In the dark: The surprising truth about how companies can keep probes quiet

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"Hey, by the way – we received a subpoena from the Securities and Exchange Commission last year."

Okay, Valeant Pharmaceuticals International Inc. wasn't quite that informal when it disclosed a formal SEC investigation this week. But it was close. After a report from research firm Probes Reporter, followed by a Bloomberg news story, Valeant "confirmed that it has several ongoing investigations," including one from the SEC, and that "it received a subpoena from the SEC in the fourth quarter of 2015 and, in the normal course, would have included this disclosure in its 2015 10-K [annual report]."

With the admission coming two months into the first quarter, not the fourth quarter in which the subpoena was received, perhaps Valeant believed the matter not terribly relevant to investors' views of the company. Yet the market response suggests otherwise: The shares fell 18 per cent Monday in New York Stock Exchange trading on three times the normal volume. While the stock began falling that day when the company pulled its earnings guidance, the losses accelerated in the afternoon when news of the probe broke.

It seems the fact of an SEC investigation was indeed important information for investors – "material," even, in the parlance of disclosure.

Yet companies who get subpoenas from the SEC can go a long time without disclosure, if they reveal them at all. In the meantime, investors can go on assuming nothing's amiss.

For example, Valeant's "fourth-quarter" subpoena could have arrived in early October, 2015, roughly five months ago. MDC Partners Inc., the New York City advertising company formerly run by Canadian Miles Nadal, got an SEC subpoena Oct. 5, 2014, but didn't disclose it until April 27, 2015.

Here is how the typical SEC query proceeds. First, the agency opens up an informal inquiry, chatting with the subject company about a matter of concern. Often, the staff chooses to start a formal investigation and use its subpoena power, which may require a judge's backing if the target of the subpoena fails to co-operate. At the end of an investigation, if SEC staff believes it can charge a company or individual with a securities law violation, it sends a "Wells notice" to the target with basic information about the allegations, allowing the potential defendant a chance to respond.

At what stage of this unfortunate process should investors find out that such SEC efforts are occurring? A 2015 ruling from a federal judge suggests the answer is "none." In Richman v. Goldman Sachs, investors argued that Goldman had a duty to disclose a Wells notice it had received relating to an SEC investigation of collateralized debt obligations, since it had previously said in its securities filings that it was co-operating with requests from several government agencies.

The ruling, according to a summary prepared by David M. Stuart for his SEC Compliance and Enforcement Answer Book 2015, said that Goldman needed to disclose a dispute only if it was "substantially certain" that litigation would occur. And since a Wells notice is merely a recommendation by SEC staff, short of a vote by SEC commissioners to proceed, Goldman could not have been "substantially certain" of a lawsuit, and therefore need not disclose anything.

It follows, then, that if a company doesn't have to disclose a notice from the SEC of potential charges, it certainly doesn't have to disclose the formal investigation leading up to it.

This being the law, things can get more complicated, of course, and there are legal cases where a differing conclusion was reached, largely because of a company's past disclosures. But, for the most part, Mr. Stuart says, "the mere existence of an SEC investigation, without more, often is not material as a matter of law."

In Canada, companies have significant latitude to not disclose the existence of an investigation, because they get first crack at determining whether the fact of the investigation is material, and therefore must be disclosed, or not, David Sischy of law firm Groia & Co. says. There are circumstances when the Ontario Securities Commission makes the decision for them – an OSC staff notice says it may direct a company to reveal details of the investigation when "investor protection outweighs factors favouring non-disclosure," such as in a continuing fraud.

I see the concerns with companies quickly disclosing even the barest whiff of an investigation; informal inquiries may lead nowhere, and even the formal investigation, with its subpoena power, may not yield any meaningful outcome. Investors, however, tend to want to know when regulators are getting serious.

Mr. Stuart, in another academic work, notes that shares of investigated companies fall an average of 40 per cent from the first "revelation of misconduct" until the investigation is resolved. This, he says, suggests "the market may view the existence of a government investigation as material information." The law may never catch up to investors' views on the matter, however.