By all appearances, the SEC has armed its staff with authorization to use a powerful weapon in its current efforts to “root out” manipulation in the securities and credit default swaps of financial institutions. On Friday, September 22, 2008, the SEC announced that, “Hedge fund managers, broker-dealers, and institutional investors with significant trading activity in financial issuers or positions in credit default swaps will be required, under oath, to disclose those positions to the Commission and provide certain other information.”1 Although this technically could refer to testimony under oath, that seems unlikely because the release separately refers to the SEC authorizing its staff to take testimony by subpoena. The reference is more likely to written statements “under oath” pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934 (“Section 21(a)(1)”).

Section 21(a)(1) written statements came in vogue in the wake of the Enron and WorldCom events of 2001 and 2002,2 but have not been used extensively in recent years. It’s time to dust off the old materials, though, because it looks like Section 21(a)(1) written statements are back.3

Section 21(a)(1) Written Statements Under Oath

Section 21(a)(1) provides that the SEC may “require or permit any person to file with it a statement in writing, under oath or otherwise as the Commission shall determine, as to all the facts and circumstances concerning the matter to be investigated.” The SEC’s enforcement staff often requests that respondents submit a report, answers to a list of questions, a chronology or other forms of written statements. This Section 21(a)(1) authority raises the bar by allowing the SEC to order a money manager, for example, to describe, in a written sworn statement, the “facts and circumstances” of its trading decisions concerning a particular security. If last Friday’s announcement indicates widespread use of this powerful tool, market participants will have many questions about this authority, its limits, and how best to respond.

Practice Points 

  1.  Disclosing positions and providing “certain other information.” It is not clear precisely what information will be required, but at a minimum, responses certainly will include trading activity. The SEC also is likely to seek a statement of the basis on which the trades were made and information available to the decision-makers at the time of the trades. The SEC may also request information regarding communications with counterparties and coordinated efforts with other market participants. 
  1. It will be important to be thorough in the first response. The SEC and its staff will expect a careful, thorough and prompt response, signed by a person with knowledge of the events and the authority to respond. This may require gathering documents, reviewing electronic communications, evaluating publicly available information and interviewing those who participated in the activities, all of which must be done quickly. The SEC’s use of this authority at the same time that it has subpoena power suggests that it intends to use its Section 21(a)(1) authority to get certain information in an expedited fashion—in days and weeks rather than months and years. The SEC will likely be less flexible in negotiating the scope, extensions of return dates and rolling productions which have become routine in connection with its document requests or subpoenas. Nevertheless, it will be important not to sacrifice accuracy at the expense of expediency. Given the challenges in today’s financial markets, gathering facts about potential market manipulation is, and will continue to be, a very high priority at the SEC. 
  1. The SEC has, in rare instances, made its orders, and the responses, public. A copy of the SEC’s Order in WorldCom is available on the SEC’s web site.4 Many orders remain nonpublic, however, and some become public only if the SEC seeks to enforce them. In one situation, an SEC administrative law judge cited a respondent’s failure to respond to an SEC Section 21(a)(1) order as a basis for granting the SEC’s motion of default and revoking the common stock listing of a registrant.5 
  1. The SEC’s authority has limits. Although most market participants will prefer to work out a means to be responsive to the SEC, some may want to consider evaluating the extent to which the SEC’s authority is limited. Because these issues generally have not been litigated, guidance is sparse. Individuals have constitutional rights, of course, and cannot be forced to incriminate themselves. Entities also have the right to protect, as privileged, communications with their lawyers. The underlying factual situations are not protected from legitimate governmental inquiry, however, and the plain language of the statute is broad. Nevertheless, given the untested history of this statute, some order recipients may find creative ways to question it, for example, asking whether the authority is limited to the period before the SEC Staff has obtained from the SEC a formal order of investigation, or on the other extreme, whether the SEC’s authority to “publish information concerning any such violations” limits the SEC’s ability to publish Section 21(a)(1) orders only after the SEC has concluded that violations have occurred.6
  1. Caveats May be Important but Provocative. It will be important for those responding to Section 21(a)(1) orders to state, in the responses, the circumstances that may have limited their completeness. Due to the SEC’s infrequent use of this enforcement tool, market participants will have little guidance on this issue. Looking back, there were no useful publicly available models when WorldCom crafted its first response to the Commission’s Section 21(a)(1) order in 2002.7 Following then-SEC Chairman Harvey Pitt’s public criticism of WorldCom’s first response to the Commission’s Section 21(a)(1) order as merely a chronology, when the SEC had expected more, WorldCom filed a revised statement.8 By that time, however, the SEC had filed charges against WorldCom alleging that a massive fraud had occurred.9 Although the current round of enforcement inquiries are unlikely to rise to that level of public discourse, we are experiencing volatile times.

The current economic and political environment, including the announcement just yesterday by New York Governor Paterson concerning New York’s emerging regulation of certain credit default swaps,10 has significantly increased the pressure on the SEC and its staff to address market misconduct. This broad statutory authority may become an important tool in passing that pressure along to hedge fund managers, broker-dealers and institutional investors.