Securities Law Alert: April 7, 2004

SEC Investigations: How Much Cooperation is Enough?

On March 17, 2004, Lucent Technologies, Inc. announced that the SEC staff was recommending a $25 million penalty for what the SEC perceived as Lucent's noncooperation during the SEC's original investigation and for non-cooperation by Lucent subsequent to a settlement announced in February 2003, which at that time imposed no penalties. This reversal of Lucent's fortune is a sharp reminder to officers and directors of reporting companies that the SEC enforcement arm wields substantial power to punish when it feels the interests of investors have not been protected. Unfortunately, the SEC has not yet advised the public of the facts on which the sanction recommendation is based. One may assume, however, that what appeared at first blush to be sufficient cooperation to avoid penalties proved, upon closer examination, to be insufficient. While the specific teaching of the Lucent "example" awaits SEC disclosure, it is instructive to revisit some [1] of the key questions the SEC demands answers to when public companies discover erroneous financial information.

Keeping in mind that the protection of investors is paramount, "self-policing, self-reporting, remediation and cooperation with law enforcement authorities, among other things, are unquestionably important in promoting investors' best interests."[2] No matter what form such self-imposed responsiveness, responsibility, remedial measures, and cooperation takes, the SEC still confers no rights, no guarantees, and no precedential effect to any given level of cooperation. Instead, the SEC asks a series of questions, some set forth here, the answers to which assist the SEC as it decides whether to take no enforcement action, to seek lighter sanctions, or to include mitigating language in announcements resolving enforcement actions.[3] Past practice may be a guide, but may be easily distinguished.

Here are some of the questions:

1. What is the nature of the misconduct involved? Did it result from inadvertence, honest mistake or simple negligence, reckless or deliberate indifference to indicia of wrongful conduct, willful misconduct or unadorned venality? Were the company's auditors misled?
2. 
   
3. How did the misconduct arise? Is it the result of pressure placed on employees to achieve specific results, or a tone of lawlessness set by those in control of the company? What compliance procedures were in place to prevent the misconduct now uncovered? Why did those procedures fail to stop or inhibit the wrongful conduct?
4. 
   
5. Where in the organization did the misconduct occur? How high up in the chain of command was knowledge of, or participation in, the misconduct? Did senior personnel participate in, or turn a blind eye toward, obvious indicia of misconduct? How systemic was the behavior? Is it symptomatic of the way the entity does business, or was it isolated?
6. 
   
7. How long did the misconduct last? How much harm has the misconduct caused to investors and other corporate constituencies? Did the share price of the company's stock drop significantly upon its discovery and disclosure? How was the misconduct detected, and who uncovered it?
8. 
   
9. How long after discovery of the misconduct did it take to implement an effective response?
10. 
    
11. What steps did the company take upon learning of the misconduct? Did they immediately stop it? Were persons responsible for the misconduct terminated? If not, are they still in the same positions? Did the company promptly, completely, and effectively disclose the existence of the misconduct to the public, to regulators, and to self-regulators? Did the company cooperate completely with appropriate regulatory law enforcement bodies? Did the company identify what additional related misconduct is likely to have occurred? Did the company take steps to identify damage to investors and other corporate constituencies? Did the company appropriately recompense those adversely affected by the conduct?
12. 
    
13. Were the Audit Committee and the Board of Directors fully informed? If so, when?
14. 
    
15. What was the extent and nature of the company's investigation, the role of senior management, Board committees, outside directors, outside counsel, and the scope limitations placed on the review of the facts?
16. 
    
17. To what extent did the company promptly make the results of the review available to the SEC staff, including relevant documentation? Did the company identify improper conduct and evidence with "sufficient precision to facilitate prompt enforcement action against those who violated the law?" Did the company produce a thorough and probing written report detailing the findings of its review, and voluntarily disclose information SEC staff did not request and may not have discovered? Did the company ask its employees to cooperate with the SEC staff, and make all reasonable efforts to secure such cooperation?
18. 
    
19. What assurances are there that the conduct is unlikely to recur? Did the company institute effective internal controls and procedures designed to prevent a recurrence of the misconduct?

Three years ago, when these questions were first put to the reporting company community by the SEC, the wave of misreporting financial information that has been made public in the past two years had not yet begun. As the Lucent case illustrates, early cooperation sufficient to avoid sanctions in early 2003, at the time it entered into the settlement agreement, turned out to be insufficient to avoid $25 million in sanctions for non-cooperation in 2004.

The message seems relatively clear: A company needs to treat financial impropriety that may damage investors as a fundamental high priority and devote perhaps disproportionate attention and resources to overcome its effects. Choosing the right course, with the best possible professional advice, may potentially save the company many millions of dollars. Veering off course can subject the company to substantial damage to its reputation, financial uncertainty, and large discretionary fines that go straight to the bottom line. If that is not punishment enough, it also puts each culpable officer and director into the cross-hairs of the plaintiff's class action bar. Who said an ounce of prevention is worth a pound of cure?

___________________________

1. The complete criteria are set forth in Securities and Exchange Commission Release No. 44969 October 23, 2001; Accounting and Auditing Enforcement Release No. 1470 October 23, 2001.
2. Id. at 2.
3. Id. at 2.

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