Securities Fraud in the Age of COVID-19: Now is Not the Time to Relax Compliance Programs or Internal Controls
Last updated May 1, 2020
The advent of the coronavirus pandemic has created a “perfect storm” for securities investigations and regulatory enforcement actions by the SEC, FINRA and the New Jersey Bureau of Securities, as well as private lawsuits by disgruntled investors and shareholders. The direct impact that COVID-19 has had on the stock market and businesses, including substantial losses and volatile share price fluctuations, will inevitably lead to an increased number of complaints, investigations and private lawsuits concerning companies’ disclosures, trading activities and their business responses to the virus. The SEC has announced that it is “actively monitoring for frauds, illicit schemes and other misconduct affecting U.S. investors relating to COVID-19 . . .”, and that it will not hesitate to use its full array of enforcement tools, including trading suspensions, if the circumstances warrant. The SEC has been true to its word. Indeed, in the month of April, the SEC’s enforcement division has already suspended the trading of the stock of twenty (20) publicly traded companies based on allegedly false COVID-19 claims and/or suspicious trading, and issued a number of warnings to investors regarding potential market misconduct, including insider trading, market manipulation and Ponzi and pump-and-dump schemes. The pressure and the opportunities for bad actors to engage in such conduct will likely only increase as economic conditions worsen.
At the same time, investment firms, broker-dealers and public companies are being faced with increasing pressure to cut their costs and overhead substantially, especially in non-revenue producing areas such as compliance. Given the substantial risks raised by the pandemic, firms and companies should resist this temptation, and instead recognize that they need now, more than ever, to remain vigilant and maintain their corporate controls and compliance programs.
Areas of pronounced risk in the current environment include the following:
The impact of the coronavirus on a business is difficult to assess, constantly changing and, in many ways, beyond an issuer’s knowledge and control. Accurate and timely reporting of financial performance will be difficult but critical for business as the news concerning supply chains, distributors, customers, costs and revenue change on virtually a daily basis. The SEC, DOJ, shareholders and plaintiff’s law firms and shareholders will all be looking for anomalies and inconsistencies in corporate filings. Companies therefore need to carefully consider how to address the impact of COVID-19 in the risk factors, financial disclosures, earnings information, description of business and other sections of their SEC filings and materials provided to investors. Companies need to make adequate disclosures of material developments on a timely basis and make full use of cautionary language (e.g., “believe” or “expect”) and safe harbor provisions wherever and whenever possible.
The SEC has been urging companies to focus on their forward-looking statements, as shareholders and investors are more likely to be focused on the company’s ability to deal with the present crisis than its past performance. As a result, the SEC has stated that it’s not prepared to second-guess good faith efforts by a company in providing such information to its investors. Such disclosures should include the anticipated impact of the pandemic on the company’s supply chain, customer demand, credit lines, financing or loans. They should also include the measures the company has engaged in or enacted to reduce costs (e.g., cutting salaries, expenses, furloughing employees or deferring rent payments) and otherwise redress the situation, including whether the company has applied for and received public assistance. In describing such items, the company should be as specific as possible as to the likely impact on the company’s business and its financial performance.
The fast-changing and volatile market conditions are fertile grounds for insider trading based on material non-public information (“MNPI”). Given the current remote work environment, it is more likely than ever that all level of employees will have some form of MNPI, and that it will not be as tightly controlled and secure as usual. In addition, employees are facing increasing financial pressure and economic uncertainty that could lead them to try to take advantage of the opportunities for insider trading that the pandemic presents. As a result, companies need to make sure that their insider trading policies and code of ethics and conduct are current and have been disseminated to all employees. All employees should be trained (and/or retrained) and fully reminded of their obligations under the securities laws, including the bar under Reg. FD against releasing MNPI to select recipients. Companies should also update and reaffirm their compliance programs in order to ensure adequate monitoring and surveillance of any trading activity. Corporate insiders in particular should make sure they have no matchable opposite-way transactions in the past six (6) months that could give rise to liability under Section 16 and make sure they satisfy all of the company’s pre-clearance procedures before trading. In order to avoid insider trading claims, companies might also want to consider barring some or all directors, officers and employees from trading in the company’s stock for the foreseeable future if their stock is subject to wild price swings.
Investment firms and broker-dealers are also likely to face a greater number of investigations, lawsuits and/or arbitrations resulting from customer losses and complaints. Not only do such entities have to continue to track patterns and trends that could be indicia of insider trading or pump-and-dump schemes, but they need to identify red flags when investigating customer complaints that could reflect patterns of other misconduct. Such misconduct could include unauthorized trading in a non-discretionary account, unauthorized transfers or uses of funds, churning or placing a customer in unsuitable securities to generate commissions. While firms should normally regularly monitor such activities as part of their compliance programs, it is especially needed under the current circumstances; where many customers have sustained substantial losses and past practices that were perhaps overlooked when accounts were profitable are likely to come under greater scrutiny.
As the above reflects, now is not the time for companies or investment firms to relax or cut back on their corporate internal controls or compliance programs. If anything, given the likelihood of increased scrutiny by regulators and plaintiff’s lawyers, greater oversight and monitoring is needed to mitigate the current risks of fraud.
For additional information pertaining to the coronavirus outbreak, please visit CSG’s COVID-19 Resource Center.
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