For someone under investigation by the Securities and Exchange Commission (SEC), the cloud of uncertainty can be frustrating and demoralizing.
In the past, people have sometimes waited an unfortunately long time to learn answers to some critical questions: Will the SEC staff recommend a potentially career-ending enforcement action? Will the staff terminate its investigation? If no charges are filed, how does one know the investigation is over? The emotional toll inflicted by this uncertainty grinds away at even the strongest people.
For companies that have disclosed the existence of the SEC investigation, the impact on relationships with customers, investors, and creditors can be enormous. A pension fund or university endowment may be prohibited (under its internal investment guidelines) from investing in a hedge fund or mutual fund subject to an open investigation, even if the funds' managers have a sterling track record. A company that otherwise wants to do business with the government may not even try out of fear of later being barred if a charge is brought. And when a public company's accounting is under investigation, its auditor may refuse to sign off on its financial statements or decline to take representations from senior officers, which, in turn, can cause a chain reaction of delayed public filings and even covenant defaults in financing agreements.
In theory, when an SEC investigation is to be closed without the filing of charges and litigation or settlement, the SEC provides "closing" letters advising subjects that the investigation has been terminated. In reality, many investigations become dormant but closing letters do not get issued. Thanks to recent work by the US Government Accountability Office (GAO), we now have some new insights into the case closing process and some recommended improvements. On Sept. 17, the GAO publicly released its report evaluating the SEC Enforcement Division's systems for planning investigations and providing information to subjects of investigations.
The report, "Securities and Exchange Commission: Additional Actions Needed to Ensure Planned Improvements Address Limitations in Enforcement Division Operations" (available at www.gao.gov/new.items/d07830.pdf), cracks open the window a bit into the status of the SEC enforcement staff's docket of investigations and the reasons for some of the delays in closing investigations.
The GAO's study also may have led the SEC to accelerate its processes for closing long-dormant investigations, much to the relief of the individuals and entities who were the subjects of those investigations.
A Large Backlog
The report reveals a large number of open investigations that, though no longer active, have never been closed. According to the SEC's internal case tracking system, 3,700 investigations are now open. Of that number, at year-end 2006, two-thirds (2,467) had been open for two or more years, one-third (1,233) had been open for five or more years, and an eye-opening 481 had been open for 10 or more years.
Surely, no one seriously expects that any of these 10-year-plus investigations are active. Yet individuals or companies subject to any of these long-running investigations effectively remain in a state of uncertainty, leading to angst and possible impairment of the subject's business.
The report also provides a glimpse into the backlog of the SEC's enforcement investigations in the Northeast. One SEC office-in New York, Boston, or Philadelphia (the report is not specific)-has 841 open investigations. Of that number, 300 (35 percent) have been open two or more years and, according to a senior enforcement official in that office, "were no longer actively pursued."
The report then diagnoses the backlog problem, in part, as follows. A reason for the delay in closing stale investigations is that SEC staff attorneys must submit memorandums explaining why each investigation should be closed and must draft termination letters for the individuals or companies under investigation. That presumably unenviable task is a time-consuming process that one SEC regional enforcement official estimated "could take as long as a month." And it goes on while SEC staff attorneys continue to work on their active cases.
The report goes on to identify a second bottleneck. After the staff attorney completes the case-closing memorandum and letters, the "package" is sent to the SEC's main office, where it is reviewed by staff within the Enforcement Division's Office of Chief Counsel. Until very recently, there was (as of March 1) a large backlog of 464 investigations in which closing packages had been completed and sent to Washington, but had not yet been reviewed.
Here's why: Until May 1, only one person was assigned to process closing packages. It appears, however, that, once the GAO began asking questions, the backlog was eliminated (in mid-June). The SEC staff told the GAO that they now aim to close investigations within two weeks of receipt of the closing package.
In addition to focusing some needed light on the backlog issue, the GAO may have caused the SEC to accelerate the issuance of termination letters.
Under the old system, such letters were issued only at the end of the closing process. But the report notes that, as of May of this year, the Enforcement Division has been able to "send the letters to individuals and companies at the start of the closing process rather than at the end" (emphasis added). The report does not explain what constitutes the start of the process, but a fair reading would suggest that the process starts when the staff attorney has been given the go-ahead to start drafting the case-closing memorandum.
That simple change will likely shave months (if not more) off the closing process. The process will be less likely to be hostage to busy schedules, staffing limitations, and competing work priorities. The change is also not likely to affect the substance of the case-closing process because, by the time a decision to write a closing memorandum is made, there is, at very minimum, a reasonable basis to conclude that no further action is warranted.
Another process improvement that may ultimately affect case closings concerns the opening and review of informal staff investigations and matters under inquiry (MUIs). Informal investigations can be opened immediately by the staff; MUIs are used when more information is required, and formal investigations (empowering the staff to issue subpoenas for documents or testimony) must be approved by the commission.
The report notes that under the SEC's new approach, one of the two deputy directors in the Enforcement Division must personally review and approve all newly opened informal investigations and MUIs. (Under the old, decentralized approach, individual staff attorneys were empowered to open informal investigations and MUIs.) In addition, after a new informal investigation or MUI has been open for six months, the staff will now have to draft a memorandum for review by one of the deputy directors describing "evidence gathered to date, whether an enforcement action is likely, resources and estimated time frames."
That change may well lead to a reduction in the number of investigations opened as well as potentially quicker case-closing times, because the early review of preliminary inquiries creates the opportunity for weeding out matters judged not likely to be a productive use of limited staff
resources, notwithstanding the initial basis for commencing the inquiry.
The report also hints at a possible change within the agency. According to the report, SEC staffers "are generally encouraged to close investigations if they know they will not be bringing any enforcement actions, even if all of their investigative steps have not yet been completed"
What does this all mean in practice? Perhaps the SEC staff will be more inclined to close unproductive investigations earlier in the process based on their judgment about the merits.
It ought not to be the case that every investigation that is commenced on the basis of an initial indication of a possible violation should be pursued for two years or longer simply because it was opened and is then difficult to close.
Early decisions to close matters would be positive for the SEC staff, as they could more readily reallocate their limited resources to matters more worthy of their attention. And it would also be positive for subjects of investigation because it would rightly remove those clouds of uncertainty
a lot sooner.
This article previously appeared in the October 15, 2007, issue of the Legal Times.