Skip to Content?

When Unregistered Companies are Drawn into SEC Investigations

September 23, 2021
Painting SEC enforcement with the same brush

What must – and should — a non-registered company do when the SEC comes calling?

By Paul Vorndran and Blaine Bengtson

It is well known that the U.S. Securities and Exchange Commission is the nation’s primary regulator of activities related to securities. The SEC has the authority to investigate registered entities and financial professionals affiliated with those entities. What’s surprising to some, however, is just how broad that investigative authority extends—to all companies and individuals involved in the securities industry, regardless of registration status.

Indeed, the SEC has the authority to investigate any companies that raise, or seek to raise, capital from U.S. investors. This includes both registered and unregistered public and private companies, broker-dealers, municipal advisors, investment advisers, investment companies, bankers, funds and pools.

So, while an SEC inquiry may start with a regulated entity, through a cross-pollination pool of activities, the inquiry can grow to encompass multiple layers of affiliated activities and entities. Any one entity or individual can be investigated for the actions of an affiliated SEC target by virtue of disclosures, folding both registered and unregistered firms and market participants into an investigation or examination.

Where registration status matters most is in the nature of responding to an SEC inquiry. A registered company must respond to SEC notifications. Non-registered companies are not under the same obligation. This raises the important questions of when an unregistered company should volunteer information, and how much? If an unregistered business or individual finds itself pulled into an SEC investigation or examination, there is typically a process that ensues and best practices to be followed.

Triggering an SEC look

Typically, the SEC uses an informal ask to fold both regulated and unregulated companies into an examination. It’s an “ask”, if not answered correctly, that can quickly snowball into an arduous multiyear process, where the SEC seeks records, testimony, and other information about the target company and its business dealings.

The ask can be particularly onerous on unregistered companies that may have fewer resources or employees to devote to responding to SEC investigative requests. In addition to the strain investigations pose on both regulated and unregulated entities and individuals, the process carries with it the potential of administrative or federal court enforcement action.

Non-registered companies get drawn into SEC investigations as a result of affiliated activities. For example, a newly registered investment advisory firm, Wealth Management Firm (WM Firm), might receive an informal request for information from the SEC. As a registered entity, the WM Firm must respond and disclose that it has placed a significant number of its clients with an investment company, Capital Fund, an unregulated issuer of securities, which raises additional questions with regulators. The SEC broadens its inquiry to the unregulated Capital Fund requesting various documents and information about their relationship and client base with WM Firm.

Although voluntary, Capital Fund responds, disclosing a separate advisory relationship with a state licensed investment advisor, State Adviser, which is then also grouped into the SEC investigation via voluntary requests about their activities. Even though State Adviser does not have main street investors, it does have a fund manager issuing ownership interest in a hedge fund through securities.

In this example, an inquiry into a single, newly registered entity, WM Firm, disclosed questionable activities well down the supply chain at a state licensed entity, State Adviser. In this case, the questionable activities are likely to lead to a lengthy, tedious and costly process that may include informal requests, subpoenas and potentially formal enforcement action.

Informal inquiries

Should the SEC want a closer look into the affiliated activities of unregulated companies and individuals, it starts with the informal ask or by opening a formal investigation, empowering the agency to subpoena the unregulated company for documents and testimony.

Any information an unregulated entity or participant forwards to the SEC in response to an informal inquiry is voluntary. This might include SEC requests to gather, among other things, the target’s financial records, internal communications, offering documents, and on the record voluntary interviews. Any communication with the SEC from the moment a target is notified through resolution of the inquiry or enforcement should be handled in cooperation with in-house counsel or an experienced securities defense attorney.

If the SEC finds likely evidence of a securities law violation and decides to move ahead with a formal investigation, the Division of Enforcement will obtain an Order of Investigation, allowing the Division to demand documents, issue subpoenas, administer oaths, and compel sworn, recorded witness testimony.

When it comes to formal actions, the SEC holds the cards on whether to terminate without further action or recommend proceeding with formal enforcement procedures. Prospective defendants typically receive a phone call first, followed by a letter, informing them of the SEC’s intention to bring an enforcement action. This letter typically is referred to as a “Wells Notice”.

Once notified, targets generally have one month to provide staff with a response to accusations, known as a “Wells response”. What this response says and what it does not say can satisfy an inquiry or prompt further investigation and must be handled delicately.

Best practices

Targeted companies must be strategic about how they respond to inquiries and actions. SEC requests can wear down a target, causing delays, reputational risk and negatively impacting staff morale, even in instances where the SEC fails to find evidence in support of a formal investigation. Wrong steps can easily sway the perception of the company among shareholders, employees, the public and regulators.

Stakeholders can follow some best practices to reduce risk and control the narrative while cooperating fully with an investigation. Communications with the SEC and state regulators should be handled by securities attorneys, either in-house or outside legal counsel.

  • Avoid public disclosures about being under investigation, which the SEC could use against the company should it bring legal action. Regulators monitor media reports, print and online, so keep proceedings to yourself.
  • Maintain a policy and procedures for managing regulatory inquiries, one that identifies a single individual to gatekeep all inquiries and establishes a strategy for cooperation and compliance.
  • When you receive an inquiry, consider whether your firm can reasonably submit the information requested promptly and cooperatively. Both registered and unregistered companies are best served by operating “audit-ready” document management systems that allow the organization to be responsive to requests from regulators.
  • Should the inquiry lead to more formal proceedings, cooperate and comply. This might include working with your securities counsel to execute a tolling agreement with the SEC to avoid a hasty public enforcement action filed to beat a statute of limitations deadline.
  • Compliance with an SEC subpoena is mandatory and the SEC can compel compliance. Individuals who receive a subpoena should take reasonable steps to preserve documentation and avoid spoliation or obstruction of justice charges.
  • When SEC Division of Examination inquiries are elevated to an official investigation, the Enforcement Division staff takes over and may bring enforcement action itself or refer cases for criminal prosecution to the Department of Justice. As a result, the same information is often requested multiple times from various regulatory bodies so, once asked, keep a library of copies at the ready.

Companies often do not know how SEC action will unfold and be used against individuals and entities, and questions of whether or not to disclose non-public formal investigations to shareholders and investors 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. When facing SEC inquiries and enforcement actions, reach out to a qualified and experienced securities attorney.

Paul Vorndran, Esq., 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.

Blaine Bengtson, Esq., 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 bbengtson@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.