Analysis

SEC Enforcement Expected To Surge On COVID Volatility

By Al Barbarino
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Law360 (April 9, 2020, 8:44 PM EDT) -- Following the erratic stock market swings fueled by the COVID-19 crisis, attorneys expect a surge in U.S. Securities and Exchange Commission investigations tackling a broad range of potential violations, from outright fraud to disclosure issues.

The SEC will put investment firms, broker-dealers and public companies under the microscope, closely examining the activities of corporate insiders, fund investment guidelines and risk disclosures — in some cases likely revealing problems that predate the pandemic by months or years, attorneys said.

"One thing I think you can be sure of is that SEC enforcement activity is going to increase, and both class action and derivative action shareholder litigation is going to increase," said Steven Scholes, a partner at McDermott Will & Emery LLP and a former attorney in the SEC's Division of Enforcement. "It's likely that many issues that were not evident when the bull market was humming along will be exposed."

The blatant offenders, such as those perpetrating schemes that are directly related to COVID-19, are likely to generate the greatest increase in investigations from the SEC and other regulatory agencies, attorneys said.

"That's the lowest hanging fruit and probably where the SEC is most focused on right now, and those are the first cases you'll see coming down the pike," said Kyle DeYoung, a Cadwalader Wickersham & Taft LLP partner and former senior counsel in the SEC's enforcement division.

"These are likely penny stocks or companies you've never heard of, issuing false statements about miracle cures or securing lucrative contracts to provide medical equipment," he said.

In some cases, the SEC is taking preliminary steps to halt potential issues before launching full-fledged investigations, just this week suspending the trading of three additional stocks making COVID-19-related claims.

"While the SEC has nipped some of these in the bud through its delisting authority, there's no doubt its enforcement division is investigating companies making these kinds of claims," DeYoung said.

The SEC and other regulators including the Financial Industry Regulatory Authority have also issued a number of warnings to investors in recent weeks regarding scams and abuses, including insider trading, so called pump-and-dumps and Ponzi schemes.

The SEC declined to comment for this article, but a spokesperson pointed to a recent statement from enforcement division co-directors Stephanie Avakian and Steven Peikin noting that material nonpublic information amid the pandemic "may hold an even greater value than under normal circumstances."

"This may particularly be the case if earnings reports or required SEC disclosure filings are delayed due to COVID-19," they said. "Given these unique circumstances, a greater number of people may have access to material nonpublic information than in less challenging times."

DeYoung noted that while company officers and directors are often aware of their obligations concerning material nonpublic information, others who are not may quickly find themselves at the center of insider trading inquiries.

"This larger group of people might not be as familiar with their obligations with respect to insider trading — or as familiar with what the government's capabilities are for identifying and investigating suspicious trading," he said.

Investigations also will likely focus on broker-dealers' investment fund guidelines and whether they have made proper risk disclosures, recommendations or potentially false statements.

Disputes between investors and their brokers could spur litigation from private plaintiffs as well as regulatory investigations, particularly from FINRA, if companies or advisers falsely claim certain stocks or investments are immune to the pandemic or fail to disclose the impacts of the crisis on their funds.

A Reed Smith alert recently warned FINRA member firms that severe market declines such as those seen in recent weeks can expose previously undetected misconduct within firms, urging them to take customer complaints seriously.

"It's a tough time as everyone is remote and we're working with limited resources. But it's really important that firms keep their antennae up," said Kiran Somashekara, a Reed Smith LLP partner who co-authored the report, noting that "strong markets hide a lot of problems."

"A significant number of similar customer complaints against different firms can spur regulators to dig further into the issues underlying the complaints and, in certain circumstances, commence investigations," added Somashekara, who advises clients on SEC, FINRA and other regulatory agency investigations and enforcement actions.

Somashekara anticipates potential upticks in customer complaints alleging portfolio concentration issues, pointing specifically to the energy and commercial real estate sectors as among those that could come under scrutiny as oil prices swing wildly and tenants struggle to pay rent.

"If some of those funds go bankrupt or start losing a lot of money, the SEC will likely look into some of the disclosures made both by the funds and issuers and what may have been misrepresented," he said. "How did they represent the yields or dividends they might pay?"

He added that at least one client has been approached by the SEC about its business continuity plan, and he expects an uptick in these inquiries, potentially as "part of a sweep in which the SEC — or possibly FINRA — examines BCP-related documents of several firms or an individual exam."

In a likely attempt to stave off a surge in disputes involving public companies as they gear up to release earnings reports, SEC Chairman Jay Clayton and William Hinman, director of the agency's Division of Corporation Finance, stressed the importance of "high quality" disclosures and forward-looking statements amid COVID-19 in a joint statement Wednesday.

"This quarter, earnings statements and calls will not be routine," they said. "We request that companies provide as much information as is practicable regarding their current status and plans for addressing the effects of COVID-19."

The SEC noted it would not second-guess companies' good-faith efforts while urging them to "avail themselves" of the safe harbors afforded under securities law.

That said, DeYoung of Cadwalader noted that providing more forward-looking information than is customary could create some issues for companies if they fail to adequately disclose how the crisis is impacting them or may impact them in the future.

"This could lead to claims of failure to comply with disclosure requirements or even fraud," he said.

Meanwhile, the regulators take on the unprecedented task of conducting business while working remotely and in some cases with reduced staffing, much like the firms they oversee, which could lead to some delays.

"I don't have any doubt that there will be a significant delay, but my experience over the last few weeks is that the SEC is going to do everything it can to reduce that delay, including conducting meetings and testimonies remotely," said Scholes of McDermott, noting that the length of the delay will be largely dependent on the duration of the crisis. 

Offering words of advice, Scholes said that "some of the best insurance a firm can buy is full and fair disclosure," stressing that now is not the time to let up on regulatory compliance.

"It's far better to identify and remediate issues yourself than to have a regulator do it for you," he said.

--Editing by Philip Shea and Jill Coffey.

For a reprint of this article, please contact reprints@law360.com.

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