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My previous column discussed the costs and benefits to public companies when it comes to cooperating with investigations conducted by the Securities and Exchange Commission. To quickly review, the SEC has significantly increased the sanctions it imposes on companies for “failure to cooperate.” And although the SEC has stated that it rewards cooperation, many more examples can be found of the stick rather than the carrot when it comes to corporate dealings with the SEC. In short, public companies have little choice but to cooperate. Now it’s time to take a look at the issue of cooperation by individuals who are targeted by the SEC. The SEC has publicly stated that one focus of its enforcement efforts are “gatekeepers” — and, in particular, lawyers. So what do you do when the SEC comes calling — and they’re asking about you? While the SEC has publicly identified the factors that it evaluates when deciding whether a company has cooperated, and what benefits such cooperation may bring, it has not done anything similar when it comes to individuals. The SEC has not publicly announced a decision not to prosecute, or to seek less Draconian sanctions against, an individual who has cooperated. Indeed, experienced SEC enforcement defense lawyers know that the agency does not provide credit for cooperation by individuals (unlike federal criminal prosecutors). Instead, the SEC’s policy is to bring an enforcement action against any individual who violates the securities laws. Accordingly, the following points are critical if you find yourself the target of an SEC investigation. First, you must understand that counsel for the company (whether in-house or outside) does not represent you as an individual. Furthermore, the desire to curry favor with the SEC will normally cause companies to waive the attorney-client privilege. Thus, if you are an in-house counsel, your employer will likely produce all of your work product and privileged communications to the SEC — regardless of your views on the subject. It is the company’s privilege to waive. Second, it is essential not to delete, change, alter or amend corporate records, particularly those of an electronic nature. This includes business records that you might have stored on your personal or home computer. Any such deletion, accidental or otherwise, will likely result in serious consequences. Third, defend yourself! The SEC does bring marginal cases against individuals, cases they cannot win in court. I recently defended a former CEO of a software company in a federal action in which the SEC alleged fraud and sought a lifetime officer and director bar, permanent injunction and significant civil monetary penalties. We tried the case and defeated the SEC. SEC v. Gane, 2005 WL 90154 (S.D. Fla. 2005). When the SEC files a federal court action, its posture is no different than any other civil plaintiff. It has the burden of proof, and proving fraud and materiality is often not easy. This is especially true if the individual had no financial gain due to the conduct under investigation, which evidences lack of motive. And courts focus on motive in drawing inferences, a point that proved pertinent in the Gane case. An independent federal judge can often be convinced that no fraud occurred. Fourth, a key defense is expertise insofar as it relates to the issue of scienter. (This is different than the failed “I know nothing” defense attempted in Bernie Ebbers’ WorldCom case.) Did the individual have the background or experience to appreciate the accounting impact of a particular transaction? A salesperson may well not understand that a contract amendment — a common event — may have revenue recognition implications. Likewise, in-house counsel may not appreciate the accounting impact of key contract terms. As to disclosure, if outside counsel knew of the transaction and never raised the issue of disclosure, this undercuts a scienter claim. Very good case law exists on all of these points. And these are not affirmative defenses but rather evidence that makes the SEC’s burden of proof on scienter more difficult. A company is liable for securities fraud if any employee has committed fraud. But if the SEC is coming after you specifically, someone else at the company may be liable for fraud while you yourself may not be responsible for it. As a result, defending yourself in federal court is a much more rational option as an individual rather than as a corporate defendant. Fifth, defending yourself in the right case is particularly important because the SEC has significantly increased its settlement demands for individuals. The SEC routinely seeks settlements that include a lifetime officer and director bar as well as a permanent injunction and significant monetary penalties. Yet it is often doubtful whether a federal judge would impose such drastic remedies. Also, the SEC is institutionally inflexible in its settlement posture. In the Gane case, the SEC never changed its settlement posture even after the court granted partial summary judgment and dismissed many bases for the SEC’s securities fraud claim. Its demands on the eve of trial were the same as on the day it filed the complaint. For these reasons, more individuals are litigating with the SEC. All of this, of course, presupposes that the individual has insurance or indemnification. Or both. Defense costs are prohibitively expensive, and it is the rare individual who can afford to defend himself. Indeed, this explains why the SEC, in its settlement demands with companies, now requires companies not to exercise their right to indemnify individuals. Although it does not like it, the SEC recognizes the fact that companies are obligated to indemnify certain individuals. But where indemnification is permissive, the SEC now is demanding in settlements that the company agree not to extend indemnification beyond what it is obligated to do. This effectively makes it impossible for an individual to defend himself. And many insurers will seek rescission. Thus, it is essential that appropriate D&O insurance and indemnification be in place — a topic I will address in my next column. In sum, individuals, including senior executives and in-house counsel, must seriously consider the option of litigating with the SEC if and when they find themselves the target of SEC investigations. This decision must be addressed (though not necessarily decided) at the outset, often before the facts and issues are clear, because this posture will affect the individual’s conduct during the course of the investigation. The only reason to cooperate in the investigation is that you believe the facts demonstrate that you did not commit a violation — and you are willing to fight to prove it. David B. Bayless, a partner in the San Francisco office of Morrison & Foerster, specializes in SEC enforcement work. He formerly headed the SEC’s San Francisco office.

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