Although prior to passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) many hedge fund managers did not have to register with the Securities and Exchange Commission (the “SEC”), they were still subject to liability under the anti-fraud provisions of the federal securities laws, including Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Section 206 of the Investment Advisers Act of 1940. In fact, hedge funds have recently been the focus of a number of SEC Enforcement Division actions under these statutes, and the trend is likely to continue.

Indeed, impending registration requirements and periodic examinations by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) are likely to provide the Enforcement with new leads to pursue. Meanwhile, hedge funds should become increasingly aware of the kinds of issues that can lead to OCIE deficiency letters and follow-on Enforcement investigations.

As Enforcement seeks to rebuild its reputation as an effective watchdog, we anticipate an aggressive campaign to ferret out fraud and other market abuses. Increased staffing in Enforcement and its creation of an Asset Management unit will enable the SEC to expand its pipeline of investigations into the hedge fund sector, an industry which the current Enforcement Director has spoken of in unflattering terms. Moreover, the SEC’s new powers under Dodd-Frank will likely be deployed to bring administrative proceedings in which the SEC may now seek penalties and other sanctions. We also expect the close coordination between the SEC and DOJ to continue, raising the specter of criminal prosecution in cases involving intentional misconduct causing investor losses.

The SEC Staff (the “Staff”) may begin an investigation for any number of reasons. In addition to following up on referrals from OCIE, Enforcement often initiates investigations based upon, among other things, investor complaints, and tips from anonymous sources and “whistleblowers” (the SEC’s new Office of Market Intelligence was established this year to analyze tips that come into the agency); information provided by other Divisions (e.g., Trading and Markets, Investment Management) and agencies; and its monitoring of market trading, media stories and private litigation filings. An investigation may be underway for some time before its subjects even become aware of its existence.

The manner in which an entity such as a hedge fund manager conducts itself during an SEC investigation can have a significant impact on the outcome, both as to whether the SEC (and/or the DOJ) ultimately decide to charge the entity, and the violations alleged. Hedge fund managers would therefore be wise to understand more fully how the SEC Staff pursues its inquiries and the kinds of issues that are likely to surface when Enforcement gets involved.

What follows is an overview of the SEC Staff’s investigative processes and a brief introduction to some of the more important issues that invariably arise.

 Informal Investigations and Industry Sweeps

Informal Investigations

Informal investigations are conducted without a formal order of investigation (“formal order”), which can now be issued not only by the Commission but also by senior Enforcement Staff pursuant to delegated powers. (See discussion of Formal Investigations, below). Because there is no formal order, the Staff does not have subpoena power. Thus, when non-registered entities are involved, the Staff’s ability to collect documents and take testimony is dependent upon the cooperation of these entities. In the case of registered entities, however, the Staff enjoys broad examination powers that enable it to review documents the registered entity is required to retain, although testimony still requires consent.

Most entities, registered or not, find it beneficial to cooperate with the Staff. First, a lack of cooperation generally results in the Staff obtaining a formal order. Second, cooperation can have a significant impact on the Staff’s view of the subject of an investigation and increasingly is something they take into account in determining whether to levy charges and what sanctions may be appropriate.

For these reasons, informal investigations should be approached in the same manner as formal investigations. Both forms of investigation have the same potential consequences, as well as similar procedures.  

Note: The initial phase of any investigation—even an informal one—is critically important. You are therefore well-advised to educate your employees on the importance of (i) referring all calls from the Staff to in-house or outside counsel, and (ii) not engaging in substantive discussions with the Staff.  

Benefits of an Informal Investigation

Various benefits may flow from the initiation of an informal, as opposed to a formal, investigation. First, an informal investigation may not attract as much attention at senior levels within Enforcement or the Commission. While the Staff members responsible for an informal investigation generally conduct them as vigorously as they would a formal investigation, there is a somewhat greater likelihood in the case of an informal investigation that the Staff will be distracted by the need to pursue and complete investigations that have higher priority within Enforcement. Further, the Staff’s inability to issue subpoenas in an informal investigation may enable you, through your defense counsel, to have some influence over the scope and timing of government evidentiary requests. For these reasons, among others, it is generally advantageous to have the Staff pursue its inquiry on an informal basis.

To avoid a formal order of investigation, you and your counsel should generally cooperate with Staff requests for documents and testimony. That does not, however, mean that you must necessarily acquiesce to unreasonable demands. For example, the Staff has, of late, been routinely requesting lists of all investors in private funds. Before submitting to unreasonable or burdensome requests such as these, your counsel should negotiate more palatable alternatives. Such negotiations with the Staff generally entail explaining, in practical terms, the burden in complying with broad requests.

Because the Staff will likely characterize even unavoidable delays and inadvertent production problems as evidence of non-cooperation, you and your counsel should, in an effort to minimize their potential impact on the Staff’s attitude, take care to alert the Staff to these delays and problems as they arise, and document your efforts to resolve them.

Sweep Letters

SEC letter requests for information targeting a broad range of members of a particular industry group increasingly are being used by the Staff to obtain information about practices that appear to be widely employed or to identify industry outliers. In addition to their use in identifying areas the SEC perceives to be potentially problematic, information collected via letter request sometimes results in the commencement of one or more investigations into those practices.

Here again, cooperation is the most advisable approach when dealing with such requests, as the agency may be more amenable to your ideas regarding how it might tailor the request to reduce the burden on you, as the responding party. At the end of the day, however, you must provide truthful and complete answers to the SEC’s questions, lest you run the risk of alienating the Staff or, worse, prosecution under 18 USC §1001.  

Formal Investigations

Formal SEC investigations commence with the issuance of a formal order. The Commission traditionally has deferred to its Enforcement Division when the latter has requested a formal order. In fact, the SEC has now permanently delegated the power to issue formal orders to the Director of the Enforcement Division and his designees. Thus, the Staff no longer has to delay its inquiry and justify its request for a formal order in a memorandum to the Commission. As a consequence, the Staff can move quickly to obtain subpoena power when, for example, a person or entity fails to timely provide complete information requested by the Staff or where the Staff has reason to believe that third parties (e.g., banks, auditors) with information about a subject of the investigation are not likely to produce that information sans a subpoena.

Generally, the person or firm that is the “subject” of an investigation will be provided a copy of the formal order upon request to the Enforcement Assistant Director who is supervising the investigation.

You, through counsel, should ordinarily request a copy of the formal order to (i) gain a sense of the scope of the Commission’s inquiry, (ii) identify the Staff members who will conduct the investigation, and (iii) learn the securities law violations that the SEC suspects are involved. Although formal orders tend to be brief and conclusory, the document may provide some insight into (i) whether your entity is a “target” of the investigation, (ii) the other parties involved, (iii) the activities being investigated, and (iv) the key documents. The formal order may also indicate the relative importance of the investigation within the SEC. For example, formal orders dealing with industry practices generally signal a significant investigative effort by the Staff. In such cases, they may also provide clues as to other firms in your industry that may be interested in sharing information about the matters under investigation and the Staff’s views and activities.

Private vs. Public Investigations

With rare exceptions, SEC investigations are private. Public investigations typically are reserved for instances in which the SEC is investigating an industry-wide problem that calls for rule-making or new legislation.

Disclosing the Investigation

A significant issue that arises is whether to disclose the existence of the investigation to your investors. There is no bright-line test for when an investigation must be disclosed. The facts of every situation must be looked at carefully to assess the materiality of the investigation and any attendant disclosure obligations.

Though many publicly traded companies historically have deferred disclosure of the existence of an investigation until a Wells call (discussed below) was received or charges were brought, they increasingly are making early disclosure (e.g., at the time a formal order is issued). While doing so will have caused unnecessary alarm to investors if the investigation is later closed without Commission action, companies prefer that to having to defend against allegations that they omitted material information in public filings. Moreover, they see a benefit to early disclosure: “conditioning the market” to the possibility of an enforcement action down the road. In other words, many companies are prepared to risk an early hit to their stock price, rather than a more severe one later on when the market is surprised by news of an unexpected enforcement action.

Hedge fund investors, too, are concerned with the financial and reputational aspects of an enforcement proceeding, and, accordingly, there is good reason for hedge fund managers to consider when and what to disclose. Both the nature of the investigation and the facts under investigation must be considered. For example, it is advisable to consider disclosure when the investigation appears to be serious and an enforcement proceeding could have a material impact on the fund’s financial condition (e.g., the possibility of large monetary sanctions), management (e.g., the possibility of an industry bar for a senior official) and reputation (e.g., the impact of intentional fraud charges). You and your lawyer will also want to give thought to whether early disclosure of an investigation creates a duty to update that disclosure upon the occurrence of material developments in the investigation.

To the extent that you are, or plan to be, taking in new money from investors, the existence of an investigation may raise issues as to the propriety or wisdom of doing so during the investigation. Disclosure obligations also may cover situations in which investors have the right to redeem. Managers must review any side letters to identify disclosure obligations they may contain. Disclosure to some, but not all, investors raises selective disclosure concerns. Investor due diligence questionnaires increasingly raise issues with respect to disclosure of regulatory investigations.

Identifying the Client(s)

Upon commencement of an SEC investigation, whether formal or informal, you and your counsel must consider whom counsel may represent (e.g., the entity, management, present or former employees, etc). There are numerous advantages to having one law firm represent as many parties as possible, ranging from significant cost savings to the benefit of having a single firm that is in full command of the factual and legal issues formulate a strategy for defending the entire investigation.

In determining whom counsel should represent, you and your counsel should consider the SEC’s “sequestration rule,” as well as any current and potential conflicts of interest that might arise from the representation of multiple parties whose interests may differ depending on the course of the investigation. Given the difficulty of predicting, at the outset of an investigation, the path it will take, it is often necessary to reconsider a multiple- representation situation as the facts and/or the government’s theory comes into sharper focus. It is not unusual, for example, for individuals who receive Wells notices to obtain their own counsel at that stage, rather than continue to be represented by the law firm that is also working with their employer.

The Sequestration Rule

One of the SEC’s lesser-known investigatory rules is the sequestration rule. In pertinent part, it states: “[A]ll witnesses shall be sequestered, and unless permitted in the discretion of the officer conducting the investigation no witness or the counsel accompanying any such witness shall be permitted to be present during the examination of any other witness called in such proceeding.”

The SEC does not often invoke the sequestration rule. However, you must be careful that your counsel’s appearance with a witness early in an investigation does not later preclude your counsel from appearing with another witness who may be a target of the investigation. To avoid this, before testimony begins, you may want to urge your counsel to discuss representational issues with the Staff. Although Staff attorneys will not commit to sequestration decisions, they will often be willing to discuss potential sequestration issues.  

Conflicts of Interest

In addition to the sequestration rule, you and your counsel must consider conflict-of-interest issues. You and your counsel should remain cognizant that, where counsel represents both the entity and persons employed by it, a conflict of interest may not become apparent until late in an investigation, when more of the facts and the SEC’s views are known. Thus, although the representation of multiple parties by one law firm at the early stage of an investigation is generally advantageous and appropriate, that decision may need to be re-evaluated as the investigation proceeds.

In addition, you and your counsel should ask yourselves the following questions:

  1. How will the documents from, and testimony by, one client affect the factual assertions and defenses of another?
  2. If a Wells notice is given and/or settlement negotiations ensue, can counsel effectively represent multiple parties given the possible impact one client’s position may have on another’s?
  3. What possible claims do the parties have against each other (e.g., corporation vs. officer)?
  4. How likely is the prospect of a criminal investigation, which could result in the magnification of what were relatively insignificant differences between clients’ positions in the civil context, to make multiple representation fraught with peril for both clients and lawyer?

While counsel may, in some circumstances, represent potentially divergent interests by obtaining the clients’ informed consent, it is important to consider, in view of the particular circumstances of the case, whether an individual’s interests may be better served by separate counsel.

Indemnification for, and advancement of, legal defense costs (whether covered by insurance or not) are issues that often arise when a decision is made to retain separate counsel for targeted individuals. While entitlement generally turns on the terms of a firm’s organic documents (e.g., investment management agreements, limited partnership agreements, by-laws and offering documents), employment contracts or partnership agreements, it is generally advantageous to the entity being investigated that its current and former officers and employees be financially able to conduct a vigorous defense. Consequently, advancement of defense costs, subject to the entity’s right to recover them in certain circumstances, is common.

Gathering the Facts

After the SEC commences an investigation, you should have your counsel gather as much information as possible concerning the underlying facts of the investigation, with the aim of learning the relevant facts before the Staff does. To do so, your counsel needs to understand your business and how it operates. Thus, your counsel will need to be educated by those persons in your organization who are knowledgeable about the issues and the conduct under scrutiny. To identify the important legal and factual issues underlying the investigation, your counsel also will need to interview all employees involved in or knowledgeable about the acts and transactions at issue. That effort can be aided by your review of the formal order, as well as your communications with the Staff. Further, you and your counsel should discuss the strategic benefits of your counsel communicating with counsel for other parties under investigation, as well as the possibility of entering into informal or formal joint defense and common interest agreements with these parties.

Interviewing Employees and Identifying Documents

Early on, your counsel should interview all knowledgeable employees of the entity and work with in-house counsel to identify all documents in the manager’s control that are potentially relevant to the investigation. With the assistance of counsel, you should also take steps to ensure that all such documents are preserved. Thus, you should identify persons likely to have relevant documents and send them a memorandum instructing them to preserve the documents and to not alter or destroy them. In this age of electronic communications, it is also important that you have your IT personnel ensure that relevant electronic documents are preserved and not be overwritten or destroyed under otherwise operative protocols.  

Interviewing Other Witnesses

If possible, your counsel should interview anyone outside the firm who has testified or may testify before the SEC concerning information relevant to the investigation. These witnesses should have their counsel present at such interviews. Former employees of a manager are often represented by the manager’s counsel in situations where the interests of the manager and former employee do not diverge.  

Internal Investigations

Depending on the circumstances, you may find it beneficial to conduct, through counsel, a more detailed, internal investigation into the areas in which the SEC seems interested. Such an inquiry should be protected under the attorney-client privilege and work product protections, unless its fruits are turned over to third parties, such as your auditors or the government. Generally more robust than the interviews discussed above, these inquiries can help you understand and, if need be, take steps to stop and/or rectify, any problems they bring to light.

The SEC may expect you to share the results of the internal investigation. In that case, great care must be taken to avoid waiving your attorney-client and/or work product protections. Once the attorney-client privilege is waived and its fruits are shared with the government, you will likely be unable to prevent their subsequent discovery by investors and other parties.

Consulting with SEC Staff

At an early stage, you will want your counsel to contact the Staff members who are directing the investigation. They may elaborate on the formal order, perhaps providing insight into the Staff’s perception of the important issues and players. Though the Staff is fond of saying that its investigations have no “targets,” an experienced counsel can generally develop a reasonable sense of where his or her client fits in the Staff’s view of an investigation. Although early discussions are not likely to yield significant results, the Staff, and particularly its more senior members, may, in some cases, be open to talking about what it is looking at and why. Further, these conferences sometimes result in postponements with respect to certain demands.  

The Staff’s inclination to speak candidly about an investigation often varies by office, attorney and investigation. Communications with the Staff should begin with the Staff attorneys assigned to the investigation; it is generally not advisable to bypass the Staff attorneys because you risk alienating the person(s) on whom senior officials will rely for the facts.

Subpoena Power and Document Production

The SEC’s subpoena power is extremely broad. The SEC may issue two types of subpoenas: (i) a subpoena duces tecum (for documents), and (ii) a subpoena ad testificandum (for testimony).

Moreover, the SEC is paying more attention lately to issues involving document production, and missteps in this area can have severe consequences in terms of the Staff’s perception of your cooperativeness and integrity. (Indeed, the SEC often requires a certification that all documents called for by a subpoena have been produced.)

At the same time, document subpoenas are becoming increasingly burdensome, demanding not just hard copies but also electronic files, tape recordings, hard drives, etc. Also, the Staff regularly asks for email and instant message communications spanning extended periods of time and encompassing large numbers of people.

After discussing with your counsel the undue burden the Staff’s request will place on your business, your counsel should consider discussing the subpoena with the Staff with an eye toward narrowing its scope and coming to some agreement as to a workable timeline for production of the material. For example, when a significant number of documents are involved, your lawyer should devise a plan for producing the requested materials on a rolling basis.

Your lawyer should help you structure, if not undertake, a comprehensive document review plan consisting of the following steps:

  1. Preservation of documents. Those individuals who may have potentially responsive documents should be advised not to withhold, alter or destroy them. In accordance with this, you need to make sure that your firm does not unwittingly destroy electronic records by overwriting tapes, erasing emails, etc., even to the extent that doing so would be consistent with its document retention/destruction policies.  
  2. Collection of potentially responsive documents. First, you should determine those persons who may have potentially responsive documents and then thoroughly search those individuals’ documents (including electronic documents and hard drives) for responsive documents. Increasingly, this includes enlisting the aid of IT personnel in retrieving electronically stored documents.  
  3. Review of potentially responsive documents. Your goal here is to determine (i) if they are responsive to the subpoena and, if so, (ii) if they reflect privileged attorney-client communication or protected attorney work product.  
  4. Duplication of documents to be produced. Typically, the SEC will not require production of originals. In duplicating responsive documents, your counsel should have a set of everything as produced.  
  5. Production of documents. Increasingly, the SEC is dictating that documents be produced in electronic form as per its guidelines. Even absent such requirement, documents should be stamped with identifying numbers and described in an accompanying letter. To preserve the confidentiality of produced documents, the production should also be accompanied by a written request for confidential treatment under the Freedom of Information Act (FOIA).  

While information obtained in investigations is generally “non-public,” the SEC is free to share, and often does share, such information with other government agencies, such as the DOJ or FINRA. The Dodd-Frank Act increased the opportunities for different regulators to share information, while also providing additional confidentiality protection. The SEC also may be forced to turn over information provided to it by reason of a FOIA request made after the conclusion of an investigation or a subpoena in a civil action.  

Challenging a Subpoena

If you fail to produce documents under a subpoena, the SEC can and will commence a public court proceeding to enforce the subpoena. The courts have made it clear that it is up to the SEC to bring such cases, not the party receiving the subpoena. Thus, should you decide to challenge the breadth of an SEC subpoena by taking the agency to court, you will not find the courts to be hospitable. You should also recognize that such challenges are rarely successful and that a subpoena enforcement proceeding will make the investigation public, causing reputational damage to the subpoenaed party.  

Testifying Before the SEC

Preparing for Testimony

After receiving a subpoena for testimony, the witness, through counsel, should consult with the Staff to negotiate a time and place for testimony.

There is no more important part of defense counsel’s role than ensuring that witnesses are adequately prepared to testify, so make sure to set aside a sufficient amount of time for this purpose. Preparation should include a thorough review of the following areas:

  1. The witness’s document collection and production efforts  
  2. Discussion of the relevant securities laws and regulations, and how the witness’s testimony may factor into establishing violations of those laws and regulations  
  3. Questions the SEC commonly asks at the beginning of testimony  
  4. Substantive questions the witness will likely be asked  
  5. Documents the witness is likely to be shown  

Witnesses should review all testimony, affidavits and sworn statements they have previously provided on relevant subjects. Note, however, that, as a general rule, witnesses should not review transcripts of the testimony of other witnesses.

The Testimony

While most testimony is “on the record” (i.e., transcribed verbatim by a court reporter), in some circumstances, the SEC may be willing to conduct an informal interview. You and your lawyer should discuss this option in cases where there may be advantages to a more informal interview process in which the only “record” will be the notes of the various attorneys who are present.

During testimony (or an interview), a witness has the right to be represented by counsel. Further, SEC rules pertaining to investigations provide that, at the conclusion of the examination, the witness may be questioned by defense counsel in order to clarify answers given by the witness during the examination. That important safeguard notwithstanding, counsel nevertheless can, and should, ask questions during the course of testimony to ensure that the record is accurate and complete. The Staff will usually allow this, provided the interruptions are within reason.

Because enforcement decisions depend largely upon documents and transcripts of testimony, you and your defense counsel should do all you can to ensure that the record supports all of your defenses and includes all mitigating evidence. Whether to do that before or as part of testimony or at the Wells Submission stage will vary, depending on the particular situation.

In testifying before the SEC, the Federal Rules of Evidence and the Federal Rules of Civil Procedure do not apply. Therefore, the SEC may ask questions that are leading or repetitive, or that solicit hearsay answers. While your counsel should object on relevancy grounds to questions that exceed the scope of the formal order of investigation, the SEC will want its questions answered and you should answer them, unless your counsel directs otherwise. Further, your lawyer can and should do his or her best to ensure that the SEC’s questions do not become unreasonable by objecting to questions that are, for example, argumentative, vague or overly hypothetical.

Your counsel also may be permitted to arrange for an expert to be present when you testify. While this is generally disfavored by the SEC, it is sometimes allowed in appropriately technical cases, such as where a CPA would help a witness to understand and/or respond to questions involving highly technical accounting issues.

Obtaining Testimony Transcripts

In formal testimony, transcripts are recorded by an official reporter. The SEC’s rules provide that a witness is entitled, upon written request, to a copy of his or her transcript of testimony on payment of the appropriate fees, though the Commission may “for good cause” deny such request. Even then, any witness has the right to inspect the transcript of his own testimony.

In all but the rarest of cases, the SEC will allow the witness to purchase his or her transcript. Witness and counsel should bear in mind that, whether or not they request a copy, a transcript may be discoverable, either from the client or the SEC, by plaintiffs in related private civil actions, including private class actions, or the government may itself use the transcript in subsequent civil, administrative, or criminal cases, For this reason, counsel should ensure that the transcript of his or her client’s testimony is accurate. After reviewing the transcript, the witness, through counsel, should file a statement of corrections with the SEC, should one be necessary. In addition, if, to create an accurate record, certain answers need to be supplemented, the witness and counsel should consider providing such addenda in the statement of corrections.

If you are already involved in, or anticipate, a private suit from, for example, disgruntled investors involving issues similar to the ones the SEC is investigating, you might conclude that not having a copy of the transcripts will protect you from having to produce them to the plaintiffs. While that might seem a sensible precaution, you should be aware that most courts presiding over civil actions related to the same subject matter as your investigation, would nevertheless require that you obtain and produce the transcripts.

Witnesses before the SEC may share transcripts of their testimony with others, and your counsel should attempt to obtain transcripts of testimony directly from other witnesses. Most experienced counsel agree that sharing transcripts with counsel for others with common interests is the best way to avoid surprises as to what the record establishes. However, it is not advisable for hedge fund managers or employees who may be called upon to testify in the investigation to review anyone else’s testimony, as it may suggest to the Staff an effort to coordinate stories in a less than honorable manner.

Constitutional and Other Privileges

Fifth Amendment Privilege

The Fifth Amendment privilege against compulsory self-incrimination may be asserted to withhold personal testimony and personal records. However, the privilege does not extend to corporate records or to documents owned or possessed by another person or entity.

A witness should understand that while, in criminal cases, an adverse inference may not be drawn against a defendant taking the Fifth, the Staff takes the position that it may draw such an inference in presenting its enforcement recommendation to the Commission and, more importantly, in subsequent civil or administrative proceedings. Moreover, assertion of the Fifth Amendment privilege increases the likelihood that an enforcement proceeding will be instituted against the witness who declines to testify, and one who persists in asserting his Fifth Amendment rights in the subsequent enforcement proceeding may not be able to offer evidence regarding those issues.

While the Staff does not have the power to grant immunity, it can recommend to the DOJ that immunity be granted. Thus, a witness may find himself directed to testify by a DOJ grant of immunity that the witness has not himself requested. This immunity extends only to criminal prosecution and will not prevent the SEC from using the information to bring civil charges.

Some years ago, the Staff began giving “Queen for a Day” letters to persons, using a form similar to the one developed by the U.S. Attorney’s Office in the Southern District of New York. These letters typically provide “use immunity,” i.e., a promise that the prosecutor will not use or introduce the statements made by the witness as evidence against him in an ensuing prosecution. There are important limitations that can undermine that protection. For example, the government can use a statement made in a Queen for a Day session to prove that the witness gave an inconsistent statement at trial. In addition, the government can pursue any leads it obtains from the witness via immunized testimony; e.g., subpoena a bank account the witness acknowledges he controls.

A witness and his counsel should consider asking for such a promise of limited use immunity, particularly where there is the prospect of a criminal investigation. Indeed, it is not uncommon for the SEC and the U.S. Attorney’s Office to jointly interview a witness under separate “Queen for a Day” letters.

Should You Take the Fifth?

This is perhaps the most important decision an individual and his counsel will make during the course of an investigation. In determining whether one who may have committed securities violations should testify before the SEC, the witness and his counsel should consider several points, including:

  1. How the witness’s version of the facts compares with other evidence  
  2. What mitigating evidence the witness can provide the agency that it might not be able to garner from other sources  
  3. The likelihood of the testimony affecting the outcome of the SEC investigation (i.e., is the Staff going to recommend charges no matter what the client says?)  
  4. The likelihood of a criminal investigation into, and charges concerning, the subject matter of the investigation  
  5. Whether the witness can testify for the government against other targets of the investigation  

It may be possible to have a lawyer “proffer” what a witness would say as part of an effort to obtain immunity or some other form of protection for a witness who has reason to be wary of testifying.  

Fourth Amendment Privilege

The Fourth Amendment privilege against unreasonable searches and seizures applies in SEC investigations. However, in light of the SEC’s broad investigatory powers, courts are reluctant to interfere with, or limit the terms of, SEC subpoenas unless the agency is clearly acting outside its authority, or the parameters of the investigation will cause irreparable injury.

Attorney-Client Privilege, Work-Product Doctrine The attorney-client privilege and work-product doctrine may be asserted in SEC investigations. In considering application of the attorney-client privilege to corporate counsel’s communications with corporate employees, it may be useful to bear the “Upjohn test” in mind.

The Supreme Court in Upjohn v. United States held that communications between counsel and the employees of a corporation are privileged when “[t]he communications concern [ ] matters within the scope of the employees’ corporate duties, and the employees themselves [are] sufficiently aware that they [are] being questioned in order that the corporation [can] obtain legal advice.”

For fund managers, it is particularly important that the communication at issue relates to legal advice, as opposed to purely business or operational issues.

Accountant-Client Privilege

The accountant-client privilege is not federally recognized and may not be invoked in SEC investigations.

Wells Submissions

The Wells process provides an opportunity for you and your counsel to obtain information from the Staff about the nature of the charges they are considering and to submit a brief rebutting the Staff’s allegations. Essentially, the Wells Submission contains legal, factual and/or policy arguments in support of the proposition that the Staff should not bring an action against a particular individual or entity.

The Staff is not required to allow the subject of an investigation to submit a Wells Submission; however, the opportunity to make a submission is typically allowed when the Staff’s recommendation to the Commission will be for enforcement.

Should You Prepare a Submission?

Whether to prepare a Wells Submission is a difficult decision, especially where there is a possible criminal interest in the case. Wells Submissions are not only costly endeavors, but they reveal much of the defense’s case. Therefore, a Wells Submission should not be prepared unless there is a reasonable possibility that it would be beneficial in some way. Remember, too, that the SEC could share your Wells Submission with other governmental agencies and SROs, or, after the enforcement proceeding, it could become discoverable by private parties.

On the other hand, Wells Submissions can be effective in narrowing the issues and convincing the Staff not to recommend an action or to recommend charges or a settlement that is more favorable to the client than might otherwise be the case. They can be particularly effective in defending individuals and entities that are not the principal targets of an investigation.  

The Submission Process

The Wells Submission process is informal. The Wells notice can be given by telephone call and follow-up letter. In providing notice, the Staff typically sets forth the federal securities laws and regulations under which it intends to recommend an enforcement action.

The amount of information the SEC will be willing to share will vary from case to case. For example, in cases where a witness has invoked his Fifth Amendment rights, the Staff tends to share very little information. Because more-senior Enforcement officials are generally more willing to discuss issues openly and honestly than are less-experienced staff, it is prudent for your counsel to request a meeting with senior Staff members to obtain as much information as possible about the Division’s legal and factual theories.

Your Wells Submission should generally include a detailed statement of facts and the defense’s legal and factual arguments. Special attention should be given to rebutting the Staff’s version of the facts, its interpretation of the law and the policy implications of the proposed action. The Wells Submission may spark further discussions between defense counsel and the Staff.

Indeed, your counsel will likely want a follow-up meeting with the Staff to gauge their reaction to the Wells Submission and whether it caused them to reconsider their preliminary conclusions about whether to bring charges and, if so, based on what alleged violations. If such discussions are fruitless, you and your counsel should consider commencing discussions with higher-ranking officials within the SEC.

Possible Settlement

In addition to providing an opportunity to argue against enforcement proceedings altogether, a Wells Submission may, in cases where a proceeding is likely, be used to broach the possibility of settlement.


The Dodd-Frank Act changes the timing of the process by imposing a 180-day time limit on the SEC after giving a Wells notice to decide whether or not to bring charges. This time limitation can be extended in certain circumstances.

Settle or Litigate?


In determining whether to settle or litigate a potential enforcement action, you should consider:  

  1. The strength of your case vs. the SEC’s case  
  2. The relative reputational damage, and concomitant negative impact on business, of settling on the charges proposed by the SEC (e.g., intentional fraud charges are likely to cause investors to redeem and hurt the firm’s ability to raise money) vs. litigating with the SEC (and the uncertainty that creates for investors)
  3. Whether you can afford the costs of litigation, financial and otherwise  
  4. The likely sanctions that will be imposed under a settlement vs. litigation  
  5. The collateral effects of a settlement (e.g., on possible investor lawsuits)  
  6. Your relationship with the SEC (i.e., regulated entities may not want to litigate with their primary regulator)  

Under Dodd-Frank, the SEC is required to issue new rulemaking that will limit the ability of fund managers to rely on the Rule 506 exemption of Regulation D if they have been subject to certain regulatory sanctions.  

Potential Benefits of Settlement

Further, there are potential benefits to be gained through settlement. These include:  

  1. Minimization of adverse publicity (e.g., by settling for non-fraud charges)  
  2. The defendant/respondent neither admits nor denies the allegations  
  3. Possible avoidance of the collateral estoppel effect of an administrative or judicial finding (by settling, as noted, without admitting or denying the allegations)  
  4. Quicker resolution of the issues  
  5. Review of and input into settled order’s language  
  6. Settling for a lighter sanction than may be imposed after litigation  
  7. Using cooperation to try to avoid or minimize charges and sanctions  

Commencing Settlement Negotiations

Settlement negotiations generally commence sometime between termination of the Staff’s fact-finding efforts and its recommendation for enforcement to the Commission. You should consider deferring settlement negotiations if there is a reasonable likelihood that the Commission will not authorize an enforcement action (perhaps on account of the Wells Submission). However, sometimes commencing settlement negotiations before the Commission considers whether to initiate an enforcement action can be beneficial because the Staff can fashion its submission to the Commission in a way that endorses the settlement.  

The SEC’s Arsenal of Remedies

The SEC may seek some or all of the following civil remedies:

  1. Injunction or cease-and-desist administrative order  
  2. Rule 102(e) suspension or bar for professionals  
  3. Disgorgement of “ill-gotten gains” (in addition to seeking the return of direct benefits such as insider-trading profits, the Staff increasingly is going after salaries or bonuses in accounting fraud cases)  
  4. Monetary penalties (which will vary according to the violation and the respondent’s level of involvement)  
  5. A bar against serving as an officer or director of a public company  
  6. Remedial actions (such as the appointment of a special monitor or receiver, a commitment to adopt new policies and procedures, education and training, etc.)  

The Dodd-Frank Act filled several statutory gaps with respect to remedies for securities law violations (e.g., the SEC may now impose industry-wide suspensions and bars—so, for example, a person suspended for associating with a broker-dealer may no longer be permitted to associate with an investment adviser).  

Wording of Settlement Documents

Because of the negative publicity that can follow a settlement with the SEC and the interest the plaintiffs’ bar has in the charges brought, you will want your counsel to review and negotiate, to the extent possible, the language of any settlement documents, including the SEC’s complaint or administrative order.  

Commission Approval

The Commission has to approve a settlement and, for this reason, the Staff is generally reluctant to settle on terms that are out of line with current enforcement trends and sanctions. Once the Commission approves a settlement, it will issue a public release setting forth the charges and describing the settlement. The Staff will often allow you to review the release, but has been generally reluctant to change anything after having negotiated the charging documents.


Mitigating Factors in Enforcement Decisions

In considering whether to take enforcement action, and what sanctions to impose, the Staff considers each case individually. However, the SEC, in a 2001 release entitled “Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions,” outlined 13 factors for Enforcement to consider. The release is commonly referred to as the “Seaboard Report,” in reference to the Seaboard Corporation’s avoidance of SEC enforcement proceedings by the firm’s quick and public disclosure of the fraudulent activities of its controller, and the prompt steps taken to remedy the misconduct.

The following are the factors outlined in the report:  

  1. Was the misconduct at issue the result of inadvertence, honest mistake, simple negligence, reckless or deliberate indifference to indicia of wrongful conduct, or intentional misconduct?  
  2. Did the misconduct result from pressure placed on employees to achieve specific results, or a tone of lawlessness set by those in control of the company?  
  3. How high up in the chain of command was knowledge of, or participation in, the misconduct?  
  4. How long did the misconduct last?  
  5. How much harm did the misconduct inflict upon investors and other constituencies?  
  6. How was the misconduct detected and who uncovered it?  
  7. How long after discovery of the misconduct did it take to implement an effective response?  
  8. What steps did the company take upon learning of the misconduct to stop the misconduct, discipline the wrongdoers, provide redress to the victims and cooperate with appropriate law enforcement bodies?  
  9. What processes did the company follow to resolve many of these issues and ferret out necessary information?  
  10. Did the company do a thorough review of the nature, extent, origins and consequences of the conduct and related behavior and, if so, who oversaw the review?  
  11. Did the company promptly make available to the Staff the results of its review and provide sufficient documentation reflecting its response to the situation?  
  12. Did the company adopt and ensure enforcement of new and more effective internal controls and procedures designed to prevent a recurrence of the misconduct?  
  13. Is the company the same company in which the misconduct occurred, or has it changed through a merger or bankruptcy reorganization?  

Borrowing from the DOJ’s Toolbox

More recently, the SEC signaled its intention to reward individuals and companies who cooperate and provide the Staff with assistance that may lead to the prosecution of others. Borrowing certain tools from the DOJ’s toolbox, the SEC stated that it may be willing to enter into the following kinds of arrangements with early cooperators:

  1. Cooperation Agreements. Formal written agreements in which the Enforcement Division agrees to recommend to the Commission that a cooperator receive credit for cooperating in investigations or related enforcement actions if the cooperator provides substantial assistance such as full and truthful information and testimony  
  2. Deferred Prosecution Agreements. Formal written agreements in which the Commission agrees to forgo an enforcement action against a cooperator if the individual or company agrees, among other things, to cooperate fully and truthfully and to comply with express prohibitions and undertakings during a period of deferred prosecution  
  3. Non-Prosecution Agreements. Formal written agreements, entered into under limited and appropriate circumstances, in which the Commission agrees not to pursue an enforcement action against a cooperator if the individual or company agrees, among other things, to cooperate fully and truthfully and comply with express undertakings  

The Commission also described the manner in which it will evaluate whether, how much, and in what manner to credit cooperation by individuals. Taking an approach similar to what is contained in the “Seaboard Report,” it identified four general considerations:

  1. The assistance provided by the cooperating individual
  2. The importance of the underlying matter in which the individual cooperated
  3. The societal interest in ensuring the individual is held accountable for his or her misconduct
  4. The appropriateness of cooperation credit based upon the risk profile of the cooperating individual

The Commission’s record on cooperation is difficult to evaluate. While the Commission maintains that it has rewarded cooperators, defense counsel and their clients are skeptical. A number of commentators have noted, for example, that entities that self-report possible violations generally are named in an enforcement proceeding, but that the monetary sanctions are often lighter in cases involving cooperation. However, because each case is so different, it is hard to make the kind of comparison necessary to draw such a conclusion.

Because the decision whether to self-report and cooperate with the Staff is an important one, you and your counsel will want to evaluate all the pros and cons in planning this aspect of your defense strategy.