[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE ROLE OF ATTORNEYS
IN CORPORATE GOVERNANCE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
FEBRUARY 4, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-66
93-424 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio ARTUR DAVIS, Alabama
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida BRAD MILLER, North Carolina
JEB HENSARLING, Texas DAVID SCOTT, Georgia
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
February 4, 2004............................................. 1
Appendix:
February 4, 2004............................................. 25
WITNESSES
Wednesday, February 4, 2004
Cohen, George M., Edward F. Howrey Research Professor, University
of Virginia School of Law...................................... 9
Keller, Stanley, Partner, Palmer & Dodge LLP..................... 5
Madrid, Linda A., Managing Director, General Counsel and
Corporate Secretary, CarrAmerica Realty Corporation, on behalf
of the Association of Corporate Counsel........................ 4
Morgan, Thomas D., Professor, George Washington University Law
School......................................................... 11
Painter, Richard, Professor, University of Illinois College of
Law............................................................ 7
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 26
Emanuel, Hon. Rahm........................................... 27
Gillmor, Hon. Paul E......................................... 29
Gonzalez, Hon. Charles A..................................... 31
Kanjorski, Hon. Paul E....................................... 32
Cohen, George M.............................................. 34
Keller, Stanley.............................................. 52
Madrid, Linda A.............................................. 57
Morgan, Thomas D............................................. 71
Painter, Richard............................................. 85
Additional Material Submitted for the Record
Piper Rudnick LLP, prepared statement............................ 91
THE ROLE OF ATTORNEYS
IN CORPORATE GOVERNANCE
----------
Wednesday, February 4, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:01 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Manzullo,
Kelly, Shadegg, Ryun, Capito, Kennedy, Kanjorski, Sherman,
Inslee, Moore, Lucas of Kentucky, McCarthy, Emanuel and Scott.
Mr. Gonzalez was also present.
Chairman Baker. [Presiding.] I would like to call this
meeting of the Capital Markets Subcommittee to order. The
committee meets today to consider the role of professional
conduct of attorneys and their responsibility toward
appropriate corporate governance. Unfortunate events all too
public now, from Enron to WorldCom and others, have
necessitated the committee's work in review of the role of
accountants, corporate officers, board members, credit rating
agencies, research analysts and others.
The hearing today is a continuation of that review of all
responsible parties and today we will focus on the professional
accountability of corporate attorneys in disclosing material
violations of securities law. The SEC is now in the process of
considering two significant modifications to current standards,
one referred to as the ``up the ladder'' responsibility to
disclose to the chief legal counsel or the chief executive of
the corporation material breaches of professional conduct;
secondly, to report the evidence to the company's audit
committee and the independent director specifically, or to the
board of directors if the counsel does not appropriately
respond to the evidence.
Another recommendation which has seemed to draw more
attention and comment is the obligation of an attorney to file
a ``noisy withdrawal'' from representing the company, and
simultaneously notifying the SEC as to the reasons for this
action. Significant debate continues over the appropriateness
of the ``noisy withdrawal'' requirement, and we are here today
to receive perspectives as to the appropriate direction the
committee should take in regard to the SEC's consideration of
this important matter.
I would also point out for the conduct of the hearing that
we do expect at 11 o'clock this morning to have a joint session
of the Congress, of course requiring us to adjourn the meeting
for that purpose. It would be my hope that we could proceed in
a timely manner this morning, perhaps limiting opening
statements as much as is possible and asking all witnesses to
engage their testimony in 5 minutes or less in order to give
the committee opportunity for some interchange before the hour
comes for adjournment. It is unfortunate, but at the time this
was planned, we did not know and were not aware of this
development. I suggest that for the witnesses's convenience,
because I would not want to keep you here unnecessarily while
the joint session was proceeding.
With that statement, I would call on Mr. Kanjorski for his
comments.
Mr. Kanjorski. Thank you, Mr. Chairman.
We adopted the Sarbanes-Oxley Act during the last Congress
after a rash of corporate scandals. This statute modified the
regulation of auditors, business executives, corporate boards
and research analysts. A key section of this law also revised
the oversight of attorneys in our capital markets. This part of
the law and its related pending regulatory proceedings at the
Securities and Exchange Commission are the focus of today's
hearing.
The regulatory system for our capital markets depends in
large part on the effectiveness of a variety of independent
gatekeepers. These skilled professionals include the lawyers
and accountants who verify and analyze the disclosures and
documents of publicly held companies. These experts, from my
perspective, have a special obligation to behave ethically and
follow the law. Professionals like lawyers also have a
responsibility to police themselves. If, however, such
professionals fail to effectively monitor their actions and
those of their peers, we have an obligation to protect
investors by taking action in Washington.
After examining the corporate scandals at Enron, WorldCom
and other companies, we ultimately determined that securities
lawyers played a role in these debacles and decided to alter
the rules governing the profession. One year ago, the
Securities and Exchange Commission adopted a regulation to
implement the reforms affecting securities attorneys mandated
by the Sarbanes-Oxley Act. This rule requires lawyers to report
``up the ladder'' evidence of material wrongdoing to a
company's officers and, if necessary, a company's board. This
regulation, which I strongly support, became effective last
August.
When adopting the rule governing the professional
responsibilities of securities lawyers, the Commission also
extended the public comment period on a proposal to require a
``noisy withdrawal'' by attorneys who do not receive a
satisfactory response from a company to internal reports of
wrongdoing. This plan to require the notification by the
attorney to the Commission of his or her withdrawal immediately
met with strong opposition from many practitioners in the legal
community. In response, the Commission put forward for review
an alternate plan. This substitute would require the issuer,
rather than the attorney, to report the withdrawal of a lawyer
for professional reasons.
The two withdrawal-and-notification proposals presently
pending before the Securities and Exchange Commission raise
important questions that we should carefully examine today.
Each one has the potential to alter the attorney-client
privilege and could have a chilling effect on communications
between management and counsel, making executives less likely
to consult and speak frankly with lawyers. These proposals
might also unintentionally reward those lawyers with lower
ethical standards, who would stretch the law beyond its
reasonable interpretations and never withdraw from a client. We
should closely examine each of these concerns.
In their observations today, I hope that our distinguished
witnesses will answer a question that I have about restoring
the ability of victims of securities fraud to sue those who aid
and abet issuers in defrauding the public. Prior to a 1994
decision by the Supreme Court, individuals had the right to
pursue a private cause of action against lawyers and other
professionals who helped public corporations to deceive the
public.
Although we partially overturned this decision when passing
the Private Securities Litigation Reform Act of 1995 to allow
the commission under certain circumstances to bring cases
against aiders and abettors of securities fraud, we may have
failed to do enough to protect investors. After all, past
leaders of the Securities and Exchange Commission from both
political parties have stressed the integral role of private
lawsuits in maintaining investor confidence.
Since 1994, however, the victims of securities fraud have
been unable to bring claims against lawyers and other
gatekeepers who abuse the public trust by aiding issuers in
misleading shareholders. Rather than adopting either one of the
pending alternatives for reporting an attorney's withdrawal
from representation because of concerns about the client's
potential or actual wrongdoing, it may make sense for the
Congress to instead restore the right of individuals to pursue
their legal claims in our courts.
In closing, Mr. Chairman, I commend you again for your
sustained leadership in studying these matters. This timely
hearing will help us to better appreciate the decisions facing
the commission as it continues its work to bolster investor
confidence, restore the integrity of financial statements, and
rebuild trust in our securities markets.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 32 in the appendix.]
Chairman Baker. I thank the gentleman for his statement. It
is my understanding Members on my side do wish to file for the
record their opening statements, but do not wish to be
recognized at this time. I would ask, are there Members on your
side, Mr. Kanjorski, who wish to be recognized for an opening
statement? Mr. Gonzalez, did you have a unanimous consent
request?
Mr. Gonzalez. Sir, I will be submitting something for the
record, and I appreciate the opportunity to do that, but I do
not wish to speak at this time.
[The prepared statement of Hon. Charles A. Gonzalez can be
found on page 31 in the appendix.]
Chairman Baker. We welcome your insightful participation,
Mr. Gonzalez. Thank you, sir.
If there are no further opening statements at this time,
then I will proceed to recognize our first participant this
morning, Ms. Linda A. Madrid, managing director, general
counsel and corporate secretary, CarrAmerica Realty
Corporation, appearing on behalf of the Association of
Corporate Counsel. Welcome, Ms. Madrid.
STATEMENT OF LINDA A. MADRID, MANAGING DIRECTOR, GENERAL
COUNSEL AND CORPORATE SECRETARY, CARRAMERICA REALTY
CORPORATION, ON BEHALF OF THE ASSOCIATION OF CORPORATE COUNSEL
Ms. Madrid. Good morning, Mr. Chairman, Ranking Member
Kanjorski, and other Members of the committee.
I am Linda Madrid, and I serve as managing director,
general counsel and corporate secretary of CarrAmerica Realty
Corporation. CarrAmerica is a commercial office REIT that is
traded on the New York Stock Exchange.
I am pleased to appear on behalf of the nearly 16,000
members of the Association of Corporate Counsel, or ACC, and
the more than 7,000 private organizational entities that they
represent in over 47 countries. Because outside counsel are not
eligible for membership, we understand the issues and concerns
facing in-house counsel probably better than any other
organization.
The comments I offer here today are those of ACC and do not
reflect the positions of my employer, CarrAmerica Realty
Corporation. My oral testimony summarizes a more detailed
statement which I hope you will include as part of the
permanent record.
Chairman Baker. Without objection, all witnesses's
testimony will be made part of the official record. Thank you.
Ms. Madrid. Thank you.
The passage of the Sarbanes-Oxley Act reflects an
understandable response to recent and devastating corporate
scandals. ACC strongly supports the law's intention to restore
shareholder and investor confidence. Corporate counsel play the
key role in helping management and the board enact governance
reforms that ensure the company's ethical culture is supported
by sound governance systems. Our members embrace their
professional and fiduciary duties, which include reporting
allegations up the ladder to the highest authority necessary to
ensure that the client can and does remedy the legal problems
caused by rogue employees or executives.
Lawyers who represent corporations owe their allegiance to
the institution, not to any individual within it. It is a basic
tenet of all professional rules, not just those of the SEC,
that have been promulgated under section 307. Our members fully
support section 307 reforms that help in-house lawyers to work
closely with managers to instill compliance values and
guarantee sound legal systems.
My full statement as to how companies and law departments
are ensuring compliance with 307 rules has been included, but I
am happy to report today that the majority of law departments
that have implemented policies under 307 have gone beyond the
SEC's requirements.
I would be happy to respond to any questions you may have
regarding the law departments's efforts, as well as the
unanticipated problems they have discovered through practical
implementation. These include the concern that too much time is
spent on process, and it will take away focus from the
preventive counseling that is necessary, continuing problems
with the definition and scope of many of the important aspects
of the Act and its terminology, and the proliferation of
conflicting attorney conduct rules by governmental agencies and
state bars.
However, ACC strongly opposes mandatory reporting-out
requirements, which the SEC has kept on the table for
consideration. We believe that they will damage the underlying
relationship between in-house lawyers and their clients.
Mandatory reporting-out by lawyers inhibits legal compliance
efforts because it discourages clients from welcoming lawyers
into every aspect of the company's most sensitive of matters.
In-house lawyers are only effective if they are integrated
and trusted members of corporate management teams. If lawyers
are viewed as in-house cops whose regulatory duties to outside
enforcement agencies outweighs the client's need for
confidential counsel, then the attorney-client relationship
will have been undermined in a manner that is both
counterproductive to the purpose and intent of the Act, and a
disservice to the effective protection of the public and the
client.
Thank you for this opportunity. I would be happy to answer
any questions.
[The prepared statement of Linda A. Madrid can be found on
page 57 in the appendix.]
Chairman Baker. Thank you very much.
Our next witness is Mr. Stanley Keller, partner in the law
firm of Palmer and Dodge. Welcome, Mr. Keller.
STATEMENT OF STANLEY KELLER, PARTNER, LAW FIRM OF PALMER &
DODGE, LLP
Mr. Keller. Thank you, Chairman Baker, Ranking Member
Kanjorski and other Members of the committee. I am pleased to
have the opportunity to testify before the subcommittee on this
important subject.
Because Linda is here speaking for in-house lawyers, I can
speak for out-house lawyers, having spent over 40 years in
private practice representing corporations, and many public
corporations. I have been actively involved in the subject of
this hearing, having chaired until last August the American Bar
Association's Committee on Federal Regulation of Securities.
I was also actively involved in the ABA's Task Force on
Corporate Responsibility, known as the Cheek Commission, as a
special adviser. Just to round it out, I was actively involved
as liaison to the ABA's Task Force on Implementation of Section
307 of the Sarbanes-Oxley Act. In that capacity, I had a
primary role in preparing the comments of the ABA to the SEC.
Having said that, I do not appear here as a representative
of the ABA, but note that just as background. Rather, I am here
in my individual capacity. I refer you to a letter submitted by
the ABA, as well as a letter from Peter Moser, who chaired the
section 307 task force. I embrace those letters.
I would like to very quickly, given the time constraints,
address just two points, and two related points: one, the
significant changes that have taken place in corporate
governance and lawyer professional responsibility since the
enactment of what we fondly refer to as SOX; second, the issues
surrounding the need for additional action, namely the SEC's
proposed ``noisy withdrawal'' rule.
Let me make clear that when I speak about the ``noisy
withdrawal'' rule, I am speaking about either alternative that
is still on the table. To me, it makes no difference if the
mandate is that the lawyer withdraw, whether it is the lawyer
that ends up reporting that withdrawal or it is the company
that then is put in the position of having to report that
withdrawal. The problems, I think, are the same with either
alternative, although one has a cosmetic appeal.
The two issues are related because attorney professional
conduct rules are best understood and considered in the context
of the enhancements that have already taken place in corporate
governance and in lawyer responsibility. My written testimony
lists those. I will not dwell on them, but just to check-off a
handful, we really have a new corporate governance structure
requiring a majority of independent directors and effective
committees of the board, notably the audit committee and
recommendations that have been embraced widely for improved
corporate governance from various groups, including the ABA's
task force on corporate responsibility.
The ABA's approval this past summer of revisions to the
model rules of professional conduct enhance the lawyer's role
in ensuring legal compliance. We have the SEC's ``reporting
up'' rules. I would like to say that the SEC did an outstanding
job in responding to the mandate from Congress in section 307,
to adopt the ``reporting up'' rules.
Those rules, while I must admit 307 was not
enthusiastically embraced when it was proposed, have had a
beneficial impact and have been widely accepted and are being
followed or being implemented, because they are consistent with
the ethics rules that lawyers have been subject to and, if
anything, they have brought renewed attention to the need to
comply with professional responsibility requirements.
The SEC's effort to override inconsistent state rules so as
to permit lawyers in appropriate circumstances to report out
again is consistent with existing state ethics rules. As I
said, there have been significant compliance efforts by law
firms, by corporate law departments, continuing legal education
efforts and the like.
The result of all of these efforts has been the creation of
a system in which we can all take confidence. Lawyers who are
aware of their responsibility and are vigilant, having had
brought, if you will, to their attention what their
responsibilities always have been, and who are now paying
attention to them reporting up when there is a problem to a
board with independent directors who are in a position to
receive, consider and act upon those reports. I think this is a
system that we should allow to operate, that addresses the
problems.
In the face of these circumstances, the ``noisy
withdrawal'' proposals bring with them serious risks of adverse
consequences, not in the lawyer's interest, if you will, but
rather in the interest of the client and access to effective
legal representation, to the core values of our legal system,
and to principles of corporate governance.
These adverse consequences, put very simply, are erosion of
the attorney-client relationship by making the lawyer a
potential adversary; two, encouraging or promoting early
withdrawal by lawyers who have to be more concerned about their
own exposure to a violation of federal law than just hanging in
there, seeking corporate compliance by the client, and serving
the best interest of the client and the investors of those
clients.
Perhaps even worse, because of the serious nature of having
to withdraw, we may find lawyers discouraged from looking at
the hard issues, the hard questions, so as not to turn over the
stone and see the problems which would then put then in the
position of having to report and potentially to withdraw. To
me, that would be contrary to the best interests of promoting
legal compliance.
Finally, judgments on critical business decisions, where a
mandatory rule would suddenly put the lawyers in the position
of making those decisions, rather than boards of directors and
independent directors who are charged with that responsibility
and expected to fulfill that responsibility.
Let me conclude, and leave the rest to my written
testimony, really with my conclusion that we should allow the
measures that have been put in place to operate before we
embark on these fundamental changes to the lawyer's role, with
the potential serious consequences that can result from those
changes.
Thank you, and I would be happy to respond to questions at
the appropriate time.
[The prepared statement of Stanley Keller can be found on
page 52 in the appendix.]
Chairman Baker. Thank you, Mr. Keller.
Our next witness is Professor Richard Painter from the
University of Illinois College of Law. Welcome, professor.
STATEMENT OF PROFESSOR RICHARD PAINTER, UNIVERSITY OF ILLINOIS
COLLEGE OF LAW
Mr. Painter. Thank you, Mr. Chairman and Members of the
committee.
Wherever possible, I believe it is best to leave regulation
to the states, rather than to the federal government. There
are, however, exceptions, and section 307 is one of them. I
pointed out in the early 1990s my frustration that out of
dozens of lawyers accused by federal banking regulators of
aiding and abetting savings and loan fraud, not one was
disciplined by a state bar association, at least that I know
of. This was so despite the fact that many of these lawyers
settled cases brought by federal regulators for $20 million,
$30 million and even over $40 million. The fact is that state
bar discipline is virtually meaningless for policing the
practice of securities and banking law.
It is for this reason that I proposed in a 1996 law review
article that Congress enact a statute requiring securities
lawyers to report known illegal acts of corporate clients up
the ladder to the client's full board of directors. It is also
for this reason that I appealed to the ABA in 1998 to amend the
model rules of professional conduct to require such ``up the
ladder'' reporting, only to have the proposal rejected in favor
of the prevailing view at the time that such matters ought to
be left to the lawyer.
It is for this reason that I and 40 other law professors
wrote SEC Chairman Harvey Pitt in March of 2002 to request that
the Commission promulgate rules requiring ``up the ladder''
reporting. Finally, this proposal made its way to Congress and
Congress in the summer of 2002 enacted section 307, which
requires the SEC to promulgate the ``up the ladder'' reporting
rule.
Section 307 and the SEC rules thereunder appear to be
working. Just last month, the New York Times reported that
because of section 307, outside lawyers for TV Azteca, Mexico's
second-largest broadcasting company, reported to its board of
directors the fact that the company was probably violating
United States securities laws. For the most part, I support the
SEC's final rules under section 307 and would be happy to go
into detail with respect to that if you would like.
With respect to the SEC's proposed rules, which have not
yet become final, the most controversial provision is, of
course, the proposal for ``noisy withdrawal.'' I would support
a requirement that the lawyer withdraw from representing a
client when they have reported to the full board of directors
known securities law violations and the full board of directors
refuses to obey the law. The amount of noise, however, should
perhaps be left to the lawyer. Indeed, most lawyers, who do not
want to find themselves in a position where they could be
exposed to civil liability for their client's conduct, will
take prompt steps once they have resigned to make sure that the
fraud does not come to pass.
So with respect to that issue, I agree partially with the
SEC's position that withdrawal should be required, but the
``noisy withdrawal'' proposal that has been so controversial is
perhaps unnecessary.
I would then move on to other issues that I believe deserve
our serious attention. One of these is the level of knowledge
required to trigger section 307's reporting obligations to
begin with. I believe the SEC's definition of ``evidence of
material violation'' is exceedingly narrow and does not comply
with the broad language of the statute. Second, the SEC needs
to consider how easy or difficult it is for issuers to use the
opt-out mechanism, which is a qualified legal compliance
committee. The SEC should solicit commentary on how this aspect
of the rule is working in practice.
Finally, Congress in section 307 gave the SEC quite broad
authority beyond ``up the ladder'' reporting requirements. As I
mentioned, I would not, if I were the Commission, use this
authority and the political capital that the Commission might
have on this issue, to fight over ``noisy withdrawal,'' but
rather turn to some other areas of concern. One of them that I
mention in more detail in my written testimony is contingent
fees in connection with corporate transactions. In the AOL-Time
Warner merger, Time Warner's counsel, according to press
reports, received a contingent fee of $35 million contingent on
the deal closing. It would have only been around $5 million if
the deal had not closed.
I am not going to imply in any way that Time Warner
received anything other than the most competent and loyal
representation of counsel, but I am seriously concerned about
contingent fees in securities transactions where the lawyer
gets paid far more if the deal closes than if it does not, and
this is the same lawyer who is supposed to be looking out for
problems with the deal where it may not be in the interests of
their client.
In sum, while the ``noisy withdrawal'' debate has received
much attention, I urge the SEC to consider requiring withdrawal
without requiring noise, and then to move on to other more
pressing issues in carrying out its congressional mandate.
Thank you, Mr. Chairman.
[The prepared statement of Richard Painter can be found on
page 85 in the appendix.]
Chairman Baker. Thank you very much.
Our next witness is Professor George M. Cohen, University
of Virginia Law School. Welcome, sir.
STATEMENT OF PROFESSOR GEORGE M. COHEN, UNIVERSITY OF VIRGINIA
LAW SCHOOL
Mr. Cohen. Thank you very much. Thank you, Mr. Chairman,
and thank you for having me here.
I want to state my conclusions that I give in the testimony
first, and then talk about some responses to some of the
objections that lawyers have made to the existing and the
proposed rules.
First, the rule as it exists I support wholeheartedly. I
believe that it needs to be fixed in several respects. One, the
``reporting up'' trigger is a very difficult trigger, I think,
for lawyers and anyone else to understand, and very difficult
for the SEC to enforce. Let me read to you what the rule
actually says. The rule says that you have to report evidence
of a material violation, and the definition of ``evidence of a
material violation'' is ``credible evidence based upon which it
would be unreasonable under the circumstances for a prudent and
competent attorney not to conclude that it is reasonably likely
that a material violation has occurred, is ongoing, or is about
to occur.''
This kind of formulation, with its double negative, makes
it very difficult for the SEC to enforce actions against
lawyers who engage in wrongdoing. I think that that needs to be
changed because if the initial trigger, which is the main
purpose of section 307 and the SEC rules, does not work well,
then the whole thing does not work well.
Secondly, there is a problem with the ``appropriate
response'' definition, that is, that if a lawyer reports
wrongdoing to the CEO or the chief legal officer of the court,
the question is, does the lawyer get an appropriate response,
because that determines whether or not the lawyer needs to go
up the ladder to the board. The ``appropriate response''
definition contains what you might expect.
That is, if after an investigation it is determined that
there is no problem, or if it is determined that there is a
problem, but it is being fixed. But there is another
possibility that is listed in the SEC rules, and that is, if a
lawyer is hired to investigate the alleged wrongdoing and is
able to assert or is willing to assert a so-called ``colorable
defense,'' then that is deemed to be an appropriate response.
I submit to the committee that that is not an appropriate
response. It is an appropriate stance that one might take
perhaps in litigation, but there is an important difference
between lawyers' role as advocates in litigation and lawyers'
roles as counselors in determining whether or not the company
is more likely than not engaged in serious wrongdoing.
Finally, I think the rule needs to be changed to apply not
only to individual lawyers, but to law firms. Firms are hired
generally by corporations, not individual lawyers. The firm as
a whole ought to be responsible. If the firm is not made
responsible, there is a danger that work will be parceled out
in such a way that no individual person, no individual lawyer
will have sufficient knowledge of what is going on, what the
big picture is.
The imputation of knowledge is a common feature of agency
law, partnership law, and exists throughout the law. The SEC
itself has used this idea under its former and still continuing
authority under Rule 102(e). That should be adopted as part of
the new SEC rules as well.
Secondly, I support wholeheartedly the ``noisy withdrawal''
rule that the SEC has proposed. I think that it is consistent
with the traditional approach to this problem that has existed
in the lawyer rules. In fact, the ``noisy withdrawal'' proposal
is a creature not of the SEC, but of the ABA itself, which in
its own comments to its own model rules says that there may be
times when it is necessary for a lawyer to withdraw and also to
disavow any documents or opinions that have proven to be false
on further investigation. This is necessary in order for the
lawyers to avoid becoming complicit in wrongdoing by
corporations.
So the question is, if you go up the ladder and you have a
board that is a corrupt board and insists on engaging in
wrongdoing, how is the lawyer supposed to extricate himself or
herself from being an assister, an aider and abettor in the
wrongdoing? I think that the only way to do that, and I hope
and expect that it would be in very rare circumstances, but I
think that past experience suggests that it can happen, is that
we ought to take a stance and say that if it does happen, that
the board is engaged in wrongdoing and will not stop, that the
lawyer ought to be required to make the noisy withdrawal.
Whether or not the lawyer does it or the company does it, I do
not have strong feelings about.
Third, I think that it is important to go beyond the SEC
rules and fixing the SEC rules, to think about other ways to
deal with some of the problems of lawyers assisting in
corporate wrongdoing, the most important of which, in my view,
is to restore private lawsuits, private damage suits for aiding
and abetting liability, which were taken away by the Supreme
Court decision in Central Bank in the mid-1990s, and were not
restored, even though Congress had the chance to do it, in the
Private Litigation Securities Reform Act. I think that that
needs to happen. In some sense, the potential for liability for
aiding and abetting is the most effective deterrent, the most
effective regulator for lawyer behavior. I would urge Congress
to restore the aiding and abetting cause of action.
Finally, I think that it is important to recognize that
although the SEC is an important federal agency that regulates
lawyers, it is not the only one. I think it would be wise for
Congress to consider extending the SEC's rules to other lawyers
who also appear before other federal agencies, both in the name
of uniformity and consistency in an approach to the problem of
corporate wrongdoing and lawyers' assistance in that
wrongdoing.
I see that my time is up. I would be happy to answer
questions and to talk about some of the other arguments I make
in the testimony later on.
[The prepared statement of George M. Cohen can be found on
page 34 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is Professor Thomas D. Morgan from George
Washington University Law School. Welcome.
STATEMENT OF PROFESSOR THOMAS D. MORGAN, GEORGE WASHINGTON
UNIVERSITY LAW SCHOOL
Mr. Morgan. Thank you, Mr. Chairman, Members of the
committee. I, too, appreciate the chance to be here with you
today. You have heard from all of us, and we all agree that
there is no right of any lawyer knowingly to assist a client,
corporate or otherwise, to commit a crime or fraud. The problem
is that there are a number of serious questions about how a
given lawyer should be required to act in any particular
concrete situation. But we all agree that the boundaries of
appropriate zealous representation of a client end where
knowingly assisting a crime or fraud begins.
The testimony that I have submitted to you, and that I will
simply stand on, makes three important points. First, a
comprehensive body of state and federal regulation already
exists that renders doubtful the need for additional
regulation. It includes, under some circumstances, a
requirement of withdrawal and even permission of noisy
withdrawal.
Second, the role of corporate attorneys in actually
formulating corporate policy and in some cases even being aware
of the intricacies of what the company is doing, very often
tends to be much smaller than we sometimes think. Thus, the
responsibility for much of the corporate wrongdoing is not
likely to be significantly at the feet of attorneys. I leave
the statement to develop that.
Third, federally mandated ``noisy withdrawal'' in the face
of possible wrongdoing would potentially create more problems
than it would solve. In the interest of time, I would like to
focus my oral comments on that issue. Under current SEC
standards, matters that an attorney is required to report
within the client are quite broad. As Professor Painter
suggested, the standard of knowledge is really quite low.
It includes matters about which the attorney may have very
little knowledge, may not have worked on, may not even
understand the subject matter area. Indeed, the attorney may
not even be well equipped to evaluate the company's response.
Yet, the lawyer may very conscientiously conclude that he or
she must withdraw or does not want to continue representing the
client.
What I suggest in my written testimony is that ``noisy
withdrawal'' in those circumstances does not, will not provide
investors with direct reliable information. I describe it as
the professional equivalent of the parlor game of charades, the
game in which people are asked to read content into otherwise
ambiguous gestures. The problems of restoring investor
confidence and of getting lawyers to give good legal advice and
to respond appropriately in tough situations is just too
serious for that kind of simplistic response.
I suggest to you that disclosure of ambiguous information
to securities markets is not an unvarnished good. Accurate,
easily understood information makes markets work better, but
confusing, ambiguous information makes markets work less well.
If investors are led to believe by the conscientious noisy
withdrawal of a lawyer that they know facts about the company
that later prove to be less significant than they once thought,
real Americans are going to lose real dollars for no good
reason.
Today, under existing regulation both of the SEC and of the
states, attorneys can make disclosure to regulators, but their
disclosures should be based on sound information, and before
information goes to the markets, it ought to be confirmed and
accurate and not simply be part of a single process.
Finally, Mr. Kanjorski asked us to talk about Central Bank.
In response to Professor Cohen, I would simply suggest to you
that moving to creating aiding and abetting liability for
attorneys would not be a good idea. Under the Newby case, the
Enron case in Texas, the judge has moved the law of primary
violation of the securities law much more in the direction of
saying that if a lawyer is actively involved in reporting
inaccurate information to the public, the lawyer may be guilty
of a primary violation. Simply creating a rule that ropes into
every investor lawsuit every lawyer who might have touched the
matter at some point in time, I would suggest to you is a great
overreaction to the problem.
Thank you very much.
[The prepared statement of Thomas D. Morgan can be found on
page 71 in the appendix.]
Chairman Baker. Thank you, Professor Morgan.
I would like to start with you, and for the sake of the
committee's conduct, I will announce that we will try to adhere
to the 5-minute rule strictly today to give as many Members the
opportunity because of the 11 o'clock joint session.
I think in order to determine the appropriateness of the
revisions, one has to first establish the role of the corporate
counsel within the structure, much like the committee did in
viewing the role of the accountants and their fiduciary duty to
shareholders. We had CPAs appear before the committee. When
asked, to whom do you feel ultimate responsibility? They made
the statement it is a shared responsibility between management
and shareholders, which I found disappointing; that their role
was to provide a true and accurate picture of financial
condition so shareholders could assess the value of that
holding.
If we determine that the role of corporate counsel is to
ensure that corporate conduct does not engage in unintentional
or intentional violations of law for the protection of the
shareholder, that seems to create a higher standard of
accountability than if we simply view it as an attorney-client
relationship working on behalf of that executive to isolate
that executive from any statutory or criminal liabilities.
To that end, if in your example it is unclear, uncertain,
outside the area of specialization, and he acted, that would be
in the shareholders's disinterest, I believe was your
conclusion. On the other hand, where there is a three-act play,
an opening, an explanation and a conclusion, it is clear. You
have gone to the board; you have done all appropriate action.
Isn't there some point at which a withdrawal appropriately
should be made, when there is clear knowledge that all
appropriate responses have been without remedy? Is this a
moving target where one standard, as you describe it, does not
fit all, but there are cases where such a withdrawal might be
advisable?
Mr. Morgan. Yes, Mr. Chairman. I do not think there is any
question there are cases where it might be desirable, and where
under current regulation it is appropriate and indeed, as
Professor Cohen suggested, it is consistent with current state
regulations that a lawyer should withdraw. Indeed, any lawyer
who puts his or her reputation behind a situation that they
know to be dishonest and fraudulent is clearly violating the
rules today.
Chairman Baker. It would appear to me that reestablishing
that professional accountability would not be adverse to public
interest, wherein you have established, and you are leaving it
to the attorney; we are not prescribing the elements, the
material facts that must be engaged in order for the step to be
taken. We are merely establishing the fiduciary standard for
your conduct.
I am not sure that the ``noisy withdrawal'' rule as
currently constructed achieves the goal it is intended to
achieve. But I have seen circumstances where I think it should
have been appropriate and it was not taken, and shareholder
interests were dissipated as a result of that failure to act.
There has not been a corresponding responsibility for the
attorney who did not engage in proper conduct. That really goes
to the heart of my concerns about it.
Did anyone just want to jump in? Yes, Professor Painter?
Mr. Painter. I believe you are exactly right, Mr. Chairman.
The lawyer for the corporation represents the corporation,
which is run by its board of directors, not its officers, but
its board of directors. That is why the ``up the ladder''
reporting is so critical. Directors have the right and the
responsibility to know about violations of the law.
Second, the lawyer is also an officer of the corporation.
The lawyer has some public obligation. If the lawyer knows the
client refuses to obey the law, and they have exhausted all
remedies with the board of directors, the lawyer should be
required to resign. I support that part of the SEC's rules. The
amount of noise involved can be a debatable question, but the
lawyer should get out of there, and any intelligent lawyer will
get out of there because they will be sued. We do not really
need to overturn Central Bank of Denver to make it possible to
sue lawyers in these situations.
If the company goes bankrupt, the trustee comes in and sues
the lawyers. We saw that in the savings and loan cases. Indeed,
the civil liability regime for the past 10 or 15 years has been
way ahead of the ethics rules on this point. It was the civil
liability regime that was really the sole disciplining factor
for the bar until Congress decided in section 307 to step in
and mandate SEC ethics rules, which was the right thing to do.
Chairman Baker. Thank you.
Yes, Mr. Keller?
Mr. Keller. May I just comment briefly? I think there is no
question that there are circumstances when lawyers are well
advised to withdraw. But I think the issue is whether you do
more harm than good in trying to define any kind of bright-line
rules as a matter of federal regulation or federal legislation,
given the complexity of situations that we are confronted with.
We know when someone announces they are going to rob a bank
that there is a clear violation of law. But very frankly, in
the area we deal with, disclosure concerns, breach of fiduciary
duties, there are subtle complex issues. That is why the regime
that permits lawyers, indeed encourages lawyers, to take those
actions helps; a regime that backs up the failure to act
reasonably within a range of reasonableness, through being
exposed to liability. Aiding and abetting liability exists. It
is sanctioned by the SEC. You also can be a primary violator.
That provides the kind of incentives, if you will, for proper
conduct. I just do not think that this is an area susceptible
to a bright-line test.
Chairman Baker. Thank you sir. My time has expired.
Mr. Kanjorski?
Mr. Kanjorski. In lieu of section 307, I am curious as to
how great a problem the witnesses's feelings are as to how much
of a problem exists today as compared to prior to 307. Are we
beating a dead horse, that we need additional rules? Or is
there any evidence out there that there is a failure to comply
with either ethical codes or standards that were implied in
section 307?
Mr. Keller. As I indicated in my remarks, I think there has
been a dramatic impact as a result of 307. Most every law firm
in the country, I assume every in-house legal department, has
put in place procedures to implement the SEC rules adopted
pursuant to 307. There is a great deal of attention. This is
part of what I think has been the overall impact of the
Sarbanes-Oxley Act, which is reminding people and getting their
attention back to what their fundamental responsibilities were.
Mr. Kanjorski. Mr. Keller, I am going to direct it to you.
We have a little difference between Professor Cohen and
Professor Morgan in terms of aiding and abetting, whether we
should go back and let the marketplace work out with the legal
system on this problem. If you had to make a choice as a
private practitioner to go back and reinstate the legal
liability of aiding and abetting to investors or other
individuals, as opposed to extending the ``noisy withdrawal,''
which would you choose?
Mr. Keller. I would choose to let the law evolve as it is
evolving in the Newby case, because the problem is the
disproportionality of the exposure based upon the conduct and
the financial interest, and the chilling effect of
automatically being named in the proliferation of lawsuits
which Congress sought to address in the Private Litigation
Securities Reform Act would have on the ability of lawyers to
counsel clients zealously and in the best interest of the
client, as opposed to protecting their own interest. So I would
let the common law evolve, given the anti-fraud rules that are
now in place.
Mr. Kanjorski. Professor Morgan, you indicated that there
are instances where lawsuits can be brought by the trustee of a
bankrupt estate, but how about in those situations where the
fraud is successful?
Mr. Morgan. Perhaps I do not understand the question.
Mr. Kanjorski. The lawyer participates in a fraudulent
transaction, but the corporation does not fail. There is no
lawsuit by those people injured for aiding and abetting.
Mr. Morgan. I was not intending to speak to the question of
bankruptcy.
Mr. Kanjorski. You mentioned in your response that there
are in fact lawsuits that can be brought for aiding and
abetting. You cite as an example a trustee in bankruptcy of a
bankrupt corporation can bring an action. That is true, but
what if the corporation does not go bankrupt? What if the fraud
actually succeeds and the corporation makes a great deal of
benefit, but at someone else's cost where a lawsuit for aiding
and abetting in fraud would give that person a chance to
recover?
Mr. Morgan. There are two answers. One, to the extent the
lawyer can be shown to have aided and abetted fraud, and there
is a suit for fraud, the victim of the fraud can recover today.
Mr. Kanjorski. That would only be if the attorney is
directly involved in fraud, not aiding and abetting, as I
understand it.
Mr. Morgan. At least not under the federal securities laws.
The question is, what is going to constitute a primary
violation? The point that I was trying to make and that Mr.
Keller reiterated was that under the Newby case, the law is
moving more in the direction of saying that such a suit is
available to a person who is injured by direct activity of the
lawyer, as opposed to simply the lawyer having been involved at
some point in time in the activities of the company.
What many of us are concerned about is that lawyers will be
swept into a large undifferentiated mass of people who will be
accused of aiding and abetting, but who have no primary
responsibility. That is the concern.
Mr. Kanjorski. I understand that, but why can't we put a
filtering mechanism of the review of peers, and the suit does
not have merit to proceed against the lawyer unless the peers
decide that it was very clear that he had information,
knowledge, and participated? We are doing a black and white
situation here. I say why can't we move to a little bit of a
gray area to reinforce and restore the aiding and abetting
obligation or standard. As I understand it, the objection would
be made now if a lawyer is named in a lawsuit as an aider and
abettor. It would be stricken under existing law.
Mr. Morgan. What happens today is that they will accuse him
of being a primary violator. If the law as stated in the Newby
case becomes the law, becomes generally accepted, then we will
have moved in the direction that I think you are seeking to
move. What some of us are saying is that we think the law is
moving in the direction that you prefer, and that a general
move toward aiding and abetting liability would not be
desirable. Whether there is an interim step is a question about
which I guess we would just simply have to look at the language
that is selected.
Mr. Kanjorski. Thank you. If I could take one more second,
Mr. Cohen, I think, has something to add to this discussion.
Mr. Cohen. Yes, I do. Let me just say something about
aiding and abetting. First of all, it is important to remember,
one, aiding and abetting is a crime. It is a federal crime if
there is sufficient criminal intent. Now, it is hard to prove
criminal intent, but it has always been a crime to aid and
abet. It has always been an ethical violation to aid and abet.
The SEC currently has the authority to prosecute aiding and
abetting. So to me, the idea that lawyers cannot figure out
what aiding and abetting is, they have been living with aiding
and abetting forever. So I do not find that a valid argument.
As to the Newby (Enron) case, I agree with the result in
that case, but I think that, to go back to Professor Morgan's
point about making sure that we want to clarify the law, Newby
was not predicted by many securities lawyers ahead of time, the
result. In fact, Professor John Coffee from Columbia had
written a statement before that case was decided saying he did
not think there could be a primary violation found.
So yes, you can stretch the law and call things primary
violations that used to be called secondary violations, but why
should you do that? We had a history under the securities laws,
several decades of case law defining what aiding and abetting
was. That was overturned in Central Bank. So there is a
history. There is an understanding of what that means, and I do
not think we should need to resort to subterfuge in expanding
what primary violations are in order to have an effective rule.
Chairman Baker. The gentleman's time has expired.
Ms. Kelly?
Mrs. Kelly. Thank you, Mr. Chairman.
There is one consideration here. There is an elephant in
this room that has not been mentioned, so I am going to mention
it. That is the shareholders. Because what any attorney does
with regard to a corporation, anything that they do has to be
focused on the shareholders. Whether the corporate people are
focusing there or not, I believe there is a duty that the
attorneys need to focus on what the effect is on the
shareholders.
Professor Cohen, I am interested in what you said about
making a mandatory corporate waiver statutory. Did I get that
right? Would you like to talk about that a little bit? I am
interested in what you were saying there.
Mr. Cohen. If you are referring to the ``noisy withdrawal''
proposal, I think what I was referring to there was that the
SEC initially came out with a ``noisy withdrawal'' proposal
that would require the lawyer who had reported the wrongdoing
up to the board and was rebuffed, to make the noisy withdrawal.
There was a firestorm about that and a lot of objections about
that. So the SEC then came out with a revised proposal whereby
rather than the lawyer making the noisy withdrawal, the company
would have to make a filing with the SEC that stated that the
lawyer, this law firm or lawyer, had resigned and explain the
circumstances under which the resignation was made. So that is
what I was referring to as the alternative proposal. What I was
saying was that I think either proposal is fine, but I think
that there should be some kind of noise at that point, whoever
makes it.
Mrs. Kelly. No, that is not exactly what I was going after,
but let me just continue on in that vein since you brought it
up. In essence, that becomes then really a quiet withdrawal,
because then it becomes a discussion between the corporation
and the SEC, if I understand what you are saying.
Mr. Cohen. Yes, the corporation would have to make a
disclosure to the SEC. Of course, it is possible that the
corporation would not do that or would not say very much, but
the theory is that as long as the SEC is alerted to some
possibility, then the SEC could make a judgment about whether
it is desirable to investigate further and the like. That is
the theory behind it.
Mrs. Kelly. In general, inasmuch as most lawyers in
corporations are there to help corporations comply with the
law, an adjunct of that is to help corporations find where
there is a loophole in the law. That is the conundrum we face.
So basically, if I understand this panel correctly, most of you
are not interested in the SEC pursuing a ``noisy withdrawal.''
Is that correct?
Mr. Cohen. I believe so.
I am not in favor of it. It looks like I am not the only
one.
Mr. Painter. I have very mixed views on it. I think it is
nowhere near as harmful as opponents of the ``noisy
withdrawal'' proposal have said. Indeed, it is an opt-out rule.
If you do not like it, under the SEC rules you simply set up a
qualified legal compliance committee, and then all the
reporting goes to the committee and there is no ``noisy
withdrawal'' requirement anymore. So the company can opt out. I
do not think it is anywhere near as bad as it has been
described.
On the other hand, I see a lot of attention being focused
on this issue, rather than some other potentially much more
serious issues. I mentioned contingent fees in connection with
merger deals and so forth. So I think the commission might want
to re-phrase the rule in a manner that is somewhat more
acceptable to its opponents, if necessary, because it is not
that big a deal in the end. People will find out if the lawyer
resigns. The Commission will find out. The underwriters will
find out and start snooping around. I am not so sure we need a
telephone call to the Commission saying, ``I have withdrawn for
professional reasons, hint, hint,'' I am not sure that is
necessary.
Ms. Madrid. If I may, I would have to say that there are a
lot of theoretical issues, but the fact of the matter is there
are many, many lawyers who are inside of corporations every day
trying to figure out how to do this. I think that with a noisy
withdrawal, there are very serious consequences that can flow
from that. Fundamentally, the trust relationship between the
inside counsel and the management team is critical to ensuring
that there is sound corporate governance, and that there is
legal activity.
To the extent that inside counsel are essentially cops,
this is going to discourage management from including lawyers
in on the conversations. If we start with the assumption that
lawyers are going to help the management work through issues
and find legal mechanisms and not loopholes, but really sound
corporate decisions, having a ``noisy withdrawal'' we believe
would really discourage that type of activity.
Mrs. Kelly. My time is up, but I would like to follow that
up with written questions. Will you keep the hearing open?
Chairman Baker. Certainly.
Mrs. Kelly. Thank you.
Chairman Baker. I thank the gentlelady.
Mr. Scott?
Mr. Scott. Thank you very much, Mr. Chairman.
I think there is certainly an important role that we must
have for the attorneys in any of the ethics conflicts of
interest, but I would also think that we must not overreach,
that there is a balance with the ``noisy withdrawal.''
I have a two-point question. First, Ms. Madrid, there is a
requirement in the Sarbanes-Oxley legislation that requires the
first attorney, the ``up the ladder'' provision. What is your
appraisal of that? How well has that performed and do you have
any evidence that it has helped in the governance area?
Ms. Madrid. What we know from our membership is that, soon
after the enactment of Sarbanes-0xley and the effectiveness of
rule 307, the in-house counsel and the in-house law departments
very quickly responded to the requirements. There were written
requirements that were prepared in many, many law departments
across the country. There was training that was delivered.
We understand that while there is still some confusion and
ambiguity in terms of what the requirements are in the
``reporting up'' within the legal departments, I think that we
find that the lawyers who bring this information or evidence to
the chief legal officer, that that is an appropriate mechanism
to work through these issues.
Mr. Scott. Thank you.
The other part of my question, I believe it was you,
Professor Painter, you talked about contingency fees as
probably the most serious issues, as opposed to ``noisy
withdrawal'' and some of the other things. You used the example
of the AOL Time Warner merger, the spread of maybe $30 million,
from $5 million to $35 million. How would you restructure that?
What recommendations would you offer us to deal with how we can
more effectively restrict contingency fees in a way that would
be in the best interests of the American shareholder?
Mr. Painter. First, it is not a widespread practice at this
stage, to charge the contingency fee in that manner on the
corporate transaction. That was one of several incidents, but
it is not a common practice. But it was an enormous contingency
fee for an enormous transaction, which has turned out not to be
in the interests of counsel's client.
As I say, I have no evidence that there was inadequate
representation there, but I do believe that in a securities
transaction where it is the job of the lawyer to look for
problems with the deal and to say no when there are problems,
that it is not good for the lawyer to be paid several times
more if the deal closes than if it does not. Accountants are
not put on a contingency fee. Lawyers should not be. Investment
bankers are, but investment bankers have a different function.
Lawyer contingency fees primarily have been used in the
plaintiffs's lawyers area. I have other concerns. That is a
different issue about excessive contingency fees in that area.
But I think the spreading of contingency fees into corporate
transactions is something that ought to be watched very
carefully. There are a lot of other ways, whether it is hourly
rates or other more traditional methods of billing the client
that most law firms adhere to, and we do not need to see more
of those types of contingent-fee arrangements.
Mr. Scott. Thank you.
Chairman Baker. Does the gentleman yield back?
Mr. Scott. Yes.
Chairman Baker. Mr. Manzullo?
Mr. Manzullo. I just have a couple of questions. Do in-
house corporate attorneys qualify for key person liability
insurance coverage?
Ms. Madrid. Yes. I am sorry. Is the question in terms of
D&O liability or another type of policy?
Mr. Manzullo. Yes, that is correct. Go ahead.
Ms. Madrid. What we know is that today that is in flux. The
insurance companies are taking varying positions and are
modifying policies currently. It is unclear, at least from the
perspective of the insurance companies, whether the attorneys
when delivering professional advice to the corporation, they
would be included in the D&O coverage.
This is an area that is probably going to, I would imagine,
be getting a lot of attention in the near term. Frankly, these
issues had not been coming up before, and now with attorneys
being named as defendants in these types of cases, the issues
are now coming to the forefront.
Mr. Manzullo. Lawyers always sue anybody available,
including other lawyers. In the past when a lawyer has been
sued individually in the corporation, isn't there an obligation
on the part of the corporation to indemnify, unless there was
malfeasance? When I practiced law, if I gave bad advice and it
worked to the injury of a client, I was liable for malpractice.
Should that be any different in a corporation?
Ms. Madrid. As a general counsel, I would hope that we
would have coverage. I think that what we are finding, however,
is that the insurance companies may be taking a different view.
You may have professional liability policies within a company
that really are for third-party claims with respect to others
that you may have provided professional advice to, as opposed
to providing professional advice to the insured itself, that
being the company as embodied through either its board of
directors or its officers.
Mr. Manzullo. I don't see any difference in whether you are
employed on a retainer, on an hourly, or a member of the
corporation as an employee. The obligation is that there has to
be responsibility for giving bad advice. That can happen to
anybody, and that is why you have insurance. I am just a little
bit surprised it may be in flux. Are you telling me that you do
not know if corporate attorneys now are covered by malpractice
insurance?
Ms. Madrid. What I can tell you is that under D&O policies
that have been issued to corporations, we have found that
insurance companies are taking the position that in-house
counsel may not be a covered insured under certain policies. As
you know, many of the policies have different languages; they
have different exclusions. Each one would be read individually,
but we certainly are finding among the insurance industry a
position that attorneys may not be covered under D&O policies.
We obviously would hope to find a different opinion on that,
but certainly we are seeing it today.
Mr. Manzullo. So if there is an action that is brought by
the shareholders against a member of the board of directors,
who is relying up legal advice of the in-house corporate
counsel, the member of the board of directors would be eligible
for D&O coverage, but not the attorney giving the advice. Is
that correct, under some circumstances?
Ms. Madrid. Under some circumstances.
Mr. Manzullo. But in that circumstance, if the judgment is
in excess of D&O coverage against the member of the board of
directors, doesn't he have a right to be indemnified by the
attorney personally for the excess?
Ms. Madrid. No, I do not believe that would be the case.
Mr. Manzullo. So the member of the board who acts, I am not
talking illegally, but acts improperly, based upon the bad
advice of the attorney would have no recourse against that
attorney. If the attorney were not a member of the corporation,
it is obvious that he would. But the fact that the attorney
works for the corporation insulates him from a lawsuit by a
fellow employee?
Ms. Madrid. No, I do not believe he is insulated, but he
may not have insurance. That would be the issue. Today what we
are finding is that even when insurance policies are being
triggered, they are being triggered only for defense costs, and
not indemnification in terms of any liability.
Mr. Manzullo. Okay. Thank you.
Chairman Baker. I thank the gentleman.
Mr. Emanuel?
Mr. Emanuel. Thank you, Mr. Chairman.
To the professors on the panel and if others want to reply,
they can obviously come in. On a slightly different issue in
dealing with some of the issues that we on this committee have
looked at, as well as in the Senate, in looking at the issue of
tax shelters and the role of attorneys in advising on tax
shelters. In some of the recent articles, much of the focus has
been on the accounting industry. A lot of this would not be
allowed to continue if it was not for some of the legal advice
and some of the counsel being given by outside attorneys.
Have you conducted any research on the role of attorneys in
the tax shelter business? What is the outcome of that research?
This is to anybody; don't all jump at once. It is a jump-ball
question.
[Laughter.]
Mr. Cohen. I have not looked at what has been going on with
tax opinions. What I have looked at a little bit is the
``advice of counsel'' defense, which tends to be interpreted
differently in different areas of the law. That is something
that I think one ought to be very skeptical about because one
of the problems with the ``advice of counsel'' defense is the
more likely that a court is to recognize such a defense, the
more likely it is that lawyers are going to have an incentive
to give a kind of ``get out of jail free'' card to people who
are asking for that advice, and that more clients are going to
demand that kind of advice.
I think the premise of the ``advice of counsel'' defense is
that, well, if people act in good faith and go to see a lawyer
and they happen to get bad advice, then they ought not to be
penalized as harshly for that. But I think the problem is that
once you recognize the defense, you undermine the premise for
the defense being given in the first place. That is one area
that I think needs to be studied further.
Mr. Painter. One other issue with respect to tax opinions
is that if an accounting firm provides the tax opinion, and the
IRS finds out that the tax opinion is wrong, the IRS can say to
the accounting firm, ``I want a list of the people to whom you
provided this tax shelter to.'' They go to the law firm and the
law firm starts claiming the attorney-client privilege. I do
not believe that the mere identity of the clients that you have
provided tax advice to should be subject to the privilege; that
people ought to be able to take this work, put it in a law firm
and claim an attorney-client privilege where the IRS cannot
even find out who the law firm has been advising. That has
become a serious problem that has been litigated in the courts.
Mr. Morgan. This is an area, as you know Mr. Emanuel, that
the IRS has recently addressed.
Mr. Emanuel. That was my follow-up question.
Mr. Morgan. I must admit that I have not prepared any
analysis of those regulations. It is an area that clearly needs
review because there is a real risk that people will be tempted
to give opinions that, as Professor Cohen says, look like they
are providing security or reliable information, and in fact
turn out to not be reliable. Beyond that, I really do not want
to go on the record about something that I have not researched
yet.
Mr. Emanuel. I appreciate that. That has been the main
focus, as you know, Mr. Chairman. You and I have talked.
Mr. Keller. I just wanted to point out that, going back
quite a number of years now, the American Bar Association came
out with a very strict ethical position imposing very strict
rules on lawyers rendering tax shelter opinions. I think it was
recognition that it is important, as a professional matter, to
hold lawyers to high standards in rendering those opinions.
I think there are issues now that need to be reviewed in
terms of in fact who is the lawyer representing. Are they
representing those who are peddling the tax shelter or are they
representing those who are purchasing the tax shelter? We are
seeing litigation evolving that will tell us the propriety of
the behavior that has taken place.
Mr. Emanuel. If you go back to Sarbanes-Oxley and some of
the reforms given the last 2 years in corporate behavior, a lot
of focus has been on the accounting industry and investment
banking. But the truth is, the legal profession was equally a
participant in some of the, in my own view, flimsy tax shelter
advice. They are issuing one opinion, overcharging clients for
the same opinion that they were Xeroxing and faxing around.
They were a participant.
A number of accounting firms have recently announced that
they are going to shut down those departments with that
service. I think we need to be as vigilant on the legal
profession as we have done in the other financial services
sectors in making flimsy or questionable tax shelter advice.
The truth is, besides what the accounting industry has
done, you could not go forward if the green light was not
provided by the legal firm. So whether they are at the steering
wheel or not, they definitely have been sitting in the car seat
encouraging people to hit the gas. We need to be vigilant here,
because the tax shelter and the tax code, and you talk about
the IRS's ability to enforce. I am not against people trying to
find if they can pay less in taxes, they can do that, but there
has been a question of where the professional ethics stands in
issuing this advice in the profession.
Chairman Baker. The gentleman's time has expired.
I am sorry. Would you want to respond quickly, sir?
Mr. Painter. I just want to say that I think the IRS is
vigorously pursuing this issue. It is very important for this
body to back up the IRS and not to have a scenario where
special interests simply run to the Congress to try and get
Congress to undermine the IRS.
We had similar experiences with the Securities and Exchange
Commission a number of years ago that former Chairman Leavitt
wrote about in his book. I think it is very important for this
Congress to back up regulators, whether it is the SEC or the
IRS or other agencies who pursue professionals who are acting
irresponsibly.
Mr. Emanuel. Thank you.
Thank you, Mr. Chairman.
Chairman Baker. The gentleman's time has expired.
Mr. Gonzalez?
Mr. Gonzalez. Thank you very much, Mr. Chairman. Again,
thanks to you and Ranking Member Kanjorski, as well as to the
Chairman and Ranking Member Frank, for allowing me this
opportunity.
It really was my question during the hearings that we had
in fashioning our own House version of the legislation that
addressed the role of attorneys, which was of course taken up
by Senator Edwards over in the Senate. So here we find
ourselves today.
But for Professor Cohen, what I am hearing, and correct me
if I am wrong, is we have the attorneys withdrawing now. Isn't
that sufficient? Isn't that wonderful? In my opinion, it is
not. The objective is stockholder and shareholder confidence,
investor confidence, right?
Then we have to determine how we arrive at that, so we work
backwards. That is the SEC. The SEC has to be knowledgeable of
what is going on out there in order to impose the rules and
regulations so that we have that kind of confidence. So how do
they get that information? We are working backwards. How do we
get it?
I am going to give you two examples. Let us use Enron and
the creation of the SPEs and everything that is out there now,
whether it is being litigated in the civil environment or
whether it is criminal. One scenario is we have a ``noisy
withdrawal.'' The other scenario is we do not have a ``noisy
withdrawal.'' Under those two scenarios, you tell me which best
serves the interest of the public, and that is to make sure
that we have an informed SEC.
Anybody, it does not matter in what order.
Mr. Keller. Can I suggest that when the question is posed
that way, it sounds as though the answer is obvious. But that
is taking the issue, I think, out of an overall context,
because as I tried to note in my remarks, it seems to me we
have to keep in mind the role that lawyers play, both as part
of the core value of our legal system and the right to
independent counsel. Independent counsel, if you will, is the
bulwark against oppressive regulation, oppressive government,
wrong charges and what have you. That is an important principle
I think we would all agree to preserve.
We also have lawyers who indeed every day, and I do this,
are the policemen. We are working towards compliance. Our
securities law system is very much a self-regulatory system.
Yes, we have enforcement and we have civil actions. That keeps
people in check, but that is limited, based on the vast array
of what is going on. We are the people who are working towards
fostering legal compliance. It is important that lawyers be
kept in the middle of that process. Yes, held to be
accountable; held to professional responsibility.
So I think you need to assess the ``noisy withdrawal''
situation against the broader value. It is part of the total
picture. Those who promote it will admit that it is the rare
circumstance. There is a distinguished former general counsel
of the SEC who said it is a once in a lifetime event. Yes, you
can find the one case where it would make a difference, but I
would suggest that that one case is far outweighed by the
ongoing countless times when lawyers are counseling legal
compliance; where the ability to do so would be eroded by the
problems that would be created by ``noisy withdrawal.'' So I
think it is question of balance.
The ABA professional rules recognize that confidentiality,
trust and confidence of clients and their lawyers is a core
value. It is not immutable, however. There are exceptions. It
is carefully tailored and its balancing those exceptions the
way the professional rules have done that is important.
Mr. Painter. Congressman, in the scenario you describe, I
believe that not only is withdrawal required, but a noisy
withdrawal is what definitely should take place. A lawyer who
does not make a noisy withdrawal in that context is very likely
to expose himself to liability and enforcement actions and the
like, regardless of what the SEC's rule is under section 307.
That is the reason why I have decided I was going to take
the middle position on this. What the SEC must do is require
the separation of the lawyer-client relationship in a
circumstance where your client refuses to obey the law. You are
required to terminate at least the securities side of the
representation, if you are advising him on securities law and
they won't obey the securities laws. This requires the
resignation of the lawyer.
Once you have severed the lawyer-client relationship, I
believe the lawyer is highly likely to take the step the lawyer
needs to take to prevent the fraud from taking place. They have
only downside in this situation, and not up-side if the client
goes ahead and perpetrates the fraud.
So it is for that reason I have taken the position that it
is not as big a deal either way, the actual SEC ``noisy
withdrawal'' requirement as it is being made out to be. I am
not opposed to the requirement, and indeed, as I said, it is
optional. The client can opt-out simply by setting up a
qualified legal compliance committee under these rules. So I do
not understand all the fuss.
On the other hand, I am not so sure it is an issue that the
SEC should continue to fight over when there are many more
important things than the amount of noise in the withdrawal.
But the withdrawal absolutely should be required.
Chairman Baker. The gentleman's time has expired.
I want to insert into the record a statement from Mr. Peter
Moser, who was unable to appear today. He is chief counsel to
Piper Rudnick, but serves on the ethics committee and the task
force of the American Bar Association on compliance with
section 307 of Sarbanes-Oxley.
[The following information can be found on page 91 in the
appendix.]
I also want to express my appreciation to each of you for
your courtroom conduct today. You were not only informative,
you were more importantly timely. To assure you that no
enforcement action or liability will attach because of your
participation here today, the committee will maintain the
record open for at least 5 days to allow those who have more
questions to formally submit those to you for additional
response.
This is the beginning of the committee's exploration in
this area and we do need to take care that the end result of
our efforts is to assure shareholders that corporate governance
is meeting the highest possible standard, while at the same
time not unreasonably constraining appropriate business
decisions for the overall best advantage of that corporate
structure.
We do appreciate your participation and look forward to
working with you in the days ahead.
Our meeting stands adjourned.
[Whereupon, at 11:22 a.m., the subcommittee was adjourned.]
A P P E N D I X
February 4, 2004
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