ABA Section of Business Law

Volume 12, Number 6 - July/August 2003

Recipe for an overdue change
Why corporate lawyers sometimes need to give business advice
    By Martin B. Robins

Usiness lawyers as business advisers? Could be. Read on.

The recent series of corporate implosions should cause every business lawyer to wonder what counsel could have done to prevent these disasters. Many observers, in and outside of the profession, wonder the same thing.

While it will take years for the courts and regulators to sort out exactly what happened in these corporate debacles, I suggest that a big part of the problem is the written and unwritten constraint taught to most aspiring business lawyers concerning the need to defer to their clients' business decisions. See, for example, the Model Rules of Professional Conduct, Sec. 1.2(a): "A lawyer shall abide by a client's decisions concerning the objectives of representation ...." From law school through the associate and junior partner ranks, business transactional lawyers are taught the traditional paradigm that their job is to advise clients as to available options and legal implications and work diligently to implement the client's decision from among the options.

The product of the present approach has been noted in the pages of this magazine: "In this dramatic context, what has been the role of lawyers? Has our profession been battling misconduct, and taking heroic steps to protect companies and their investors? For the most part, our profession has not distinguished itself." Murphy, "Enron, ethics and lessons for lawyers," Bus. Law Today, January/February 2003 at 11.

The author's thesis is that we must revisit this premise in order to make meaningful the current admonitions to public company counsel in Section 307 of the Sarbanes-Oxley Act (the act) and related regulations, to protest illegal acts of corporate management. SEC Release 2003-13 announcing the release of regulations under the act, Jan. 23, 2003, "SEC Adopts Lawyer Conduct Rule under Sarbanes-Oxley Act," at the SEC Web site, www.sec.gov (the "Implementing Release") summarizes the objective:

The rules adopted today by the commission will require an attorney to report evidence of a material violation, determined according to an objective standard, ‘up the ladder' within the issuer ... [ultimately to] the full board of directors; ....

See also, Cramton, "Enron and the Corporate Lawyer: A Primer on Legal and Ethical Issues," 58 Bus. Lawyer 143, 179 (2002).

It is submitted that in the transactional context, a potential legal violation must in most cases be analyzed in the context of an economic transaction. Disclosure violations and fiduciary violations almost invariably involve a misrepresentation or diversion of economic consequences.

Accordingly, counsel must be made responsible for understanding the economic basics of their client's business, industry and the financial marketplace as well as being responsible for a minimal critique as to whether a given major action is at least minimally viable in such context. Protest as to a legal violation will often require advice as to economic flaws in a proposed transaction or policy.

This article suggests a new requirement to govern the manner in which a lawyer advises their client. Pending any change in formal requirements, lawyers engaged at an entity level are urged to take a broad view of their roles and speak up to their direct contacts whenever they see something that appears questionable, whether or not the matter is clearly legal in nature.

Of course, they must in all events heed the language of the act to pursue "up the ladder" evidence of legal violations. Frequently, an objective perspective from counsel not directly involved in the matter will be sufficient to dissuade clients from disastrous paths that they have lost the ability to identify. Counsel choosing to act in this way should communicate their intention to their client, preferably at the inception of the representation in order to minimize any disruption from counsel's acting in a "nontraditional" way.

The traditional approach may have worked well during the early and middle parts of the last century in the midst of a goods-based economy where it was frequently possible to easily distinguish business and legal issues. Where people and companies usually made their livings by producing and selling things to each other and financial markets consisted essentially of common stock and long term bonds, intellectual property and financial engineering were much less important than they are today.

Opportunities for financial maneuvering by operating companies, let alone businesses based solely on financial maneuvering, were of little significance, meaning that in most cases, legal concerns did not directly affect business viability and it was often possible to identify "pure" business issues not warranting legal review.

Today, however, things are different. With so many businesses based on intellectual capital, as opposed to plant and equipment, and so many businesses tied directly to the financial markets and the exotic strategies they now permit, it is often impossible to readily distinguish "legal" and "business" issues.

Yet, in the face of so much change, we still see lawyers seeking to limit their advice to legal matters when it is clear that such matters could not be meaningfully distinguished from business matters and that the client's fundamental approach to its business was seriously flawed and leading it toward disaster. A headline in the Wall Street Journal of May 10, 2002, is illustrative: "Lawyers for Enron Faulted its Deals, Didn't Force Issue."

Perhaps the most graphic example of a lawyer standing by while the client careened toward business disaster is found in the case of Commercial Financial Services Inc. In this case, a partner in a large law firm that represented the now- defunct company in connection with numerous securitized financings is alleged to have been advised by the company's departing CEO (after five months on the job) that its business model was flawed in that it involved a scheme to provide investor returns by selling off assets, instead of from income generated by retained assets.

However, the firm is alleged by its client to have said nothing to the client about the unsustainability of this approach but simply used carefully couched language pertaining to the CEO's departure in public disclosures pertaining to other financings. It was not until long after the CEO's departure that the problems came to light and litigation was brought against all concerned — including the law firm.

The client's founder complained that "they were making so much stinking money on the deals that they didn't want it to end" and that "they didn't tell anyone not to do any more deals" and that "the advice we should have gotten is to slow down the operation and change the way we did business." Pacelle, "As Firm Implodes, Lawyer's Advice Is Point of Contention," Wall Street Journal, Oct. 29, 2002.

While the foregoing is necessarily anecdotal and considerations of lawyer-client privilege and client confidentiality make it impossible to say for sure what advice has been given in any particular situation, what is striking is the total absence of vigorous public pronouncements by lawyers involved in these situations as to their affirmative efforts to persuade their clients to stop doing things that in many cases must have appeared ex ante to be as perilous as they turned out to be ex post.

Based on my own training and observations of numerous other transactional lawyers, I believe that in the majority of cases, well-meaning lawyers felt powerless to challenge their clients' "business decisions" despite the fact that it was clear that client management was either personally interested in the specific decision or policy or had become so close to the situation that they could no longer objectively analyze it — making a third-party critique that much more important.

Our complex economy and financial markets and the critical "gatekeeper" role of lawyers vis a vis those markets (See "Understanding Enron: "It's About the Gatekeepers, Stupid," Coffee, 57 Business Lawyer 1403 August 2002) demand that we banish this arcane distinction and require lawyers to use their objective perspective to advise their clients of significant reservations as to the prudence or propriety of the clients' business practices.

Both client expectations and the public interest in these troubled times demand that those who are capable of heading off catastrophic losses be charged with the responsibility for making reasonable efforts to do so, as opposed to using their narrow specialty to rationalize looking the other way. When counsel sees their client headed for disaster, they should be required to speak up, whether or not the disaster is strictly "legal" in nature.

Are lawyers equipped to do so? From my observations, it appears that a business lawyer who has practiced at least 10 years or so will pick up enough of a feel for what makes economic sense and what doesn't, to make their comments meaningful at a high level. Senior-level lawyers by definition possess the talent and training to advise intelligently on all legal aspects of a given matter. Frequently, lawyers will have addressed a given situation enough times to develop a good idea of an intelligent business solution, in contrast to a client who may not have prior experience with the particular matter.

It is suggested that if a lawyer does not develop or has not yet developed some feel for the business ramifications of major client actions, he or she should not be functioning in a senior capacity. The effort is not to constitute the business bar as some sort of uber-board-of-directors or management committee sitting in judgment on day-to-day matters.

The goal simply is to keep them alert for fundamental problems that imperil the future of the enterprise or its investors. That would include, among other things, major accounting irregularities that should be palpably evident without formal accounting training — such as drastic changes in accounting policy, financial statements that are not readily understandable and transactions producing material financial-statement benefit to the organization or its management without a discernible business purpose.

To the author, existing standards and commentary dealing with organizational-level violations fall short of the mark by defining the problem in strictly legal terms. Murphy argues persuasively for a "beefing up" of the compliance function but implicitly defines compliance in terms of existing legal authority. Similarly, Sarbanes-Oxley and the related regulations condition the lawyer's obligation to do anything on a breach of statutory or common securities or fiduciary law.

By encouraging such a narrow view, the authorities make it likely that lawyers will fail to note the existence of many situations requiring their vigilance. Without counsel being required to address the business rationale for a given action, simply admonishing them to report legal violations is likely to be of limited practical value.

The SEC, in the Implementing Release, has come down at least temporarily in favor of a heightened counseling role for business lawyers as opposed to an enforcement role. The latter would require a so-called "noisy withdrawal" by the lawyer in which the lawyer must resign the engagement and disclose to the SEC and the marketplace their concern with the company's conduct.

In the Implementing Release, the SEC permitted but did not require the noisy withdrawal, extended the comment period for the noisy withdrawal requirement, and proposed an alternative of requiring the company — not the lawyer — to disclose the lawyer's withdrawal on a Form 8-K or equivalent. While the author strongly endorses the SEC's decision, it is also submitted that for lawyers to be stronger counselors, they must approach difficult situations with a broad view as to the needs of the organization, as opposed to focusing on the four corners of the statute books.

This could be implemented by adding to existing Section 1.2 of the Model Rules of Professional Conduct a new subsection (f) containing language such as:

(1) In accordance with their professional experience, a lawyer representing an organizational client in an entity- level capacity, other than as an advocate, shall use reasonable efforts to counsel such client's management in writing when they become aware or have reason to become aware of the contemplated or actual pursuit by such client of any act or omission or series of same that reasonably appears to such lawyer, based on the totality of the circumstances known to them, to be likely to cause serious financial or other harm to such organization or its investors taken as a whole, irrespective of whether the likelihood of such harm is based solely or primarily on legal or nonlegal considerations. Such advice shall be directed to at least the same level of management as that from which the lawyer learned the information.

(2)Serious financial or other harm shall be defined to include only such consequences as would reasonably be expected to imperil the existence of the organization or the financial security of its investors and shall be deemed to involve consequences that substantially exceed the level of materiality.

(3) No disciplinary charge or civil or criminal action shall be based solely on the failure of any lawyer to comply with the foregoing. So long as the lawyer shall act in good faith under this subsection (f), no advice given hereunder or failure to give such advice shall, of itself, constitute a basis for a claim for failure to satisfy any duty of competent representation under these rules or other ethical standards or applicable statutory or common law. However, the failure to comply with this subsection (f) shall be relevant to the consideration of disciplinary charges or legal action brought on other grounds.

(4) The obligation imposed on the lawyer hereunder shall not be waivable.

(5) Nothing contained herein shall modify the lawyer's obligations under sections 1.13 or 2.1 of these rules.

(6) It is intended that any advice pursuant to (1) above shall be protected from discovery and admissibility to the fullest extent permitted by applicable law and rules of practice.

These suggested additions are intended to implement the recommendations and supplement Sarbanes-Oxley by:

• making clear that as a result of the need to avoid undue disruption of the lawyer-client relationship to promote the open exchange of views, unlike the act, counsel need go no further with their reservations than client management and shall be under no obligation of any kind to go to a board of directors in the event that their reservations are rejected;
• applying the new standard to lawyers for all organizations and not merely those representing public companies, as is the case with the Sarbanes-Oxley legislation;
• limiting the obligation of counsel in this regard to those providing representation in a "corporate level capacity," seeking to avoid overlawyering by lawyers engaged to deal with discrete matters
• making largely advisory this standard, in order to be fair to lawyers trained in the traditional manner — that is, noncompliance by itself will not support disciplinary or legal action; and
• reserving these obligations for truly drastic problems; a mere material loss from the action in question (the act's standard) would not trigger any duty to act.