January 10, 2003

On December 3, 2002, I wrote to express my strong support for your proposed rule: Implementation of Standards of Professional Conduct for Attorneys. When I wrote, there was only one comment letter. Today there are 141, many with multiple signatories or representing large groups. I think it's fair to characterize 133 of the letters as comments from lawyers who are baffled, disturbed, dismayed, embarrassed, outraged, puzzled, shocked or surprised (to list only the most common words) by the proposed rule. That suggests that no lawyer read a newspaper during 2002.

It seems that every major law firm and legal professional organization in the world has weighed in, including many former Commissioners and senior staffers. Even former Commission Chair Joseph Grundfest, who is generally sound on shareholder rights, opposed the proposed rule. On the other side stand eRaider, six individual investors (David Feldman, Eliot Cohen, Joe Drain, Tom Power, William Livingstone and Marv Eatinger) of various opinions but more supportive than critical of the proposed rule, and Professor William Simon of Stanford (keep his number, you may have to start a law firm together when you leave the SEC). I apologize to anyone I missed or miscategorized.

While many of the lawyers' comments concern details of the proposed rule, and made some points I agreed with in my previous comment letter, none shows any appreciation of the need for the proposed rule. The public perception is that billions of dollars was looted from major companies, causing hundreds of billions of dollars of direct economic damage plus perhaps a 25 percent decline in world stock markets as investor trust in public filings evaporated. Hundreds of lawyers played essential roles in preparing these misleading filings. Some of them had to be aware that the purpose of the misleading filings was to abet or conceal insider self-dealing and excessive compensation, and to maintain control of the issuer through deception. In all cases the majority of directors and officers have claimed not to have been informed that the filings were misleading. Therefore it seems unarguable that lawyers should be required to inform the issuer's Chief Legal Officer if they become aware of any material breach of duty by officers connected with misleading SEC filings.

Of course, the public perception may be incorrect. But I don't see how anyone can argue against the proposed rule without disputing the perception. Claims that existing rules and regulations are adequate, appeals to attorney-client privilege, complaints about how much trouble it will cause for lawyers are beside the point. If lawyers are abetting a gigantic problem that imperils the world economy and everyone's financial security, then it's the Commission's job to make them stop. Personally, I feel that the proposed rule would probably not have had much effect in the recent spate of major disasters. I think it will help in the more common violations of much smaller scale, and I base my support for the rule on that. But either way, a comment opposing the proposed rule that does not mention the role of lawyers in the recent corporate scandals suggests that the author just doesn't get it. Taken as a whole, the reaction of the legal community suggests that no lawyers (except Professor Simon) get it.

To an investor, the soul of the proposed rule is:

Representing an issuer. An attorney appearing and practicing before the Commission in the representation of an issuer represents the issuer as an organization and shall act in the best interest of the issuer and its shareholders. That the attorney may work with and advise the issuer's officers, directors, or employees in the course of representing the issuer does not make such individuals the attorney's clients.

Alfred P. Carlton, Jr, writing on behalf of the American Bar Association, counters with:

[T]he organization, and not its shareholders or other constituencies, ...[is] the client...The interests of shareholders are...[not] relevant ...for defining a duty.

In this Orwellian controversy, everyone agrees that the organization is the client but the Commission means organization-and-shareholders and Mr. Carlton means organization-not-shareholders. The Commission specifically sets organization-and-shareholders against insiders. Mr. Carlton clearly (if implicitly) assumes that insiders are the client. When he writes:

Lawyers...should not be placed in the position of substituting the lawyer's judgment for that of the client.

The idea that issuers' interests have to be protected from shareholders in the context of the proposed rule is preposterous. Shareholders owe no duty to the issuer, so they cannot breach it. Shareholders do not prepare filings on behalf of the issuer, so they cannot prepare misleading ones. If a shareholder were to ask the issuer's counsel for help in inserting material misleading information into an issuer filing, no one doubts that the counsel should inform the issuer, especially if there is a chance of success. The proposed rule addresses the problem of lawyers not informing the issuer when its managers and directors ask for help in breaching their duties and making misleading filings. If the American Bar Association doesn't understand that, then we doubly need the proposed rule.

The American Bar Association Model Rule 1.13(d) takes an intermediate position:

In dealing with an organization's directors, officers, employees, members, shareholders, or other constituents, a lawyer shall explain the identity of the client when the lawyer knows or reasonably should know that the organization's interests are adverse to those of the constituents with whom the lawyer is dealing.

This says the client is the organization-not-anybody. The formulation covers the CEO asking for advice about suing the issuer. But it gives no guidance about what are the interests of the organization as distinct from its constituents and how are those interests to be determined. It appears to treat all constituents equally so that an action that overcompensates directors and officers, at the expense of shareholders, is arguably in the net interests of the organization. If it's arguable then the lawyer will probably rely on the determination of managers, which gets us back to Mr. Carlton's position. We need a specific rule for public security issuers that states making misleading filings that cause material harm to shareholders is never in the organization's interest.

This distinction among organization-and-shareholders, organization-not-shareholders and organization-not-anybody underlies most of the comment letters that attack the entire proposed rule as a violation of attorney-client privilege. When everyone agrees on the organization's interests, the formulations are identical. When there is legitimate debate about the organization's interests, no one expects lawyers to make the determination. Dispute arises when a corporate Louis XIV claims "l'Etat, c'est moi."

For a specific example, suppose Fast Andy, the CFO of a major public corporation, has made $43 million from partnerships he controls which do business only with the corporation. He asks a staff attorney for advice about how to avoid reporting this money. The attorney reviews the facts and determines the money meets the section 14 definition of compensation and makes Fast Andy one of the five highest paid executives, so it must be disclosed to the public by amending the proxy statement. Fast Andy replies, "I'll find some way around that," and asserts that it is in the interests of the corporation not to disclose anything. Public disclosure will hurt the stock price, which will cause lower credit ratings, which will trigger downrating clauses, which will cause the company to collapse harming shareholders, employees and everyone else. The attorney also determines that the Board of Directors must be informed in order to fulfill its duties. Disclosure to the Board is a bad idea because, according to Fast Andy, "the Directors already know but want to maintain deniability for protection in possible shareholder lawsuits."

Mr. Carlton's position suggests that the lawyer should accept Fast Andy's determination of the company's interests, because it is not unreasonable. While the lawyer cannot participate in making a false filing or lying to the Board, his conversation with Fast Andy is protected because it concerns the interests of the company, not Fast Andy personally. So the conversation cannot be ethically reported outside the organization and need not be reported within the organization. There is no affirmative duty to disavow the misleading proxy statement. The ABA model rule appears to allow but not require this interpretation.

The proposed rule clearly requires the attorney to report the matter to the company's Chief Legal Officer. This can have only beneficial results. If Fast Andy was operating without the knowledge of directors and other officers, the report will alert them to the problem. If Fast Andy is correct that everyone knows already, the report will force them to perform their duties or else it will help shareholders collect damages later.

If Fast Andy knows the money should be reported, the proposed rule may change his behavior. If it stops him from taking the $43 million in the first place, that's the best possible result. If it only stops him from consulting the company lawyer, that is still a good thing. Shareholders will save the money (and insult) from paying a lawyer to work against their interests. Moreover, Fast Andy will have to conceal the money in some more obviously illegitimate way, strengthening shareholders' ability to recover it later.

Whatever changes are made in the proposed rule, I urge the Commission to retain the essential statement that a lawyer's client is the organization-and-shareholders. This is the simple and honest truth of the matter. The alternative definitions fail to address the problems the proposed rule is meant to solve.

Sincerely,

Deborah Pastor
eRaider.com Inc.