I've been asked to give a speech to a meeting of a major multinational corporation's in house legal department (you will have heard of it), focusing on the role in house counsel play as corporate gatekeepers. For the benefit of those of you who weren't invited, here's what I plan to say:
One hears a lot these days about so-called “corporate gatekeepers.” But what does that mean? A gatekeeper is someone—be it a person or entity—who, if they withhold their blessing, can prevent the corporation from effecting a desired transaction or from maintaining some desired status.[1]
Often, a gatekeeper will be a reputational intermediary who provides certification services for investors. Auditors and rating agencies are good examples of this category. They have a lot of reputational capital. Indeed, it must be so, because their reputation is their stock in trade. Investors say “this must be a good investment, because it got a good rating from an agency I trust.”
In theory, they will not besmirch their reputation to benefit one client. Hence, they hold the gate between the corporation and the promised land of investor capital. Without the blessing conferred by the auditor’s letter or the rating agency’s evaluation, the corporation will have a more difficult time selling securities or remaining listed on a securities exchange.
Lawyers also are corporate gatekeepers, albeit of a different sort. To be sure, sometimes a very high profile general counsel or law firm partner might be able to give a client in trouble the benefit of the lawyer’s reputation for probity and upstanding ethics. Usually, however, we play a more behind the scenes role.
But while we may not function as reputational intermediaries, we too have a gatekeeping role. As counsel, we are well positioned to block the effectiveness of a defective registration statement or prevent the consummation of a transaction.
Back when I was a summer associate at White & Case, we used to talk about SEC v. National Student Marketing as the case that could not be named. Looking back at that case today, however, it looms large as a harbinger of what legal counsel increasingly are expected to do.
As you may recall, Interstate National Corporation was going to merge with National Student Marketing. The closing was conditioned upon an exchange of opinion letters from each corporation’s attorneys, as well as “comfort letters” from each corporation’s accountants. At the closing, the lawyers became aware of serious problems with National Student marketing’s financial statements. The auditors refused to issue a clean cold comfort letter. The lawyers knew that, but they went ahead an issued the necessary opinion letters. Next, the lawyers failed to object to the closing going forward.
Whether the lawyers should have gone public with their concerns, blowing the whistle on their client, remains a matter of debate. At a bare minimum, however, it now seems clear that the lawyers need to close the gate, preventing the merger from being consummated, by withholding their opinion letters and advising their clients to hold off until the accounting concerns could be addressed. They had a duty to keep the gate and they failed to do so.
In recent years, particular attention has been paid to the role of in house legal counsel as gatekeepers. Inside counsel have gained influence, both within the corporate structure and also as compared to the role of outside counsel.[2] Most general counsels now sit near the top of the corporate hierarchy. And that hierarchy often is pervasively dotted with in-house attorneys. In house counsel increasingly are involved early in the decision-making process and, thus, are capable of influencing management decisions at the strategy-setting stage. In addition, they frequently have responsibility for educating and monitoring lay employees with respect to corporate compliance.
This educational and monitoring function became even more important after Sarbanes-Oxley and Dodd-Frank toughened the rules on issues like whistleblowing and document destruction. In house counsel should be actively engaged in such areas, given the tough sanctions for violating the new rules.
These provisions, along with other compliance mandates in the Federal Organizational Sentencing Guidelines, the SEC’s up-the-ladder reporting requirement, and other federal regulations, are based on a presumption that corporate compliance programs can more cheaply and effectively regulate corporate employees than can external government regulators. And that’s probably right. Inside compliance program managers do not face the information and resource constraints inherent in regulatory agency oversight. As a result, however, there is a lot of pressure these days by regulators to essentially deputize corporate compliance managers as law enforcers. In turn, this compounds the pressure on in house counsel to educate lay compliance personnel, to monitor those personnel, and to play an active role in compliance themselves.
Unfortunately, the recent financial crises brought to light all too many instances in which lawyers failed to fulfill their responsibilities, albeit as was also true of many other gatekeepers.
In the litigation aftermath of the savings and loan crisis of the 1980s, Judge Stanley Sporkin famously threw up his hands and asked:
Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment, when these clearly improper transactions were being consummated?
Why didn't any of them speak up or disassociate themselves from the transactions? Where also were the outside accountants and attorneys when these transactions were effectuated?
What is difficult to understand is that with all the professional talent involved (both accounting and legal), why at least one professional would not have blown the whistle to stop the overreaching that took place in this case.[3]
More recently, when Congress was considering the bill that became the Sarbanes-Oxley Act, Senator John Edwards took a hard look at the behavior of the lawyers for firms like Enron and WorldCom, before concluding that:
When “executives and/or accountants are breaking the law, you can be sure that part of the problem is that the lawyers who are there and involved are not doing their jobs.”
Edwards’ claim finds support in Enron’s internal investigation, which found that there “was an absence of forceful and effective oversight [of the company’s disclosures] by ... in-house counsel, and objective and critical professional advice by outside counsel at Vinson & Elkins,” along with senior management and the auditors. The report expressly criticized Vinson & Elkins, which the investigators argued “should have brought a stronger, more objective and more critical voice to the disclosure process.”
Senator Edwards therefore persuaded Congress to include the now familiar up the ladder reporting requirement in SOX, with which we are still struggling today.
As I’m sure you know, Section 307 of Sarbanes-Oxley required the SEC to issue minimum standards of professional conduct for attorneys appearing and practicing before the SEC. Specifically, the SEC adopted a requirement that attorneys report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company, to the chief legal counsel or the CEO. If the CEO or chief legal officer fails to take appropriate remedial measures, the attorney is required to go to the audit committee of the board of directors of the company.
To date, there has been very little, if any, activity by the SEC under the Section 307 rules. Instead, the SEC has gone after lawyers as primary violators of the securities laws where they, for example, facilitated backdating of options. Likewise, the SEC frequently has brought ethics actins against litigators whom the Commission thinks violated the rules while defending clients charged with securities violations.
Despite the paucity of enforcement actions, the Sarbanes-Oxley Act nevertheless made clear that lawyers representing public companies have gatekeeping responsibilities. As the SEC explained when it adopted the Part 205 rules, they are intended to create an “early warning system” about management wrongdoing through mandatory attorney disclosures to top independent directors “who might otherwise, due to their limited involvement in day-to-day corporate operations, fail to identify potential problems.”
Granted, many lawyers still blanch at the notion that they are gatekeepers. The relationship between lawyers and clients is often intensely personal. Former SEC Chairman Harvey Pitt went so far as to compare the lawyer-client relationship to that between priest and penitent in the confessional. Lawyers are zealously supposed to guard, defend and promote the interests of their clients. To do that, Pitt argued, clients must feel comfortable confiding in their lawyers. Efforts to turn lawyers from advocates into gatekeepers can infringe upon the willingness of clients to confide in their lawyers, and curtail their ability to receive the benefits that flow from an unfettered lawyer-client dialogue.[4]
I believe, however, that that concern applies mainly to representing individuals in litigation, not to doing transactional work for public companies.
Let’s start with the most basic question every in house corporate lawyer needs to ask: "Who is my client?" Contrary to popular belief, it’s not the guy who signs your paycheck. Rather, it the people whose interests you are sworn to protect. When a corporation hires a lawyer, the lawyer represents the corporation and its shareholders, not the managers. This should be self-evident, but the basic lesson of the financial crises has been that corporate lawyers all too easily lose sight of this axiom.
To cite just one very prominent example, Enron Bankruptcy Examiner Neal Batson observed that:
One explanation for the attorneys' failure may be that they lost sight of the fact that the corporation was their client. It appears that some of these attorneys considered the officers to be their clients when, in fact, the attorneys owed duties to Enron.
But why? What dulls counsel’s vision?
First, compensation. One thinks here of an old case, In re Carter and Johnson. In 1979, the SEC charged attorneys Carter and Johnson with violating the federal securities laws and their professional responsibilities by assisting their client in authoring a false and misleading press release and filings with the Commission. The SEC also charged them with failing to bypass the chief executive officer and report to the board that the company’s failure to make required disclosures was a continuing violation of law. Although the SEC tossed the case out for technical reasons, it did adopt a new standard that said:
When a lawyer with significant responsibilities in the effectuation of a company's compliance with the disclosure requirement of the federal securities laws becomes aware that his client is engaged in a substantial and continuing failure to satisfy those disclosure requirements, his continued participation violates professional standards unless he takes prompt steps to end the client's noncompliance.
Today, of course, counsel face liability not just for participating in such violations but also for merely failing to report such violations up the ladder.
Carter and Johnson were outside lawyers who got into trouble because they were afraid to lose their client by rocking the boat. Their economic incentive was to keep their mouths shut and the fees flowing.
Today, in house counsel face an even greater temptation when it comes to issues like shading disclosures.
It’s hard to be independent when a large chunk of your compensation comes in the form of incentive stock options or restricted stock grants in shares of your employer or when a big chunk of your savings is squirreled away in a 401(k) stuffed with that employer’s stock. Indeed, at that point, you become subject to the same pressures as any other manager to keep the stock price up, to make sure the company hits its numbers, to puff up good news and downplay bad news. In other words, the in house counsel inherently is subject to a conflict of interest created by dual roles as gatekeeper and as a business person with an interest in the financial success and longevity of the entity.
Second, most of us are habituated to hierarchy. We are generally inclined to take orders from superiors without talking back. This is just as true of inside counsel as any other employee of the firm.
Technically, of course, the employer is the firm itself, but in practice, we tend to view our supervisors in management as the “real” employer.
We’re inclined to take orders from our management “boss” without raising a lot of objections that will be seen as picky or naysaying. I’ll come back to the naysayer point in a minute.
Hierarchical pressures are especially pronounced if the managers we work with closely have the power to fire us. After all, inside counsel are necessarily economically dependent on a single client. If they get fired, they lose their income, their insurance and other benefits, and their basic livelihood.
Although a general counsel often is formally appointed by the board of directors, his tenure normally depends mainly on his relationship with the CEO. As the ABA’s corporate governance task force explained, this means that “the general counsel may be reluctant to communicate with the board of directors” for fear that doing so will “destabilize the relationships among senior executive officers and directors.” All the more so, when talking about lawyers further down the organizational chart with no access to the board.
Third, research in behavioral economics suggests certain basic cognitive biases that are likely to discourage lawyers from detecting or acting upon management misconduct. Behavioral economists have identified a number of well-documented cognitive errors relevant to the problem in hand. One is the overconfidence bias, which has been defined as “the belief that good things are more likely than average to happen to us and bad things are less likely than average to happen to us.”[5] If a lawyer is subject to this bias, his judgment will be skewed against believing that his clients are bad people committing fraud. A closely related bias is the confirmatory bias, which is defined as the tendency for actors to “interpret information in ways that serve their interests or preconceived notions.” As former Delaware Chancellor Allen aptly noted, albeit in a rather different context, “human nature may incline even one acting in subjective good faith to rationalize as right that which is merely personally beneficial.”[6] Lawyers who made the decision to associate with a particular firm therefore are less likely to recognize management misconduct, because evidence thereof would be inconsistent both with the lawyer’s self-interest in maintaining a relationship with the co-worker and the lawyer’s self-image as someone who identifies and associates with honest people. Taken together, these systematic decision-making biases generate a type of “cognitive conservatism” that makes a lawyer “likely to dismiss as unimportant or aberrational the first few negative bits of information that she receives regarding the client or situation.”[7]
Last, and perhaps most important, is the pressure to be a team player. Lawyers are widely perceived as naysayers. We don’t facilitate business deals, we put up obstacles against them. Business people hate that. And so they push back. Hard.
In his book, The Terrible Truth About Lawyers, Mark McCormack, founder of the International Management Group, a major sports and entertainment agency, wrote that “it’s the lawyers who: (1) gum up the works; (2) get people mad at each other; (3) make business procedures more expensive than they need to be; and now and then deep-six what had seemed like a perfectly workable arrangement.” McCormack further observed that, “when lawyers try to horn in on the business aspects of a deal, the practical result is usually confusion and wasted time.” He concluded: “the best way to deal with lawyers is not to deal with them at all.”
As such, there is a lot of pressure on in house counsel to get things done. Not to use the law not as a barrier, but to help management achieve its goals as quickly and effectively as possible.
Business leaders love inside lawyers who help get things done. Indeed, once your reputation as a facilitator rather than a naysayer is established, executives often become very receptive to you participating in core business discussions, at least if you’re also savvy about products, markets, competitors, etc.
An effective in house lawyer, of course, needs precisely that access. You need a deep understanding of the business. You need access to top management. All so you can give wise counsel.
Thus, as a practical matter, general counsels and other in-house lawyers have properly wanted to be seen as team players responsive to management in order to have credibility within the management group. An in-house lawyer who is perceived as having an exaggerated view of his or her authority, or as being aloof from those managers involved in revenue-generating functions, is likely to become marginalized within the organization.
But what if getting that kind of access requires you to bless management decisions that push the edge of the envelope? Or step over the line, to switch metaphors?
Again, I’ll quote Enron examiner Batson, who observed that Enron’s “attorneys saw their role in very narrow terms, as an implementer, not a counselor. That is, rather than conscientiously raising known issues for further analysis by a more senior officer or the Enron Board or refusing to participate in transactions that raised such issues, these lawyers seemed to focus only on how to address a narrow question or simply to implement a decision (or document a transaction).”
To be clear, the point is not that lawyers are pervasively co-opted or immoral. The point is only that lawyers have both economic incentives and cognitive biases that systematically incline them to at least shut their eyes to instances of client misconduct.
Given these various factors, what can we do as in house lawyers to overcome those incentives and serve the interests of our corporate employer and its shareholders rather than those its officers?
It seems trite, but I think you have to start by recognizing that your duty to the organization comes first. Where managers are pursuing a legally improper course, you must be prepared to take such steps as are necessary, even including reporting to the board or a board committee, even where doing so means going outside the normal chain of command. It is important that counsel ensure that both management and the board are aware that the lawyer recognizes the scope of such duties, even when that means bringing unpleasant truths home. This is a dance that is difficult to describe in the absence of specific facts, but it is increasingly important that, while preserving your working relationship with management and co-workers, the lawyer must make it clear that you are not prepared to bend the rules to accomplish a business objective where the course proposed involves a violation of law or fiduciary duty.[8]
It’s also useful to create a system of routine access. At a minimum, the general counsel should meet routinely with the board and board committees like the executive, audit, and compliance committees. Where such meetings part of a regularly scheduled process, they are less likely to be seen by management as end running the chain of command and more likely to be seen as simply a part of good corporate governance.
Next, the general counsel should make it clear that legal department lawyers are expected to bring any concerns to the general counsel on a timely basis—even where those concerns involve supervisory personnel or senior officers—and should communicate the same message to outside counsel. Frequently, if an issue can be surfaced early on, before steps have been taken in reliance on a questionable plan, the relevant personnel can be re-directed into a more appropriate course, or steps can be taken to prevent or remediate any improper actions before they become unmanageable—for example, by bringing higher authority in the organization into the loop to exercise control over potentially wayward subordinates, or by promptly self-reporting any actual violation before a regulator or prosecutor discovers it and takes action.
The good news, of course, is that where in-house counsel is both firm in insisting on legal compliance and, at the same time, creative and responsive to management's desire to pursue legitimate goals within the law, most legal issues should be resolved amicably through open dialogue between counsel and management.
In closing, I trust that will always be the case as you help your management team continue to produce your wonderful product.
Thank you.
[1] I think this definition originated with John C. Coffee.
[2] I’ve cribbed sections of what follows from my friend and UCLA law school colleague Sung Hui Kim’s article The Banality of Fraud: Re-Situating the Inside Counsel as Gatekeeper, 74 Fordham L. Rev. 983 (2005).
[3] Lincoln Sav. & Loan Ass'n v. Wall, 743 F. Supp. 901, 920 (D.D.C. 1990).
[4] I cribbed portions of this section from a speech by former SEC Chairman Harvey Pitt. Harvey L. Pitt, SEC Chairman: Remarks Before the Annual Meeting of the American Bar Association's Business Law Section (Aug. 12, 2002), http:// www.sec.gov/news/speech/spch579.htm.
[5] Russell B. Korobkin and Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics, 88 Cal. L. Rev. 1051, 1091 (2000).
[6] City Capital Associates Ltd. Partnership v. Interco Inc., 551 A.2d 787, 796 (Del. Ch. 1988).
[7] Donald C. Langevoort, Where Were the Lawyers? A Behavioral Inquiry Into Lawyers’ Responsibility for Clients’ Frauds, 46 Vand. L. Rev. 75 (1993).
[8] I cribbed parts of this section from an article by William W. Horton at 3 J. Health & Life Sci. L. 187.
