What D&Os Should Know About SEC Fraud Investigations

As an officer or director of a public company, there are few things that will impact your professional life more profoundly than an investigation by the U.S. Securities & Exchange Commission’s Division of Enforcement. As an SEC investigation is launched, it is critical that you do not become lost among the frenzy of external and internal interests that will compete for your time and attention. At the onset, regardless of whether the SEC is examining revenue recognition, conflicts of interest, off balance sheet transactions or reserve issues, having a basic understanding of what’s at stake—and the interests of the different players that emerge—will have an immediate beneficial impact on your livelihood, career, and personal freedom.

You are not a target. But you may be. Unlike the Department of Justice, which will place you in one of three categories—target, subject, or witness—and subsequently allow you to ascertain how much risk you face, the federal securities laws only authorizes the Enforcement Division to conduct fact-finding investigations to determine whether there have been violations of the federal securities laws. The staff of the Enforcement Division can do this either formally or informally.

In most instances, the staff will initiate an informal investigation to determine whether facts exist to reasonably conclude that a violation of the federal securities laws may have occurred. At this stage, the staff will issue requests for documents, meetings, interviews, or testimony on a voluntary basis. Although it is theoretically possible to decline these requests, companies and its officers and directors rarely do because of the superseding benefit of affirming a cooperative stance with the government.

The informal stage of the investigation rarely lasts longer than a few months. In situations where there are more publicly visible signs of accounting misconduct, the staff will skip the informal stage of the investigation and move quickly to obtain a Formal Order, which will empower them to subpoena documents and compel testimony.

Chances are that you will be subpoenaed for testimony, which is a formal proceeding where your statements will be taken under oath and a record, in the form of a transcript, will be compiled. This does not and should not be thought of as a sign that you have done something wrong; rather, the staff believes that you have information to contribute to its fact-finding investigation. The SEC, however, has already developed multiple theories concerning the chain of potential liability, and if you are within certain high risk areas—such as accounting, finance, or sales—you should be aware that they will be looking at your potential involvement. The SEC builds its cases on testimony and documents. Be assured that every memo, email, and correspondence relating to the accounting issue in question will be scrutinized.

Finally, in the midst of the SEC’s investigation, you must stay cognizant of the Department of Justice’s interests in the investigation. Now, more than ever, U.S. Attorney Offices are—in instances when they themselves are not leading the charge—following the SEC’s investigation closely to determine whether any alleged impropriety rises to the level of criminal conduct.

The FBI is here. And they want to come in. White collar prosecutions involving accounting fraud continue to pique U.S. Attorneys’ interests across the country. In pursuing these prosecutions, federal prosecutors’ and the SEC’s interests often coincide, resulting in parallel civil and criminal investigations into the alleged misconduct. In instances where the SEC is taking the lead, information gathering will take a different turn. The staff will still subpoena documents, but, because of the notorious difficulties associated with white collar prosecutions, you will probably be asked to be voluntarily interviewed by the staff, assistant U.S. Attorney, and FBI agents for strategic trial preparation reasons. Although there will not be a formal record of your statements—as in SEC testimony where there is a transcript—the stakes are substantially higher.

Don’t lie. You could go to jail. Regardless of whether there is a parallel criminal investigation or the SEC is conducting a stand-alone investigation, lying to the SEC will immediately jeopardize your freedom. Ask Martha Stewart. Stewart, who caught the attention of the SEC because of certain ill-timed trades in ImClone stock, was convicted of lying to federal officers and obstructing justice. The government alleged, among other things, that she lied about her reasons for trading the stock during a telephone interview with the SEC and tried to cover it up. She spent several months in federal prison.

As Stewart’s federal prosecution illustrates, the government, and specifically the SEC, casts a far-ranging net that allows the staff to gather information from multiple sources that may uncover archived emails, drafts of documents, recorded conversations, and witness accounts from colleagues, subordinates, and customers. At times, the SEC will take several years to complete its investigation, converging in a massive record that will make an attempted omission or misstatement easy to detect and punish.

It’s about fraud.

But, most likely, it won’t turn out to be. Companies, through the illusion of legal fiction, act as a singular entity. In reality, companies are a collection of individuals with a wide array of duties and responsibilities—these individuals make mistakes and there can be errors in judgment that find their way to—or are diverted from—your company’s financial statements. Not all of these omissions or misstatements are a result of an act by an individual or individuals bent on perpetrating an accounting fraud. The SEC often finds that the individuals’ actions were more akin to negligence than intentional or reckless conduct and, as such, no fraud charges are brought.

Chances are that you don’t often think about the vagaries of intentional, reckless, or negligent acts concerning omissions or misstatements in financial statements. In SEC investigations, these distinctions determine your risk and liability. Although the SEC focuses on collecting evidence of accounting fraud—translated to violations of the antifraud provisions—there are far-ranging collateral violations that do not hinge on intentional or reckless conduct. These include provisions governing your company’s reporting, internal controls, and books and records obligations as well as your interactions with independent auditors.

Your primary concern will be your exposure to a securities fraud violation, which amounts to a misstatement or omission of material fact flowing through to your company’s financial statements, made with “scienter.” Generally in pursuing a fraud charge, the SEC’s main obstacle is proving scienter, which is a mental state embracing the intent to deceive, manipulate, or defraud. Absent proof of intentional conduct, scienter can be shown through recklessness. Recklessness is a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care. Ordinary negligence does not qualify as recklessness; it must be extreme, equivalent to a lesser form of intent.

Specifically, reckless conduct must be something more egregious than even innocent but stupid good faith, and represents an extreme departure from the standards of ordinary care—such that the individual must have been aware of it. Disseminating inaccurate accounting statements is not enough; however, violations involving the premature recognition of revenue suggest a conscious choice and may support a stronger inference of scienter. For example, other factors probative of scienter include conduct contrary to your company’s established revenue recognition practices; actions taken that artificially caused your company to meet analyst expectations over several consecutive quarters; and withholding documents from auditors.

Apart from your primary concerns regarding fraud, the SEC also examines an individual’s more mechanical contributions to the company’s financial reporting and disclosure requirements, such as your company’s reporting, books and records, and internal control requirements found in the federal securities laws. Your company has an obligation to file accurate annual and quarterly filings with the SEC. If your company has an error in any of its historic financial statements, these filings will be deemed in violation of these reporting provisions. Financial reports that are not in accordance with generally accepted accounting principals are presumed to be misleading. Your risk and liability comes with aiding and abetting or causing your company’s violations and the SEC need not prove scienter relating to these provisions.

Your company is required to keep and maintain books and records that accurately reflect its transactions and disposition of assets and devise and maintain a system of internal controls surrounding these books and records. Books and records reflect transactions in conformity with accepted methods of reporting economic events—in conformity with GAAP—and deliberate acts resulting in inaccurate books and records violate this provision. Internal controls ensure that the books and records are kept in conformity with GAAP. Such internal controls need only provide a reasonable assurance of the reliability of the financial records, not the absolute accuracy of those records. Your risk lies in aiding and abetting in or causing your company to violate these obligations. Proof of these violations do not require scienter.

Finally, the SEC examines individuals’ role in the knowing failure or circumvention of your company’s internal controls, knowing falsification of books and records, and lying to your company’s auditors in contributing to your company’s omission or misstatement of its financial statements. These violations involve an overt action or inaction reflecting an element of knowledge on the part of the individual wrong-doer that results in inaccurate financial statements. In other words, intentional or reckless conduct is not necessary to show violations of these provisions. Rather willfulness—which does not require intent to violate the law, nor does it require “deliberate or reckless disregard” of a regulatory requirement—provides the legal guidance here. A willful violation arises when the individual intentionally commits an act that does not fulfill the regulatory requirement, or if charged with a duty, failed to meet his or her responsibility.

It will mean your job. And your hope to land another one like it. Given proof of wrong-doing, the SEC will move to permanently enjoin the bad actor from future violative conduct.

Regardless of the severity of the allegations, an injunction against you has career-ending ramifications. Provided that you are still employed at the company, the company will have to disclose in its future filings with the SEC, and consequently the entire investor world, the nature of the remedial action the SEC has taken against you. If you leave the company, any potential public company seeking to employ you will assume those same disclosure obligations.

The SEC has also been aggressive in pursuing officer and director bars, which prohibit you from serving as an officer or director in a public company, even in situations that do not impute intentional or reckless conduct, such as lying to the auditors or falsification of a books and records charge. Due to statutory restrictions, the SEC has historically sought officer and director bars only in instances of fraud. This, however, changed with the passage of Sarbanes-Oxley, which contained a little noticed provision that allowed the SEC to pursue any equitable relief that may be appropriate or necessary for the benefit of investors. In SEC v. Del Global et al., a former director of Del Global settled to allegations of falsifying books and records, circumventing internal controls, and lying to the company’s auditors. The SEC’s investigation of Del Global involved numerous allegations of accounting fraud, and although other defendants were charged and eventually settled to fraud charges, this particular former director did not. The SEC, however, sought and obtained an officer and director bar, albeit in a settled context, through the general equitable relief provision described above.

The SEC is not your only concern.

But it’s your primary one. In recent years, companies have followed a typical pattern in responding to SEC investigations due to their lawyers’ recommendations based upon their read of market, statutory, and regulatory imposed pressures. For better or worse, your company’s audit committee will most likely initiate an internal investigation into the alleged wrong-doing and retain an outside independent counsel to conduct it. This will cause an immediate separation of interests between the company’s management, specifically you, and the Board.

From the standpoint of the company as a whole, this is done, in part, under the theory that the quick initiation and execution of an internal investigation reflects well upon the company’s intent to cooperate with the SEC. With the ongoing SEC investigation in the background, the internal investigators will do two things: request a separate voluntary interview and collect documents. Be aware that these internal investigators are acting on behalf of the company and do not represent your interests. Your interview will be memorialized and may be provided to the SEC, should your company waive the attorney-client privilege—as another milestone reflecting its intent to cooperate—and become a part of the SEC’s growing record.

But the auditors won’t sign off.

And you still need to run the company. Allegations of financial wrongdoing will trigger another separate set of actions by your company’s independent auditors; that is, if the auditors don’t immediately resign due to a loss of confidence in management.

The auditors are guided by a set of principles (GAAS) as well as a statutory regime, including those promulgated by Sarbanes-Oxley. If there are signs that illegal acts may have occurred within the company, the auditor will take an active role in initiating and executing separate audit procedures designed to address these allegations. The auditors may not sign off on your company’s financial statements until the internal investigation has concluded and they are satisfied with the procedures employed during that investigation. Without their sign-off, your company will be unable to complete its yearly filing obligations with the SEC, which jeopardizes your company’s stock and future capital raising ability.

The column solely reflects the views of its author, 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.

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