[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
____________________________________________________________________________
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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

                              ----------                              
                                                                   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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