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The U.S. Securities and Exchange Commission has recently been monitoring the market for fraud and other misconduct related to the Covid-19 pandemic. To further its market monitoring efforts, the SEC created a 12-person cross-divisional Covid-19 Market Monitoring Group to “prepare for the possible adverse effects” of the pandemic. The SEC group was tasked with, among other things, responding to requests for assistance from other regulators and public sector partners. At the same time, the SEC's own enforcement efforts in this space have steadily increased.
Companies should, therefore, prepare for additional scrutiny from the SEC, as well as from other regulators, in areas prone to Covid-19-related fraud. Companies should also re-evaluate their ability to comply with long-standing regulatory requirements in light of the additional obstacles created by the pandemic.
One of the SEC group's focuses was the inevitable reporting challenges faced by public companies due to the pandemic. The myriad Covid-19 unknowns have complicated companies’ predictions of their future operational and financial condition.
But, in April 2020, the SEC unequivocally encouraged public companies to provide “as much information as is practicable” regarding the potential impact of Covid-19 on the company's future operational and financial condition, as well as information about the company's current status and its Covid-19 response. The agency urged public companies to “provide disclosures that allow investors to evaluate the current and expected impact...through the eyes of management,” and to be proactive in revising and updating disclosures as necessary.
The SEC specifically noted that companies receiving financial assistance through the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) should disclose “the nature, amounts and effects of such assistance.” In addition, the SEC Division of Corporation Finance issued guidance to assist public companies in evaluating the potential effects of the pandemic on their current and future financial and operational status. The guidance provides examples of questions that companies should consider, including the impact of travel restrictions and border closures, supply chain disruptions and remote working environments.
The SEC has acknowledged the difficulty of providing accurate information, as the Covid-19 situation is still evolving, and has recognized companies’ hesitation to provide detailed forward-looking disclosures given the accompanying legal risks if such statements are later deemed to be inaccurate. In April 2020, the chairman and director of corporation finance encouraged companies to provide forward-looking disclosures as requested, while “avail[ing] themselves of the safe-harbors for such statements.” The SEC stated that it does “not expect good faith attempts to provide appropriately framed forward-looking information to be second guessed by the SEC.”
While this statement may provide some comfort, SEC scrutiny is not the only peril companies face if they provide inaccurate information. Shareholders are already initiating class actions against companies that allegedly made misrepresentations related to Covid-19. For example, on May 27, 2020, shareholders filed a class action against Sorrento Therapeutics Inc. after it allegedly made misleading statements that it had discovered an antibody that “demonstrated 100% inhibition” of the virus. The company's share price spiked before precipitously dropping after a report described the company's claims as “sensational,” “nonsense,” and “very hyped.” Wasa Medical Holdings v. Sorrento Therapeutics, No. 3:20-cv-00966-AJB-AGS, Complaint, ECF No. 1 (S.D. Cal. May 25, 2020).
Companies should carefully consider the best way to accurately, and in good faith, disclose how Covid-19 risk factors, such as supply and distribution disruptions, may impact their future operations while minimizing potential shareholder litigation. However, given the SEC's explicit request for companies to provide detailed forward-looking disclosures, the SEC is unlikely to be forgiving if companies omit known, material Covid-19 information from their financial disclosures or during analyst calls.
Companies also should disclose any receipt of financial assistance, including loans funded through the CARES Act, and the potential impact on business operations of satisfying the loan's requirements. For example, CARES Act funding provided to distressed sectors, such as aviation, is subject to limitations on reductions in employments levels, stock buybacks, dividends and executive compensation. Companies should consider how the applicable requirements may affect their future financial and operational condition and ensure this analysis is factored into any forward-looking disclosures.
The SEC is monitoring other public information that may mislead investors, and has already brought enforcement actions and issued trading suspensions against companies alleged to be disseminating inaccurate, false or misleading information in an attempt to influence share price and trading volume or to otherwise defraud the public. In late May 2020, the director of the SEC's New York regional office noted a “spike in COVID-19 related tips, complaints and referrals, which has already led to an increase in investigations and enforcement actions into companies attempting to profit from the pandemic.”
In May 2020, the SEC brought enforcement actions against two companies alleging that they offered products to combat Covid-19, thereby defrauding the public and artificially inflating their share prices. In one case, the SEC charged a digital marketing company that issued two press releases saying that it would be the exclusive distributor of thermal scanning equipment designed to detect fevers through a “multi-national public-private partnership” with government entities—but that agreement allegedly did not exist. SEC v. Turbo Global Partners, Inc. & Robert W. Singerman, No. 8:20-cv-01120 (M.D. Fla. May 14, 2020). According to the complaint, the company's press releases resulted in a doubling of trade volume and a stock price jump of approximately 15%.
The SEC brought another enforcement action against a biotechnology company that allegedly misled the public by claiming it had started to offer home coronavirus testing kits for private use in several press releases, which resulted in an increase in the company's stock price and trading volume. SEC v. Applied Biosciences Corp., No. 20-cv-03729 (S.D.N.Y. May 13, 2020). The complaint alleges that these tests had not been shipped, were not meant to be used at home, and had not been approved by the U.S. Food and Drug Administration.
In addition to bringing enforcement actions, the SEC has issued trading suspensions related to Covid-19 claims to more than 30 different companies since early February 2020. By contrast, the SEC only issued 13 trading suspensions in the entire first and second quarters of 2019. These trading suspensions have been levied primarily against companies involved in health-care products or services. In one example, the SEC temporarily suspended trading in Custom Protection Services, Inc.’s securities due to questions surrounding statements in its press releases that it had developed frontline screening solutions for Covid-19, the “overwhelming response” it had received for those solutions, and its estimate that it would earn gross revenue of $10,000 per day on new contracts.
The dramatic increase in trading suspensions will likely continue, given the SEC's ability to use them as a tool to quickly respond to potential market manipulation and because trading suspensions are a prime area for cooperation. For example, the Financial Industry Regulatory Authority (FINRA) National Cause and Financial Crimes Detection Programs has already referred Covid-19 matters to the SEC that have resulted in trading suspensions against public companies.
It is also likely that the SEC will be involved in some U.S. Department of Justice investigations that result in criminal actions in this area. Like the SEC, the DOJ has pursued companies engaged in fraud related to the pandemic—although schemes pursued by the DOJ tend to be more egregious. For example, in its first Covid-19-related fraud case, the DOJ filed a complaint alleging that the operators of a website attempted to profit off consumer anxiety by fraudulently claiming it offered access to World Health Organization “vaccine kits”—which did not exist—if consumers paid a $4.95 shipping fee.
The DOJ has also been pursuing criminal cases in the area of investment fraud, including a case against a Southern California man for allegedly soliciting investments in a company he claimed would be used to market pills that would prevent coronavirus infections and an injectable cure for those already suffering from Covid-19. The defendant in that case allegedly made a series of false claims and promises, including guaranteeing that a $300,000 investment in the company would yield $30 million. Attorney General William Barr expressly directed all U.S. Attorneys to prioritize Covid-19-related fraud schemes, and additional criminal prosecutions against companies that commit fraud related to the pandemic are likely.
Companies should carefully review any public statements or disclosures made, particularly if the company is engaged in industries involving health care, vaccines, or personal protective equipment. The SEC will heavily scrutinize any statements that insinuate a company's products or services could stop Covid-19's spread or otherwise help the public weather the pandemic. As with all public statements, companies should ensure that they have justifiable reasons for making any such claims and should document any underlying analysis.
As in pre-pandemic times, the SEC continues to be heavily focused on identifying insider trading. When a company discloses material information that affects share price, regulators inevitably investigate any increase or abnormalities in trading preceding the disclosure.
In March 2020, the co-directors of the SEC's Division of Enforcement emphasized the increased importance of safeguarding nonpublic information and maintaining controls and procedures that keep material nonpublic information confidential during Covid-19. They further cautioned that “corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances.” The SEC, moreover, is reportedly working with the DOJ to investigate a U.S. senator for Covid-19-related insider trading.
The SEC's focus on insider trading during Covid-19 is unsurprising—the disease is uncharted territory, which makes it difficult to predict how it will impact a number of businesses or industries. Therefore, certain corporate insiders may be privy to material information about the pandemic's impact on their company prior to disclosure, such as information about potential supply and distribution chain disruptions, which could greatly affect investor confidence in the company and its future financial performance.
Covid-19 also has forced employees to work from home unexpectedly, and remote working conditions may impact policies and controls previously sufficient to monitor trading and maintain confidentiality of material, nonpublic information. For example, despite companies’ best efforts to safeguard material nonpublic information, ad hoc work-from-home arrangements inevitably increase the risk that other individuals, such as family members or neighbors, may learn material, nonpublic information.
Companies should be mindful that investigations into insider trading do not stop with the individual who allegedly made the illicit trades. The SEC may start an investigation into a company's policies and procedures, test their effectiveness, and open an investigation leading to numerous requests for documents (including emails), information and testimony—which can then uncover other issues. The SEC may also request documents and information related to trading records from third-parties, such as broker-dealers, and question their respective insider trading policies and procedures to determine why they did not detect the activity.
To mitigate these risks, companies should re-evaluate their compliance programs, and ensure that there are safeguards in place to ensure that all material, nonpublic information is accessed and shared strictly on a need-to-know basis. Companies should also ensure that insider trading policies include blackout periods and that management is aware of those trading restrictions. In addition, those with access to material nonpublic information should be reminded of their obligation to ensure that others do not inappropriately access material, nonpublic information, and of the importance of maintaining the confidentiality of such information, particularly in work-from-home environments.
The SEC Office of Compliance Inspections and Examinations is focused on the adequacy of registrants’ Business Continuity Plans and their ability to comply with regulatory requirements during the pandemic. The OCIE announced that, in an effort to protect investors and the integrity of the markets, it is reaching out to firms about the implementation and effectiveness of their BCPs.
FINRA is also monitoring Covid-19's impact on broker-dealers’ business and operations. Rule 4370 (Business Continuity Plans and Emergency Contact Information) requires a firm to have a BCP reasonably designed to enable it to satisfy its obligations to customers and regulators in the event of an emergency.
FINRA has urged broker-dealers to review their BCPs to ensure their ability to satisfy their regulatory obligations and financial responsibilities in the event of a pandemic. In May 2020, FINRA issued a regulatory notice sharing practices that firms had implemented to assist in transitioning to and supervising remote working environments during the pandemic.
In this and other regulatory notices, FINRA has focused on potential supervision issues, cautioning firms to take steps to ensure their BCPs are reasonably designed to ensure supervision of associated persons working remotely, as well as supervision of trading and communications. FINRA also has reminded firms of the need to implement appropriate measures to address increased vulnerability to cybersecurity attacks due to remote working environments, and to protect customer and firm data as firms transition to those working arrangements.
When examining Covid-19-related disruptions, the SEC and FINRA may hold firms accountable for Rule 4370 violations. Broker-dealers and registered investment advisers have likely already activated their BCPs in response to Covid-19. In preparation for potential regulatory inquiries, companies should take time to identify and remediate their BCPs’ failures or weaknesses. If the pandemic presented unforeseen complications, companies should take measures to address those issues now and document the steps they have taken.
Firms should pay particular attention to whether their BCPs are equipped to prevent against cybersecurity attacks. FINRA has suggested that firms conduct business on a secure network connection, such as a company-provided virtual private network (VPN) or through a secure firm or third-party website, and ensure that software updates and patches are done on a timely basis, and that anti-virus and anti-malware software is installed. Companies should also take particular care to address supervision issues, such as appropriate retention of communications and other books and records, arising from the sudden change in work conditions.
Companies have been navigating these same regulatory requirements for years—the novel challenge stems from ensuring that a company's existing policies and systems are adequate to appropriately address new risks and to continue to meet its obligations despite obstacles arising from the Covid-19 pandemic. Companies that take the time to review their existing programs and modify accordingly now will have an easier time responding to regulatory inquiries and examinations later.