ABA Section of Business Law

Volume 15, Number1 September/October 2005

When the SEC comes knocking
What to expect in an investigation
    By Kevin J. Harnisch and Natasha Colton

It seems hardly a day goes by without word of a new SEC investigation concerning a well-known company or industry. You know — Enron, WorldCom, AIG, Wall Street research analysts as well as mutual funds. The commission's increased enforcement activities make it important for lawyers to have at least a basic understanding of their investigative process.

The staff of the commission's Division of Enforcement (the enforcement staff) conducts two types of investigations: informal investigations and formal ones. Both types are conducted in a nonpublic manner unless the commission takes them public. Only in rare circumstances does the commission pass down that order.

Generally, investigations begin as "informal" investigations. An investigation's designation as "informal" does not mean that the matter is not serious. In fact, the commission can opt to take enforcement action without an informal investigation ever becoming "formal." The "informal" designation simply means that the enforcement staff cannot issue subpoenas to compel the production of documents or investigative testimony, which is an on-the-record question-and-answer session similar to a deposition.

An investigation becomes "formal" when the SEC issues a formal order of investigation (formal order). Such an order empowers the enforcement staff to issue subpoenas compelling investigative testimony and the production of documents. The formal order describes the nature of the investigation in very general terms and identifies the provisions of the federal securities laws that might have been violated.

The commission issues a formal order on a recommendation from the enforcement staff in which the staff explains why it believes there may have been or may be continuing violations of the federal securities laws. The staff also notes how the ability to issue subpoenas would further its investigative efforts. The threshold for issuing a formal order is very low and the staff's requests are almost always granted.

The scope of the investigation is not necessarily limited by the contents of the formal order. While some defense counsel may raise objections if the investigation stretches beyond the order, the enforcement staff typically ignores such objections. Also, as a practical matter, such objections are rarely effective because the staff can rather easily obtain an amended order.

In informal investigations, because it cannot issue subpoenas for evidence, the enforcement staff instead asks persons and groups to provide information voluntarily. Care must still be taken when giving information to the staff because knowingly providing false or misleading information to them is a criminal offense. There are also certain mandatory document production requirements for various commission-registered groups, such as the requirements imposed on broker-dealers under 15 U.S.C. § 78q and investment advisers under 15 U.S.C. § 80b-4.

In practice, the scope of document requests and the types of questions posed during testimony do not depend on whether the investigation is formal or informal. Instead, the distinction typically provides the recipient of a voluntary request with more options on how to respond — that is, the recipient can opt not to provide the requested information or may have more leverage in negotiating modifications to the scope of the requests.

However, not responding fully to the enforcement staff's voluntary requests generally raises staff suspicions and may prompt the staff to seek a formal order.

From a defense counsel standpoint, it is important that once an investigation becomes formal, the enforcement staff is often less willing to terminate the probe.

Prior to providing information in a formal investigation, a witness has a right to review the formal order, although a witness is not permitted to see the enforcement staff's recommendation that resulted in the order being issued. A witness may also obtain a copy of the order by making a written request to the staff and representing that he or she will maintain the confidentiality of the document.

Although violations of the federal securities laws can be criminal offenses, the SEC does not have the ability to bring criminal charges. The U.S. Department of Justice and the U. S. attorneys' offices criminally prosecute federal securities cases. The enforcement staff, however, can suggest that a criminal investigation be conducted. Such criminal referrals are becoming increasingly common as prosecutors have become more willing to pursue complex securities and white-collar cases.

Investigative testimony is one of the primary methods the enforcement staff uses to get information. This testimony is similar to a civil deposition in that the witness is asked a series of questions and is often shown exhibits and asked about them. Like a deposition, a court reporter records the questions and answers and a transcript is generated. Unlike a civil deposition, however, the Federal Rules of Civil Procedure are inapplicable. Thus, there are no limitations on the number of witnesses that can be subpoenaed, and there are no time limits on the length of the testimony sessions. Also, sessions are not subject to judicial oversight.

The witness may order a copy of the testimony transcript, but the enforcement staff must approve the order. As a practical matter, the staff routinely permits witnesses to purchase copies of their transcripts. In any event, a witness has a right to inspect an official copy of the transcript at the SEC. Witnesses are not permitted to purchase or inspect the testimony transcripts of other witnesses.

Witnesses have the right to be accompanied, represented and advised by their counsel during their testimony. In addition to the witness, the court reporter and the enforcement staff, the only other people permitted to attend are the witness' lawyers. Other interested persons or counsel for such persons are not permitted. Each lawyer who attends will be asked to confirm on the record that he or she represents the witness. If the witness is a company employee, company counsel can attend the testimony by stating that he or she represents the witness in the witness' capacity as an employee.

In a formal investigation, only enforcement staff members identified in the formal order are permitted to ask questions. Therefore, defense counsel should always determine whether the staff members present are included in the formal order.

During testimony, the witness is permitted to assert any applicable privileges, such as the attorney-client privilege or the Fifth Amendment right against self-incrimination. Unlike in criminal proceedings, adverse inferences may be drawn against a witness who refuses to answer questions by invoking the Fifth Amendment.

In instances where a witness is unwilling to answer questions without some form of protection, the enforcement staff may be willing to enter into a so-called "queen-for-a-day" agreement or seek immunity for the witness. "Queen-for-a-day" agreements prevent the staff from using a witness' statements against him or her, although the staff is permitted to use the statements to develop other evidence against the witness.

Immunity, which is granted by the Department of Justice at the enforcement staff's request, precludes using the witness' statements and information derived from those statements in a criminal proceeding against the witness; it does not preclude the staff from using the statements or information derived from them against the witness. The staff may enter into a queen-for-a-day agreement or seek immunity when the witness has valuable information that is difficult to obtain from other sources and the witness would otherwise assert his or her right against self-incrimination absent such protections.

Document requests — either voluntary or following a subpoena — are another one of the enforcement staff's information-gathering tools. The staff often issues broad requests to the persons and groups it believes have information pertinent to the investigation.

By beginning with a broad request, the enforcement staff places the recipient in the position of not being able to discard documents (including e-mail and server back-up tapes), even following an established document-retention policy, without being exposed to prosecution for obstruction of justice. The staff has been making increased use of sending broad document-preservation requests either in advance of or contemporaneous with document requests.

While the enforcement staff often is willing to engage in some negotiation on the scope of what must be produced and the timing of the production, any limitations on the scope typically come with the caveat that the staff reserves the right to change its mind and to require production of all responsive documents.

Because the Federal Rules of Civil Procedure do not apply to these investigations, there are no express provisions for recipients of subpoenas to challenge the scope of the subpoena as being overly broad, burdensome or vague. Therefore, while defense counsel may raise practical reasons for modifying the scope of a subpoena, whether to accept defense counsel's suggestions lies within the sole discretion of the enforcement staff.

In order to obtain judicial review of an investigative subpoena, the recipient must refuse to comply with the subpoena's requirements. In such a situation, the director of enforcement has the ability to authorize the enforcement staff to make a filing in federal district court for an order compelling compliance with the subpoena. Because such filings are publicly available, and the commission generally issues a corresponding press release, the existence of the otherwise nonpublic investigation becomes a matter of public record.

If the staff is successful in obtaining a court order enforcing the subpoena and the witness nevertheless refuses to comply, the staff can seek to have the witness held in contempt of court.

Although enforcement investigations generally are conducted in a nonpublic manner, people may file Freedom of Information Act (FOIA) requests with the commission for copies of documents pertaining to investigations. FOIA requests may be denied if the producing party claimed at the time of production to the enforcement staff that the documents are subject to various exemptions from disclosure.

There is an exemption for investigatory records obtained in connection with law enforcement proceedings. There are also exemptions for information that contains trade secrets or confidential business information. Therefore, in order to protect the confidentiality of information provided during an investigation, the producing party should claim at the time the information is submitted that the information is exempt from FOIA production requests.

In order to further minimize the risk of production in response to FOIA requests, the producing party should also request that the enforcement staff return the documents at the conclusion of the investigation. Irrespective of exemptions from production under the FOIA, the staff may share information provided to it with other federal, state or foreign government agencies, including the U.S. Department of Justice, self-regulatory organizations and state securities regulators.

The SEC often says that it weighs cooperation during the investigation when deciding whether or what charges to file. Some of the factors the commission uses to evaluate cooperation are:

• how quickly the corporation responded to the reported misconduct;
• remedial measures taken, including compensation of injured persons;
• the nature of the internal review, including the involvement of the audit committee and board of directors;
• the sharing of information with the commission, including a thorough and probing written investigative report; and
• encouraging employees to cooperate with the commission. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Exchange Act Release No. 44,969, 76 SEC Docket 220-18 (Oct. 23, 2001).

• an injunction (in a federal court action) or a cease-and-desist order (in an administrative proceeding) prohibiting current and future violations of the provisions of the federal securities laws at issue in the case;
• disgorgement of any ill-gotten gains; and
• monetary penalties.

• the audit committee;
• another committee of the board of directors comprised of directors not employed by the issuer; or
• the board of directors.