Inside an information-gathering phone call with the SEC.
Distributed software and blockchain projects often tangentially worry about the SEC. The Enforcement Division of the SEC is charged with enforcing federal securities law and taking regulatory action against those entities breaking the law.
So far, there is not much precedent to indicate how the SEC will regulate blockchain tokens and distributed software. However, this dearth of regulatory guidance should not be taken lightly. SEC scrutiny could easily stop a project in its tracks with hefty fines, injunctions, civil and criminal lawsuits, and irreparable reputational damage.
So, what happens when you get a call from the SEC? Is it the end? What should you do?
The SEC’s Mission
The Enforcement Division is charged with protecting investors and ensuring that markets operate in a fair, honest, and forthrightly way. If your project is public-facing, honesty, integrity and fairness should be fundamental considerations that are embedded at all levels of your organization and part of your culture.
Considerations the SEC Contemplates
The SEC takes several considerations into account before proceeding with an enforcement action. One of the chief considerations is the capacity for or the existence of investor harm.
The SEC’s mandate, however, is much broader. They allocate resources to enforcement actions based on, among other things, whether the alleged wrongdoing is a National Priority Matter, whether the matter presents the opportunity to send a particularly strong and effective message of deterrence, whether the matter involves particularly egregious or extensive misconduct/widespread and extensive harm to investors, and whether the matter involves potential wrongdoing as prohibited under newly-enacted legislation or regulatory rules.
The Process—MUIs and Investigations
Just like any other investigative agency, the SEC pursues leads based on a variety of sources that include referrals from SROs, State Securities Offices, Congress, the PCAOB, press reports, as well as complaints and tips from the public. If the Division of Enforcement believes that the leads obtained are promising, they have the option to open a Matter Under Inquiry (“MUI”).
A MUI is opened to evaluate whether any information gathered and/or facts known to the SEC demonstrate the need to address conduct that violates federal securities laws. Generally, a staff attorney and an Assistant Director of the Enforcement Division decide when to open a MUI and assess whether a sufficiently credible source or set of facts suggest that a MUI could lead to an enforcement action that would address a violation of federal securities law. Importantly, the presence or absence of US investors is not, in and of itself, a dispositive factor as to whether the SEC will open a MUI.
While a MUI can be opened based on very limited information, an “Investigation” is usually only opened after the Division of Enforcement has determined that an Investigation has the potential to address violative conduct of securities laws.
The threshold issues as to whether an investigation should be opened are:
- Do the facts suggest a possible violation of the federal securities laws involving fraud or other serious misconduct?
- If yes, is an investment of resources by the SEC merited by:
- the magnitude or nature of the violation,
- the size of the victim group,
- the amount of potential or actual losses to investors,
- for potential insider trading, the amount of profits or losses avoided, or
- for potential financial reporting violations?
So, what should you do if the SEC Calls?
1. Develop a “Playbook”.
Developing a “playbook” in anticipation of an SEC request is an excellent way to ensure that your company has anticipated the steps it will need to take in response to an SEC inquiry. You should identify all those who may need to be notified when an SEC investigation commenced (e.g., the board, auditors, insurance carrier), provide information concerning the company’s systems and documentation policies, include a template for document preservation notices, and identify issues to consider in conducting an internal review of the facts and circumstances that are the subject of the SEC’s request. Even an informal playbook can save a company critical days in responding to an SEC investigation.
You are going to want to retain counsel before responding to an SEC inquiry. Even if the SEC is conducting a simple information gathering exercise, having an attorney on hand can be an invaluable resource.
3. DO NOT LIE.
The attorneys in the Enforcement Division are officers of government, so while you may be under no obligation to speak to them (and this will be a determination you should make with your attorney) or do so under oath, you should not lie or obfuscate the truth. Lying is only going to get you into more trouble and certainly does not get you off on the right foot should your conduct skirt the line of federal securities laws. Further, if you and your attorney decide to speak with the SEC, be aware that they can share what you say with other agencies of government. So, proceed carefully.
4. Be Prepared to Answer Specific Questions.
The SEC likely has a good reason they want to speak with you and you should prepare for the call by anticipating the questions that they are going to ask you. Specifically, you are going to want to be ready to explain:
• your business model;
• all service and product lines of your business and how the former interacts with the public;
• your customers and their relationship to your products and/or service lines; and
• any potential conflicts of interests and how you disclose those potential conflicts of interest.
5. Maintain Attorney-Client Privilege.
Even if your company is under investigation it still needs to conduct its business. Management and your board are likely going to develop strategies surrounding the SEC response and they must understand how to preserve the attorney client privilege around those SEC communications. One should appreciate that any discussions concerning the investigation, or the historical facts giving rise to the investigation, that occur OUTSIDE the presence of an attorney may be discoverable and will likely be the topic of SEC testimony later. Stay vigilant and stand on your rights.
Remember, the SEC is there to protect investors. If they contact you, it may not be the end of the world and may just be a simple information gathering exercise rather than a full-blown investigation. Getting prepped for potential SEC scrutiny and hiring an attorney early on in your business is an effective way to anticipate and avoid any potential issues should you get contacted.