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Lawyers' Liability for Financial Fraud By Charles Hecht December 2006 (SmartPros) — Sarbanes-Oxley required the Securities and Exchange Commission to adopt minimum standards of professional conduct for attorneys practicing before the SEC. Except for Rule 405 (relating to up-the-ladder reporting), no such rules have been adopted. Rather, the SEC has filed enforcement actions. An analysis of those enforcement actions is critical in determining the possible legal exposure of attorneys, especially in-house counsel, for allegedly participating in financial fraud. Generally, the decision of whether or not to bring a particular enforcement proceeding is made by two SEC divisions: the Division of Enforcement and the Office General Counsel. In the first two years after the adoption of Sarbanes-Oxley, more than 30 proceedings were filed naming attorneys. In addition to a traditional injunctive action, the SEC can also discipline attorneys pursuant to Rule 102(e), commonly known as a 2e proceeding. An analysis of these proceedings indicates certain trends. Most of the cases are filed against in-house counsel. In part, this is because an attorney working as an employee/officer of a corporation is often viewed by the staff as a decision-maker or gatekeeper rather than as an attorney furnishing legal advice. In almost all of the cases, in-house counsel was deemed to be a direct or indirect beneficiary of the wrongful conduct. This is often the case where the wrongful conduct resulted in the reporting of inflated earnings or other criteria that enabled the attorney to receive additional compensation, either by receipt of additional stock or stock options, bonuses or additional retirement benefits, or indirectly through an artificially inflated price for the stock he or she already owns or controls pursuant to stock options. SEC staff provides no guidance as to when the drafting or preparation of a legal document transforms the in-house lawyer into a decision maker or gatekeeper (rather than an attorney who is drafting or reviewing a legal document until it is already too late). The SEC has sometimes taken the position that in-house counsel has received a benefit because he was able to keep his job as a result of either participating in or approving the wrongful conduct or filing of a document reflecting the wrongful conduct. Some examples of the general patterns of these SEC enforcement actions are illustrative. In one 2e proceeding, the attorney did not advise the outside auditors that sales totaling over $4 million were conditional. In this case, the attorney indirectly participated in the negotiation of these conditional sales agreements and knew that they were not binding contracts. As a result, the company's revenues were overstated by approximately 15 percent. In another 2e proceeding, the general counsel and secretary to the company was deemed to have aided and abetted a false 10-K filing and in signing an inaccurate 10-Q. The 10-K contained an inaccurate financial restatement and the 10-Q inaccurately reported cash and debt. In an injunctive action, the attorney was alleged to have participated in the preparation of disclosures in the SEC filings, press releases and other financial information because the inflated financials permitted him and other executives to obtain certain bonuses and additional retirement benefits for reaching specified targets. In another case the general counsel did not advise the audit committee and the outside auditor of a number of misrepresentations being made by management in everyone's presence which he knew to be false. Civil and criminal actions (which are often referred to the U.S. Attorney's office by the SEC) were filed against an in-house attorney in 2004, long before the recent disclosure of widespread back-dating of stock options, who manipulated stock option exercise dates to enable himself and others to profit from the exercise of stock options. Similarly, civil and criminal actions were filed against an in-house general counsel for back-dating contacts and counseling employees to keep this information from outside counsel and the SEC. In one unusual case, the SEC sued an in-house counsel for aiding and abetting another company's fraud even though there was no showing that he received any financial benefits for structuring the two sham transactions at issue, which were used by the other company to add $500 million to its loss reserves on the balance sheet. SEC v. Ferguson Index No. 06 CV 0778 (S.D.N.Y.). Although I have tried to clarify the categories and situations underlying some of the enforcement proceedings and in some instances corollary criminal actions that have been filed against in-house counsel, there is no bright-line category of what will trigger these proceedings. Nor are there clear standards as to what type of benefits to the in-house counsel are sufficient to cause the staff to bring an enforcement proceeding. Even more problematic is how to draw the line between when in-house counsel is acting as a decision maker/gatekeeper instead of an attorney. In any event, in-house counsel must be aware that even though they are not deemed a financial professional, they could nonetheless become the target of an SEC enforcement proceeding involving a financial fraud. Each factual situation is unique. Of course, recognizing the potential problem and not putting yourself in that type of situation is the best option. CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com © Copyright 2006 SmartPros Ltd. All rights reserved. |
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