21st February 2024

Scholars discuss the promises and pitfalls of corporate lawyers’ gatekeeping function.

In 2021, a publicly traded Delaware company relied on a “sham” legal opinion to justify taking the company private, reportedly generating $1.5 billion for the company. When investors sued for damages, the Delaware judge found that the company’s decision-makers “intentionally and opportunistically” contrived the “sham” legal opinion to make a profit, harming its investors in the process. As the judge put it, “a bevy of lawyers strived to paper the record” in order to make the challenged transaction look legitimate.

Yet neither the company’s management nor its lawyers faced any consequences as a result of litigation. The investors lacked recourse because the company’s founding documents stipulated that decision-makers could prove good faith dealing by showing that they relied on attorney advice. The Delaware Supreme Court found that this stipulation applied despite the manufactured nature of the advice.

That attorneys’ “goal-directed reasoning” can benefit a corporation’s management is not a new observation. Perhaps most infamously, Enron lawyers helped conceal that company’s wrongdoing before its implosion in 2001. When informed that the self-dealing transactions they had authorized could jeopardize Enron’s future, the lawyers conducted a limited investigation before erroneously advising that no further inquiry was needed. Enron collapsed later that year, costing investors $67 billion.

After Enron and similar scandals rocked the corporate world, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) to reform corporate governance standards. SOX Section 307 charges the U.S. Securities and Exchange Commission (SEC) with issuing standards of professional conduct for attorneys “in the public interest and for the protection of investors.”

In response, the SEC enacted a professional conduct rule requiring attorneys to report evidence of illegal activity “up-the-ladder” to the company’s executives. The rule only applies to attorneys who work for publicly traded companies, and the agency has never pursued an enforcement action against an attorney for violating it.

But the SEC is not the only source of attorney disciplinary controls. States also enforce rules of professional conduct, most of which are modeled after the American Bar Association’s Model Rules of Professional Conduct. The Model Rules, however, only encourage attorneys to report client misconduct—they do not require it. And enforcement of these rules often falls short: because of their limited resources, regulators tend to prosecute only small law firms that cannot afford prolonged legal battles.

In considering the adoption of professional conduct rules, the SEC has cited widespread concern about hampering zealous advocacy by requiring attorneys to report on clients. This apprehension revives an old debate about the attorney’s role in the corporation: Should corporate counsel be a hired gun, offering absolute loyalty “subject only to the constraints of the law”? Or should counsel be a gatekeeper, monitoring the propriety of corporate dealings? To the extent that legislators and regulators have attempted to impose more gatekeeping duties on lawyers, have those duties made an appreciable difference?

In this week’s Saturday Seminar, scholars discuss the role of legal advice in corporate wrongdoing, elucidating corporate counsel’s potential to stop—or stimulate—bad actions.

  • In a 2022 speech, former SEC Acting Chair and Commissioner Allison Herren Lee recommended that the SEC protect investors and markets by adopting and enforcing a “minimum set of standards for lawyers who practice before the Commission.” Lee argues that, despite its mandate under SOX, the SEC has not adopted a broad set of rules. Instead, Lee notes that the agency’s only standard requires lawyers to “report certain potential violations up the chain of management inside a corporate client.” According to Lee, this approach fails to recognize that lawyers may bend to their clients’ goals because they view themselves as their clients’ problem solvers. She suggests adopting firm-level quality controls and rules requiring legal advice to serve corporate shareholders as opposed to executives.
  • In an article for the Southern Methodist University Law Review, Carliss Chatman of Southern Methodist University Dedman School of Law argues that the idea of the attorney as a whistleblower is a myth. Chatman contends that the premises underlying the SEC’s gatekeeping provisions are “fundamentally flawed” because they fail to understand the “attorney-client relationship, corporate structure, and corporate criminal wrongdoing.” Chatman identifies two problems with the reporting structure: First, it turns on attorney judgment, and second, it is based on a traditional corporate hierarchy. Chatman argues that these flaws compound the lack of protection for attorney whistleblowers and create incentives to avoid knowledge of fraud rather than report it.
  • Alexander Klein argues in The University of St. Thomas Journal of Law and Public Policy that greater disclosure standards are essential to recuperating the legal profession’s public image. By analyzing the largest corporate scandals in U.S. history, Klein finds that lawyers implicated in scandals have not often faced consequences for their misconduct. According to Klein, this is because attorneys value client confidentiality more than other professionals. To avoid future reputational damage to the legal profession, Klein recommends three reforms: first, that attorneys be required to verify their clients’ disclosures; second, that ethics boards impose penalties on attorneys who are willfully blind to client dishonesty; and finally, that law schools educate students about past attorney misconduct.
  • In an article published in the DePaul Law Review, Robert Brown, Jr. and Eli Wald of Denver University Sturm College of Law suggest that regulators may need to adopt an equivalent of the Public Company Accounting Oversight Board (PCAOB) for attorneys. Brown and Wald argue that under current disclosure rules, lawyers have an incentive to support disclosure decisions management makes, creating a risk of erroneous or misleading disclosures. Brown and Wald point out that although the SEC has authority to bring actions against attorneys for erroneous disclosures, it has not done so since the 1970s. Brown and Wald suggest that an independent standards and oversight organization akin to the PCAOB may be necessary to ensure disclosure accuracy.
  • Sung Hui Kim of the University of California, Los Angeles School of Law makes a cautious case for lawyers serving as successful gatekeepers in her chapter in The Cambridge Handbook of Investor Protection. Although Kim acknowledges that outside counsel are less likely to compel their clients to follow the law, she finds that in-house lawyers are more willing to police illegal conduct. Despite in-house lawyers’ tendency to tolerate some unethical behavior, Kim cites empirical research showing that in-house lawyers reduce levels of insider trading and monitor for other misconduct in order to reduce corporate liability. Kim suggests that appointing board members with legal expertise and giving them direct responsibility for financial reporting may improve corporate compliance.
  • In a recent paper, Dhruv Aggarwal of Northwestern University Pritzker School of Law finds that corporations with longer-serving general counsel increased their stock value more than other companies during the time that Congress considered and passed SOX. He observes that these corporations gave their attorneys disproportionately large pay increases during the years immediately following that period. One hypothesis Aggarwal offers to explain the trend is that more experienced general counsel are more loyal to the corporation and more socially enmeshed with its executives. Consequently, Aggarwal suggests that these lawyers might have been more willing to ignore misconduct. He explains that attorney failure to report misconduct might have added monetary value by shielding corporations from agency investigations and private lawsuits.

The Saturday Seminar is a weekly feature that aims to put into written form the kind of content that would be conveyed in a live seminar involving regulatory experts. Each week, The Regulatory Review publishes a brief overview of a selected regulatory topic and then distills recent research and scholarly writing on that topic.

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