Banking sector volatility increases government enforcement risks across multiple industries
Recent volatility in the banking sector – triggered by the high-profile failure of, and Federal Deposit Insurance Corporation (FDIC) receivership over, two financial institutions – will have far-reaching impacts on not just the banking sector, but across multiple industries.
These events are expected to trigger numerous investigations by state and federal regulatory and law enforcement agencies across a wide range of persons, including, but not limited to, banks, public companies, executives, private and public investment funds and other asset managers as well as other market participants.
This alert outlines potential areas of investigation and relevant preparatory steps to consider.
On March 12, 2023, the Department of the Treasury, Federal Reserve, and the FDIC announced measures to prevent losses to all depositors after two banks, Silicon Valley Bank and Signature Bank, were closed and entered into FDIC receivership, and to provide liquidity support to banks generally. Following this announcement, the White House stated that the government is “committed to holding those responsible for this mess fully accountable.” While the White House’s remarks appeared to be focused primarily on the banking sector, firms across industries should be prepared for increased government examination and enforcement activity.
Public reports have indicated that the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) have already commenced investigations related to the bank closures that likely will focus on potential insider trading, market manipulation or fraud or self-dealing by insiders and others. Such investigations also may include staff of the Inspectors General of the Board of Governors of the Federal Reserve System (the Fed), the FDIC, or the Treasury (for the Office of the Comptroller of the Currency (OCC)), including auditors and/or law enforcement agents.
Government investigations are expected to be broad in examining the conduct in question and the universe of targeted persons and entities. Regulators may assess a variety of areas, including: (i) compliance with banking and trading rules and regulations; (ii) possible securities law violations such as market manipulation, insider trading and disclosure failures; (iii) the role of third parties in events leading to the closures; and (iv) other areas such as consumer protection and antitrust, including issues related to the widespread use of social media and other communication networks. These investigations could generate criminal and civil subpoenas as well as other information requests from both state and federal government agencies.
Potential areas of investigative focus
- Unsafe or unsound practices: Consistent with the White House’s remarks, the Fed has announced that it will specifically investigate what led to one of the recent bank closures. We note, however, that the Fed and other federal banking regulators – including the FDIC and the OCC – also have broad enforcement authority to investigate any “unsafe or unsound practice” and can be expected to launch investigations into the conduct of directors, officers and other senior personnel of any failed bank.
Federal banking regulators may probe other banking institutions for compliance, safety and soundness in light of recent events. Regulators have the ability to, if necessary, take a number of supervisory actions to bolster individual bank’s capital, such as “prompt corrective action” measures pursuant to Regulation H (12 C.F.R. § 208.43), or to impose limits on bank activities. Similarly, banking regulators also may take steps to require bank holding companies to serve as a source of strength for their subsidiary banks, including limiting their subsidiary banks' distributions to them. In addition, any bank or bank holding company that fails to promptly remedy an “unsafe or unsound” condition or practice could be subject to public enforcement action, including cease and desist orders, civil money penalties and other measures.
- State Attorneys General: Although much of the discussion to date has been focused on the role of federal enforcers, the 2008-09 financial crisis suggests that state attorneys general (as well as state banking regulators) are likely to take a prominent role in activity in this space. For instance, the California Attorney General’s Office, among others, took a lead role with the US Justice Department in bringing consumer protection suits arising from the financial crisis. For state-chartered banking institutions and other companies (especially those in states like California and New York), state-level scrutiny will be an important consideration.
- Congressional investigations and hearings: Members of Congress have been outspoken about SVB’s closure and potential legislative fixes to ensure similar failures do not arise in the future. Similar to the FTX collapse late last year, Congress will likely hold hearings with the former leadership of both of the closed banks, leadership of other banks and government officials in the coming weeks to bring to light exactly how these bank closures occurred and what could have been done to prevent them. Patrick McHenry, Chair of the House Financial Services Committee, has unilateral subpoena authority and the ability to compel witnesses to testify. The Senate Banking Committee also has broad subpoena authority and the ability to compel witnesses to testify. Both the House and the Senate are likely to investigate.
The Financial Industry Regulatory Authority (FINRA), SEC, DOJ and state securities regulators are all likely to conduct investigations into securities law compliance. These organizations may investigate separately or may cooperate and coordinate in their evaluation of potential violations. Companies and individuals can face serious civil and criminal sanctions (including imprisonment for criminal violations) related to securities law violations. Stockholders and other investors also have private rights of action under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Exchange Act Rule 10b-5.
Key areas of investigation may include:
- Insider trading: Any person or entity identified by the SEC or FINRA as having engaged in timely trading (in this case most likely selling or shorting) in the securities of the failed banks may face investigation, including those whose trades occurred under Rule 10b5-1 plans. Reportedly, the SEC and at least one state regulator have commenced these investigations. Government regulators have extensive access to trading records and information and are able to identify connections between trading activity and public and private communications regarding the events surrounding the closure of the banks.
- Market manipulation: The SEC is likely to investigate whether individuals and entities engaged in market manipulation in violation of Exchange Act Section 9(a). In particular, the SEC may explore whether any market participants engaged in activities designed to affect the price or volume of securities transactions involving the banks. The SEC may review public statements regarding the banks (including through social media) and trading or coordination among market participants. The SEC may investigate the existence of any undisclosed conflicts of interest by those making statements about the banks financial condition and deposit withdrawal or other actions to take in relation thereto.
- Public disclosures: Material misstatements or omissions of material facts can lead to securities fraud and other claims by the SEC as well as by investors. Regulators may review the disclosures of the affected banks as well as other registrants to assess whether risks and related disclosures were properly considered and disclosed. Areas of particular focus may include risks related to any concentration of uninsured deposits and assets, and impacts related to volatility in the financial system.
Investment advisers are fiduciaries and therefore must act in the best interests of their clients. We believe that the SEC staff may focus its examination and investigative efforts in the following areas:
- Investment decisions. Private funds that hold positions in the affected banks could be subject to SEC inquiry related to their diligence and investment processes. Specifically, the SEC may seek to understand an adviser’s diligence of, and decisions to make an investment in, an affected bank on behalf of one or more private fund clients, including any documentation or investment committee meeting minutes to support such determinations. We also note that limited partners may make separate inquiries.
- Conflicts of interest. The SEC may evaluate whether an adviser’s Form ADV disclosures (including Form CRS) and a private fund’s organizational documents adequately disclose any potential conflicts of interest.
- Custody of client assets. The SEC may seek to understand whether an adviser’s client assets, including private fund client assets, have been custodied by an affected bank and any resulting plans to transfer client assets to a different qualified custodian. The SEC will look for timely notifications to be made to affected clients and private fund investors that identify the new custodian(s), and that advisers have a reasonable basis that custodial statements will be timely provided to the affected clients and private fund investors.
- Diligence. Registered investment advisers that custodied private fund client assets with the affected banks may expect inquiries from the SEC staff and/or private fund investors requesting information and/or documents evidencing the initial and ongoing due diligence of a private fund sponsor’s decision to engage an affected bank as a qualified custodian to safeguard private fund assets.
- Disclosures. As advisers work with their clients to transfer assets and prepare their annual amendments to Form ADV which generally are due by the end of March, advisers should review and revise, if necessary, their responses to Form ADV Part 1A Item 9 and Part 2A Item 15 relating to custody practices. In addition, if applicable, advisers should consider enhancing any conflicts of interest disclosures, including adding risk disclosures to Part 2A Item 8 to address any potential exposure to bank regulatory issues.
Public company audit firms
There are already questions regarding the role of the auditors of the closed banks. The PCAOB and SEC may investigate whether audits of the closed and publicly traded banks more generally comply with PCAOB and SEC audit and independence standards.
Preparing for government investigations and enforcement
Government investigations and enforcement can take many forms and proper preparation and responses can be crucial to minimizing risk and potential adverse outcomes. Key steps to consider include:
- Evaluating whether to proactively preserve certain documents in anticipation of government information requests
- Establishing and/or updating clear company policies and procedures with respect to (1) cooperating with lawful government investigations and inquiries, including whether the company will permit employees to make statements to the government without company counsel present, and (2) responding to inquiries from the press about government investigations or law enforcement activity
- Reviewing or implementing policies on government interactions to address unannounced law enforcement visits such as “knock and talks” (where law enforcement seeks voluntary contact without a search warrant) or “dawn raids” (where law enforcement has a warrant)
- Training for employees regarding how to respond to government contacts
- Preparing document preservation notices and transmission of such notices to impacted employees and relevant IT personnel in the event that a request for information is received
- Evaluating whether employees are using ephemeral messaging services and implementing steps to ensure such usage is consistent with policies and regulations and preserving such messages and
- Identifying key contacts, including counsel and insurers, and notice protocols.
DLA Piper has significant experience in governmental inquiries, investigations and enforcement and is available to help during this period. If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact any of the authors or your relationship attorneys.
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