Effective Responses to Findings of Deficiency

             Despite the best efforts of broker-dealers and investment advisers to fully comply with all relevant rules, there are times when NASD or SEC examiners find deficiencies during an examination.  This is not surprising, given the increasing complexity of securities regulation and current harsh political climate.  The manner in which a firm responds to a notice of deficiencies is critical.  This article describes the regulatory decisionmaking process and effective responses to such a notice.

The Examination Process and the Importance of Remedial Action

            Both the NASD and SEC send examiners into the field to conduct examinations on either a routine (periodic) or “cause” basis.  These examiners are rarely attorneys, and have varying securities industry experience.  You should always inquire whether the examination is “for cause,” since that would indicate the staff’s belief that wrongdoing has occurred, or that the subject matter may be part of a industry-wide “sweep.”  Cause examinations can originate from news articles, complaints from customers or rival firms, regulatory market surveillance, or referrals from other agencies or self-regulatory organizations.

            Examiners have the discretion to advise you of deficiencies at any time. During the examination, you should maintain a good relationship with the regulators, and inquire if they have identified any problems.  Both the NASD and the SEC will formally notify you of any problems at the conclusion of the examination.  The SEC’s practice is to send a “deficiency letter,” while the NASD’s practice is to hold an “exit conference” orally advising you of the deficiencies (or, to use NASD terminology, “apparent violations”), and providing you with a memorandum memorializing its findings.   Both the NASD and the SEC will request that you provide a written response within a specified time period. 

            You should immediately attempt to resolve any identified deficiencies by taking  appropriate “remedial action.”   At this stage, your paramount goal is to convince the examiner that a referral to the enforcement staff is unnecessary.   Taking prompt remedial action tells the examiners that your firm has a “culture of compliance,” and takes their concerns very seriously.   Depending on the complexity and importance of the identified deficiencies, you might consider hiring an outside compliance consultant or outside counsel to ensure that the remedial action is thorough and effective. 

            Your written response to the notice of deficiencies is an important advocacy tool.   It should convey an apologetic tone, and contain assurances that future violations will not occur.  Obviously, the response should be submitted on a timely basis in compliance with the stated deadline. 

Referrals to the Enforcement Staff

            Unfortunately, taking prompt remedial action does not always prevent a referral from the examination staff to the enforcement staff.   Findings of fraudulent conduct are likely to be referred to enforcement.  Further, even seemingly trivial violations can result in a referral if they concern politically charged issues such as anti-money laundering policies and procedures.  The identity of the examining entity also is significant.   SEC examiners are primarily interested in completing their quota of routine examinations, generally do not have a close relationship with the agency’s enforcement staff, and reserve referrals for egregious violations.  In contrast, NASD examiners work closely with their enforcement counterparts, and refer a high percentage of examination deficiencies.

Enforcement Investigations

            Examination referrals often result in an enforcement investigation.  Notice of an investigation usually comes in the form of a request for documents.  Enforcement staff members, who are usually attorneys, conduct their investigations from their offices and usually, but not always, refrain from visiting the firm.  If you are not sure whether the regulators in your office are examiners or enforcers, you should obtain their business cards and titles and seek to determine to whom they report.  Generally, SEC and NASD personnel will identify their office, branch or section. 

            The existence of an investigation is a very serious matter, because it indicates the enforcement staff’s belief that serious violations have occurred.   There is a high likelihood that an enforcement action will ultimately be filed.   Again, you should quickly remedy any remaining unresolved deficiencies, and agree to cease any ongoing conduct that appears to be the focus of the investigation.  This will prevent the regulator from pursuing an emergency enforcement action against you.  You should also retain a defense attorney to develop a friendly relationship with the enforcement staff, frame the issues in a way favorable to the firm, and analyze whether there are any affirmative or equitable defenses.

            After the enforcement staff has obtained additional documents, they will almost certainly seek to interrogate knowledgeable representatives of your firm in a proceeding transcribed by a court reporter.  The NASD calls these proceedings “on-the-record (OTR) interviews,” while the SEC calls them “sworn testimony.”  Your outside counsel will play an important role before testimony by advising witnesses what to expect and how to answer questions effectively.   He or she will also help you review important documents and anticipated topics of questioning.  During testimony, your attorney will seek to clarify ambiguous questions, make appropriate objections,  and ensure that the transcript includes exculpatory or mitigating facts.

            Immediately following the conclusion of the investigation, you and your attorney should have a meeting with the enforcement staff to discuss the relevant facts, potential legal violations, the firm’s defenses, and any planned or completed remedial actions.   Your goal is to persuade the staff that any violations are not egregious, have been corrected, and that it is unnecessary to issue a “Wells notice.”

Wells Notices and Submissions

            If the enforcement staff members cannot be persuaded to abandon their interest, the staff will probably issue a “Wells notice” to you.   A Wells notice (named after a Mr. Wells who participated in an SEC reform panel in the 1960’s) advises you of the NASD or SEC staff’s intention to recommend that an enforcement or disciplinary action be instituted.  Wells notices identify which persons and entities may be charged, the statutes or rules that the staff believes were violated, and the factual basis for the proposed charges.  They invite you to submit a written response stating why an enforcement action would be unjustified or inappropriate.  The Wells submission is your only chance to speak directly to the ultimate decisionmakers – the five SEC Commissioners or James Shorris, the NASD’s Head of Enforcement.  This is important, because the enforcement staff lacks the authority to file an action without approval.

            A thoughtful, well-researched response to a Wells notice (“Wells submission”) can be effective.  Preparing a Wells submission is particularly advisable if there are ambiguous factual or legal issues, or the alleged misconduct could result in draconian sanctions (including large fines or license revocations). Even if the violations are both numerous and obvious, a good Wells submission can point out mitigating circumstances justifying reduced sanctions, or other comparable settled cases in which relatively modest sanctions were imposed.    A good Wells submission corrects harmful alleged facts that may be contradicted by other evidence, articulates important exculpatory facts that the staff may have overlooked, and makes appropriate legal and policy arguments that may weigh against the proposed enforcement action.   In a close case, a Wells submission can persuade the enforcement staff to withdraw the contemplated recommendation, or can persuade the ultimate decisionmakers to reject the staff’s recommendation.   

            There are disadvantages to making Wells submissions.  Paying an attorney to prepare such submissions can cost more than $5,000.   Further, such submissions may be detrimental if you are determined to go to trial.   Since the submissions are not privileged, any statements contained within can be used against you in litigation, and inevitably give the enforcement staff a “sneak preview” of your factual and legal arguments. 

Offers of Settlement

            

            Both the NASD and the SEC are understaffed, and have relatively few litigators.  For this reason, they are highly motivated to settle.   At the Wells notice stage, the NASD will often provide you with an Letter of Acceptance, Waiver and Consent (AWC), containing the terms of settlement that the staff would recommend be accepted.   At the same stage, the SEC staff often broaches the subject of potential settlement.  Usually, the SEC staff requires that you submit a written offer of settlement before they will provide any guidance as to whether it is acceptable.  The enforcement staff will recommend that an offer of settlement be accepted or rejected, but it must be approved buy the ultimate decisionmakers.

            Before deciding to preparing a Wells submission, you should seriously explore making an offer of settlement.  If the staff’s terms are acceptable, though distasteful, it may be worth avoiding further legal fees.  However, if the sanctions appear disproportionate or excessive, you may wish to make a Wells submission before revisiting the possibility of settlement on more favorable terms. 

            You should remember that the enforcement staff may punish you for delaying settlement. Regulators dislike expending scarce resources and want to discourage you from playing “Chicken.”  Therefore, the staff will often insist on harsher terms after an enforcement action has been commenced. 

            There are downsides to settlement, including adverse publicity and the possibility of investor lawsuits.  Such lawsuits can be avoided by including a “findings footnote” in the settlement documents indicating that any factual findings are irrelevant to any other proceedings. 

Going to Trial

            Absent settlement, an unresolved enforcement action will go to trial – the “nuclear option.”  Litigating an enforcement action is very expensive, the chances of winning are statistically low, and you run the risk of increased sanctions.  Further, in the case of the SEC, you may fear getting a fair trial, because the administrative law judge will be an employee of the agency.  For these reasons, it is preferable to avoid going to trial.  If you decide to do so, you should make sure your attorney is experienced in such matters.