Since the United States Securities and Exchange Commission (''SEC'') announced its new cooperation initiative in January 2010, the agency and its staff have created new programs designed to invite, incentivize, and reward cooperation. The past few months have brought the SEC's first deferred prosecution agreement (''DPA''), on the heels of the agency's first non-prosecution agreement (''NPA''). Now, when the SEC staff reaches a preliminary conclusion that a cooperating corporation has violated the federal securities laws, the agency has four choices rather than two for resolving that matter: the result could be an enforcement action, a DPA, an NPA, or a ''full pass.''

The SEC resolved four enforcement investigations in recent months that illustrate this spectrum and the factors that may guide which result is appropriate for particular future cases.

One situation involved a February 2011 enforcement action against ArthroCare Corp. (''ArthroCare'') that was resolved, after extensive cooperation by the company, in a settled cease-and-desist proceeding with no penalties against the company.1

The two novel cooperation agreements illustrate the solutions in the middle, between enforcement action and a ''full pass'': a May 2011 DPA with Tenaris S.A. (''Tenaris''),2 and a December 2010 NPA with Carter's Inc. (''Carter's'').3

The fourth situation was a ''full pass'' involving Zale Corp. (''Zale''), in which an individual marketing vice president settled an injunctive action alleging that she aided and abetted Zale's periodic reporting, books and records, and internal controls violations, while Zale itself was not charged and was not required to enter into any cooperation agreements.4

After briefly describing these four resolutions, focusing in particular on the extensive cooperation steps the public documents cite, this article describes the common threads in, and distinctions among, the four situations. Litigation risk, which is always a factor in the analysis, is not something we are able to assess from the public documents. Even so, the facts cited in the publicly available information for these four situations suggest that the SEC's 2001 Seaboard Report5 continues to guide SEC cooperation analysis. And the Zale situation provides public confirmation that it remains possible to navigate an investigation in which the SEC arguably could allege a violation of law to a conclusion involving a ''full pass.''

The ArthroCare Cease and Desist Order

In this February 2011 settled enforcement proceeding, in which the company neither admitted nor denied the SEC's findings, the SEC found that ArthroCare, a medical device company, ''materially overstated and prematurely recognized revenue'' on the sale of its products to agents and distributors for over two years, in violation of the periodic reporting, books and records, and internal controls provisions of the federal securities laws. The company restated several quarterly and annual financial reports and settled the matter with a cease-and-desist order involving no fraud charges and no financial penalty. In accepting the settlement, the SEC ''considered the remedial acts undertaken by ArthroCare and the substantial cooperation provided by the company.'' ArthroCare stated in its most recent Form 10-K that the Department of Justice was continuing its investigation on this issue.

The ArthroCare order reads like a cooperation roadmap. In the category of personnel changes, ArthroCare:

  • replaced its senior management team;
  • expanded its legal department;
  • created a compliance department;
  • hired a new compliance officer, a new corporate controller, a new international controller, and a new contract administrator; and
  • expanded its internal audit function.

In the category of structural and procedural changes, ArthroCare:

  • enhanced revenue recognition controls;
  • began sending quarterly ethics-based messages from senior management to employees;
  • implemented a sub-certification process for its financial statement reporting;
  • standardized its customer contracts and created ''rigorous approval requirements'' for modifying the standard forms; and
  • implemented regular training programs on ''proper revenue recognition accounting'' and ''appropriate procedures for handling contracts.''

Finally, in the category of cooperation during the SEC's investigation, ArthroCare:

  • conducted its own internal investigation;
  • provided the SEC staff with regular updates concerning the internal investigation;
  • organized ''critical documents'' for the SEC staff by subject matter and by witness, and provided those sets to the staff ''without waiting for staff requests or subpoenas;''
  • ''responded promptly and completely to the staff's requests for additional information;''
  • made the company's ''consulting expert'' available to the staff ''routinely'' to discuss accounting and internal control issues;
  • made international witnesses, who otherwise would have been ''beyond the staff's subpoena power,'' available for testimony; and
  • shared with the SEC staff a ''schedule of restatement categories,'' and an analysis of the restatement, including the impact of the restatement on ArthroCare's historical financial statements.

This detailed list is consistent with the expectations implicit in the list of questions set forth in the Seaboard Report and is likely to become a useful resource for companies who are striving to achieve maximum cooperation credit from the SEC.

The extent of ArthroCare's cooperation credit became apparent on June 27, 2011, when the SEC reached a settlement alleging that John Raffle and David Applegate, two former vice presidents at ArthroCare, aided and abetted ArthroCare's fraud, as well as its books and records violations. The complaint states: ''Based on the conduct alleged herein, ArthroCare violated Section 10(b) of the Exchange Act and Rule 10b-5 by filing materially misleading annual and quarterly reports with the Commission and by making public misrepresentations and omissions arising from the improper revenue recognition and schemes and fraudulent courses of business.''6 Thus, it is reasonable to infer that, but for its extensive cooperation, ArthroCare would have faced much more severe sanctions.

The Tenaris Deferred Prosecution Agreement

In the SEC's first DPA, the agency alleged in May 2011 that Tenaris, a Luxembourg corporation that manufactures steal pipe products, violated the Foreign Corrupt Practices Act (''FCPA'') between April 2006 and May 2007 through payments to certain Uzbekistani government officials that were not recorded properly in Tenaris's books and records. The company discovered the alleged violation through an internal investigation by a law firm retained by the Audit Committee of Tenaris's Board of Directors to follow-up on a 2009 tip from a third party about a different issue. According to the DPA, Tenaris ''provided extensive, thorough, realtime cooperation . . . which included timely, voluntary and complete disclosure of certain conduct,'' including the Uzbekistan transactions. Further, the agreement states that Tenaris took steps to update and improve its compliance program and enhance its compliance measures, including ''adoption of a strengthened Code of Conduct, Business Conduct Policy, and Agent Retention Procedure that addresses anticorruption and compliance with the Foreign Corrupt Practices Act, and provides for enhanced due diligence procedures related to the retention of third party agents.'' The SEC stated that the agency offered Tenaris the DPA because of the company's cooperation.7

The DPA sets forth an extensive statement of facts and then prohibits Tenaris and any of its present or future attorneys, employees, or agents from denying any aspect of the agreement, except in legal proceedings in which the Commission is not a party. This provision does not apply to statements made by an individual defending himself or herself in a proceeding, ''unless such individual is speaking on behalf [of Tenaris].'' Any press release related to Tenaris's DPA must be approved by the SEC. In addition, Tenaris is required to pay $5.4 million in disgorgement and prejudgment interest. For the next two years, Tenaris must annually review and update its Code of Conduct, ensure that each director, officer, and management-level employee annually certify compliance with the Code of Conduct, conduct FCPA compliance and anti-corruption training, and refrain from violating securities laws. Tenaris and its subsidiaries must cooperate ''fully and truthfully'' with any SEC investigations or proceedings related to Tenaris's misconduct. In addition, Tenaris and its subsidiaries must, if directed by the SEC, cooperate ''fully and truthfully'' with any other U.S. federal, state, or self-regulatory organization investigation or proceeding, including by producing non-privileged documents, making witnesses available for interviews and testimony, and responding to all inquiries.

The Carter's Non-Prosecution Agreement

The SEC posted its first NPA on its web site in December 2010. Unlike Tenaris's DPA and ArthroCare's proceeding, the Carter's NPA and the SEC's companion release do not include a statement of facts and provide little information about the circumstances. The SEC, however, also filed a complaint against a former Carter's Executive Vice President of Sales, Joseph M. Elles, alleging that, ''from at least 2004 through March 2009,'' Elles committed fraud and aided and abetted Carter's violations of the SEC's reporting and books and records provisions in connection with discounts provided to the company's largest wholesale customer. Carter's restated five fiscal years and three fiscal quarters to address these issues.

In complimenting the company for its cooperation with the SEC, the release notes that Carter's identified Elles' conduct, reported the circumstances to the SEC, conducted an internal investigation using outside counsel supervised by the Audit Committee, and restated its earnings for the affected periods. The Elles Complaint states that his employment was terminated by Carter's ''as of March 2009,'' but does not specify whether the termination occurred in connection with the internal review of its accounting for margin support provided to its wholesale customers, which the company first disclosed to the public in late October 2009. The release also notes the ''relatively isolated nature of the unlawful conduct,'' which, according to the complaint, lasted over five years and involved the company's largest wholesale customer but occurred through circumvention of the company's internal controls. Finally, the SEC's release commends Carter's ''extensive and substantial remedial actions,'' which are laid out in more detail in the company's filings and included personnel, corporate governance, and internal controls changes. All of the agreed-upon cooperation requirements in the Tenaris DPA appeared first in the Carter's NPA.

Zale's 'Full Pass'

On April 14, 2011, the SEC announced a settled injunctive proceeding against a former marketing vice president for Zale's largest division, alleging that she aided and abetted Zale's violations of the SEC's books and records requirements by causing Zale to record certain advertising costs as prepaid advertising, rather than expensing them. The same day, according to a Form 8-K filed by Zale, the SEC staff notified Zale that the investigation had ended and that it did not intend to recommend any SEC enforcement action against Zale. Because no enforcement action or cooperation agreement occurred, no public SEC statements exist as to why Zale received a full pass. Zale's disclosures, however, describe cooperation steps similar to those undertaken by ArthroCare, Tenaris, and Carter's. In September 2009, Zale announced that it would restate its financial statements for fiscal 2007 and 2008 and interim quarters. On Oct. 13, 2009, Zale terminated the marketing vice president, according to the SEC's subsequent complaint against her. On Oct. 29, 2009, the company filed its Form 10-K for fiscal 2009, which contained the restatement of the prior periods. In that filing, Zale announced that it discovered the advertising cost issue and another matter, its audit committee retained outside counsel to review those matters, and the audit committee was overseeing remediation for the two material weaknesses identified in internal controls. The Form 10-K identifies the two material weaknesses as not maintaining effective controls over certain account reconciliations, and not maintaining effective segregation of duties and oversight with respect to the company's advertising programs. According to the Form 10-K, remediation steps included hiring a new Chief Financial Officer, a new Controller, a new Internal Audit leader, and additional finance personnel; adding third-party internal audit resources; performing a review of Zale's internal controls, policies, and procedures and organization structure relating to the areas relevant to the material weaknesses; and retraining existing finance personnel. The company stated that the SEC staff contacted the company after the company's Sept. 18 disclosure, suggesting that although Zale self-disclosed, it did not directly self-report to the agency.

Because the SEC (appropriately) does not announce ''full passes,'' we identified Zale by looking for recent instances that were similar to the Seaboard facts. We looked specifically for instances since January 2010 in which (i) the SEC charged one or more individuals with aiding and abetting and/or causing a company's securities law violation (and therefore, arguably, the SEC concluded that a company violation occurred), (ii) the company remains in business as of this writing, (iii) no SEC charges have been filed against, and no SEC cooperation agreements have been announced with, the company, and (iv) the company has disclosed the closing of the SEC investigation. Only Zale satisfied all these criteria.8

Receiving a Pass From the SEC: When Does It Happen?

While the current SEC Enforcement Manual continues to refer to the Seaboard Report, the recent—and welcome—use of cooperation agreements has prompted some to question whether Seaboard still guides the agency and whether the ''full pass'' result awarded to Seaboard is achievable under the current regime. Zale confirms that it is possible, although apparently uncommon. The misconduct alleged in Arthro- Care, Tenaris, Carter's, and Zale all allegedly involved violations of the SEC's books and records requirements, and all were uncovered and disclosed in some fashion by the companies themselves. The ArthroCare cease-and-desist order, the Tenaris DPA, the Carter's NPA, and the Zale disclosures each lists specific steps taken to address the alleged violation, to improve the company's structure and processes to avoid similar situations in the future, and to assist the government's investigation. While the public documents in the four recent cases do not address every one of Seaboard's thirteen questions and sub-parts, these companies seemed to cooperate extensively, and their efforts will provide useful guidance to companies planning out their own remediation and cooperation steps. So why did only Zale receive a ''full pass?''

The answer may be that no full pass was possible for ArthroCare, Tenaris, and Carter's, no matter how much cooperation and remediation occurred, because of factors that could not be changed by the companies' subsequent actions. For example, relative perceived harm to investors may have been one factor. ArthroCare's stock price declined more than 42 percent the day after the company's Form 8-K disclosure of its restatement. According to the SEC's allegations, Carter's stock price fell after each disclosure it made about its issues, ''ranging from a decline of 23.8 percent after one disclosure to a decline of 2.9 percent after a subsequent disclosure.'' Although Tenaris's stock price fell a smaller amount, 4.5 percent, after its disclosure of possible FCPA violations, that disclosure occurred in the company's annual report on Form 20-F, the form for foreign private issuers. As a result, the Tenaris disclosure was part of an overall picture of the company's financial statements, rather than a highlighted individual item. In contrast, Zale's stock declined less than 1 percent after its Sept. 17, 2009 Form 8-K disclosure announcing the errors and restatement, and Seaboard's stock did not decline following its disclosures and restatements.

The comparative egregiousness of the conduct and level of intent may also have been a factor. ArthroCare has disclosed that the Department of Justice is conducting an investigation into its sales, accounting, and billing procedures, although no criminal charges have been filed against the company, and the SEC settled fraud charges with the individuals allegedly responsible for ArthroCare's misconduct. The Tenaris DPA was released the same day as the company's settlement with the Department of Justice, confirming that the violative conduct was viewed as serious and significant, despite the apparent lack of need for a restatement. Similarly, although criminal enforcement was not apparent in public statements about Carter's, the SEC is currently litigating fraud charges against Carter's former executive vice president of sales, who had reported directly to Carter's president. In contrast, although the Zale and Seaboard situations each involved a restatement of multiple reporting periods and charges against an individual, in each instance the individual settled allegations not involving fraud.

Although another factor inspiring the SEC to take action rather than passing may have been the extent to which each company's internal procedures were deficient at the time the violations occurred, the record is mixed on this point. As then-Commissioner Cindy Glassman aptly said, ''No system of controls can prevent all misconduct; however, if a company can demonstrate that it has satisfied its obligation to implement good procedures, then in my eyes it has a significantly better chance of receiving leniency (assuming the other criteria set out in the [Seaboard] report are met).''9 It is possible that the internal procedures at Carter's, Tenaris, and ArthroCare were so flawed that even extraordinary cooperation still did not result in a ''full pass.'' Zale's two material weaknesses, however, suggest that this factor does not necessarily control the ultimate outcome.

ArthroCare received the harshest result of these four companies, and the charges against the individuals for aiding and abetting ArthroCare's fraud make clear that a non-fraud settlement without monetary penalties or continuing cooperation requirements was a good result for the company. Neither Tenaris nor Carter's faced enforcement action, but they both entered into public agreements with continuing cooperation obligations. It may be that the SEC's need for continued cooperation required these agreements. Tenaris is a Luxembourg company, and although as a foreign private issuer its American Depositary Receipts are listed on the New York Stock Exchange, many of its activities are outside the United States. The DPA secures Tenaris's cooperation with the SEC notwithstanding these jurisdictional challenges. Although Carter's is a U.S.-based company, the SEC benefits from agreed continued cooperation by Carter's as well, because the SEC is currently litigating a case against a former company senior officer, and the SEC and DOJ Tenaris press releases confirmed the investigations were continuing. Even so, both Tenaris and Carter's provided extensive voluntary cooperation prior to the agreements and seemed likely to continue even if no agreements existed. Presumably no continuing agreement was necessary for Zale because the employee settled the SEC's claims, as did the individual in Seaboard. It may be that those situations were viewed as involving rogue, lower level employees whose misdeeds ultimately were caught by their employers and dealt with fully in the settled actions.

It is also possible that Seaboard's determination not to invoke its attorney-client or other privileges may have led to a different result for Seaboard than what the other companies experienced, although the SEC has consistently confirmed that waiver of privilege is not necessary to get cooperation credit as long as a company shares all relevant facts with the SEC.10 Plenty in the public documents for Tenaris, ArthroCare, and Carter's suggests that those companies provided as much factual information as possible to the government, but the government's silence on the privilege issue suggests that there were limits to the documents produced and the communications revealed. There is no indication of what, if any, role privilege assertions or the lack thereof played in the Zale case.

In sum, these four recent public resolutions demonstrate that the SEC continues to apply the Seaboard factors when evaluating a company's cooperation and determining the appropriate resolution for a case. The ArthroCare case demonstrates that it remains possible for a cooperating company to resolve a matter with an administrative enforcement action and no penalties. The Tenaris and Carter's agreements show the SEC's determination to incentivize corporate cooperation by agreeing not to bring enforcement actions in situations where cooperation agreements are signed and honored. And the Zale situation confirms the SEC staff has recently concluded, in at least one situation, not to recommend enforcement action against a company even though it charged an individual with aiding and abetting that company's violations. Whether a ''full pass'' for confirmed violations occurs in particular instances may be partially beyond the company's control, but this spectrum of situations confirms that the SEC and its staff are paying a great deal of attention to cooperation when deciding the outcome of an enforcement investigation.

Footnotes

1 In re ArthroCare Corp., Exchange Act Release No. 63,883 (Feb. 9, 2011), http://www.sec.gov/litigation/admin/2011/34-63883.pdf.

2 Deferred Prosecution Agreement between Tenaris, S.A. and the Securities and Exchange Commission (May 17, 2011), http://www.sec.gov/news/press/2011/2011-112-dpa.pdf.

3 Non-Prosecution Agreement between Carter's Inc. and the Securities and Exchange Commission (Dec. 17, 2010), http://www.sec.gov/litigation/cooperation/2010/ carters1210.pdf; see generally SEC Litigation Release No. 211,784 (Dec. 20, 2010), http://www.sec.gov/litigation/litreleases/2010/lr21784.htm; Elles Complaint, SEC v. Joseph M. Elles, Civil Action No. 1:10-CV-4118 (N. Ga. Dec. 20, 2010), http://www.sec.gov/litigation/complaints/2010/comp21784.pdf.

4 See Securities Exchange Act Release No. 21,930 (Apr. 14, 2011), http://www.sec.gov/litigation/litreleases/2011/lr21930.htm; Form 8-K of Zale Corp. (Apr. 15, 2011), http://www.sec.gov/Archives/edgar/data/109156/000115752311002037/a6685577.htm.

5 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, Securities Exchange Act of 1934 Release No. 44,969 (Oct. 23, 2001), http://www.sec.gov/litigation/investreport/34-44969.htm (''Seaboard Report'') (setting forth what the agency ''will consider in determining whether, and how much, to credit self-policing, self-reporting, remediation and cooperation—from the extraordinary step of taking no enforcement action to bringing reduced charges, seeking lighter sanctions, or including mitigating language in documents we use to announce and resolve enforcement actions'').

6 Complaint at 14, SEC v. John Raffle, Civil Action No. 1:11- cv-540 (W.D. Tex. June 27, 2011), http://www.sec.gov/litigation/complaints/2011/comp22027.pdf. As part of their settlement, without admitting or denying the allegations in the complaint, Raffle and Applegate agreed to be enjoined from violating and aiding and abetting multiple securities laws, including fraud. In addition, Raffle and Applegate were ordered to pay disgorgement and prejudgment interest and were barred from serving as officers or directors of any public company for five years.

7 See Press Release, SEC, ''Tenaris to Pay $5.4 Million in SEC's First-Ever Deferred Prosecution Agreement,'' (May 17, 2011), http://www.sec.gov/news/press/2011/2011-112.htm. The $5.4 million involved disgorgement and interest payments. Separately, Tenaris paid a $3.5 million penalty in a settlement with the U.S. Department of Justice. See Non-Prosecution Agreement between Tenaris, S.A. and the U.S. Department of Justice (Mar. 14, 2011), available at http://lib.law.virginia.edu/Garrett/prosecution_agreements/pdf/tenaris.pdf.

8 Zale is not necessarily the only ''full pass'' since January 2010; based on our review of public information, a couple of other situations appear to have been full passes, but the entities involved have not released confirmation. We are not commenting here on situations in which we represent clients.

9 Cynthia A. Glassman, former SEC Comm'r, Sarbanes- Oxley and the Idea of ''Good'' Governance (Sept. 27, 2002), http://www.sec.gov/news/speech/spch586.htm.

10 See, e.g., Linda Chatman Thomsen, former Dir., SEC Div. of Enforcement, Remarks before the 27th Annual Ray Garrett, Jr., Corporate and Securities Law Institute 2007 (May 4, 2007) (''First, we do not—indeed we cannot—require waiver of the attorney-client privilege. Second, waiver of a privilege or a protection is not a prerequisite to obtaining credit in a Commission investigation. The credit given is based on, among other things, the factual information given, the timeliness of the provisions of information and the usefulness of the information.'') (quoted favorably by SEC Comm'r Kathleen L. Casey in her remarks before the First Annual Southeast Securities Enforcement Conference (Mar. 27, 2008), http://www.sec.gov/news/speech/2008/spch032708klc.htm).

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