Recent SEC Settlement Shows Remediation Goes a Long Way in Avoiding Fraud Penalties

In October 2021, Gurbir Grewal, the Director of the Securities and Exchange Commission’s (SEC or the Commission) Division of Enforcement, delivered a speech that included his observations about cooperation credit for companies and individuals charged with securities laws violations. Pointing to prior SEC guidance and policy statements regarding cooperation, Director Grewal said: “I look to whether the would-be cooperator took significant, tangible steps that enhanced the quality of our investigation, allowed us to conserve resources and bring charges more quickly, or helped us to identify additional conduct or other violators that contributed to the wrongdoing.”

A recent enforcement action provides real world guidance on cooperation and remediation credit under the current SEC enforcement program. On January 28, 2022, the Commission announced that it had settled fraud charges with a Silicon Valley technology startup, HeadSpin, Inc. (HeadSpin), without requiring a civil penalty or an admission of wrongdoing. Notably, the press release was titled, “Remediation Helps Tech Company Avoid Penalties.” The settlement offers a roadmap for how companies, especially young or startup technology companies, can successfully receive credit for cooperation and remediation should they later be investigated by the SEC.

HeadSpin Background

From approximately 2018 to 2020, HeadSpin allegedly engaged in a fraudulent scheme led by its former CEO and co-founder, Manish Lachwani, to inflate the company’s valuation to over $1 billion. The CEO, still a defendant in pending civil and criminal actions brought by the SEC and the US Attorney’s Office for the Northern District of California, respectively, in August 2021, purportedly inflated key financial metrics including the value of customer deals, falsified invoices, and deceived investors. Lachwani was allegedly able to do so by controlling and/or managing HeadSpin’s financials and sales operations, including retaining sole ownership of a number of key financial documents. When HeadSpin’s board of directors became aware of issues concerning the accuracy of financial information provided to investors in March 2020, it promptly began an internal investigation, which resulted in the CEO’s resignation in May 2020 and a self-report to the SEC.

In the SEC’s recent press release, Director Grewal states that this case “offers an excellent example” of how companies can receive cooperation and remediation credit from the SEC. He elaborated that the company’s “remediation and cooperation included not just its internal investigation and revised valuation, but also repaying harmed investors and improving its governance—all of which were factors that counseled against the imposition of a penalty in this case.”

Among the remedial efforts, HeadSpin:

• Promptly conducted an internal investigation when concerns arose;
• Forced the resignation of the CEO, hired a new CEO, and hired new senior management, including a Chief Operation Officer, General Counsel, and Controller;
• Revised the company’s valuation from approximately $1.1 billion to approximately $300 million;
• Returned approximately 70% of principal to investors through recapitalization and offered to return the remaining funds through promissory notes with 1% interest;
• Expanded the board of directors; and
• Instituted processes and procedures designed to ensure transparency and accuracy of deal reporting and associated revenues.

Similar Remedial Efforts Highlighted by the SEC in the Past

The SEC has, in the past, identified similar remedial efforts in connection with technology companies that experienced rapid growth. For example, in September 2018, the SEC issued a press release announcing that it had settled fraud charges against LendingClub Asset Management LLC and its former president (and founder) for improperly adjusting monthly returns and using fund money to benefit its parent company. As part of the settlement, the Commission indicated that it decided not to recommend charges against the parent company because it had “promptly self-reported its executives’ misconduct following a review initiated by its board of directors, thoroughly remediated, and provided extraordinary cooperation with the agency’s investigation.” The press release further noted that the parent company reimbursed approximately $1 million investors adversely impacted by the improperly adjusted monthly returns.

Similarly, in October 2017, the SEC instituted settled cease-and-desist proceedings charging violations of Section 17(a)(2) of the Securities Act of 1933 (Securities Act) against YourPeople, Inc., dba Zenefits FTW Insurance Services, a software and technology company (Zenefits), for making materially false and misleading statements and omissions to investors about the company’s compliance with state insurance regulations. In connection with the misstatements, Zenefits raised more than $565 million from accredited investors in two separate private placements. While the SEC imposed a $450,000 monetary penalty on Zenefits as part of the settlement, the Commission’s order found only a non-scienter-based fraud violation of Section 17(a)(2) and highlighted Zenefits’ cooperation. For example, Zenefits immediately initiated an investigation into the matter when issues were identified, replaced top leadership, created a chief compliance officer position and established a compliance team, implemented new administrative and technical licensing controls, required its insurance producers to complete additional continuing education, and hired a national accounting firm to test the operations of the new controls and then reported those results to various state insurance regulators. Zenefits also self-reported to state insurance regulators before the issues became public and worked with investors to resolve their claims related to the underlying conduct.

Key Takeaways

Director Grewal’s speech and these SEC settlements are helpful in informing how and when companies can receive cooperation credit when allegations or concerns about potential fraud or securities violations arise. It is clear that cooperation involves something more than simply responding to SEC subpoenas after an issue is publicly identified. Conducting a prompt investigation, followed by thoughtful remediation along the lines detailed above, are factors that weigh in favor of receiving cooperation credit. To receive credit, cooperation and remediation should be top of mind from the moment issues are identified, throughout any internal investigation, and when implementing any corrective actions.

Additionally, although we do not know whether there was a whistleblower involved in the HeadSpin matter, many internal investigations are prompted by corporate whistleblowers. These whistleblowers may also submit a tip to the SEC, especially if the whistleblower perceives that the company is not taking appropriate action to address the concern. Given this, companies should promptly acknowledge and give careful consideration to whistleblower complaints. Internal reports give companies a critical opportunity to investigate, take corrective action, and determine whether to self-report. In a previous Advisory, we identified practical considerations for companies with respect to internal whistleblowers.

Please be on the lookout for additional advisories as Arnold & Porter continues to monitor developments in this space, informed by its substantial experience investigating, working cooperatively to remediate, and defending these types of cases.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.