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Disclosure or Non-Disclosure: Governmental Investigation of Securities-Related Activity

April 14, 2022
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When—and should— a company disclose the existence of an investigation? Companies facing this question must consider their own specific circumstances while remaining attentive to potential consequences implicated by the decision.

By Paul Vorndran and Javier Heres

Federal and state regulators are increasingly pursuing enforcement actions against companies and individuals that engage in activities related to securities. In 2021, the U.S Securities and Exchange Commission (SEC) reported a marked increase over the prior year in the number of new enforcement actions that it filed.[1] In early March 2022, legislation was signed into law that increased the SEC’s funding by 7.5 percent, and more recently, on March 28, 2022, the Biden White House released its $5.8 trillion budget plan, which includes a proposition of even higher funding for the SEC.[2] The White House’s proposal would bump up the SEC’s annual appropriation to $2.15 billion, an 11.4 percent increase from fiscal 2021.[3] The agency’s Enforcement Division would get a $53 million increase to its annual funding.[4]

Given this trend of increasing enforcement actions, and lawmakers’ accompanying enthusiasm to fund the regulatory agencies that pursue these actions, companies and individuals engaged in activities related to securities should expect to see an increase in their interactions with regulators. When securities regulators believe that a violation of securities laws may have occurred, before they bring a formal enforcement action, regulators will first “investigate” companies and individuals that may have been involved with the suspected violation. These investigations are usually carried out by regulators from the SEC’s Enforcement Division or its state counterpart. In practice, this often means that companies and individuals may be contacted by state or federal securities regulators in the course of an investigation that may or may not be targeting that company or individual.

Regardless of the way in which the company or individual receives an inquiry from a government agency (e.g., a subpoena, a Civil Investigative Demand, or an informal request for information), of crucial concern to companies is determining when and to whom they should disclose that fact, if at all.

In many cases, a public company may choose to immediately disclose the existence of an investigation because it is the safest decision for the company and its management, especially when disclosure of the existence of an investigation is likely to have a negligible impact on the value of the securities in question.  Put another way, the circumstances are usually such that the risks of non-disclosure far outweigh the downsides of disclosure.

In a private company setting, parties subject to an investigation face a more difficult decision on whether to disclose. In situations where a private company is not involved in ongoing securities offerings, or investors are otherwise locked into a 10-year bond or other longer-term investment, there is no reason to disclose an SEC or state investigation if it does not render other representations misleading. This is particularly true where investors have no exit ramp—they are contractually locked into their investment with the private company. Disclosure in these circumstances may not be necessary from a securities offering standpoint, and may harm other, non-securities related, aspects of the business.

The decision to disclose to investors varies by “who” is being investigated. Is it the management of the private company, or an underlying entity to the private company, such as an investment advisory firm? In either case, the company must consider any duties that it may have under existing contracts, such as under certain indemnification provisions, or if the company is contractually obligated to notify investors that an investigation exists. In any situation, companies under investigation should consider all potential consequences of disclosure or non-disclosure with the assistance of counsel in determining the correct strategy.

Generally, the securities laws do not require a company to disclose the existence of an SEC investigation. See In re Lions Gate Ent. Corp. Sec. Litig., 165 F. Supp. 3d 1, 15 (S.D.N.Y. 2016) (“there is no independent duty to disclose a Wells Notice or an SEC investigation”). However, it may be that once an affirmative statement has been made—and that statement could be rendered misleading without disclosing the existence of an investigation—non-disclosure could serve as the basis of a securities claim. In Lions, the court emphasized that in the case before it, there were no statements that needed to be corrected via disclosure, because the plaintiffs failed to point to any statements about transactions that were the subject of the SEC investigation or statements about the SEC investigation.  Id. at 13. Additionally, the court observed that the plaintiffs failed to allege that the SEC investigation was material and would have “significantly alter[ed] the total mix of information available to an investor” because the potential penalty was less than one percent of the company’s third-quarter revenue. Id. at 14. The court’s reasoning in Lions implies that disclosure or non-disclosure of an SEC investigation may form the basis of a securities claim under certain circumstances (e.g., when statements need to be corrected via disclosure, or when the existence of the investigation is material).

Similarly, the Ninth Circuit has held that, while disclosure of an SEC investigation does not necessarily serve as a corrective disclosure for purposes of loss causation (which is an element necessary to prove a securities fraud claim), “it can do so when paired with a revelation of the inaccuracy of the underlying statements.” Evanston Police Pension Fund v. McKesson Corp., 2021 WL 4902420, at *4 (N.D. Cal. Oct. 21, 2021) (citing Lloyd v. CVB Fin. Corp., 811 F.3d 1200, 1203 (9th Cir. 2016)). In Lloyd, the company made representations in SEC filings that there was no basis for “serious doubt” about the ability of its largest borrower to repay certain loans.  Lloyd, 811 F.3d at 1207.  After the company filed a form 10-Q disclosing receipt of a subpoena from the SEC regarding the loans, the company’s stock declined by 22%.  Id. at 1204. One month later, when the company disclosed that it had charged off the loan, its stock declined only slightly.  Id.  In the Ninth Circuit’s view, the later disclosure’s “minimal effect” on the company’s stock price indicated “that the earlier 22% drop reflected, at least in part, the market’s concerns” about the loans.  Id. at 1211. The outcome in Lloyd suggests that disclosing the existence of a government investigation could make it more difficult for companies to defend themselves against subsequent claims of violations of the securities laws.

Accordingly, as demonstrated by these recent cases, disclosing an SEC investigation may allow companies to better prepare and control the response to the disclosure, but companies should also consider how the disclosure may affect potential securities actions against them. In deciding whether to disclose SEC or other agencies’ investigations, companies must consider their own specific circumstances while remaining attentive to potential consequences implicated by the decision.

Because companies often do not know how an SEC investigation will unfold, or how it may be used against individuals and other entities, questions about whether to disclose the existence of the investigation are common. It is easy for companies and individuals to feel overwhelmed when confronted with an investigation by the SEC and the breadth of what they do not know.[5] When facing SEC inquires and enforcement actions, reach out to a qualified and experienced securities attorney.

[1]See SEC Announces Enforcement Results for FY 2021, here.

[2] See Politico, Breaking down the Biden budget, here.

[3]See Bloomberg Law, SEC Would See Enforcement Funding Boost in Biden’s Budget Plan, here.

[4] See Id.

[5] See Paul Vorndran and Blaine Bengtson, When Unregistered Companies are Drawn into SEC Investigations, here.

Paul Vorndran is a securities litigation and enforcement defense attorney with Jones & Keller in Denver. Paul defends individuals and entities in investigations and enforcement actions brought by the SEC, FINRA and state securities commissioners. He can be reached at pvorndran@joneskeller.com.

Javier Heres is an associate securities litigation and defense attorney, representing entities and individuals in securities-related disputes under state and federal securities laws. He can be reached at jheres@joneskeller.com.

This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.