The New World of SEC Enforcement


The Sarbanes-Oxley Act has provided the Enforcement Division of the Securities and Exchange Commission ("SEC") with significant new enforcement tools, including new causes of action, new remedies, and new regulators. As a result, the SEC is opening more investigations, conducting them more quickly, and making more aggressive settlement demands, all of which is resulting in more litigation. This "new world" of SEC enforcement has significant ramifications upon public companies, their directors, senior executives, and in house attorneys, as well as the outside professionals who advise them–auditors, lawyers, and investment bankers.

New SEC Enforcement Tools

New Causes of Actions Available to the SEC

Sarbanes-Oxley has established new causes of action for the SEC against senior executives of a public company. The CEO and the CFO of a public company must certify under oath both the accuracy and the completeness of the issuer's financial results. These certifications include specific representations about both "internal controls" and "disclosure controls" of the public company. Internal controls relate to a company's processes and procedures designed to ensure that a company's accounting and financial reporting is accurate and in accordance with GAAP. In contrast, disclosure controls focus upon a company's processes and procedures relating to its narrative disclosure such as its MD&A discussion. This focus on "disclosure controls" flows from the SEC's belief, as expressed in recent enforcement actions, that, even if a public company's accounting is in accordance with GAAP, its public disclosures can still be misleading if certain transactions are not disclosed, or not disclosed fully.

Thus, senior management must make difficult disclosure judgments (which will be second-guessed with the benefit of 20/20 hindsight), concerning whether a transaction, even though accounted for correctly, must be disclosed because the failure to disclose the transaction might later be deemed misleading. Such transactions in the SEC's eyes include material "one-off" transactions or material end-of-quarter transactions. And, under the SEC's Staff Accounting Bulletin 99, materiality can be either quantitative or qualitative. Thus, a large end-of-quarter transaction that results in a company's meeting analysts' expectations for revenue or earnings per share is material and arguably must be disclosed. This gives the SEC enforcement division a "hook" to go after senior management even if the accounting is right.

The SEC also can now sue an officer or director for "improper influence" on the conduct of an audit. And a "willful" violation renders the officer or director guilty of a crime, punishable by fines and jail time. Also, an individual can be sentenced for up to 20 years for destroying, altering or falsifying records in connection with a federal investigation.

The SEC has new claims available against public companies and their directors. Public companies are barred from making loans to their directors and executive officers. The audit committee of a public company must approve all services the company's outside auditors provide, and it must confirm the outside auditor's independence and experience. Members of the audit committee, in turn, must meet certain independence and expertise criteria. They must establish and adhere to a written charter.

Whistleblowers who complain to the SEC about possible wrongdoing are now protected from retaliation with a private right of action. This provision will no doubt embolden people to make assertions of wrongdoing to the SEC (whether founded or unfounded) to protect themselves from adverse employment action. And while the SEC cannot directly enforce this section, the Department of Justice can seek criminal sanctions against any person who retaliates against a whistleblower, and these sanctions can be quite severe, including jail time.

In terms of investment bankers, the SEC has issued Regulation AC, which imposes significant disclosure and record-keeping obligations on securities firms and their research analysts. Further, at the SEC's urging, the NYSE and NASD have issued rules relating to the substantive conduct of research analysts, above and beyond the SEC's disclosure and record keeping requirements.

Finally, attorneys who represent SEC reporting companies now have certain "reporting-up" obligations when they discover credible evidence of a violation of federal or state securities law or a breach of fiduciary duty. An attorney's breach of these "reporting-up" obligations can be the basis for an SEC enforcement action.

New Remedies in the SEC's Arsenal

Sarbanes-Oxley provides that the SEC can now seek an officer and director bar against an individual not only in federal court but also in an administrative proceeding before the SEC's own administrative law judges. Further, the standard the SEC must meet for obtaining this remedy was lowered from showing that a person is "substantially unfit" to be an officer or director of a public company to merely showing that the person is "unfit." The SEC is seeking this remedy retroactively–that is, for conduct that occurred before the statute's enactment.

These changes will not only make it easier for the SEC to obtain this remedy, but will also have significant ramifications in a litigated case. Previously, a defendant would face this issue only after full-fledged discovery in federal court and at the conclusion of trial before an independent federal judge. Now the SEC can seek this remedy in an administrative proceeding–which is expedited and has very limited discovery. Also, the SEC sits in appellate review of the decisions of its own ALJs, and the SEC has not hesitated recently to reverse its own ALJ's initial decisions when they are favorable to a defendant. The SEC, of course, has no such review authority regarding the decision of a federal judge.

Second, the SEC now can seek to disgorge bonuses and other incentive-based compensation, as well as equity-based compensation such as profits from stock sales made by the CFO or CEO, if there has been a restatement due to an issuer's material non-compliance with any financial reporting requirement which resulted from misconduct. "Misconduct" is not defined, nor does the statute limit "misconduct" to the CFO and CEO, whose bonuses or other incentive-based compensation would be disgorged. This new remedy significantly ups the ante on the amount of money at stake for senior management.

Third, the SEC now has the right to seek in federal court a temporary freeze of a company's intended "extraordinary" payment to an officer or director who is under investigation by the SEC. The SEC interprets this provision to cover anything other than normal salary. If the individual is not charged within 45 days of the SEC's obtaining this temporary freeze, the monies must be released. The SEC has been aggressive in asserting its rights under this section.

Fourth, a person found to have committed securities fraud cannot discharge this debt in personal bankruptcy. While not strictly a new remedy, this provision makes it easier for the SEC to enforce any monetary judgment it obtains against an individual.

Finally, the SEC has submitted a proposal to Congress to obtain a new remedy–the ability to impose civil monetary penalties in an administrative proceeding against public companies or their officers and directors. Currently, the SEC can only obtain civil penalties in administrative proceedings against entities or persons the SEC directly regulates–broker-dealers, investment advisors and their associated persons. The SEC must file a complaint in federal court and seek the approval of a federal judge before it can obtain monetary penalties against a public company or its officers and directors. This new proposal before Congress would allow the SEC to circumvent the protections of an independent federal judiciary and to seek monetary penalties from its own administrative law judges.

New Regulators

Sarbanes-Oxley creates a new regulator for auditors of public companies: the Public Company Accounting Oversight Board ("PCAOB"). It is modeled on the self-regulatory organization structure that Congress created for the broker-dealer community. Just as the NYSE and NASDR serve as the first line of regulation and enforcement of broker-dealers–with the SEC acting largely in an oversight and appellate review capacity–the PCAOB will serve a similar role with respect to public accounting firms. The PCAOB will conduct examinations of public accounting firms, and will conduct enforcement investigations and proceedings. Appeals from the PCAOB's decisions will go to the SEC for review before being appealable to a federal appellate court. Public companies will fund a significant portion of the budget of this self-regulatory organization. And while the PCAOB is primarily a concern for auditors, it has the power to subpoena documents and testimony from public companies and their officers and directors. The PCAOB also has the right to share information it gathers in its investigations with any law enforcement agency, including the SEC and the Department of Justice.

Further, while state attorney generals are not new regulators, their activity and intensity in the area of securities enforcement have increased dramatically in recent years. Elliott Spitzer is a household name, and he has embarrassed the SEC by being in the forefront of the actions against research analysts, investment banks and mutual funds. Spitzer's actions have emboldened other state attorney generals–and state securities regulators–to become more aggressive, especially in an era where states' tax coffers are dwindling.

Finally, federal and state criminal prosecutors are far more active in the securities fraud area than ever before. Historically, federal prosecutors from the Southern District of New York and, to a lesser degree, the Northern Districts of Illinois and California, were the only federal offices that regularly filed criminal securities fraud actions. Now federal prosecutors from all over the country (e.g., Michigan to Alabama) are filing criminal indictments for securities fraud. And state criminal prosecutors are also active–witness the criminal indictments of Bernie Ebbers in Oklahoma.

New Tone in SEC Investigations

SEC More Demanding in Investigations

All of these changes have resulted in a new tone in SEC investigations. Investigations are being done more quickly. Companies and individuals have less time to respond to ever more massive subpoenas for documents. The SEC is issuing Wells notices (wherein it informs a company or an individual that the staff of the SEC intends to recommend an enforcement action against it) far earlier than it has historically. And the time to respond to the Wells notice has been significantly shortened.

The SEC staff has also become more aggressive in its demands during an investigation. For example, the SEC now de facto demands a public company's waiver of the attorney-client privilege in connection with a company's internal investigation of possible wrongdoing. As a practical matter, SEC staff often views the failure or refusal of a company to waive the attorney-client privilege as a failure to cooperate. And even waiver of the privilege is sometimes not enough. A failure to "admit" wrongdoing during the investigation–and the staff sometimes perceives the defense of a company as evidence of failure to admit wrongdoing–can lead to the conclusion that the company is not cooperating, and so it will not receive "cooperation credits" when the staff makes its charging decisions.

Further, the SEC's increased coordination with the Department of Justice, and the resulting parallel civil and criminal investigations, creates a real hornet's nest for defense lawyers during SEC investigations. Fifth Amendment concerns surface, and joint defense agreements can be implicated. And, of course, the stakes are much higher for the public company and the affected individuals.

SEC Toughens Its Settlement Demands

The SEC staff has become more stubborn in settlement demands. The staff now often seeks fraud charges against a public company in settlement, whereas historically public companies were often able to negotiate a settlement involving non-fraud claims if they cleaned house and strengthened internal controls to fix what went wrong. Even though civil monetary penalties come right out of the shareholder's pockets–and for this very reason, Congress, when it passed the statute granting the SEC the right to impose monetary penalties, directed the SEC to rarely impose a civil penalty on a public company–the SEC now will bring fraud charges against a public company, along with multimillion-dollar monetary penalties. And this happens even if the individuals who committed the fraud are gone and the public company waived the attorney-client privilege during the SEC's investigation.

With respect to individuals, the number of officer and director bars has significantly increased as well as the length of time out under these bars. Whereas historically a one-or three-year bar was considered high and rarely imposed, now five- to ten-year bars, and even lifetime bars, are becoming the norm. Further, the dollar amount of civil penalties being sought against individuals has increased significantly. And, as a matter of policy, the SEC has been insisting, in settled fraud actions, that an officer or director who agrees to pay a civil monetary penalty must also agree not to seek indemnification from his current or former employer for that payment. Finally, the SEC is stretching the concept of disgorgement to cover payments not obviously related to the idea of "ill-gotten gains," such as salary earned during the time the alleged misconduct occurred.

Consequences for Issuers, General Counsel, and Senior Management

As noted, the SEC is demanding that a company waive the attorney client privilege to show its cooperation, which creates significant legal representation problems. Historically, unless it was obvious that an individual officer or director had committed fraud, a company would often retain the same law firm to represent the company and its current and former officers and employees in an SEC investigation. If individuals had "shadow counsel," there was often a joint defense agreement. Now the SEC has taken the view that having the same law firm represent the company and individuals is often a sign of lack of cooperation, or even obstruction of a government investigation. It also takes the same view of joint defense agreements. Thus, the representation issues are more difficult–and more expensive.

Likewise, the SEC has stated that, if an audit committee hires the same law firm to conduct an internal investigation that normally represents the public company, the internal investigation is inherently tainted. Thus, an audit committee must hire an independent law firm to conduct any internal investigation when there is an allegation of wrongdoing that may touch senior management. And senior management must understand that they will need their own counsel to represent them, counsel who may or may not be able to coordinate with counsel for the company and the audit committee.

As the SEC staff continues to be stubborn and difficult in its settlement discussions, individuals (and even some companies) have refused to settle and instead have chosen to litigate with the SEC. This trend will inevitably increase. Companies must seriously begin to question the benefits of waiving the privilege and providing cooperation with the SEC. Many companies have waived the privilege and cooperated with the SEC only to wind up having privileged information used against them to extract settlements that the companies might not have had imposed on them if they had litigated. And, of course, the waiver of the privilege has enormous implications for private litigation, both class action and derivative lawsuits. And, as noted, the sanctions against individuals have increased so greatly that it now often makes sense for individuals to litigate against the SEC.

For these reasons, directors, public companies, and senior executives must have defense counsel experienced both in SEC enforcement matters and in litigation and trial. Historically, many defense counsel in SEC enforcement matters often had little first-hand federal court trial experience; on the other hand, those attorneys with litigation and trial experience often had little SEC enforcement background and were not familiar with the process and procedures of an SEC investigation. Given that more enforcement matters are winding up in litigation and the stakes are much higher for all involved, it is important to have counsel who are experienced on both sides of the equation.