Remediation: The SEC Smiles on Proactivity

The SEC regularly emphasizes the potential benefits companies can obtain through "cooperation" and "remediation." But understanding precisely what will garner meaningful cooperation credit for companies­ – outside the longstanding Seaboard factors and occasional hints in statements, press releases and administrative proceedings orders – can prove challenging. This can make the decision for companies about when, whether and how to cooperate a tough one, especially against the backdrop of admissions being back on the table. On Jan. 28, 2022, the SEC announced a settled action where, in its press release, it focused expressly on what remedial decisions and actions taken by a company caused the agency to abstain from imposing a (likely hefty) civil penalty in a scienter fraud action.

Background on Seaboard and the SEC's Guidance on Cooperation

Before turning to the action, a quick review: the Seaboard factors – self-policing, self-reporting, remediation and cooperation – are the traditional four pillars under which the agency deliberates a company's actions to consider "whether and how to take enforcement action." Post-Seaboard analysis, the SEC can then choose to "credit" a company for its cooperative efforts in a variety of ways: from simply reducing sanctions to lesser charges to ultimately not pursuing any enforcement action at all.¹

But what, exactly, this means for companies seemingly varies on a case-by-case basis. If anything, there tends to be more statements on what doesn't constitute cooperation from commissioners or the enforcement staff. For example, Commissioner Caroline Crenshaw recently made clear that cooperation credit will not be afforded to companies that "merely respond" to Enforcement Division requests or to those that offer to conduct "not-so-independent investigation[s] led by corporate counsel."

The SEC has not been vague on its view that rigid metrics on cooperation credit don't exist; in the Seaboard report, the agency specifically noted that "[i]n the end, no set of criteria can, or should, be strictly applied in every situation to which they may be applicable." But this type of opaque guidance can leave companies paralyzed as they deal with fast-moving questions about cooperation and remediation. Worse, the SEC's settled cease-and-desist orders typically only include a simple statement outlining that a company cooperated and/or remediated, noting "[i]n determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff." There's no question that facts-and-circumstances of individual cases must control, but there is a wide gap between "see the Seaboard factors" and a rigid framework. As a result, the black box on cooperation credit has proved to be a cruel mistress for companies attempting to meaningfully cooperate and remediate to satisfy the agency's wishes.

Following the Bread Crumbs

Although the amorphous general guidance can prove to be challenging for entities as they discover possible wrongdoing and consider an approach to cooperation and remediation, the SEC has provided some clues for companies and counsel to consider. In recent years, the agency's settled orders have included – in limited circumstances – more details about what, exactly, entities did to earn cooperation credit. For example, since 2018, settled orders against Pyxus International Inc., Provectus Biopharmaceuticals Inc., the Options Clearing Corporation, GWFS Equities, Tandy Leather and ProPetro Holding Corp. provide a peek behind the curtain at what the entities actually did to "earn" cooperation.

A review of these orders reveals common themes companies and counsel can turn to for guidance. For example, in order to cooperate with the staff's investigations, the agency has noted:

• each of the entities retained independent counsel who, with the aid of subject matter experts, conducted an independent internal investigation
• the entities voluntarily shared the results of the internal investigations to save the Enforcement staff time and resources
• as appropriate, shared with the staff relevant documents and voluntarily provided targeted analyses to the staff

Remediation is a more fact specific analysis, but a review of settled orders similarly reveals common patterns:

• After discovering the misconduct, the companies either convened a special committee of independent directors or, as appropriate, elevated issues to the audit committee.
• Entities identified individuals responsible for – or otherwise complicit in – the wrongdoing and terminated their employment.
• Similarly, the companies removed personnel from executive positions who, although not responsible for or otherwise complicit in the wrongdoing, failed to carry out their responsibilities to prevent such wrongdoing or were otherwise unqualified for their executive positions.
• Conversely, as needed, the companies hired new, qualified personnel, retained subject-matter experts to correct prior deficiencies and/or elected new board members with appropriate subject-matter expertise.
• The companies implemented new internal control and compliance policies and procedures and started new training programs on the deficient areas at issue.
• If necessary, the companies instituted legal action against wrongdoers to seek monetary recovery.

Another Bread Crumb

The SEC's recent settled action against tech company, HeadSpin Inc., provides a few additional details that companies and counsel should know. Before getting to the finer points of the SEC's action against HeadSpin, there is one immediate difference that's worth noting: unlike the actions detailed above, the SEC filed its case against HeadSpin in district court. In contrast to settled orders in cease-and-desist proceedings, the agency typically does not include any specifics of defendant cooperation in the district court complaint.² However, in this action, the complaint includes some similarities to the remedial efforts language that has been seen sporadically in cease-and-desist proceedings like those mentioned above.

As for the factual allegations, HeadSpin sold app developers hardware and software tools to test their applications across a variety of mobile devices and networks. (See Sec. & Exch. Comm'n v. HeadSpin, Inc., No. 5:22-cv-00576 (N.D. Cal. Jan. 28, 2022)). According the SEC's complaint, HeadSpin would either enter into agreements with its customers directly or through third-party resellers. See Id. ¶¶ 17–18. As is common in software companies that continually gain revenue from their subscription base, HeadSpin's valuation depended largely on its annual recurring revenue (ARR), a yearly measure of the total revenue expected from customers still in contract with, and still paying fees to, HeadSpin. See Id. ¶ 20. From at least 2018 through 2020, the SEC alleged that the company's CEO drastically and artificially inflated HeadSpin's ARR, resulting in an overvaluation of about $800 million. See Id. ¶¶ 1, 5.

The most illuminating aspects of the complaint involve paragraphs 36–39. There, the commission included details of HeadSpin's response to the issues and subsequent remedial measures. Consistent with the themes detailed above, HeadSpin personnel elevated the issue to the board, the company conducted an internal investigation, subsequently removed the alleged wrongdoer, hired new senior management, expanded its board and adopted new processes and procedures designed to ensure transparency and accuracy of deal reporting and associated revenues. See Id. ¶ 36-39. In line with the bullet points above, HeadSpin not only took steps to correct the mistakes of its former CEO but also took prophylactic measures to minimize the chance that such mistakes could happen again.

Although these facts provide the latest affirmation of the loose cooperation/remediation checklist, some of HeadSpin's measures provide additional insight on factors the agency may consider when it comes to cooperation. First, HeadSpin reviewed the board's findings, determined the correct ARR and revised its grossly inflated valuation from $1.1 billion to about $300 million. See Id. ¶¶ 36, 38. Second, HeadSpin independently provided restitution to investors. At the time of the complaint, HeadSpin had already returned about 70 percent of principal to investors through a "recapitalization process" and "offered to return the remaining funds in the form of promissory notes with one percent interest." See Id. ¶ 38.

Key Takeaways

As noted above, this is not the first time the agency has forgone civil penalties based on an entity's actions in line with Seaboard. That said, this feels different. For one, the agency still filed fraud charges against the company itself and did not impose a civil penalty at all, a combination missing from the cease-and-desist settlements mentioned above. Second, this settlement comes at a time when the commission has been seeking stiffer penalties against entities, even those that cooperate and remediate as set forth in commission orders.

With recent U.S. Department of Justice (DOJ) policy changes articulated in the Monaco memo – policies which SEC Chair Gary Gensler has stated are "broadly consistent" with his own view of how to deal with corporate offenders – companies are searching for bread crumbs in settled resolutions to see what exactly an entity needs to do to get tangible cooperation benefits. If HeadSpin provides any indication of the Enforcement Division's interpretation of the chairman's remarks, companies following the bullets points above and implementing creative remedial measures – such as repaying victim investors – can still obtain significant cooperation benefits with the Gensler-led commission. Depending on the circumstances, a combination of identifying wrongdoers, self-policing misconduct, conducting an effective and impartial internal investigation, removing ineffective management, taking actions to remedy harm to investors and remediating deficient policies may be a satisfactory way to earn cooperation credit.

As the SEC continues to provide more details on cooperation and remediation, SECond Opinions will provide updates on noteworthy developments. If you need any additional information on this topic – or anything SEC- or internal investigations-related – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.

Notes

¹ For reference, please read the SEC's separate statement for cooperation by individuals.

² This is even the case when a defendant has executed a signed consent at the time of filing for the enforcement staff to move the district court to enter an agreed judgment. Unlike the settled order, the district court final judgment will not include details of a defendant's cooperation or remediation.