American Bar Association – Business Law

Volume 12, Number 6 - July/August 2003

Recipe for an overdue change
Why corporate lawyers sometimes need to give business advice
By Martin B. Robins

Usiness lawyers as business advisers? Could be. Read on.

The recent series of corporate implosions should cause every business lawyer to
wonder what counsel could have done to prevent these disasters. Many observers, in
and outside of the profession, wonder the same thing.

While it will take years for the courts and regulators to sort out exactly what happened
in these corporate debacles, I suggest that a big part of the problem is the written and
unwritten constraint taught to most aspiring business lawyers concerning the need to
defer to their clients? business decisions. See, for example, the Model Rules of
Professional Conduct, Sec. 1.2(a): "A lawyer shall abide by a client's decisions
concerning the objectives of representation ...." From law school through the associate
and junior partner ranks, business transactional lawyers are taught the traditional
paradigm that their job is to advise clients as to available options and legal
implications and work diligently to implement the client's decision from among the
options.

The product of the present approach has been noted in the pages of this magazine: "In
this dramatic context, what has been the role of lawyers? Has our profession been
battling misconduct, and taking heroic steps to protect companies and their investors?
For the most part, our profession has not distinguished itself." Murphy, "Enron, ethics
and lessons for lawyers," Bus. Law Today, January/February 2003 at 11.

The author's thesis is that we must revisit this premise in order to make meaningful the
current admonitions to public company counsel in Section 307 of the Sarbanes-Oxley
Act (the act) and related regulations, to protest illegal acts of corporate management.
SEC Release 2003-13 announcing the release of regulations under the act, Jan. 23,
2003, "SEC Adopts Lawyer Conduct Rule under Sarbanes-Oxley Act," at the SEC
Web site, www.sec.gov (the "Implementing Release") summarizes the objective:

The rules adopted today by the commission will require an attorney to report evidence
of a material violation, determined according to an objective standard, 'up the ladder'
within the issuer ... [ultimately to] the full board of directors; ....

See also, Cramton, "Enron and the Corporate Lawyer: A Primer on Legal and Ethical
Issues," 58 Bus. Lawyer 143, 179 (2002).

It is submitted that in the transactional context, a potential legal violation must in most
cases be analyzed in the context of an economic transaction. Disclosure violations and
fiduciary violations almost invariably involve a misrepresentation or diversion of
economic consequences.

Accordingly, counsel must be made responsible for understanding the economic basics
of their client's business, industry and the financial marketplace as well as being

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 responsible for a minimal critique as to whether a given major action is at least
minimally viable in such context. Protest as to a legal violation will often require
advice as to economic flaws in a proposed transaction or policy.

This article suggests a new requirement to govern the manner in which a lawyer
advises their client. Pending any change in formal requirements, lawyers engaged at an
entity level are urged to take a broad view of their roles and speak up to their direct
contacts whenever they see something that appears questionable, whether or not the
matter is clearly legal in nature.

Of course, they must in all events heed the language of the act to pursue "up the
ladder" evidence of legal violations. Frequently, an objective perspective from counsel
not directly involved in the matter will be sufficient to dissuade clients from disastrous
paths that they have lost the ability to identify. Counsel choosing to act in this way
should communicate their intention to their client, preferably at the inception of the
representation in order to minimize any disruption from counsel's acting in a
"nontraditional" way.

The traditional approach may have worked well during the early and middle parts of
the last century in the midst of a goods-based economy where it was frequently
possible to easily distinguish business and legal issues. Where people and companies
usually made their livings by producing and selling things to each other and financial
markets consisted essentially of common stock and long term bonds, intellectual
property and financial engineering were much less important than they are today.

Opportunities for financial maneuvering by operating companies, let alone businesses

based solely on financial maneuvering, were of little significance, meaning that in
most cases, legal concerns did not directly affect business viability and it was often
possible to identify "pure" business issues not warranting legal review.

Today, however, things are different. With so many businesses based on intellectual
capital, as opposed to plant and equipment, and so many businesses tied directly to the
financial markets and the exotic strategies they now permit, it is often impossible to
readily distinguish "legal" and "business" issues.

Yet, in the face of so much change, we still see lawyers seeking to limit their advice to
legal matters when it is clear that such matters could not be meaningfully distinguished
from business matters and that the client's fundamental approach to its business was
seriously flawed and leading it toward disaster. A headline in the Wall Street Journal
of May 10, 2002, is illustrative: "Lawyers for Enron Faulted its Deals, Didn't Force
Issue."

Perhaps the most graphic example of a lawyer standing by while the client careened
toward business disaster is found in the case of Commercial Financial Services Inc. In
this case, a partner in a large law firm that represented the now- defunct company in
connection with numerous securitized financings is alleged to have been advised by
the company's departing CEO (after five months on the job) that its business model
was flawed in that it involved a scheme to provide investor returns by selling off
assets, instead of from income generated by retained assets.

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 However, the firm is alleged by its client to have said nothing to the client about the
unsustainability of this approach but simply used carefully couched language
pertaining to the CEO's departure in public disclosures pertaining to other financings.
It was not until long after the CEO's departure that the problems came to light and
litigation was brought against all concerned — including the law firm.

The client's founder complained that "they were making so much stinking money on
the deals that they didn't want it to end" and that "they didn't tell anyone not to do any
more deals" and that "the advice we should have gotten is to slow down the operation
and change the way we did business." Pacelle, "As Firm Implodes, Lawyer's Advice Is
Point of Contention," Wall Street Journal, Oct. 29, 2002.

While the foregoing is necessarily anecdotal and considerations of lawyer-client

privilege and client confidentiality make it impossible to say for sure what advice has
been given in any particular situation, what is striking is the total absence of vigorous
public pronouncements by lawyers involved in these situations as to their affirmative
efforts to persuade their clients to stop doing things that in many cases must have
appeared ex ante to be as perilous as they turned out to be ex post.

Based on my own training and observations of numerous other transactional lawyers, I

believe that in the majority of cases, well-meaning lawyers felt powerless to challenge
their clients' "business decisions" despite the fact that it was clear that client
management was either personally interested in the specific decision or policy or had
become so close to the situation that they could no longer objectively analyze it —
making a third-party critique that much more important.

Our complex economy and financial markets and the critical "gatekeeper" role of
lawyers vis a vis those markets (See "Understanding Enron: "It's About the
Gatekeepers, Stupid," Coffee, 57 Business Lawyer 1403 August 2002) demand that we
banish this arcane distinction and require lawyers to use their objective perspective to
advise their clients of significant reservations as to the prudence or propriety of the
clients' business practices.

Both client expectations and the public interest in these troubled times demand that
those who are capable of heading off catastrophic losses be charged with the
responsibility for making reasonable efforts to do so, as opposed to using their narrow
specialty to rationalize looking the other way. When counsel sees their client headed
for disaster, they should be required to speak up, whether or not the disaster is strictly
"legal" in nature.

Are lawyers equipped to do so? From my observations, it appears that a business

lawyer who has practiced at least 10 years or so will pick up enough of a feel for what
makes economic sense and what doesn't, to make their comments meaningful at a high
level. Senior-level lawyers by definition possess the talent and training to advise
intelligently on all legal aspects of a given matter. Frequently, lawyers will have
addressed a given situation enough times to develop a good idea of an intelligent
business solution, in contrast to a client who may not have prior experience with the
particular matter.

It is suggested that if a lawyer does not develop or has not yet developed some feel for

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 the business ramifications of major client actions, he or she should not be functioning
in a senior capacity. The effort is not to constitute the business bar as some sort of
uber-board-of-directors or management committee sitting in judgment on day-to-day
matters.

The goal simply is to keep them alert for fundamental problems that imperil the future
of the enterprise or its investors. That would include, among other things, major
accounting irregularities that should be palpably evident without formal accounting
training — such as drastic changes in accounting policy, financial statements that are
not readily understandable and transactions producing material financial-statement
benefit to the organization or its management without a discernible business purpose.

To the author, existing standards and commentary dealing with organizational-level

violations fall short of the mark by defining the problem in strictly legal terms.
Murphy argues persuasively for a "beefing up" of the compliance function but
implicitly defines compliance in terms of existing legal authority. Similarly,
Sarbanes-Oxley and the related regulations condition the lawyer's obligation to do
anything on a breach of statutory or common securities or fiduciary law.

By encouraging such a narrow view, the authorities make it likely that lawyers will fail
to note the existence of many situations requiring their vigilance. Without counsel
being required to address the business rationale for a given action, simply admonishing
them to report legal violations is likely to be of limited practical value.

The SEC, in the Implementing Release, has come down at least temporarily in favor of
a heightened counseling role for business lawyers as opposed to an enforcement role.
The latter would require a so-called "noisy withdrawal" by the lawyer in which the
lawyer must resign the engagement and disclose to the SEC and the marketplace their
concern with the company's conduct.

In the Implementing Release, the SEC permitted but did not require the noisy
withdrawal, extended the comment period for the noisy withdrawal requirement, and
proposed an alternative of requiring the company — not the lawyer — to disclose the
lawyer's withdrawal on a Form 8-K or equivalent. While the author strongly endorses
the SEC's decision, it is also submitted that for lawyers to be stronger counselors, they
must approach difficult situations with a broad view as to the needs of the
organization, as opposed to focusing on the four corners of the statute books.

This could be implemented by adding to existing Section 1.2 of the Model Rules of
Professional Conduct a new subsection (f) containing language such as:

(1) In accordance with their professional experience, a lawyer representing an

organizational client in an entity- level capacity, other than as an advocate, shall use
reasonable efforts to counsel such client's management in writing when they become
aware or have reason to become aware of the contemplated or actual pursuit by such
client of any act or omission or series of same that reasonably appears to such lawyer,
based on the totality of the circumstances known to them, to be likely to cause serious
financial or other harm to such organization or its investors taken as a whole,
irrespective of whether the likelihood of such harm is based solely or primarily on
legal or nonlegal considerations. Such advice shall be directed to at least the same

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 level of management as that from which the lawyer learned the information.

(2) Serious financial or other harm shall be defined to include only such consequences
as would reasonably be expected to imperil the existence of the organization or the
financial security of its investors and shall be deemed to involve consequences that
substantially exceed the level of materiality.

(3) No disciplinary charge or civil or criminal action shall be based solely on the
failure of any lawyer to comply with the foregoing. So long as the lawyer shall act in
good faith under this subsection (f), no advice given hereunder or failure to give such
advice shall, of itself, constitute a basis for a claim for failure to satisfy any duty of
competent representation under these rules or other ethical standards or applicable
statutory or common law. However, the failure to comply with this subsection (f) shall
be relevant to the consideration of disciplinary charges or legal action brought on other
grounds.

(4) The obligation imposed on the lawyer hereunder shall not be waivable.

(5) Nothing contained herein shall modify the lawyer's obligations under sections 1.13
or 2.1 of these rules.

(6) It is intended that any advice pursuant to (1) above shall be protected from
discovery and admissibility to the fullest extent permitted by applicable law and rules
of practice.

These suggested additions are intended to implement the recommendations and

supplement Sarbanes-Oxley by:

• making clear that as a result of the need to avoid undue disruption of the
lawyer-client relationship to promote the open exchange of views, unlike the
act, counsel need go no further with their reservations than client management
and shall be under no obligation of any kind to go to a board of directors in the
event that their reservations are rejected;
• applying the new standard to lawyers for all organizations and not merely those
representing public companies, as is the case with the Sarbanes-Oxley
legislation;
• limiting the obligation of counsel in this regard to those providing
representation in a "corporate level capacity," seeking to avoid overlawyering
by lawyers engaged to deal with discrete matters
• making largely advisory this standard, in order to be fair to lawyers trained in
the traditional manner — that is, noncompliance by itself will not support
disciplinary or legal action; and
• reserving these obligations for truly drastic problems; a mere material loss from
the action in question (the act's standard) would not trigger any duty to act.

The reference to Section 2.1 is intended to reflect the fact that the Model Rules already
permit the analysis that would be required here: "In rendering advice, a lawyer may
refer not only to law but to other relevant considerations such as moral, economic,
social and political factors, that may be relevant to the client's situation." To the extent
that the draftsmen of the Model Rules believed that lawyers possess the necessary

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 expertise to incorporate nonlegal factors into their advice, I suggest that present
circumstances mandate the use of such expertise.

It is the author's desire that the new standard would come into play in situations such
as but not limited to, the incomprehensible structures that caused so many problems
for Enron, the "too-good-to-be-true" tax strategy that embarrassed Sprint, and the
mismatched revenues and commitments that hinted at trouble in the Commercial
Financial Services situation.

The author would also require cautionary notes to clients in situations where counsel
learns that the client is proposing to extend large amounts of credit to or place
significant operational reliance on an obviously financially weak counterparty or
where a client exceeds its own economic limits as to price.

Of course, the optimal use of counsel's expertise is to couple the business observations
with specific recommendations for legal techniques that may be used to bolster the
client's position (where possible; there are often cases where "don't do the deal" is the
best advice). Advice given to lawyers in a closely related context is apropos here:

If one is dealing with complex matters, it is an obligation to do sufficient due diligence

to understand the transaction and the driving force behind it. The attorney needs to use
more creativity in making complex transactions understandable to the investing public
and less creativity in obfuscating what is really going on." Murdock, "Attorney
Liability Under Enron, CBA Record, April 2003 at 36.

This standard should be considered only a "first cut" effort and will require a great deal
of thought and refinement from interested parties. It is the author's hope that this
article will stimulate debate about how law is to be practiced under circumstances that
are far different than anything envisioned during the training of most of today 
lawyers. What is important is not the precise confines of counsel's obligations, but
rather inducing counsel to take a broader view of their role.

Make no mistake, these recommendations represent a substantial departure from the

traditional — and at one time appropriate — role of the senior business lawyer as a
technician and presenter of options. What is being urged here is to require counsel to
educate themselves as to the broad confines of the client's business and industry and,
most important, to sometimes confront the client on what some clients feel is the
client's "turf."

However, it is clear that the traditional approach is simply not working; it is

incomprehensible that senior level lawyers advising major companies will not see and
have not seen the folly of the clients' approach in several of the widely publicized
debacles. However, it appears that none of them has prevailed on their clients to
change their ways.

In addition to the compelling public policy issues discussed above, lawyers should also
take into account that when the problem arises, there will be plenty of blame to go
around. The client will not thank the lawyer for deference.

An overview of Sarbanes-Oxley

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 In an effort to avoid a recurrence of the well publicized corporate scandals of
2001-2003, the statute makes wide- ranging changes in virtually all aspects of
corporate governance and financial reporting at public companies. In pertinent
part, it:

• requires lawyers "practicing before the SEC" to report within the

corporation — to the board of directors, if necessary — any suspicion of
serious legal violations;
• creates a public board, under the SEC, to regulate the accounting
profession;
• imposes limits on the nonaudit services that may be provided by
accountants to their audit clients;
• drastically enhances the authority of audit committees;
• requires personal certification by CEOs and CFOs of reported financial
information; and
• prohibits most loans to executives by their employers.

Robins is a sole practitioner in Buffalo Grove, Ill., with a practice limited to business
transactions. His e-mail is mrobins@mr-laws.com

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