It has become almost axiomatic that financial crises breed government financial investigations. As the tide of financial prosperity washes out, previously concealed securities and investor frauds become exposed, attracting the scrutiny of regulators. The financial crisis and the pronounced market volatility that followed the coronavirus (COVID-19) pandemic will be no different. The co-director of enforcement for the U.S. Securities and Exchange Commission (“SEC”), Steven Peiken, made this point in a speech in mid-May, when he stated that, in direct response to COVID-19, the SEC “is monitoring the investment advisor and investment company space for failures to honor redemption requests at both private and registered investment companies, which could indicate an underlying issue.” Put differently, government enforcement actions will not be limited to new misconduct connected directly to COVID-19, but will also include pursuing preexisting issues exacerbated by the current financial crisis. That will include increased regulatory attention on how private and registered investment advisors have managed investor funds. Investigations likely also will focus on investment fund guidelines and whether advisors have made proper risk disclosures, recommendations, or potentially false statements.

This pattern of increased regulatory scrutiny following financial crises was on full display following the 2008 financial crisis, which saw a dramatic spike in enforcement cases initiated by both the SEC and the U.S. Department of Justice (“DOJ”). The SEC, for example, initiated litigation or settled claims against 204 entities and individuals for conduct relating to the financial crisis, with resulting total penalties exceeding $3.76 billion. The government, including the SEC, focused on pursuing certain misconduct related to the 2008 financial crisis, such as alleged frauds involving Collateralized Debt Obligations and mortgage-related investments. The government also pursued other cases, including the case against Bernie Madoff, whose Ponzi scheme was discovered, in part, because his hedge fund could not honor redemption requests in the fall of 2008. Briefly, when the financial crisis hit, many of the investors in Bernie Madoff’s hedge fund sought to redeem at a dramatically faster pace than normal, including redemption requests in the multi-billions of dollars in November 2008 alone. Madoff’s failure to honor those redemption requests led eventually to both civil and criminal enforcement actions, as well as private litigation. While Madoff’s case is by far the most famous, it eclipsed many similar—but smaller—actions.  In short, in times of financial uncertainty, the government will scrutinize the historical conduct of financial advisors, especially where investment companies and advisors have failed to honor redemption requests.

The 2008 financial crisis also led to a significant enhancement in the SEC’s ability to detect and pursue these types of cases against financial advisors. In 2010, the SEC established five specialized units, including the Asset Management Unit, which focuses on investigations involving investment advisors, investment companies, and private funds. Also in 2010, pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC established the Office of the Whistleblower, which offers individuals who report possible violations of federal securities laws a monetary incentive of between 10% and 30% of any recovery. That office has been busy.  Since 2012, when the SEC issued the first whistleblower award, the SEC has awarded $501 million to 85 individuals. The onset of COVID-19 has led to an even further increase in whistleblower complaints:  the SEC is reporting that it has already seen a 35% increase in tips for the two-month period beginning in mid-March compared to the same period in 2019.  The practical impact of this is that insiders at investment companies and investment advisors, as well as the investors themselves, have a financial incentive to report any perceived misconduct to the regulators. And, investors are paying more are paying more attention to how their financial advisors and wealth managers have been investing their assets now that the market has become so volatile.  Put simply, because of the volatility of the market, and the resulting losses, investors’ attention is focused on whether their financial intermediaries have been making misallocations and misrepresentations, or in some cases intentionally mismanaged funds, or invested in assets incompatible with their investment mandate.

Should the SEC or another regulatory entity contact you, either for targeted conduct, an industry sweep, or as part of a routine exam, you should be prepared to provide thoughtful, thorough, and responsive information. In addition, financial advisors should be prepared to address any compliance programs, including third-party audits, that they employ to detect potential misconduct. Specifically, financial advisors should focus on the three general areas of deficiencies that the SEC Office of Compliance Inspections and Examinations has recently identified in its examinations of registered investment advisors: (a) conflicts of interest, (b) fees and expenses, and (c) policies and procedures related to the handling of material non-public information or insider trading. And, while remote work may have changed the way advisors and companies maintain data, registered investment advisors should ensure that they are maintaining their books and records as required by the Advisor Act and related regulations. Finally, financial advisors concerned either about their historical practices or about their compliance programs should proactively seek legal counsel.

Stephen Cook is a partner and practice group leader of Brown Rudnick's White Collar Defense & Government Investigation practice group. Ashley Baynham is a partner in Brown Rudnick’s White Collar Defense & Government Investigation practice group.