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SEC As Aggressive Enforcer: The Role Of In-House Counsel

The list of companies subject to SEC enforcement actions in 2002 reads like a “Who’s Who” of the business community — including Adelphia, Enron, K-Mart, Microsoft, Raytheon, Tyco, WorldCom, and Xerox.

Buoyed by a perceived public mandate to root out and prosecute violations of the federal securities laws by corporations and the individuals who run them, the SEC enters 2003 armed with a record budget, increased staffing, and a host of innovative regulatory measures designed to foster transparency and accountability in the nation’s securities markets.

In short, the SEC will pick up in 2003 where it left off at the close of 2002 — a year that saw the SEC:

  • file a record number of enforcement actions — 598 new cases were commenced, which is over 100 cases more than the previous year;
  • announce that it will focus on claims of “financial fraud,” as evidenced by its commencement of 165 new cases alleging improprieties in accounting practices, inadequate or misleading disclosures, or outright financial fraud; and
  • announce that it will also focus on cases brought against so-called “gatekeepers” of public companies, principally accountants, outside directors and (potentially) attorneys, as demonstrated in 2002 enforcement actions against the major accounting firms of Arthur Anderson, KPMG and PricewaterhouseCoopers.

    These developments highlight the ongoing expansion of the SEC’s regulatory and enforcement role, which is occurring when the statutes and regulations governing public companies are becoming increasingly complex. Perhaps no single development better illustrates this trend than the passage of the Sarbanes-Oxley Act of 2002 and the numerous rulemakings in its wake concerning new audit committee responsibilities, restrictions on loans to directors and officers, CEO and CFO certifications of regulatory filings, and other reforms in the areas of corporate governance and financial disclosure.

    In this environment, a looming question for in-house counsel is how best to minimize the risks of costly, disruptive and potentially fatal involvement in the SEC enforcement process. An important step in that direction is to develop an understanding of the current focus and priorities of the SEC.

    Financial Fraud Cases

    Stephen Cutler, director of the SEC’s Division of Enforcement, has made clear that financial fraud will remain a priority for the SEC staff in 2003 and beyond. In addition to outright fraud and theft, the SEC will focus on accounting improprieties that result in an inaccurate or misleading presentation of a company’s financial affairs.

    The types of accounting practices that have been, and likely will continue to be, subject to SEC scrutiny include:

  • revenue recognition procedures that permit the improper acceleration of revenue into an earlier fiscal period, or allow revenue items subject to contingencies to be booked as “good” revenue;
  • the improper use of reserves, including so-called “cookie jar” reserves, to manipulate earnings on a quarterly or annual basis;
  • overstatements of revenues and/or earnings as a result of merger and acquisition transactions; and
  • loans to corporate insiders that are not properly accounted for or fully disclosed to stockholders.

    In this new environment, any restatement of a company’s financial statements is likely to draw the SEC’s attention and trigger a review. Except in the most benign of cases, such a restatement probably will result in a thorough investigation by the commission’s enforcement staff.

    Cases Arising Under Regulation FD

    Another area of concern for public companies is SEC enforcement activity arising under Regulation FD. This regulation, which became effective October 2000, prohibits public companies from selectively disclosing material nonpublic information to securities markets professionals or to security holders who might trade on the basis of that information.

    On Nov. 25, 2002, the SEC completed its first enforcement actions against companies for violations of Regulation FD, issuing cease and desist orders against (i) Raytheon Company and its CFO; (ii) Siebel Systems, Inc.; and (iii) Secure Computing Corporation and its CEO for violations of Regulation FD’s prohibition of the selective disclosure of material nonpublic information.

    The SEC also issued an investigation report concerning selective disclosure by Motorola, Inc., but declined to seek enforcement in that matter.

    In these enforcement actions, the commission emphasized the following disclosure guidelines for public companies:

    1. If a company officer engages in a private discussion with an analyst concerning earning estimates, the company is taking a “high degree of risk” of violating Regulation FD’s prohibition on selective disclosure.

    2. If, during a private discussion with an analyst, a company officer provides a more specific quantitative definition (e.g., specific numerical guidance) that clarifies qualitative information disseminated in a prior public disclosure, the company may have violated Regulation FD.

    3. An officer should be very cautious in making statements at industry or investor conferences, especially when responding to questions. He or she should not make any comment that expands on or clarifies an extant disclosure by the company, unless there is a simultaneous Web cast of the conference, preceded by advance public notice, or the company simultaneously issues a press release or files a Form 8-K disclosing the statements to be made by the officer.

    4. Companies must ensure that information posted on their websites does not include or refer to material nonpublic information. If a material development occurs, a company should issue a press release or make other appropriate public disclosure(s) before posting information on its website.

    Insider Trading Claims

    In keeping with its historical practice, insider trading remains a priority for the SEC. The best protection for a public company facing an inquiry or investigation into possible insider trading is to have adopted and implemented a written insider trading policy, which includes a description of the law governing trading by insiders and a set of procedures to be followed by insiders in the event they wish to buy or sell company stock.

    The SEC will typically view such a written policy, if consistently enforced, as significant evidence that the company has met it obligation to “reasonably supervise” the trading activities of its employees. In response to the recent amendments to Rule 10b-5, another protective device available for directors and officers who own large blocks of company stock is the individual adoption of a “Rule 10b5-1 Plan” providing for the pre-planned sale of stock regardless of subsequent black-out periods.

    Sarbanes-Oxley Act Of 2002

    President Bush’s signing of the Sarbanes-Oxley Act (the “Act”) on July 30, 2002 ushered in a number of far-reaching reforms and other significant changes in the laws impacting all public companies. On corporate governance, financial reporting, “insider” transactions, and the responsibilities of professional service firms, the Act has altered the legal landscape for future SEC enforcement efforts involving officers and directors of public companies.

    The Act promises to impact the SEC enforcement agenda in the following areas:

    Audit Committees. The Act directs the SEC to promulgate rules requiring that audit committees consist solely of independent directors, have direct responsibility for overseeing outside auditors and the authority and funding to retain any outside adviser deemed necessary to fulfill its responsibilities. These committees must establish procedures for handling anonymous treatment of complaints concerning accounting and auditing matters that protect employees against retaliatory discharge or other adverse action as a result of providing information as “whistleblowers” to the employee’s supervisor or any governmental authority.

    Loans To Officers and Directors. The Act prohibits a company from making or arranging a loan for any of its directors or executive officers, and the broad language used in the relevant provisions is susceptible of being interpreted to ban or restrict a variety of existing practices.

    Certification of Financial Reports. The Act requires CEOs and CFOs to certify the accuracy of all periodic reports filed with the SEC, a requirement that has led a number of public companies to adopt new internal procedures for the verification of interim financial data.

    Attorney Conduct. The Act directs the SEC to establish minimum standards of professional conduct for attorneys representing public companies before the commission, including reporting evidence of material violations of the securities laws, breaches of fiduciary duty and similar violations by public companies or their agents to the general counsel or CEO of the company, or to the audit committee or full board of directors.

    The Act combines these and other elements with new and expanded remedial powers for the SEC and a range of sanctions for conduct proscribed by the Act and its predecessor statutes and regulations.

    For example, the Act allows the SEC to bar an individual who has violated the anti-fraud provisions of the federal securities laws from acting as an officer or director of a public company in the future through an administrative proceeding rather than requiring a court order. The Act also imposes criminal penalties on individuals and companies who are responsible for the destruction of documents while an SEC investigation is pending.

    Anyone who obstructs any investigative or administrative proceeding by a federal department or agency, including a bankruptcy proceeding, by altering, concealing, falsifying or destroying documents and other tangible objects will be subject to fines and/or imprisonment of up to 20 years.

    Responding To SEC Inquiries

    In those instances where a company comes under SEC scrutiny, it is incumbent upon senior management and/or the board of directors to conduct an immediate and thorough investigation of the underlying facts. In such cases, it is generally recommended that the company establish a small number of persons to act as the “control group” for purposes of overseeing the investigation, often through the creation of a special committee of the board of directors.

    It is common for the board to grant broad authority to outside counsel to conduct or to assist the special committee in conducting the investigation, including hiring experts such as forensic accountants.

    At the inception of such an investigation, in-house counsel should advise the board of directors how important it is to protect the attorney-client and work-product privileges, and to maintain all information developed during the investigation in the strictest confidence.

    At the same time, in-house lawyers should educate the board that the SEC is becoming increasingly aggressive in requesting companies to agree to at least limited waivers of attorney-client privilege and work product protections in the course of inquiries or investigations.

    And management and the board should be aware that any selective disclosure of privileged information to the SEC could result in the waiver of that privilege as to third parties.

    As a practical matter, the selective disclosure of privileged information raises the very real possibility that all information pertaining to the subject matter of the information provided to the SEC may be subject to discovery in any ensuing civil litigation.

    A significant issue in SEC investigations is the need to preserve evidence in its original condition, with particular care paid to the preservation of e-mails and electronic records. In-house counsel should issue a memorandum to pertinent company employees that they are to avoid the destruction or alteration of any record, including e-mail communications, until advised otherwise. In an enforcement context, the failure to preserve evidence may cause irreparable harm to the company’s credibility in the eyes of the government and the investing public.

    It also can severely undermine the company’s negotiating posture vis-à-vis the SEC and the company’s effort to maintain the position of a cooperating witness. And, as recent history illustrates, the destruction of documents can lead to criminal prosecution for obstruction of justice. It also is crime under the Sarbanes-Oxley Act to destroy, alter or conceal records in connection with an SEC investigation.

    Self-Reporting To SEC

    A closely related issue is whether a company, upon learning of potential violations of the federal securities laws, should proactively approach the SEC and “self-report” those potential violations. While companies are understandably hesitant to bring such matters to the attention of government regulators, in the post-Enron era the SEC increasingly expects public companies to “self-report” serious violations of the law.

    Indeed, early cooperation makes it easier for a company later to convince the commission staff to exercise its discretion to decline to pursue action against the company or, at a minimum, to achieve a more palatable remedy.

    Disclosure Of SEC Investigations

    In-house counsel also needs to consider whether to disclose to the company’s shareholders, and the general public, the fact that an SEC investigation has been commenced. Absent an affirmative duty of disclosure under the federal securities laws, or other legal mandate, no freestanding duty exists requiring disclosure of the commencement of an internal investigation or the receipt of an investigative inquiry or subpoena from the SEC.

    Nevertheless, the company and its board of directors may decide as a matter of policy to disclose the existence and/or results of the internal investigation or SEC inquiry. Such a decision raises a variety of issues, including whether the company is prepared to update its disclosure as the investigation proceeds and the risk of promoting civil litigation while the investigation is ongoing.

    R. Todd Cronan is a partner at Goodwin Procter in Boston and co-chair of its securities and corporate governance practice group. He specializes in securities litigation, and representing emerging growth and public companies and the venture capital firms that help finance their growth. He can be reached at tcronan@goodwinprocter.com.

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