By Amanda Maine, J.D.
Melissa Hodgman, an associate director in the SEC’s the Division of Enforcement, appeared on a panel with members of the securities defense bar to discuss recent Commission enforcement actions involving financial disclosure and accounting fraud. The panel, hosted by the Securities Docket’s 2020 Securities Enforcement Forum, addressed a number of topics, including how the SEC identifies financial fraud cases and strategies for obtaining credit for cooperating with the staff.
Identifying cases. Panel moderator Steven Richards of Ankura Consulting Group asked Hodgman what tools the SEC uses to identify financial fraud cases. Hodgman said that while the Division receives self-reports as well as tips, complaints, and referrals, it is also seeing a lot of cases that are generated internally through the use of data analytics and other expertise to identify patterns and outliers.
Richards also asked the other panelists how the SEC’s use of internal and external tools affects the way they represent their clients. Bill Baker of Latham & Watkins advised that at the outset of an investigation, it is unlikely that defense counsel will know if the staff used data analytics or algorithms to detect a pattern. At this point in the litigation, the defense doesn’t know if a subpoena comes from a tip from a whistleblower, from traditional market surveillance, or from data analytics, he said.
Dixie Johnson of King & Spaulding commented that at times, it can feel like the SEC is conducting a fishing expedition. Even if the staff reveals the pattern behind the investigation, the defense still has to figure out what is behind the pattern, which diverts companies from their regular work. According to Johnson, it feels like an examination conducted by the Office of Compliance Inspections and Examinations (OCIE), but with more urgency because it’s the Enforcement Division.
Hodgman responded that the staff’s work is not meant to be a fishing expedition and that the source of the information does not change how the staff pursues its investigation. She added that Enforcement has been using data analytics for decades, so it is not really anything new. She emphasized that the SEC considers communication and cooperation important and urged defense counsel to engage in dialogue with the staff.
Hodgman also said cases have been identified through auditors. The staff tries to leverage its scarce resources by looking at gatekeepers such as auditors, she advised. The SEC focuses on auditors across issuers to see if there are any patterns or repeat problems by using technology. Claudius Modesti of Akin Gump, who previously served as the director of the PCAOB’s Division of Enforcement, inquired about the SEC’s tools for finding potential audit cases and how the staff coordinates with the PCAOB. Hodgman said the SEC and PCAOB work closely together to avoid overlapping efforts. Regarding identifying auditing cases, she said that the staff looks at both public and nonpublic sources of information, as well as information from whistleblowers and self-reports. Self-reporting is the quickest and most efficient way to conclude a case, she advised.
Financial reporting issues. When asked about how the staff approaches possible enforcement actions involving the accounting of estimates and accruals, Hodgman said that the SEC does not want to second-guess accountants and allows for good faith determinations. She stressed that while the SEC wants to send a message with these types of cases, these are the outliers and not the norm. The public does not see the cases the staff investigates but does not pursue, she added. When the SEC brings an enforcement action, it is because the conduct justified it, Hodgman advised.
Regarding estimates, Modesti recommended that companies develop a sound process for determining estimates, follow it, and document it. You need a really good reason for not following the process, he said, and that’s what gets companies in trouble with the SEC. Johnson added that there has been an effort by companies to create an ongoing process for documenting estimates. Many companies have been caught by surprise when the staff asks for documentation and it is not as robust as the companies believed they had created at the time, she said. Johnson also noted that in her experience, the SEC won’t bring a case even if the company wasn’t perfect because the staff will take into consideration the company’s efforts to get it right.
Remedies and cooperation. Hodgman said that the COVID-19 pandemic has been a factor in driving the SEC to find new ways to make cases more efficient. Part of this developing creative ways of using remedies, such as using independent consultants or investigations that are done by the issuer or a market participant to move the investigation along faster.
Johnson remarked that it is still difficult to demonstrate to clients how cooperation with the SEC justifies the cost to the entity. The descriptions given about cooperation in administrative orders are uneven, with some containing a lot of information about how cooperation credit was awarded and some with very little. She also mentioned that the SEC’s "Spotlight on Cooperation" webpage has not been updated since 2016. While it does give some guidance, it is not enough to show clients that it would be in their interest to cooperate. Johnson added that it would be helpful to know what the Commission is thinking when it decides not to pursue a particular action.
Hodgman replied that the Division’s cooperation program is very active, and the staff will give out information when it can. However, sometimes the market participant does not want the details of its cooperation and remediation made public, she said. In addition, the SEC does not want to be prescriptive on what leads to cooperation credit, according to Hodgman.
Baker remarked that the Department of Justice is more prescriptive on what kind of remedies are available, while the Commission has preserved maximum flexibility. There is no "penalty grid" at the SEC, which can be frustrating when trying to negotiate a resolution, he said. Hodgman advised that at the SEC, remedies are facts and circumstances-based. Forms of cooperation include not just monetary figures, but also which charges are brought and who is charged, she added.
Disclosing an investigation. Richards asked the panelists when a company should disclose that it is under investigation by the SEC. Baker said this is also driven by facts and circumstances. If counsel is being contacted regarding an investigation resulting from data analytics and the misconduct is unknown, it is impossible to draft a meaningful disclosure about it. It is necessary to understand the scope of the problem before disclosing it, he advised. Modesti agreed, noting that there is no bright-line rule, such as the receipt of a Wells notice, that should trigger disclosure. Not all Wells notices are the same and not all investigations carry the same significance, he said.