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Enforcement Action for Failure to Disclose SEC Investigation as Loss Contingency

Alan J Wilson

Enforcement Action for Failure to Disclose SEC Investigation as Loss Contingency

On September 22, 2022, the Securities and Exchange Commission (“SEC”) brought an enforcement action against two officers and a director of Spyr, Inc. for false and misleading statements to the company’s auditors in violation of Rule 13b2-2 under the Securities Exchange Act of 1934 regarding an SEC investigation that was not disclosed as a loss contingency.

Although not involving directly a lawyer’s audit response letter, this latest enforcement action underscores the SEC’s continued focus on loss contingencies. It serves as a reminder, not only to directors and officers, but also to lawyers responding to audit requests, of the need to carefully assess the statements made to auditors about loss contingencies, especially the challenges often associated with government investigations when making disclosure and/or accrual determinations under Accounting Standards Codification 450-20 (Contingencies—Loss Contingencies). The loss contingency at issue in this action involved an SEC investigation into the company’s investment in a biotechnology company.

According to the complaint filed by the SEC in the United States District Court for the District of Nevada, the SEC commenced an investigation in 2014 and carried it on over several years. Shortly after the investigation commenced, the company sent a letter to its auditor from its outside counsel regarding the SEC investigation. Thereafter, nothing was updated or disclosed to the auditor and, in fact, in response to a question whether management knew of any possible violations of law, the company’s response was “no.” During the course of the investigation, the SEC Division of Enforcement sent multiple subpoenas to the company and its officers and directors seeking documents and testimony related to the investigation, and in April 2017 sent a Wells Notice that indicated that the SEC staff intended to recommend to the Commission that charges be brought for violating the federal securities laws, describing the charges and potential remedies.

After responding to the Wells Notice and having several interactions with the SEC staff, in January 2018 the company sent a settlement offer to the SEC staff, to which the staff responded(i) that any settlement offer must include an injunction prohibiting further violations and a civil penalty and (ii) that the SEC’s process was moving forward. The company replied, indicating that if it could come up with a counteroffer, it would present it, but no counteroffer was ever presented.

On April 2, 2018, the company filed its Form 10-K for 2017, which did not include any mention of the pending SEC investigation, nor was the SEC investigation disclosed to the company’s new auditor. Instead there were representations that there had been no communications from the SEC and no possible violations of law. The SEC filed the action against the company and its chairman of the board on June 18, 2018 (in which they subsequently agreed to a consent judgment entered on April 14, 2020). The company filed a Form 8-K on July 9, 2018, indicating that the auditor had advised the company that its audited financial statements could no longer be relied upon.

ASC 450-20 requires, in general, disclosure of a loss contingency when “there is at least a reasonable possibility that a loss or an additional loss may have been incurred” In its complaint, the SEC asserts that by April 2, 2018, when the company filed its Form 10-K for the fiscal year ende d December 31, 2017, it was reasonably possible that the company could incur a material loss in connection with the SEC investigation because: (i) the SEC staff had advised the company that it intended to recommend charges and a civil penalty against the company; (ii) settlement discussions with the SEC’s staff had broken down; (iii) any penalty would be material (as admitted by the company); and (iv) an SEC action was likely coming, and coming soon. Moreover, the SEC alleged in its complaint that the company and its officers “never conducted a good faith assessment as to whether the possible pending [e]nforcement action needed to be disclosed. Instead, the [c]ompany and its officers did the opposite — they mislead [sic] [the company’s] auditors and failed to disclose the existence and status of the SEC’s . . . investigation.”

Although there is authority that a Wells Notice alone does not require a disclosure, that does not necessarily end the inquiry from the SEC’s perspective. Consideration of the likelihood of a material loss as a result of an investigation that would have to be disclosed as a loss contingency frequently involves highly fact- specific inquiries. Depending on the stage and nature of the investigation and information that may be known about the government agency’s intentions, lawyers responding to audit requests and advising their client on disclosure may have to exercise judgment regarding disclosure of pending government investigation.

This latest SEC enforcement action follows some notable developments this year involving loss contingencies, including the Second Circuit’s ruling in Noto v. 22nd Century Group, 35 F.4th 95 (2d Cir. 2022), that plaintiffs had succeeded in stating a claim that failure to disclose an SEC investigation violated Rule 10b-5. These developments intensify the pressure on companies to err on the side of earlier disclosure of government investigations. These and other developments are worth monitoring as lawyers and their company clients make good faith assessments as to whether a possible pending enforcement action should be disclosed.

This article was prepared by the Business Law Section's Legal Opinions Committee.