Lawyers Beware

In the first 3 months of 2005, the SEC filed 18 cases against lawyers. More are clearly coming. Just last month, SEC Chairman William Donaldson warned that the SEC is “firmly committed to both the rules governing attorney conduct, and to the principles that underlie them, and we will enforce them when violated.” As if Donaldson's message were too oblique, the SEC's chief litigation counsel put it bluntly: the SEC “has made cases against lawyers a priority.”

The government has had mixed results prosecuting attorneys. In 1999, a Kansas judge issued an order of acquittal for two health care lawyers after the government charged them with participating in Medicare fraud. The government had alleged that the attorneys drafted fraudulent consulting agreements that allowed executives to receive more than $2 million in kickbacks for Medicare patient referrals. The judge disagreed. The Manhattan District Attorney's Office also came up empty in July 2003 after its prosecution of former Tyco General Counsel Mark Belnick collapsed in an acquittal on all counts. Belnick had been charged with defrauding the company by receiving more than $30 million in bonuses and loans that were not approved by the board of directors.

The government has scored victories as well. During an investigation of The Warnaco Group, Inc., the government found evidence that Warnaco's General Counsel, Stanley Silverstein, approved the company's 1999 annual report, which the SEC considered misleading. Because Silverstein “knew or should have known” the misleading nature of the report, the SEC barred him from practicing before the SEC for 2 years and required $165,772 in disgorgement. Rite Aid's General Counsel, Franklin Brown, fared much worse. During the investigation of Rite Aid for artificially inflating the company's value, the government charged that Brown allegedly helped cover up related-party transactions, filed false statements with the SEC, and helped backdate severance letters benefiting himself and other executives. Brown was tried, convicted of 10 counts (including obstruction, witness tampering, and securities fraud) and sentenced to 10 years in prison and a $21,000 fine.

Seeking to avoid that fate, the General Counsel of Computer Associates, Stephen Woghin, pled guilty to charges of conspiring to commit securities fraud and obstruction of justice stemming from his involvement in improper revenue recognition practices at CA and an alleged scheme to impede the government's investigation. Interestingly, part of the obstruction charge was that Woghin provided false information to CA's outside lawyers with the knowledge that the information would be passed on to the government. The SEC added its two cents by charging Woghin with securities fraud and violations of '' 17(a) and 13(b)(5), as well as aiding and abetting similar violations by others. Woghin consented to civil a judgment enjoining him from violating the federal securities laws, barring him from serving as an officer or director of a public company, and barring him from practicing before the SEC. He faces a maximum sentence of 25 years in prison based on his guilty plea, although he hopes for a more lenient sentence in light of his agreement to testify against CEO Sanjay Kumar and other CA executives.

Sanctioned for Omissions

Although Woghin ultimately admitted the illegal conduct, other cases show pursuit of reputedly honest lawyers for alleged negligence or lack of sufficient vigilence. For example, the SEC recently imposed a cease and desist order on Google, Inc.'s General Counsel, David C. Drummond, after Drummond allegedly failed to prevent violations of ' 5 of the Securities Act, which requires registration of stock option offerings. Google issued more than $80 million in options in violation of ' 5, based in part on Drummond's erroneous belief that the company would qualify for exemptions. According to the SEC, Drummond should have reported to the Board that the exemptions upon which his advice relied might not apply. In essence, Drummond was sanctioned for misunderstanding the law.

Similarly, John L. Milling of LinkNet, Inc. was charged with violating ' 5 of the Securities Act after LinkNet sold securities through an affiliate without complying with registration requirements. Milling drafted documents in connection with the offering. When notified about the SEC's investigation, Milling recommended that the company conduct an unregistered rescission of the offering. Like Drummond, Milling consented to a cease and desist order prohibiting future violations.

While Drummond and Milling were punished for misunderstanding the rules, John E. Isselmann, Jr., the General Counsel of Electro Scientific Industries, Inc. (ESI), faced the music for failing to object loudly enough about arguable wrongdoing. According to the SEC, ESI's CEO and CFO decided — without Isselmann's knowledge — to alter the company's bottom line by eliminating $1 million in retirement and severance benefits for ESI's employees in Asia. Isselmann subsequently received an opinion from ESI's outside counsel that such a move was illegal under Japanese law. When Isselmann tried to raise this point at a disclosure committee meeting, the CFO cut him off. The CFO later signed the company's Form 10-Q that included the $1 million increase to the bottom line. The SEC charged Isselmann for his failure to escalate the issue to ESI's Board, thus contributing to the fraudulent Form 10-Q. Isselman ultimately acceded to a cease and desist order without financial penalty.

Outside Counsel in the Crosshairs, Too

According to Stephen M. Cutler, the SEC's Enforcement Director, nearly half of the SEC's actions against lawyers during the past 2 years involved outside counsel. In late 2004, for example, the SEC served a Wells notice on Christopher McGrath, who had conducted an internal investigation for Endocare, Inc. in response to a claim of accounting irregularities. While the details have not been made public, Endocare announced, after this probe, that the company found no evidence of “fraud or intentional wrong-doing.” Presumably, then, the SEC believes McGrath's investigation either missed or hid something. Either way, the SEC's Wells notice to McGrath may be a sign of things to come: Cutler has warned that outside lawyers' conduct during internal corporate investigations will be “an area of particular focus.”

The government can also strike outside counsel indirectly. In two recent cases, corporate targets retained prominent firms to conduct an internal investigation on behalf of senior management. When prosecutors believed the firms were not doing enough to uncover suspected fraud, they contacted the boards, expressed a lack of confidence in the internal investigations, and threatened enforcement proceedings. In short order, the boards hired new outside counsel.

Avoiding Traps for the Unwary

If you pledge to cooperate with the government's investigation as in-house or outside counsel, then cooperate fully you must. Trouble comes if you make half-hearted excuses to defend or explain pernicious conduct instead of straightforwardly reporting of the facts. But lawyers who communicate with the government honestly and carefully document what they say should not fear reprisal from regulators or prosecutors.

Part of that honest communication is to be transparent with the government and advise them of your progress along the way. Investigate thoroughly, albeit responsibly. While no lawyer's investigation should run roughshod over the business, the investigative plan must be reasonably designed to identify wrongdoers and victims, fully capture all the patterns of improper conduct, and deliver a cogent and complete set of facts to the government. The opportunity for a company to avoid prosecution by investigating itself is a privilege, not a right. It will surely be revoked if the government perceives a whitewash.

If the executive who hired you promises cooperation and then fails to deliver, or places unreasonable pressure on the internal investigator to limit the investigation's scope, you must go up the ladder. As distasteful as it may seem to tattle on a client, the outside lawyers conducting an internal corporate investigation are duty-bound to protect the company and its shareholders, not the senior manager who hired you. Of course, you don't run to the board at the first signs of trouble. You must be clear and direct about problems with the immediate client. But if your warnings go unheeded, you should take the problem as high as necessary to get it resolved.

In certain circumstances, outside counsel may be required to explain or defend the investigation. The pressure placed on companies to waive the attorney-client privilege makes such scrutiny even more likely. Careful documentation, including the consistent maintenance of a case chronology, is essential. The case chronology should document all important aspects of the investigation, advice and direction given to management, and problems encountered and the resolution of those problems.

Conclusion

Government interest in attorney conduct has reached an all-time high and shows no sign of waning. Attorneys should be constantly watchful of potential pitfalls and, upon discovering questionable conduct, should take care to communicate clearly and effectively with regulators and prosecutors. In today's environment, anything less than heightened vigilance makes the lawyer a target of enforcement.

In Open Water, one of last year's most successful independent films, two experienced divers are abandoned by the crew of a dive ship in shark-infested waters. They struggle throughout the film to keep their wits about them. Neither makes it out alive.

These days, the environment seems no less hostile for in-house and outside counsel. Facing employees who often lie, managers who increasingly view them with suspicion, a landslide of new rules and regulations, an ever-increasing pressure to cut budgetary corners, and prosecutors and regulators who expect endless self-flagellation, some lawyers have ended up in the belly of the beast.

Lawyers As Targets of Enforcement

In the first 3 months of 2005, the SEC filed 18 cases against lawyers. More are clearly coming. Just last month, SEC Chairman William Donaldson warned that the SEC is “firmly committed to both the rules governing attorney conduct, and to the principles that underlie them, and we will enforce them when violated.” As if Donaldson's message were too oblique, the SEC's chief litigation counsel put it bluntly: the SEC “has made cases against lawyers a priority.”

The government has had mixed results prosecuting attorneys. In 1999, a Kansas judge issued an order of acquittal for two health care lawyers after the government charged them with participating in Medicare fraud. The government had alleged that the attorneys drafted fraudulent consulting agreements that allowed executives to receive more than $2 million in kickbacks for Medicare patient referrals. The judge disagreed. The Manhattan District Attorney's Office also came up empty in July 2003 after its prosecution of former Tyco General Counsel Mark Belnick collapsed in an acquittal on all counts. Belnick had been charged with defrauding the company by receiving more than $30 million in bonuses and loans that were not approved by the board of directors.

The government has scored victories as well. During an investigation of The Warnaco Group, Inc., the government found evidence that Warnaco's General Counsel, Stanley Silverstein, approved the company's 1999 annual report, which the SEC considered misleading. Because Silverstein “knew or should have known” the misleading nature of the report, the SEC barred him from practicing before the SEC for 2 years and required $165,772 in disgorgement. Rite Aid's General Counsel, Franklin Brown, fared much worse. During the investigation of Rite Aid for artificially inflating the company's value, the government charged that Brown allegedly helped cover up related-party transactions, filed false statements with the SEC, and helped backdate severance letters benefiting himself and other executives. Brown was tried, convicted of 10 counts (including obstruction, witness tampering, and securities fraud) and sentenced to 10 years in prison and a $21,000 fine.

Seeking to avoid that fate, the General Counsel of Computer Associates, Stephen Woghin, pled guilty to charges of conspiring to commit securities fraud and obstruction of justice stemming from his involvement in improper revenue recognition practices at CA and an alleged scheme to impede the government's investigation. Interestingly, part of the obstruction charge was that Woghin provided false information to CA's outside lawyers with the knowledge that the information would be passed on to the government. The SEC added its two cents by charging Woghin with securities fraud and violations of '' 17(a) and 13(b)(5), as well as aiding and abetting similar violations by others. Woghin consented to civil a judgment enjoining him from violating the federal securities laws, barring him from serving as an officer or director of a public company, and barring him from practicing before the SEC. He faces a maximum sentence of 25 years in prison based on his guilty plea, although he hopes for a more lenient sentence in light of his agreement to testify against CEO Sanjay Kumar and other CA executives.

Sanctioned for Omissions

Although Woghin ultimately admitted the illegal conduct, other cases show pursuit of reputedly honest lawyers for alleged negligence or lack of sufficient vigilence. For example, the SEC recently imposed a cease and desist order on Google, Inc.'s General Counsel, David C. Drummond, after Drummond allegedly failed to prevent violations of ' 5 of the Securities Act, which requires registration of stock option offerings. Google issued more than $80 million in options in violation of ' 5, based in part on Drummond's erroneous belief that the company would qualify for exemptions. According to the SEC, Drummond should have reported to the Board that the exemptions upon which his advice relied might not apply. In essence, Drummond was sanctioned for misunderstanding the law.

Similarly, John L. Milling of LinkNet, Inc. was charged with violating ' 5 of the Securities Act after LinkNet sold securities through an affiliate without complying with registration requirements. Milling drafted documents in connection with the offering. When notified about the SEC's investigation, Milling recommended that the company conduct an unregistered rescission of the offering. Like Drummond, Milling consented to a cease and desist order prohibiting future violations.

While Drummond and Milling were punished for misunderstanding the rules, John E. Isselmann, Jr., the General Counsel of Electro Scientific Industries, Inc. (ESI), faced the music for failing to object loudly enough about arguable wrongdoing. According to the SEC, ESI's CEO and CFO decided — without Isselmann's knowledge — to alter the company's bottom line by eliminating $1 million in retirement and severance benefits for ESI's employees in Asia. Isselmann subsequently received an opinion from ESI's outside counsel that such a move was illegal under Japanese law. When Isselmann tried to raise this point at a disclosure committee meeting, the CFO cut him off. The CFO later signed the company's Form 10-Q that included the $1 million increase to the bottom line. The SEC charged Isselmann for his failure to escalate the issue to ESI's Board, thus contributing to the fraudulent Form 10-Q. Isselman ultimately acceded to a cease and desist order without financial penalty.

Outside Counsel in the Crosshairs, Too

According to Stephen M. Cutler, the SEC's Enforcement Director, nearly half of the SEC's actions against lawyers during the past 2 years involved outside counsel. In late 2004, for example, the SEC served a Wells notice on Christopher McGrath, who had conducted an internal investigation for Endocare, Inc. in response to a claim of accounting irregularities. While the details have not been made public, Endocare announced, after this probe, that the company found no evidence of “fraud or intentional wrong-doing.” Presumably, then, the SEC believes McGrath's investigation either missed or hid something. Either way, the SEC's Wells notice to McGrath may be a sign of things to come: Cutler has warned that outside lawyers' conduct during internal corporate investigations will be “an area of particular focus.”

The government can also strike outside counsel indirectly. In two recent cases, corporate targets retained prominent firms to conduct an internal investigation on behalf of senior management. When prosecutors believed the firms were not doing enough to uncover suspected fraud, they contacted the boards, expressed a lack of confidence in the internal investigations, and threatened enforcement proceedings. In short order, the boards hired new outside counsel.

Avoiding Traps for the Unwary

If you pledge to cooperate with the government's investigation as in-house or outside counsel, then cooperate fully you must. Trouble comes if you make half-hearted excuses to defend or explain pernicious conduct instead of straightforwardly reporting of the facts. But lawyers who communicate with the government honestly and carefully document what they say should not fear reprisal from regulators or prosecutors.

Part of that honest communication is to be transparent with the government and advise them of your progress along the way. Investigate thoroughly, albeit responsibly. While no lawyer's investigation should run roughshod over the business, the investigative plan must be reasonably designed to identify wrongdoers and victims, fully capture all the patterns of improper conduct, and deliver a cogent and complete set of facts to the government. The opportunity for a company to avoid prosecution by investigating itself is a privilege, not a right. It will surely be revoked if the government perceives a whitewash.

If the executive who hired you promises cooperation and then fails to deliver, or places unreasonable pressure on the internal investigator to limit the investigation's scope, you must go up the ladder. As distasteful as it may seem to tattle on a client, the outside lawyers conducting an internal corporate investigation are duty-bound to protect the company and its shareholders, not the senior manager who hired you. Of course, you don't run to the board at the first signs of trouble. You must be clear and direct about problems with the immediate client. But if your warnings go unheeded, you should take the problem as high as necessary to get it resolved.

In certain circumstances, outside counsel may be required to explain or defend the investigation. The pressure placed on companies to waive the attorney-client privilege makes such scrutiny even more likely. Careful documentation, including the consistent maintenance of a case chronology, is essential. The case chronology should document all important aspects of the investigation, advice and direction given to management, and problems encountered and the resolution of those problems.

Conclusion

Government interest in attorney conduct has reached an all-time high and shows no sign of waning. Attorneys should be constantly watchful of potential pitfalls and, upon discovering questionable conduct, should take care to communicate clearly and effectively with regulators and prosecutors. In today's environment, anything less than heightened vigilance makes the lawyer a target of enforcement.