the company to be the first to disclose a formal investigation, including investigations of management or directors.

Generally speaking, the ideal timeframe within which to make this disclosure is:

As close to the resolution date as possible to minimize the period of uncertainty; and

As far in advance of the resolution date as necessary to maintain the trust and confidence of the company’s constituents, even if there was no legal obligation to disclose the investigation.

Closure And Ramifications

Unfortunately, the majority of factors that lead to the conclusion of an SEC investigation are beyond the company’s control. The pace at which the staff moves the investigation forward, for example, is contingent on many things, including staff availability, priorities set by the Division of Enforcement or the Commission, and developments in other investigations that are simultaneously under way.

It is also a common practice for the SEC staff to seek information from people outside the company, such as former employees, vendors, customers, and suppliers. The cooperation of these parties is often indispensable to bringing an investigation to a close, and these parties—understandably—can be highly reluctant participants as well as expert procrastinators.

Owing to the dramatic increase in the number of investigations over the past two years, many companies are finding that the pace at which investigations are progressing has meaningfully slowed. This is not good news, to be sure, because the market attaches a nasty overhang to the stocks of companies that are experiencing drawn-out SEC investigations.

The SEC’s decision to seek information from third parties also carries with it other ramifications to the company with respect to the timing of their disclosure of the investigation. While the staff will advise third parties that their discussions are to be kept strictly confidential, it is naïve to think that they will be kept strictly confidential. To laypersons, investigations are sensational events, and being called to a deposition with the SEC is—for many people—too exciting (or too nerve-wracking) not to be talked about. Accordingly, it is critical that your counsel keep you informed—to the extent possible—as to when the SEC is going outside the company for information.

Last, your counsel should have some sense of when the investigation is coming to a close, and whether or not the company can expect a Wells call or Wells notice, which is basically the SEC’s way of saying, “We’re going to sue you now unless you can give us a really, really good reason why we shouldn’t.”

While the term “Wells” is enough to send shivers down the spine of the most seasoned CEO, it is actually good news for a company that has been involved in a protracted and publicly disclosed investigation by the SEC. The capital markets favor closure, and this is an ideal opportunity for the company to recoup investor and public confidence by settling with the SEC and publicly announcing the settlement.

Notably, settlement agreements do not require the settling parties to admit to wrongdoing. However, these agreements also expressly prohibit publicly denying wrongdoing. And the SEC staff monitors settling parties’ subsequent public communications very carefully in the weeks and months that follow settlement agreements (see related Compliance Week guest column by Bruce Carton at right for further details on this topic).

Accordingly, when drafting your public announcements, it is critical to exclude any self-exonerating language or any language that indicates that the company or other settling parties disagree with the SEC’s investigation or settlement terms.

Moreover, in cases where the company itself is a settling party, employees company-wide should be counseled on the company’s legal obligation to refrain from denying any wrongdoing. Arguably, the SEC can construe statements made by company employees to other interested parties, such as vendors, shareholders, or analysts as public statements. Such statements could be considered violations of the settlement agreement and grounds for revocation.

For any company, this is an extremely unfortunate event that reinstates all the uncertainty that was formerly removed by the settlement agreement itself.

This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.