HOW TO AVOID THAT KNOCK ON THE DOOR FROM THE SEC (AND WHAT TO DO ABOUT IT WHEN IT HAPPENS)

Upsurge in SEC Investigations

Why does it seem that there are more SEC enforcement actions today than in the past? Because there are more. In 2001, the SEC instituted 103 formal enforcement proceedings. In the first nine months of 2002, in the wake of Enron, Worldcom and other publicized corporate financial shenanigans, that number doubled. Following the passage of the Sarbanes-Oxley Act, as the SEC hired additional staff and responded to SOX's mandate to uncover and punish corporate fraud, spurred by activist state enforcement officials such as Eliot Spitzer of New York and competing with reformed minded self-regulatory organizations such as the New York Stock Exchange, the number continued to increase.

In 2006, the SEC initiated 914 investigations, 218 civil proceedings, and 356 administrative proceedings covering a wide range of issues, including corporate financial fraud, abusive backdating of stock options, compliance failures at SROs, violations of the Foreign Corrupt Practices Act and fraud related to mutual funds.

These numbers understate the number of ongoing investigations since they only list formal investigations recorded in the public record. Most SEC investigations start out as informal inquiries, often without notice even to the parties under investigation.

Investigation Triggers

So then, what triggers a SEC investigation? Investigations generally originate from (i) self-reporting by an issuer; (ii) information provided by a public company's independent accounting firm, or more rarely, its in-house or outside counsel; (iii) information provided by a public company's employees; or (iv) an analysis of data by the SEC or a self-regulatory organization such as the New York Stock Exchange or the Nasdaq Stock Market.

Investigations generally stem from the same criteria as set out in Section 408 of SOX as factors used by the SEC staff in scheduling a review of a company's public disclosure reports. These include: (i) material restatements of financial results; (ii) significant volatility in stock price as compared to other issuers; and (iii) significant disparities between price and earnings, particularly with respect to emerging companies or penny stocks.

Several factors have worked in conjunction to spur the increase in investigations. These can be summarized generally as an increased sensitivity to detection of fraud and other financial improprieties. Under Section 408 of SOX, the SEC is required to review the filings of public companies not less than once every three years and where certain factors are present, more frequently. These reviews generally trigger comment letters from the staff and sometimes result in the launch of SEC investigations.

In addition, accountants, the traditional gatekeepers, have become more vigilant in looking for improprieties, partly because of the increased oversight they now receive from the PCAOB, and also because of the requirements of Section 10A of the Securities Exchange Act which requires an accounting firm that discovers information indicating that an illegal act may have occurred to report the matter up the ladder and ultimately to the SEC if the Company fails to take appropriate action.

Restatements of financial results almost always trigger an inquiry from the SEC. In the wake of heightened sensitivity to financial fraud, the number of restatements has sky rocketed in recent years, reaching 1,295 in 2005, a number that reflects restatements by about 1 in 12 public companies, with early indications that restatements continued in record numbers on into 2006 partly due to option backdating's effect on financial reporting. Revenue recognition problems have been a leading cause for many restatements.

Another flag attracting SEC scrutiny is volatility in stock prices, particularly immediately prior to or after some event, such as the announcement of a bid for the company, or a favorable (or disastrous) earnings release.

How to Avoid Investigations (or at Least Minimize their Consequences)

How then, can a public company avoid an investigation? Good compliance procedures, particularly (dare I say it) good internal controls, can result in early detection of errors before they have any material impact. The so-called 'tone at the top' is important. Senior management should make it clear to their staff that compliance is important.

If an employee or the company's outside audit firm discovers what appears to be a problem, a preliminary investigation should be made and where appropriate it should be referred to the audit committee for further review. In some cases a full internal investigation is appropriate. In such circumstances it is generally advisable for the audit committee to engage independent counsel and possibly a forensic accountant.

Although not without its dangers, it is usually advisable for a company to discuss the problem with the SEC since cooperation is a factor in whether the SEC decides to prosecute a company and/or in the penalties assessed.