Once an SEC investigation or action is underway, it is a one-way street, with the SEC controlling the speed and information along the way. Securities cases typically involve high stakes and sensitive matters that could derail more than a transaction. Here, I will share some issues to be aware of and manage for transaction and business attorneys.
Securities cases typically involve high stakes and sensitive matters. Securities claims present the risk of substantial damage awards and adverse publicity and may bear little relation to the true merits of the claims.
The U.S. Securities and Exchange Commission (SEC) investigations stem from a range of actions such as routine reviews of new registrants to in-depth reviews of registrant affiliates. Investigations spin out of private lawsuits by investors seeking damages or state enforcement actions. Media reports, referrals from other government agencies and irregularities identified using market and trading surveillance technology can all result in inquiries.
Once the SEC starts digging, what they find may have little to no bearing on where they started. A routine exam of a new registrant could uncover ownership of a real estate development company that raised money for commercial real estate projects through Regulation D offerings. The development company activities could open up the registrant to added scrutiny, an investigation or even federal court action alleging securities violations.
Regardless of how the SEC learns of potential violations of the securities laws, once an investigation or action is underway, it is a one-way street, with the SEC controlling the speed and information along the way. The results can morph into any number of detours, with the SEC pursuing inquiries of both an SEC registered company and any of its affiliates.
These typically sensitive, complicated matters can disrupt business and upset due diligence efforts for transaction and business attorneys. When actions come in the form of a letter or subpoena from the SEC, keeping requests in perspective, anticipating risk, and knowing how to proceed can be critical.
Notifications from the SEC typically seek documents, testimony and interviews on a voluntary basis. If the party who has been requested to provide documents by the SEC is not a registrant, the matter is likely voluntary, and the party can refuse to produce documents.
A registrant receiving a voluntary request must produce the documents. Any stonewalling or delay in producing those documents can lead to the conversion of the examination or inquiry into a formal order for investigation, giving the SEC subpoena power to compel document production and sworn witness testimony.
SEC enforcement actions are initiated either in a federal district court or before an administrative law judge (ALJ). ALJs are appointed and compensated through the SEC, giving the ALJ significant homecourt advantage. This agency-appointed ALJ can stack the deck against defendants in proceedings, where the success rate of prosecution is exceedingly high within the SEC’s home court.
The district court system generally provides defendants with a fairer fight by virtue of the neutral Article III judge. Although the SEC’s success rate is lower in federal district court, potential success needs to be weighed against potential damage to reputation, shareholder support, stock price, and registration or licensure suspension or revocation resulting from a public lawsuit.
There are notable differences in the standards used and remedies available in both forums. Administrative proceedings are governed by SEC Rules of Practice. Appeals go to the Commission. By comparison, judicial proceedings are governed by the Federal Rules of Civil Procedure and Federal Rules of Evidence. District courts provide a right to jury trial and appeals are taken to the appropriate U.S. Court of Appeals. The remedies available to defendants in both forums largely overlap. But the judicial system offers the Commission remedies including freezing of assets, restitution and damages related to investor losses, and the appointment of a receiver.
Recently, in Jarkesy v SEC, 34 F.4th 446 (5th Cir. 2022), the court reversed an SEC ALJ decision finding the constitutional violations with the SEC’s use of ALJs in a fraud and damages case. The Fifth Circuit held that the ALJs denied Jarkesy the right to a jury trial guaranteed by the Seventh Amendment.The result may be that the SEC may be more apt to pursue civil penalties or claims of fraud to the district courts.
The SEC’s decision was vacated, and the case remanded for further proceedings consistent with the appellate court’s opinion (see Jarkesy v. SEC: What is its potential impact?). Practitioners now should consider whether to seek judicial review of the Commission’s ability to even bring the case before ALJ, depending on the remedies the SEC is seeking.
Where issues arise
The SEC pursues a broad range of actions, often prioritized each year by the Commission based on where alleged violations of federal securities laws are occurring. In 2022, significant focus areas included private funds, environmental, social and governance investing, retail investors, security controls, emerging technologies and crypto-assets.
The SEC teases out various types of violations in a wide variety of ways against an extensive list of market participants. This includes broker-dealers, investment advisers, funds and pools, investment companies, and unregistered parties, particularly those raising money from private investors. Overwhelmingly, violations stem from the obligation to provide full information and not misrepresent information in connection with the offer and sale of a security. The most common violations are misrepresentations or omissions as part of an offer in the sale of securities, and violations of Sections 10(b) and 17(a).
Private party cooperation
The decision to cooperate with the SEC must be based on the specific facts and circumstances as well as scope and types of materials requested. Rarely will the recipients of a notice know the focus or extent of what the SEC is hunting. Most companies cooperate with even the most onerous requests, preferring not to get off on the wrong foot with an organization as powerful as the SEC. It is not until the SEC is taking sworn testimony as part of their investigation that a defendant can develop an idea of the SEC’s concerns. At that late date, a company or individual who chose not to cooperate may find itself in the worst possible position to prevail.
Attorneys responding to the inquiries with their clients have the opportunity to ask the SEC for clarification in an effort to sort through what could be afoot. Although the SEC is under no obligation to confide to the company the focus of their investigation, this phone call and the requests themselves can provide an attorney with some insights into what the SEC is targeting.
After initiating an investigation, the SEC may issue a Wells Notice, which states that the SEC believes there has been a violation of the federal securities laws and cites which laws. This fairly nebulous, boilerplate notice recites statutory provisions that the SEC suspects have been violated without any factual description. The SEC may describe facts to support its Notice in a subsequent meeting or conference call that its staff believes give rise to the violations of securities laws.
Because the target of an investigation does not get to direct how an investigation proceeds, what information the SEC requests, or any subsequent action, responding to the Wells Notice is the first opportunity a client has to tell its side of the story. The response should take the form of a legal brief written by attorneys to point to facts and legal authority the Commission investigators may have missed.
Prior to responding, clients and lawyers should discuss the value proposition of the response. This includes isolating the particular issues that might get traction with the SEC and whether it makes sense to persuade the SEC not to bring action at all, effectively truncating or paring down the case, controlling the factors in play and influencing where the fight might go. Depending on the volume of documents and the type of violations and conduct at issue, it can be an expensive proposition to prepare a Wells response.
Client management is key to determining whether and when to settle an issue. Clients can get worked up over what started an investigation when they should be more concerned with how to handle the investigation. Once an investigation has started, it can take on a life of its own and go off in all kinds of directions.
Settling a Commission action is a fairly complicated affair. Consideration of any settlement offer must take into account potential private litigation and follow-on actions at the federal or state level. In some cases, fighting to the bitter end, and winning, can forestall private litigation. Settling early could give private investors a leg up on follow-on litigation, depending on the details of the settlement, the findings in the case, and whether a party has taken responsibility for securities violations.
Disclosing an SEC matter
Client questions about whether to disclose an investigation internally or publicly are common (see Disclosure or non-disclosure: Governmental Investigation of Securities-related Activity). Companies and individuals do not necessarily know how an SEC investigation will unfold or how it may be used against individuals and entities. Early disclosure sometimes allows companies to prepare and control its response to the disclosure, which may affect potential securities actions against them. It is a decision best directed by a securities attorney, who will be attentive to the specific circumstances and potential consequences inherent in disclosures of securities investigations and actions.
Often the answer to whether to disclose depends on how the investigation proceeds. At the inquiry level, disclosure may be unnecessarily damaging. At the point subpoenas are issued, disclosure may be advisable, even though it may not be legally required. Once the SEC takes action either in federal court or an ALJ proceeding, disclosure has probably become necessary.
This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.
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We protect investors by vigorously enforcing the federal securities laws to hold wrongdoers accountable and deter future misconduct. We provide investor education and resources through our Office of Investor Education and Advocacy.
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There are primarily three types of securities: equity—which provides ownership rights to holders; debt—essentially loans repaid with periodic payments; and hybrids—which combine aspects of debt and equity. Public sales of securities are regulated by the SEC.What is under the Securities Act of 1934? ›
The Securities and Exchange Act of 1934 regulates secondary financial markets to ensure a transparent and fair environment for investors. It prohibits fraudulent activities, such as insider trading, and ensures that publicly traded companies must disclose important information to current and potential shareholders.What products are considered securities? ›
In the investing sense, securities are broadly defined as financial instruments that hold value and can be traded between parties. In other words, security is a catch-all term for stocks, bonds, mutual funds, exchange-traded funds or other types of investments you can buy or sell.What are the most common types of securities? ›
Stocks, bonds, preferred shares, and ETFs are among the most common examples of marketable securities. Money market instruments, futures, options, and hedge fund investments can also be marketable securities.What are the two major asset classes of securities in the United States? ›
Many investment funds are composed of the two main asset classes, both of which are securities: equities (stocks) and fixed-income (bonds).What are the three 3 types of securities issued by the federal government? ›
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Pleading Requirements. Section 10(b) makes it unlawful to “use or employ, in connection with the purchase or sale of any security” a “manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.” 15 U.S.C. § 78j(b).What is the 10 B Exchange Act? ›
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Section 15 aids investors by making "control persons," or persons who "control" defendants liable under Sections 11 and 12 by owning stock or under agency principals, jointly and severally liable.What is 17 A of the Securities Act? ›
Section 17A of the Act, and the rules promulgated thereunder, contain requirements for registered transfer agents relating to, among other things, processing securities transfers, safekeeping of investor and issuer funds and securities, and maintaining records of investor ownership.Are assets considered securities? ›
A security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can't be called a security generally depends on the jurisdiction in which the assets are being traded.What asset class are securities? ›
Equities (stocks), bonds (fixed-income securities), cash or marketable securities, and commodities are the most liquid asset classes and, therefore, the most quoted asset classes.