Speech by SEC Commissioner:
A Lawyer's Role in Corporate Governance:
The Myth of Absolute Confidentiality and the Complexity of the Counseling Task
Commissioner Harvey J. Goldschmid1
U.S. Securities and Exchange Commission
The Orison S. Marden Lecture
The Association of the Bar of the City of New York, November 17, 2003
Thank you Leo. It is wonderful to be back at the House of the Association. The Association of the Bar is one of the nation's great legal institutions, and among institutions, only Columbia Law School competes with it for my deepest respect and affection. I am honored to have been asked to give the Marden Lecture.
Orison Marden, who died in 1975, provided the bar, in the words of Bob MacCrate, who gave this lecture ten years ago, the "model. . . of the lawyer as [a] responsible professional and public citizen." 2 My focus tonight is on what "responsible professional" and "public citizen" should mean in the corporate context in this fourth year of the 21st century. I will address the issues in the context of the lawyer's role in the large public corporation, and from a securities law perspective, but much of what I have to say is relevant to non-public corporations, other for-profit entities, and nonprofit institutions.
My lecture tonight comes in three basic parts. First, I will provide a thumbnail sketch of developments in corporate governance during my professional lifetime. Second, again relatively briefly, I will relate pre-Enron developments to corporate governance themes in the Sarbanes-Oxley Act (signed on July 30, 2002) and to the SEC's implementation of Sarbanes-Oxley. Third, I will focus on the lawyer's role in corporate governance. I will address: (i) a lawyer's legal and ethical responsibilities to report serious wrongdoing up the corporate ladder or chain of command; (ii) so-called "reporting out" issues and the myth of absolute confidentiality; (iii) state and federal tensions in the area; and (iv) an area often unaddressed or in the shadows, the lawyer's counseling responsibilities with respect to nonlegal considerations.
Thumbnail Sketch of Corporate Governance Developments
I began teaching at Columbia Law School in the fall of 1970. The great scandal of that time involved the bankruptcy of Penn Central. Penn Central was the nation's largest railroad, our sixth largest industrial corporation, and its bankruptcy was the nation's largest since the 1930s. SEC and congressional reports and a book aptly entitled The Wreck of the Penn Central 3 charged that Penn Central's directors had received almost no realistic financial information and had little idea of where the company stood. The SEC alleged that the board ignored indications of impending disaster. 4 A director who joined the board in December 1969, when bankruptcy was near, is reported to have said the following about his fellow directors:
[T]hey sat up there on the eighteenth floor in those big chairs with the [brass name] plates on them and they were a bunch of, well, I'd better not say it. The board was definitely responsible for the trouble. They took their fees and they didn't do anything. Over a period of years, people just sat there.5
In the late 1960s and early 1970s, as documented by numerous scholars, this Penn Central picture had become too close to the corporate norm.6 Senior managers dominated, and directors spent roughly 30 to 40 hours a year on the job. I, among others, urged during the 1970s that boards must be far more active and involved; the "board's truly important function is to actively check or monitor management." 7 The corporate governance movement from the early 1970s until pre-Enron 2001 was primarily aimed at creating a serious check and balance function in the board. The American Law Institute's Principles of Corporate Governance, published in 1994, set forth a "monitoring model" in which the board would principally: (1) hire, regularly evaluate, compensate, and, where appropriate, fire senior executives; (2) oversee the conduct of the corporation's business; and (3) review and approve (or disapprove) major corporate plans and actions.8 By 2001, the average director was spending roughly 150 hours on the job.
Sarbanes-Oxley Corporate Governance Themes
The corporate and financial scandals of the 1990s and early 2000s are the most serious that have occurred in this country since the scandals of the Great Depression. We have witnessed a systemic failure. The checks and balances that we thought would be provided by independent directors (acting pursuant to the monitoring model), independent auditors, securities analysts, investment and commercial bankers, rating agencies, and lawyers too often failed. The regulatory checks represented by the SEC, and by federal and state legal constraints, also proved inadequate because, in meaningful part, of scarce resources and overly protective case law and legislation.
My focus tonight is on governance. What went wrong in the boardroom? The facts will be developed as the various criminal and civil cases move forward, but Steve Cutler, the SEC's very able chief of enforcement, observed:
Yet too often. . . boards were disinterested and disengaged . . . .
[T]hey are dominated by associates and friends of senior management
. . . . Many outside directors have lacked expertise.9
Recently, in August 2003, Richard Breeden, former Chairman of the SEC and Corporate Monitor for WorldCom, reported that the "board . . . consistently ceded power over the direction of the Company to Ebbers. As CEO, Ebbers was allowed nearly imperial reign."10
Does this sound like Penn Central in 1969? Does it suggest the failure of the monitoring model? My answers are "yes" and "no." It does sound like Penn Central, but the monitoring model staffed by active, independent directors continues to make sense. Indeed, we don't know how many additional Enrons or WorldComs were prevented by active, independent directors. But the board failures do suggest that independent directors cannot carry the load alone. The monitoring model, even when directors are trying to do their jobs properly, is heavily dependent on effective information flows, proper disclosure, and the vigilance of gatekeepers like accountants and lawyers.
Sarbanes-Oxley provides the right fundamental framework for correcting the failings that were found in area after area. In the governance area, Sarbanes-Oxley, and what the SEC has done to build upon it, puts even more weight and responsibility on independent directors. The audit committee, for example, has been greatly strengthened and now is "directly responsible" for the appointment, evaluation, compensation, and replacement of a corporation's independent auditor. The audit committee also now has authority to engage independent counsel, accountants, and other advisers. For public corporations, the oversight of the accounting profession has been dramatically reformed. Auditors are now monitored by the Public Company Accounting Oversight Board, a new regulatory institution, which has effective disciplinary, rulemaking, and quality control powers.
What role should lawyers have in corporate governance? In Orison Marden's terms, what is the lawyer's role when acting as a "responsible professional" and "public citizen" today?
A Lawyer's Role in Corporate Governance
There is, I believe, a broad consensus that lawyers should play a critical gatekeeping role in large public corporations. The term "gatekeeper" suggests a guardian with independent professional responsibilities, including a responsibility for protecting the institution. Certainly, this was a virtually unanimous view of Congress when, in Section 307 of Sarbanes-Oxley, it required the SEC to establish a system for lawyers to report wrongdoing up the corporate chain of command or ladder and to establish other "minimum standards of professional conduct."
The rationale for this critical gatekeeping role relates back, at least in part, to my earlier observation about the need for independent directors to receive adequate information flows and proper disclosure. Ira Millstein, an active member of the Association of the Bar and an internationally recognized expert on corporate governance, recently answered a question about how "such a mess [could have been] created" as follows:
As agents [i.e, directors] serving the corporation, we were overcome by self-interest in the extreme, or greed . . . . [Directors] looked away as accountants, bankers and lawyers replaced responsibilities to the corporation and its shareholders with loyalty to the management team that hired them.11
Few things are more clear in the ethical codes of all of our states than that the entity is the client of a lawyer and not those who mange a corporation.12 As Bill Donaldson, the current Chairman of the SEC, recently put it: "The basic principle that [Section 307 and the SEC's] rules build upon is unassailable and needed reinforcement the client of a lawyer representing a corporation is the corporation and not the CEO, or other members of management, or the company officer doing the deal on which the lawyer is working." 13 Another basic legal and ethical proposition should also be carefully remembered by the bar: a lawyer must not participate in, or assist a client in, the commission of a fraud.
Congress in Section 307 of Sarbanes-Oxley made the following five basic policy decisions.
1. A "reporting up" system would significantly enhance the flow of key legal information (involving various "reasonably likely" material violations) to independent members of the board. "Reporting up" also empowers lawyers. I have long read Model Rule of Professional Conduct 1.13, and New York law, as strongly suggesting a "reporting up" requirement. Any ambiguity in Model Rule 1.13 was removed by the American Bar Association's amendments in August 2003. A lawyer is now clearly required even in all those areas not covered by Sarbanes-Oxley to report material violations up to a corporation's highest authority.
2. Consistent with corporate governance developments over the past 30 or so years and consistent with many other Sarbanes-Oxley provisions (e.g, involving audit committees) certain important legal issues that could materially harm the corporation must now be resolved by independent, dispassionate directors and not by managers alone. As must be obvious, I have no doubt about the validity and wisdom of this approach.
3. Sarbanes-Oxley in Section 307, and elsewhere, has placed a sensible emphasis on corporations and law firms establishing effective programs and procedures to make a "reporting up" process work. A recognition of the need to establish such programs and procedures in corporations and law firms led the SEC to postpone the effective date for "reporting up" from January 2003 until August 5, 2003.
4. Although not a matter free of legitimate controversy, Congress took a dramatic step in Section 307 when it mandated "reporting up" as a matter of substantive federal law. As of August 5, available for violations of Section 307 are the Commission's traditional broad spectrum of remedies, penalties, and other sanctions.
5. Contrary to the views of many commenters to the Commission, Congress clearly contemplated additional SEC rulemaking beyond "reporting up" under Sarbanes-Oxley. Section 307 expressly states that the "Commission shall issue rules, in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys . . . including a rule . . .[requiring 'reporting up']."
Obviously, the words "minimum standards" and "including" are critical to any serious consideration of the various "reporting out" issues that I am about to discuss.
Two things have always been clear to me about "reporting out" issues (i.e., reporting outside the corporation when its board has failed to stop ongoing financial fraud or other serious violations). First, the bar, during my professional lifetime, has never had an absolute prohibition against "reporting out." Rule 1.6 of the Model Rules of Professional Conduct, since it was promulgated by the A.B.A. in 1983, has always permitted "reporting out" to prevent acts that a lawyer reasonably believes are likely to result in death or substantial bodily harm. At least 40 states including New York have rejected the narrowness of Model Rule 1.6. The myth of absolute confidentiality protection is also demonstrated by traditional widely accepted "reporting out" dispensations for client perjury, a lawyer's self-defense, and various rectification scenarios.
Second, "reporting out" issues, while of large emotional concern to many in the bar, are of considerably less practical importance than the "reporting up" approach now accepted almost everywhere in the nation. I believe that it will be a most unusual circumstance (e.g., the OPM hard-core fraud situation in New York during the 1970s or the recent Spiegel, Inc. situation14) where reporting up to senior executives and independent directors will not stop wrongdoing or reckless behavior.
But assume securities fraud or corporate looting is occurring. Involved is serious ongoing present and future wrongdoing. And, contrary to what I believe will occur 90-plus percent of the time, the senior officers and independent directors have refused to stop the wrongdoing.
In such circumstances, for me, an absolute emphasis on confidentiality is incomprehensibly out of balance. Think of the enormous human cost of Enron, WorldCom, and other corporate scandals on employment, college plans, retirement plans, etc. Are the economic and psychological harms of those scandals to thousands upon thousands of individuals and families really less deserving of protection than threats to the life or physical health of one individual? An absolute emphasis on confidentiality for lawyers in financial fraud situations is contrary to the duties that the securities and corporate laws now place on accountants and corporate directors.15
The modern answer to old Model Rule 1.6's absolutism with respect to financial fraud is that both the SEC (in its January rulemaking) and the A.B.A. (in August 2003) have rejected it. The SEC's Section 205.3(d)(2) provides that an attorney "may reveal . . .confidential information" to "prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors." There is also a "noisy withdrawal" provision (Section 205.3 (d)(2)(iii)) to rectify a misuse of an attorney's services. After the A.B.A.'s August meeting, it and the SEC are in roughly the same position on these issues.
The key open issue for the SEC with respect to "reporting out" relates to whether to require mandatory as opposed to permissive reporting out. This would involve the kind of "noisy withdrawal" really an alerting mechanism contemplated in the SEC's November 2002 proposing release. Two alternative approaches either a company reporting requirement or a combined company, but if not, lawyer "reporting out" requirement are now under consideration. The combined company and lawyer approach would, if adopted, parallel the approach we now use for accountants under Section 10A of the 1934 Act.
The issues related to mandatory reporting out are complex and difficult; they will probably be addressed by the Commission this winter or spring. One main concern would be to avoid undue interference with attorney-client relationships. On the other hand, what are the odds of permissive "reporting out" taking place for even hard-core financial wrongdoing? At least 40 states have long allowed some kind of permissive reporting out, but there is almost no empirical or anecdotal evidence to suggest that lawyers have acted on the invitation in the financial fraud area.
Congress, in enacting Section 307 of Sarbanes-Oxley, acted under its constitutional authority to regulate commerce. Lawyers practicing before the SEC, for public corporations or mutual funds, are surely subject to federal regulation. It is true that historically lawyers have largely been regulated at the state level. But in the past, how many disciplinary actions for failure to "report up" have been brought? How much serious attention can state ethics authorities be expected to give to lawyer or law firm failures in the "reporting up" and "reporting out" areas?
In my view, no serious argument can be made that Congress lacked authority to enact Section 307 and federalize applicable standards. Section 307 and the SEC's professional conduct rules make enforcement realistic; they create accountability and deterrence; in corporate governance terms, they will effectively enhance information flows to the board.
Clearly, the SEC's January 2003 rulemaking, establishing mandatory rules for "reporting up," and permissive rules for "reporting out," now constitutes the law of the land. Last I looked, the Supremacy Clause remains a fundamental part of the United States Constitution. Yet at least one state seems to be in rebellion.
On July 23, 2003, Giovanni Prezioso, the SEC's General Counsel, with the full support of the Commission, wrote to the Washington State Bar Association. He warned that an "Interim Ethical Opinion," reaffirming Washington State's version of old Model Rule 1.6 (which is narrower than the SEC's permissive "reporting out" rule), was preempted in areas covered by the SEC's rule. The Washington State Bar Association claims that the ethics opinion would not frustrate federal policy because a lawyer can comply with both the permissive SEC rule and the narrower Washington rule by adhering to the latter. But the Commission is frustrated. The Washington State Bar Association is trying to prevent its lawyers from doing what federal law permits.
I believe that the position of the Washington State Bar Association is legally untenable, and its ethical opinion constitutes an essentially lawless act. In policy terms, the Washington State Bar Association is acting contrary to the positions of the SEC, at least 40 states, and, since August, the American Bar Association. It will be a tragedy, for which the Washington State Bar Association will have to accept substantial responsibility, if a Washington State lawyer who would have "reported out" ongoing, serious financial fraud fails to do so on the basis of the Bar Association's deeply flawed ethical opinion.
Counseling With Respect to Nonlegal Considerations
Beyond obedience to the law, the modern public corporation if it is to be effective in the long run should be operating with an ethical culture. There is a key role for lawyers in guiding corporations to do the "right thing." Traditionally, legal ethical codes have permitted a lawyer, in exercising "independent professional judgement," to render advice not only about the law, but also to take "other considerations such as moral, economic, social and political factors" into account.16 But lawyers have often been reticent about offering nonlegal advice. Today's ethical codes should work harder to encourage the provision of such advice.
One of my favorite teaching hours at Columbia involves a complex corporate-securities-tax problem that raises numerous conflict-of-interest issues for an insurance CEO. After exhaustive analysis, students who came to class certain about duty of loyalty wrongs recognize that a series of transactions will pass muster under applicable precedents. When the students are ready to move on to new material, I ask why the CEO resigned (the problem is based on real facts) when the transactions came to the public's attention. The answer, of course, is that the shareholders and public reacted to ethical concerns and loyalty dangers even if technical analysis would demonstrate that there was no legal vulnerability. Should a lawyer today feel comfortable if he or she had not alerted the insurance CEO about nonlegal concerns?
Similar contemporary questions can be posed about, for example, lawyers counseling financial institutions providing very questionable financial products, even when the products are legally permissible, which has not always been the case. Again, the same questions are raised for those counseling on CEO compensation, whether at a public corporation or at the New York Stock Exchange.
Except in special circumstances (e.g., where a sophisticated legal client demands only technical legal advice), the day of narrowly couched technical legal advice should be over. Orison Marden's "responsible professional and public citizen," in today's world, has at least an aspirational obligation to counsel clients beyond law about practical considerations, likely public perceptions and reactions, and generally, about doing the right thing.
I am delighted to be home again. It has been a great pleasure and honor being with you tonight.
1 Harvey J. Goldschmid has been a Commissioner at the United States Securities and Exchange Commission since July 2002. He is on leave from the Columbia University School of Law, where he serves as Dwight Professor of Law. The views expressed in the Marden Lecture are Commissioner Goldschmid's and do not necessarily represent the views of the Commission, his fellow Commissioners, or the Commission Staff.
2 Robert MacCrate, Preserving the Marden Legacy: Professional Responsibility in the Twenty-First Century, 48 A.B. Rec. 948, 949 (1993).
3 Joseph R. Daughen & Peter Binzen, The Wreck of the Penn Central (1971).
4 SEC, The Financial Collapse of the Penn Central Company (1972).
5 Joseph R. Daughen & Peter Binzen, supra note 3, at 308.
6 See Harvey J. Goldschmid, The Governance of the Public Corporation: Internal Relationships, in Commentaries on Corporate Structure and Governance 167 (Donald E. Schwartz 1979).
7 Id. at 174; see Harvey J. Goldschmid, The Greening of the Board Room: Reflections on Corporate Responsibility, 10 Colum. J.L.& S.P. 17 (1973).
8 Principles of Corporate Governance: Analysis and Recommendations § 3.02 (American Law Institute 1994).
9 Stephen M. Cutler, Remarks at the University of Michigan Law School (Nov. 1, 2002), available at http://www.sec.gov/news/speech/spch 604.htm.
10 Richard C. Breeden, Restoring Trust 1 (Aug. 2003).
11 Ira M. Millstein, Keynote Address to the NACD Annual Corporate Governance Conference (Oct. 20, 2003).
12 Model Rule of Professional Conduct 1.13a; EC S-18 of the Model Code of Professional Responsibility.
13 William H. Donaldson, Remarks to the Practicing Law Institute (Nov. 6, 2003).
14 See Jonathan Weil & Cassell Bryan-Low, Report Bolsters SEC's Proposal for Attorneys, Wall St. J., Sept 15, 2003 at C1.
15 See, e.g., 15 U.S.C.S. § 78j-1 (1999 & Supp. 2003); Francis v. United Jersey Bank, 87 N.J. 15, 432 A.2d 814 (Sup. Ct. 1981); 1 Principles of Corporate Governance: Analysis and Recommendations 134-98 (American Law Institute 1994).
16 Model Rule of Professional Conduct 2.1.