Stool Pigeon Update: Clipping the Wings of the Regulators

Well, at least reformers dropped the idea that lawyers should go to the regulators if corporate misconduct they encounter is not rectified, and raise a ruckus while doing so. Attorneys are now required to report material violations to a company’s chief legal officer and, if the response seems inappropriate, to the board. Many directors welcome how this attorney-as-stool-pigeon issue has panned out, even though some express reservations about an apparent erosion of attorney-client privilege.

When we last reported on the subject (“Should Your Lawyer Be a Snitch?” July/August 2003), the SEC was considering whether to compel lawyers to withdraw from a company and notify the agency of their action. The so-called “noisy withdrawal” provision is not part of the final rules of conduct prescribed by Sarbanes-Oxley that are now in effect, nor is the requirement that lawyers notify the SEC of transgressions. However, they are free to go to the SEC if they think that doing so will prevent a violation or amend one that has already been committed.

Ten directors interviewed by Corporate Board Member for this report welcome the idea of being told about violations. They say it could prevent scandals. “With the intense scrutiny they’re under today, it’s clear that conscientious directors are focused on making sure they have all the information they can get,” says Gerald Czarnecki, chairman of the Deltennium Group investment company, who serves on the boards of State Farm and Del Global Technologies. “I’d be shocked if there was a director who felt uncomfortable with that.”

Czarnecki and others point out that the rule categorically affirms that an attorney’s ultimate client is the corporation, as represented by the board of directors rather than the CEO or other managers of the company. “I don’t think a lot of lawyers would have said that before,” he says.

Richard W. Hanselman, a director of Health Net and ArvinMeritor, says that requiring attorneys to report violations up the ladder makes perfect sense. “It’s almost like brushing your teeth. I don’t see why it should cause a problem,” he says. “If counsel can’t find a receptive ear within the company, it’s an indication that there’s a pretty serious problem there.”

But giving lawyers permission to report violations to the SEC if they feel that a company and its board have not provided an adequate response is definitely a concern for many directors. “I worry about whether or not there are circumstances where the board loses attorney-client privilege,” says Dennis E. Logue, dean of the University of Oklahoma’s college of business and a director of Abraxas Petroleum, Sallie Mae, and Waddell & Reed Financial Inc. Don L. Chapman, CEO of Tug Investment Corp. and a director of AirTran Holdings and Rare Hospitality International Inc., goes further: “Any lawyer who told me up front he’d comply with a noisy-withdrawal provision, I’d get rid of.”

Have the changes made clients reluctant to open up fully to their attorneys? Not from a director’s perspectiveu00e2u20ac”at least not until it becomes clearer whether lawyers will use their ability to report violations. Both Czarnecki and Hanselman, among other board members, say they are as open as ever.

For their part, corporate attorneys are quick to say that little has changed in the way they view their responsibilities, although there is some concern about how the rule will be applied. After all, in certain cases general counsels would be required to go over the heads of the management teams that hired them and report directly to the board. “There’s a lot of consciousness about [the reporting-up requirement],” says David M. Becker, a partner in securities law at Cleary Gottlieb Steen & Hamilton in Washington, D.C. “The rules aren’t that much different, but lawyers are much more conscious of them.”

William J. Casazza, vice president, deputy general counsel, and corporate secretary of Aetna Inc., says he doesn’t think corporate lawyers are nervous about the new requirement but that they’re waiting to see how it will be used: “People are just working their way through it. We need to see situations where it’s being applied to see what’s in store for us.”

So far the one conspicuous instance in which the rule has been cited involves the Mexican broadcaster TV Azteca. In a December letter, Akin Gump Strauss Hauer & Feld, Azteca’s outside law firm on a bond offering, notified the broadcaster’s directors that it was resigning over concerns that insufficient disclosure had been made about a related-party transaction involving the company’s chairman. The letter was obtained by the New York Times. In it, an Akin Gump partner referred to the new Sarbanes-Oxley rules. The partner wrote that the law firm had not received an adequate response from the company’s general counsel and was therefore withdrawing.

The partner also wrote that Akin Gump “reserved the right to inform the SEC of our withdrawal and the reasons therefor.” Asked by Corporate Board Member whether it had done so, Akin Gump declined to comment. Meanwhile a shareholder lawsuit was filed against TV Azteca in late January, alleging improper disclosure of the transaction cited by Akin Gump.

Another recent case highlighting lawyer conduct involves the catalog retailer Spiegel Inc. The SEC charged Spiegel with hiding the fact that its auditor had indicated substantial doubt about its ability to remain in business, something the company allegedly did by delaying the filing of its 2001 annual report and subsequent quarterly reports. The case was partially settled, with Spiegel neither admitting nor denying wrongdoing, but a court-appointed examiner reported that Spiegel’s law firm, Kirkland & Ellis, had repeatedly told management and top directors that withholding the information could have serious consequences. In the absence of a regulation requiring attorney withdrawal, the examiner wrote, Spiegel was allowed to keep investors and the SEC uninformed. The SEC is still investigating.

The original noisy-withdrawal provision requiring lawyers to resign if misconduct is not corrected and to notify the SEC remains officially under consideration. But no timetable has been set for approval or rejection. Edward Schweitzer, a senior counsel at the SEC who helped draft the proposals, says he expects the issue to be resolved one way or another. But other attorneys tell Corporate Board Member that they expect noisy withdrawal to be held out as a possibility for some time and then to gradually fade away. Their suspicion was boosted in February when members of Congressu00e2u20ac”including Michael Oxley, joint sponsor of the Sarbanes-Oxley Actu00e2u20ac”criticized the SEC for considering turning lawyers into whistleblowers with the noisy-withdrawal proposal.

Meanwhile, Frederick J. Krebs, president of the Association of Corporate Counsel, a group that represents in-house attorneys, says there has been a strong increase in the number of executive sessions that boards hold with company lawyers. Those meetings are aimed at ensuring that counsel is free to address issues directly with board members. Aetna’s general counsel will meet in executive session with the independent directors at least twice this year.

“It’s institutionalizing or affirming a practice that was not uncommon but yet not everyone engaged in, either,” says Krebs. And it may help head off surprises that might require lawyers to rat out the people who pay them.

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