internal investigations

At a recent panel organized by San Francisco’s Federal Bar Association, the San Francisco Regional Director of the Securities and Exchange Commission (SEC), Jina Choi, confirmed that the agency continues to focus on investor fraud in the pre-IPO private market space. Highlighting enforcement actions against the non-public Zenefits, Credit Karma, and Theranos[1], Ms. Choi reiterated the SEC’s commitment to aggressive oversight over “unicorns,” or privately-held companies valued over $1 billion. The SEC first announced its intent to step up enforcement in this space in a March 2016 speech by previous SEC Chairwoman Mary Jo White, and Ms. Choi reported that the current SEC leadership, led by current Chairman Jay Clayton, is equally committed to policing this “beat.”

The Compliance Gap has been closely tracking SEC compliance enforcement at privately-held companies, which began in earnest last fall when the SEC announced that the non-public human resources company Zenefits and its founder, Parker Conrad had agreed to pay a combined $980,000 to settle claims that the company intentionally misled the company’s Series B and C investors. The SEC alleged Conrad and the company had misled investors about the degree to which Zenefits complied with state licensing laws, resulting in a lowered valuation when the compliance failures were revealed.

In March of this year the SEC reported a first-of-its-kind settlement with Credit Karma, in which the company agreed to pay $160,000 to settle claims that it failed to provide its employees with the disclosures required by Rule 701(e) of the Securities Act.  Rule 701 requires that a company compensating its employees with stock options provide detailed financial and risk disclosures before the date of sale. The SEC alleged that Credit Karma sold approximately $13.8 million in stock options to its employees without providing the information required by Rule 701.

Just two days after announcing the Credit Karma settlement, the SEC also filed a complaint against health care company Theranos, company founder Elizabeth Holmes, and former President and Chief Operating Officer Ramesh “Sunny” Balwani. In the complaints the SEC alleged that the company, Ms. Holmes, and Mr. Balwani made false claims about the capabilities of the company’s proprietary blood-test analyzers, regulatory approval of the proprietary blood-test analyzers, and the company’s business relationships with the U.S. Department of Defense.  Theranos and Ms. Holmes agreed to settle the claims made by the SEC, but Mr. Balwani has chosen to litigate what will surely be a closely watched case.

Ms. Choi also highlighted the SEC’s new approach to devising inventive ways to punish investor fraud in the private space. For example, Ms. Choi noted that the agency required both company and individual settlement payments in the Zenefits and Theranos resolutions (Ms. Holmes agreed to pay $500,000 and Mr. Conrad agreed to pay nearly that amount).  Ms. Holmes was also required to forfeit her ownership interest in Theranos, and was permanently banned from serving as an officer or director of any publicly-traded company.  Ms. Choi indicated that these remedies were arrived at through significant consultations with allegedly defrauded investors.  This approach indicates a shift towards creative remediation schemes that reflect the wishes of alleged victims, and the perceived need for individual punishments in the privately-held company space where founders can be interchangeable with the companies they build.

[1] Farella, Braun + Martel, LLP represents an individual in connection with the Theranos investigation. This report contains only publicly available information.

Demonstrating and ensuring independence in internal investigations is a critical issue for corporate counsel to consider, especially when facing or anticipating parallel regulatory probes. How to properly do so is a nuanced process. As this piece published by Corporate Compliance Insights explores, it is not as simple as the binary question of whether counsel conducting an internal investigation had a previous working relationship with the company.

Read the full article I co-authored with senior associate Nell Clement and associate Josh Malone: Rethinking Independence in Internal Investigations

person using touch screenIt doesn’t take a millennial to know that these days not all pertinent business-related communications are to be found on corporate e-mail servers. As we have increasingly seen in recent internal investigations, the most important written communications (especially between high-level executives), are now to be found in a place that most lawyers at the senior level have for years either ignored altogether or for some reason considered untouchable – cell phone text messages. The New York Times recently reported on the implications of this trend—which is hardly new— of executives at all levels taking sensitive communications off e-mail. See As Elites Switch to Texting, Watchdogs Fear Loss of Transparency.

The same potential loss of key communications from “the record” are present in internal corporate investigations where texts are left out of the investigation plan. If text messages and other forms of messaging are not fully considered, an internal investigation result may be at best incomplete or at worst incorrect. The worst mistake is when investigators assume that if communications are not found in corporate e-mail that they did not occur, and draw inferences based on that assumption. But text messages can be difficult to collect from individuals, and, due to a patchwork of inconsistent corporate policies regarding their preservation and use, may present privacy considerations on behalf of the individuals who are texting. Those difficulties begin to make it more understandable why most internal investigators would prefer to ignore their existence altogether and simply rely on easily attainable, and searchable, corporate e-mail. Continue Reading Use of Text Messaging Should Change the Nature of Evidence Gathering in Internal Investigations

people in meeting

In the present uncertain legal and regulatory environment, the role of shareholder activists in scrutinizing corporate behavior seems to be gaining steam. See, e.g., An Activist Investment in Whole Foods Exposes Shifting Power on Wall St. We are increasingly seeing corporate internal investigations being influenced, if not driven by, the presence of activists on the Board. It remains to be seen whether the role of activists in policing corporate governance and other corporate regulatory issues will continue to increase in an environment where SEC Enforcement is increasingly under pressure (budgetary and otherwise) from the current presidential administration.