SEC invites comment on newly revealed 2011 proposal to conduct undercover investigations of criminal violations of securities laws

The Securities and Exchange Commission (SEC or Commission) does not have authority to conduct criminal investigations – or so we’ve thought.  On January 7, 2021, the SEC issued a statement revealing a previously non-public 2011 proposal to create an SEC Fraud Surveillance Team (FST) that would conduct undercover investigations of “individuals suspected of engaging in conduct that could constitute criminal violations of the federal securities laws.” 

Under the proposal, full-time, trained members of the FST would pose as interested investors, contact individuals suspected of ongoing criminal securities law violations, and seek information to develop evidence to support criminal prosecutions by the Department of Justice (DOJ).  The SEC statement says the FST would only undertake such an investigation if it had reason to believe the targets were engaged in criminal conduct.  The program was never implemented, but notably the SEC is inviting comment on it now.

Background of the proposed undercover program

In July 2012, the SEC Office of General Counsel received legal advice from the DOJ Office of Legal Counsel (OLC) confirming the legality under the Privacy Act of 1974 (Privacy Act) of the proposed undercover program.  The OLC’s opinion became public early in January 2020 when a volume of selected DOJ opinions from 2012 was published.  Prompted by the publication, the Commission issued its January 7 statement, reporting, without explanation, that the FST program was never implemented.  If the agency were to institute such a program, the Commission stated, it would first have to approve the program in advance pursuant to an appropriate process and with appropriate safeguards. 

Set forth below are a summary of the OLC opinion, our analysis, and key takeaways.

OLC opinion

Section 522a(e)(3) of the Privacy Act requires that an agency, such as the SEC, that collects information from members of the public must inform each individual from whom information is sought about:

• the authority authorizing the solicitation of the information and whether disclosure of such information is mandatory or voluntary
• the principal purpose(s) for which the information is intended to be used
• the routine uses that may be made of the information and
• the effects on the individual, if any, of not providing all or any part of the requested information.

The Privacy Act also allows the head of any such agency to promulgate rules that would create an exemption from these notice requirements if (1) the information is maintained by an agency (or component thereof) that has criminal law enforcement as a principal function and (2) the information is compiled for the purpose of a criminal investigation, including reports of informants and investigators, and is associated with an identifiable individual.  5 U.S.C. § 522a(j)(2) (Exemption).  

The opinion notes that the SEC is authorized to investigate all conduct constituting a violation of federal securities laws and that willful violations of those laws constitute criminal conduct.  Recognizing that the SEC may take action independently to remedy civil violations of the securities laws but is not authorized to prosecute criminal activity directly, the DOJ opinion nonetheless found that the FST would qualify for the Exemption because (1) the FST would be a separate component of the SEC; (2) the FST’s principal function would be an activity pertaining to criminal law enforcement; and (3) the FST’s records system would consist of information compiled for the purpose of a criminal investigation and associated with an identifiable individual.  36 Op. O.L.C. 186, 191 (2012).

The opinion also referenced numerous similar programs in place at other agencies, such as the Office of Inspector General at the Department of State, the Office of Special Investigations in the Department of the Air Force, the Criminal Investigation Division in the Internal Revenue Service, the Postal Inspection Service in the US Postal Service, the Naval Criminal Investigation Service in the Department of the Navy, and the Criminal Investigation Division and National Enforcement Investigations Center in the Office of Criminal Enforcement, Forensics, and Training of the Environmental Protection Agency.

The Exemption is not self-executing.  Before implementing such a program, the SEC would have to comply with the procedural requirements of each of the Privacy and Administrative Procedure Acts to promulgate a rule establishing the Exemption. 

Analysis and key takeaways

It is a curious twist that the routine schedule of publications of OLC opinions revealed the proposal just before President Joe Biden took office. The FST proposal was developed in 2011 under SEC Chair Mary L. Schapiro at a time when the agency was immersed in post-financial crisis enforcement actions.  After Mary Jo White took over as SEC chair in April 2013, the program was never launched, whether due to change in philosophy, funding priorities, staffing challenges, or other reasons.  Whether the next Commission decides to implement this new tool in its enforcement arsenal remains uncertain, but the agency’s facilitation of public comment suggests that creating the FST may be under consideration. 

If the SEC implements an undercover program, it could be a game changer and increase criminal prosecutions of securities fraud. Allowing an FST to collect evidence, covertly and directly, to supplement customer complaints, statements, and testimony and then share that information quickly with criminal authorities could significantly increase the number of criminal prosecutions of securities fraud.

Should the SEC move forward with the creation of the undercover FST, here are some issues to consider:

• What limits would apply to the undercover program? There are many securities laws that can be the basis of a criminal violation of the federal securities laws.
• The OLC opinion states that “every ‘willful’ violation of [the federal securities laws] constitutes a criminal violation.”  For some violations, the SEC takes the position that willfully means no more than that the person charged with the duty knows what s/he is doing.  Will the undercover program authorize the FST to conduct operations for such violations, which may not meet the criminal intent standards?
• How will the SEC protect the rights of those under investigation? 
• Will there be any independent oversight of the SEC’s implementation of undercover investigatory tactics?

Protecting investors is an important goal, and stopping ongoing fraud in its tracks is vital to that effort.  If the SEC proposes a program such as that contemplated by the opinion, however, full evaluation of the means used to achieve that end is also imperative.

Should the Commission proceed with the necessary rulemaking that would implement the proposal, we will alert you.

If you have any questions regarding the implications of this development, please contact the authors or your DLA Piper relationship attorney.