United States: "Wildcatting" for Fraud: A New Investigative Approach by SEC Enforcement?

By William R Baker III (Washington D.C. office), David M. Brodsky, Alexandra A.E. Shapiro and Noreen A. Kelly-Najah (New York office)

Despite a formidable history and a number of recent successes, the Securities and Exchange Commission continues to receive criticism from Congress, the public and the press for failing to move quickly to detect and prevent the series of crises that have confronted the securities markets. In a recent speech to the District of Columbia Bar Association, Stephen M. Cutler, the Director of the Division of Enforcement, outlined some changes at the Commission designed to meet this criticism. ¹ Some of the changes are largely internal, but one, a strategy intended to uncover systemic problems in industries and markets, has immediate and dramatic effects for all entities within the SEC’s jurisdiction. Mr. Cutler confirmed what many defense lawyers have suspected: that the Division of Enforcement is now borrowing a technique from the Office of Compliance and Examinations (OCIE). For many years OCIE has used simultaneous examinations at a cross-section of firms to learn whether a particular practice is widespread and problematic and to uncover potential violations. These simultaneous exams are knows as "sweeps." As Mr. Cutler describes it, just as OCIE conducts an exam sweep, the Division of Enforcement has begun to investigate companies because of their affiliation by industry with a company that has found its way under the SEC’s microscope. Internally, the SEC enforcement staff reportedly refers to this approach as "wildcatting," a term used in the oil and gas industry to refer to drilling in unproven areas. ² A company on the receiving end of a subpoena or information request that is being targeted solely on the basis of industry affiliation might wonder whether a more accurate description would be "fishing expedition."

Historically, the SEC’s enforcement approach (like that of any law enforcement agency) has been reactive. The Commission typically initiates investigations of individuals or companies after evidence of a possible violation surfaces. But, in the wake of a succession of large-scale problems in financial reporting and among Wall Street analysts and most recently mutual funds, Mr. Cutler acknowledged that the SEC had to act aggressively to avoid being upstaged again: "thanks in part to the actions of the New York Attorney General . . . [the SEC has adopted] the concept of effective enforcement [that] includes ‘seeing around the corner,’ [and] identifying trends, practices and risks within our capital markets that could be exploited to the detriment of investors."³

"Seeing around the corner" is consistent with SEC Chairman William H. Donaldson’s "doctrine of no surprises," articulated in Congressional testimony last year. ⁴ Under Chairman Donaldson, the SEC has established an Office of Risk Assessment that gathers and maintains data on trends and risks in various industries, sectors, and markets. ⁵

In addition, according to Mr. Cutler, the SEC has implemented a number of other steps to increase information sharing inside the Commission with a view towards eliminating unpleasant surprises in the financial markets. One of those steps is the creation of formal committees that meet regularly and review enforcement referrals resulting from OCIE examinations of broker dealers and investment advisers, in an effort to improve the referral process and to learn of small problems before they become larger ones. Also, the Chief Accountants of the Divisions of Enforcement, Investment Management, and Corporate Finance and the Chief Accountant of the Commission meet regularly to share information. According to Mr. Cutler, this "cross-pollination" allows the "Enforcement staff [to] learn of those areas in which the OCA staff are getting frequent requests for guidance or areas on which Corporate Finance or Investment Management are frequently finding it necessary to comment in the filings they review."⁶ The objective is to identify "high-risk areas in the financial reporting arena" that may become bases for industry investigations. ⁷

While no one can quarrel with structural changes designed to improve internal information sharing and efficiency, the SEC’s new enforcement approach, whether just seeing around the corner or wildcatting, goes much further. In his speech, Mr. Cutler described an effort to "foster [ ] a subtle cultural change within the enforcement program to encourage more risk taking….[when] pursuing investigations where, at the outset, it is not clear that a securities violation has occurred."⁸ According to the Director, the Enforcement Division needs "to reach beyond investigating the cause of every announced restatement, to probe industries or practices about which we have concerns or suspicions but no clear roadmap to wrongdoing." ⁹ He sounded this theme again in a Wall Street Journal article published March 18, 2004, where he acknowledged that the Enforcement Division’s new investigatory policy would take the Division "further afield than [they] might have in the past." ¹⁰ In that same article, the Director was also quoted as stating that an objective of the new approach was to bring "big-impact cases" even if that required the Enforcement Staff to "focus [ ] attention in areas where [they] may not have solid evidence of problems at the outset, but you end up finding . . . problems."¹¹ At the same time, Mr. Cutler recognizes that the new approach will likely result in the Staff concluding that charges are inappropriate "in more of these situations than in others."¹² The SEC’s "wildcatting" is particularly troubling in light of the fact that the SEC has never been required to make a threshold showing of reasonable suspicion, probable cause or other level of proof to justify the commencement of an investigation.

The SEC has reportedly commenced several industry-wide investigations. According to public disclosures and reports, since the disclosure last spring of accounting problems at Ahold N.V., it appears that the SEC has engaged in a wide-ranging investigation of accounting for vendor allowances and other payments by retail firms.¹³ More recently, after the disclosure that Royal Dutch/Shell Group would change its accounting for oil and gas reserves, the SEC reportedly commenced a broad investigation of the oil and gas industry to determine whether there is an industry-wide problem. ¹⁴ Other industry investigations that have appeared in the public press include an investigation by the SEC of executive compensation in the high-tech sector, accounting practices in the video game industry and the use of derivative transactions by insiders to disguise their stock sales. ¹⁵

These broad investigations by the SEC present obvious concerns and inevitable costs to public companies. Moreover because of the broad net cast by the SEC and a new emphasis on secondary participants, those affected by this policy will not be limited to public companies and will include officers, directors, employees, auditors and perhaps even customers. Depending on the scope of the investigation, the company may receive a voluntary request or subpoena to produce documents or be asked to subject its employees to SEC interviews or depositions. Obviously, the receipt of a voluntary request or subpoena to produce documents in an SEC investigation is, at a minimum, disruptive to a company’s business. The stakes in an SEC investigation have never been higher, and care must be taken to respond appropriately. Companies should resist the temptation, if it exists, to treat an information request or subpoena in an industry-wide investigation with anything less than extreme caution.

• Be prepared. When an industry participant makes public an accounting problem or difficult disclosure problem, take the opportunity to review your own accounting and disclosure in anticipation of possible inquiry. Consider reviewing past SEC comments in light of recent public disclosures.

• Consider carefully the need for public disclosure of such an investigation. The disclosure decision will be driven by the particular facts of a situation.

• It appears that, at least in some industry-wide investigations, the initial contact is in the form of a voluntary request for information that often goes well beyond a simple demand for documents and will require written responses. Such a written response should be drafted carefully and checked for completeness, as well as consistency with company filings and public statements. Such a response should be viewed as an opportunity for subtle advocacy to the Commission staff to communicate that the Company’s public disclosures are accurate, complete and in compliance with all legal requirements.

• Be aware of the tough penalties for lack of complete information or incomplete document productions. In his February 12 speech, Mr. Cutler talked about several recent cases where a substantial financial penalty was imposed against a public company because the company failed to produce documents in a timely fashion or otherwise failed to cooperate in the investigation.

• Finally, remember that, as with any SEC investigation today, other agencies may be lurking in the background: the Department of Justice, State Attorneys General, and now the Public Company Accounting Oversight Board, to name a few, and a company can quickly become involved in investigations in multiple forums.

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