Editor: Evan, you were once a general counsel; what would be going through your head if you found yourself in this situation?
Stewart: I would recognize that my job is to protect John Doe Company, my client. I would have to put aside the notion of protecting the top executives. There was a time when general counsels faced with these circumstances would begin an internal investigation, ferret out the facts, counsel the client on how best to defend itself, try to convince the regulators of the company's innocence and then attempt to negotiate the best possible settlement. This approach may no longer work. It is clear that the Attorney General's game plan has changed. His approach is to put a company's future as a going business in jeopardy. We have seen this in the securities industry, next in the mutual fund business, and currently with the insurance industry.
Editor: How do the AG's actions affect the company's general counsel?
Stewart: It challenges the most fundamental tenets of the lawyer's role. Take for example, what happened at Marsh & McLennan in November 2004. Its general counsel (who had formerly served as a partner in a prestigious law firm) had "sparred" with the Attorney General's office in discussing the allegations relating to Marsh's insurance practices, namely he had attempted to raise defenses to the AG's allegations. The AG's reaction was to let Marsh (and the media) know that he was fed up with such "tactics," that Marsh faced possible indictment and that his office would not "negotiate" with the current management. Marsh caved almost immediately. Its board of directors dumped management (including the general counsel). It then selected a new CEO, who had been a colleague of the Attorney General and made peace with the AG by paying $850 million and issuing a formal "apology" to Marsh's clients.
The Attorney General is more feared than other regulators because he has the power to initiate criminal prosecutions under New York State law. The SEC cannot bring criminal proceedings. Public companies are unlikely to survive a criminal indictment. The future of the company's lawyers who attempt to defend their clients aggressively in such circumstances may also be bleak.
Editor: How does the SEC perceive the general counsel's role?
Stewart: The SEC subpoena mentioned in the hypothetical creates potential problems for the company's lawyers as well as for Doe. Sarbanes-Oxley has significantly altered a lawyer's obligations with respect to maintaining client confidences. A lawyer now "may" divulge such confidences: (i) to prevent client fraud with substantial financial injury; (ii) to prevent client fraud on the SEC; or (iii) to rectify client fraud with substantial financial injury which utilized the lawyer's services. While these disclosure options are "only" permissive, failure to act will subject a lawyer to the full range of regulatory sanctions at the disposal of the Commission under the '34 Act.
In the hypothetical, Doe's lawyers who drafted its disclosure documents had no reason to feel the business practice was illegal or that its ongoing nature or status needed to be disclosed. Furthermore, the company had received a written opinion from highly reputable outside counsel to the effect that it was legal.
The mutual fund investigation demonstrates the problem. There, the conduct at issue relates to "late trading" and "market trading." Market trading is not illegal, and was known for years to be a widespread practice. Late trading had never been judged, determined or interpreted to be illegal before the Attorney General's investigation. A number of prominent law firms had advised clients that "late trading" (a term that did not exist previously) was not illegal.
The head of New York's Investment Protection Bureau declared in February of 2004 that "we are living in a completely new regulatory world," and stated that the AG "would not hesitate" to go after law firms that were aware of, and approved, 'improper' trading in the mutual fund industry. The head of the SEC's Enforcement Division subsequently publicly announced that "you can expect to see one or more actions against lawyers who, we believe, assisted their clients in engaging in illegal late trading or market timing arrangements that harmed mutual fund investors," and that the Commission is looking at suing both inside and outside counsel who helped clients conceal mutual fund trading practices or who "prepared, or signed off on, misleading disclosures regarding [their clients'] conditions."
Editor: Given the circumstances you outlined, what is a company and its general counsel to do?
Stewart: Cooperating with regulatory investigations is the key to your client's and your survival. The price of such survival comes high as evidenced by the mutual fund industry investigation.
To please the New York AG and other regulators, mutual fund companies promptly fired a number of individuals; the companies also agreed to pay fines that had no relationship to the monetary injury that was alleged. Some funds agreed to reconstitute their fee structures. This last feature is of concern from a public policy perspective. The process for addressing such an issue has been through administrative proposal, subject to public comment, followed by possible adoption, revision, amendment, or rejection. In this case, the fee structure was determined by, in essence, one person using the threat of criminal prosecution, without any public input.
There is another aspect of such "cooperation." Waiving attorney-client and work product privilege are among the criteria used by regulators in judging a company's good faith. There is a high price to pay for such waivers. In the civil litigation that follows, plaintiffs' law firms now have access to the waived materials. Cooperation thus has at least two costs: the regulatory fines and settlements, and the higher cost of resolving related civil litigation resulting from plaintiffs' access to your client's privileged communications and your work product.
Editor: Can Doe still indemnify employees caught up in the circumstances described in the hypothetical?
Stewart: Doubt has now been cast on the practice of advancing legal fees to current and former employees under their indemnification policies. Regulators are concerned that this practice provides individual targets with the wherewithal to mount sophisticated defenses against prosecutorial attacks. Individuals, unlike companies, are strongly motivated to put the government to its proof in order to avoid imprisonment and fines.
Companies are required by their by-laws and under the law of Delaware and other states to advance legal fees. At the same time, the company may be aware that a government prosecutor/regulator is making a life or death decision about that corporation's future that may depend on whether the corporation is being fully "cooperative."
The SEC settled an enforcement case with Lucent Technologies, Inc. early in 2004, which opaquely suggested that the basis, in part, of the SEC's anger was that it "without being required to do so by state law or its corporate charter," had "expanded" the numbers of employees that could be covered under Lucent's indemnification policies.
Although the SEC's opaque complaints about Lucent were later "clarified," they reflect regulators' concern about companies complying with their own by-laws and Delaware law. In at least one case, an individual has had to sue in Delaware to compel compliance by a company reluctant to incur the Attorney General's ire by voluntary compliance. Lawyers with corporate clients need to be aware of this issue. Following clear legal obligations could have unfortunate consequences for your corporate client.
Editor: How would you sum up?
Stewart: Corporate lawyers face a brave new world. They must represent clients at the same time clients rightly view them as potential adversaries - possible witnesses against them (e.g., in Frank Quatrone's trials, the principal witnesses against him were senior lawyers at CSFB). And lawyers must do so when, if they judge their obligations incorrectly, they face harsh regulatory and civil exposure. Just as there is no safety net for clients in the post-Enron world, corporate lawyers must walk that same tightrope.