Richard Painter and Jennifer Duggan*

Practicing securities law is risky business. Although the Supreme Court curtailed private actions against lawyers and others for aiding and abetting securities fraud in Central Bank of Denver,(1) the Securities and Exchange Commission (SEC) appears ready to fill the void. With some equivocation, the SEC has over the past fifteen years become more aggressive in sanctioning lawyers for conduct in connection with their clients' violations of the securities laws.

To accomplish this task, the SEC has several means at its disposal. First, under its own Rule 2(e), the SEC may suspend or disbar a lawyer from practice before the SEC for, among other things, conduct that shows the lawyer to be "lacking in character or integrity or to have engaged in unethical or improper professional conduct."(2) Second, the SEC can enter cease and desist orders under the Remedies Act against persons found to have committed or to have been the "cause" of a violation of the securities laws.(3) Finally, the SEC has the power to prosecute aiders and abetters of securities laws violations under the newly enacted Private Securities Litigation Reform Act of 1995.(4)

These SEC disciplinary and enforcement proceedings can be lengthy and unpredictable. For example, in In re George C. Kern, Jr.,(5) Kern was the attorney for, and a member of the board of, Allied Corporation, which while the subject of a tender offer began negotiations with a "white knight;" an event that had to be disclosed to the SEC under the Williams Act. Allied failed to disclose the negotiations, and the SEC claimed that Kern "caused" this failure because Kern had assumed responsibility for determining when an amendment to Allied's Schedule 14D-9 would be filed. Kern had at most made an arguably wrong decision about the timing of disclosure in a fast-paced hostile takeover situation, yet the SEC sought to enjoin him against future violations of the securities laws, a sanction which could have cost him his reputation as one of New York's best takeover lawyers. Equally troubling are such questions as how a lawyer becomes a "cause" of a client's violation, and whether the SEC would have charged Kern if he had not been a director of Allied as well as its lawyer. These questions were never answered -- after dragging Kern through the proceedings for over a year, the SEC finally admitted that it had no jurisdiction to have commenced the proceedings against him in the first place.(6)

Proceedings such as the Kern case are particularly threatening to lawyers because they almost always arise out of situations where a client's conduct, not the lawyer's, initiated the underlying violation. Unfortunately, the SEC has not been forthcoming with a clear articulation of what a lawyer must do, may do and must not do when confronted with a client's violation. The SEC also has not clearly articulated what standard of culpability (intent, recklessness or mere negligence) in connection with a client's violation will warrant sanction of a lawyer.

The Confusing Case Law

In In Re Carter and Johnson,(7) Carter and Johnson represented National Telephone for over a year and a half during which National ignored legal advice from both Carter and Johnson, and repeatedly failed to make disclosures required under the securities laws.

Initially, the SEC's administrative law judge sanctioned Carter and Johnson under Rule 2(e) for aiding and abetting National's violations and for engaging in "unethical and improper professional conduct."(8) However, the full Commission dismissed the charges. The Commission went on to read a scienter standard into Rule 2(e) by saying that "wrongful intent" provides the basis for distinguishing between those professionals who may be appropriately disciplined and those who have acted in good faith.(9) The reversal by the SEC of its position on intent led one commentator to observe that "[i]ndeed, if the Commission in authorizing the initiation of the Carter-Johnson case had applied the same standards that it pronounced at its conclusion, it is most doubtful whether it would ever have authorized the institution of this action in the first place."(10)

Instead of sanctioning Carter and Johnson under Rule 2(e), the Commission sought to articulate standards that lawyers presumably must adhere to in the future:

[W]hen a lawyer . . . becomes aware that his client is engaged in a substantial and continuing failure to satisfy [SEC] disclosure requirements, his continued participation violates professional standards unless he takes prompt steps to end the client's noncompliance [with the securities laws].(11)

Unfortunately, it is not entirely clear from the Carter and Johnson release exactly what a lawyer's "continued participation" is and what these "prompt steps" must be. The SEC did suggest two steps that Carter and Johnson could have taken: 1) approaching other members of National's board of directors; and 2) resigning. However, would it have been sufficient for the lawyers only to approach some of the other directors, or were they required to go to the full board? If the full board failed to rectify the situation, were the lawyers required to resign? If the lawyers did resign, were they required to do anything to disavow the work product they had done for National? All of these questions went unanswered.

In House Lawyers

The SEC also has not clearly articulated what an in-house lawyer must do when confronted with a violation by his employer. In John H. Gutfreund, Salomon Brothers' chief legal officer Donald M. Feuerstein repeatedly advised CEO John H. Gutfreund to report to the government a false bid for United States treasury securities by trader Paul Mozer.(12) Gutfreund did not report.(13) Although the SEC did not sanction Feuerstein, it determined that Feuerstein was obligated under the 1934 Act's provisions regulating broker dealers to take appropriate steps to deal with Mozer's misconduct.(14) The SEC suggested that such appropriate steps would include approaching senior management, and if that failed approaching the board of directors, resigning, or disclosing the misconduct to regulators.(15)

The SEC did acknowledge, however, that the "applicable Code of Professional Responsibility and Cannons of Ethics may bear upon what course of conduct that individuals may properly pursue."(16) Does the SEC thus expect attorneys to disclose clients' illegal acts unless their jurisdictions prohibit disclosure? This is a particularly troublesome prospect when many corporate clients have offices in several states and it is not always entirely clear which jurisdiction's rules of professional conduct apply. The Salomon Brothers case also raises the question of whether the SEC would impute the same responsibilities to an in-house lawyer in any publicly held corporation that it did in this case to the general counsel at a broker dealer.

The Standard for Culpability

In 1994, in Checkosky v. SEC,(17) the United States Court of Appeals for the District of Columbia discussed the difference between lawyers and accountants, and criticized the SEC's unclear articulation of the standards it would apply to each. The Commission had suspended two partners of Coopers & Lybrand, David Checkosky and Norman Aldrich, for two years under Rule 2(e) for "improper professional conduct" in auditing a client's financial statements.(18) The Commission found that Checkosky and Aldrich had "misrepresented that [their client's] statements complied with GAAP" and stated that "[w]e affirm the [administrative] law judge's holding (and reaffirm prior Commission precedent) that proof of bad faith or wilful misconduct is not a prerequisite for the imposition of sanctions pursuant to Rule 2(e)(1)(ii)."

However, the District of Columbia Circuit, in a two sentence per curiam opinion, ordered that the case be "remanded to the Commission for a more adequate explanation of its interpretation of Rule 2(e)(1)(ii) and its application in this case."(19) Judge Silberman, in his own separate opinion, explained that "the Commission's opinion is ambiguous. The Commission declared that bad faith is not a prerequisite for a violation, but does not specify the state of mind both necessary and sufficient to constitute a violation in light of its past precedents," most notably Carter and Johnson.(20) Judge Silberman elaborated on the difficulty of reviewing a Commission disciplinary order where the Commission did not make clear the applicable standard of culpability: "I think the Commission must choose its standard and forthrightly apply it to this case. Given the enormous impact on accountants -- and lawyers -- that the Rule has, and in fairness to petitioners, the Commission must be precise in declaring the standard against which petitioners' conduct is measured and exactly why that conduct violated the standard."(21)

This the Commission sought to do in In The Matter of Angelo P. Danna and Mark P. Dentinger,(22) another case involving Rule 2(e) sanctions against accountants, this time two accountants at Arthur Young & Company in connection with an audit for one of their clients. SEC Chief Administrative Law Judge Brenda Murray stated: "I have applied a negligence standard, i.e., the failure to use such care as a reasonably prudent and careful person would use under similar circumstances; the doing of some act which a person of ordinary prudence would not have done under similar circumstances or failure to do what a person of ordinary prudence would have done under similar circumstances. . . ." Finding "that Respondents have committed unprofessional conduct" Judge Murray suspended Danna from appearing or practicing before the SEC for one year and Dentinger for six months.(23)

In applying the negligence standard, Judge Murray responds to Judge Silberman's request in Checkosky for a more definite standard. However, she does not clearly articulate why a negligence standard was appropriate for accountants in this case when the SEC had applied a scienter standard to lawyers in Carter. If the SEC were to decide the Carter case today, would it apply a negligence standard there as well?

Defining a Standard

The Private Securities Litigation Reform Act of 1995, Title III, Section 301, requires accountants to follow specified procedures when confronted with client fraud. The Act amends the Securities Exchange Act of 1934(24) by inserting a Section 10A providing that each audit performed pursuant to the securities laws must include procedures designed to discover illegal acts having a material effect on financial statements.(25) In addition, the new act requires accountants who discover information indicating that an illegal act may have occurred to report the illegal act to the appropriate level of management.(26) If the accountant does make a report to management, and the accountant is unsatisfied that management has remedied the problem, then the accountant must go to the full board of directors. The statute then requires the board within one day of the accountant's report to disclose the problem to the SEC; if the board does not, the statute requires disclosure by the accountant to the SEC.

Should the same standards apply to lawyers? Clearly not. Lawyers, unlike accountants, owe their primary duty to their clients, not to the investing public. Should, however, the SEC or Congress specify exactly what a lawyer is and is not required to do when confronted with a client's violation of the securities laws? Yes. Should the SEC or Congress clearly state what standard of culpability -- scienter or mere negligence -- will justify discipline of a lawyer by the SEC? Absolutely. Lawyers, like accountants, are entitled to clear rules articulated in advance rather than having their responsibilities determined and sanctions imposed by the SEC after the fact.

What might those rules be? Congress or the SEC could and should provide that lawyers are required to report securities laws violations to the appropriate officer within a 1934 Act registered company. Lawyers could also be required to report violations to corporate directors if reporting to corporate officers does not work. Alternatively, corporations could be allowed to opt out of this requirement by specifying in advance a compliance officer or committee to whom a lawyer should report illegal acts in lieu of reporting to the full board. For obvious reasons -- the duty to keep client confidences being one of them -- a report to the SEC should not be mandatory. Although there are some arguments for allowing SEC discipline of lawyers for mere negligence, the better approach is the higher standard of culpability articulated in Carter and Johnson. Predicating Rule 2(e) proceedings and other SEC actions against lawyers on lawyers' knowledge of underlying securities law violations would conserve SEC disciplinary resources for egregious cases of lawyer malfeasance and protect lawyers against unfounded accusations.

Most important, once a lawyer has done what she is required to do under rule or statute, a statutory safe harbor should provide that neither the SEC nor a private plaintiff may commence an action against the lawyer on account of a securities law violation perpetrated by her client. The "risky business" of securities practice should thus be made somewhat less risky by substituting clearly articulated rules of professional conduct in place of unclear and uncertain rules made up by regulators who react to incidents on an ad hoc basis.

*Richard W. Painter is a visiting professor at University of Illinois College of Law. Jennifer E. Duggan is associated with Porter, Scott, Weiberg and Delehant in Sacramento, California. This article is a synopsis of their article, Lawyer Disclosure of Corporate Fraud: Establishing A Firm Foundation (forthcoming, S.M.U. L. Rev. 1996 securities law symposium).

1. Central Bank of Denver v. First Interstate Bank of Denver, 114 S. Ct. 1439 (1994).
2. SEC Procedural Rules § 2(e)(1); 17 C.F.R. § 201.2(e) (1994).
3. 1933 Securities Act, § 8A; 1934 Securities Exchange Act, § 21C.
4. Private Securities Litigation Reform Act of 1995, Section 104, amending section 20 of the 1934 Securities Exchange Act.
5. George C. Kern, Jr., [1988-1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) 84,342 (Nov. 14, 1988).
6. The case was later dismissed on jurisdictional grounds; thus the administrative law judge's findings were never expressly ratified by the SEC. In Re Kern, supra at 89,595-89,596. Under the Remedies Act, which authorizes actions against persons who are a "cause" of a violation, the SEC would now have jurisdiction.
7. In the matter of William B. Carter and Charles J. Johnson, Jr., Release No. 34-17597, CCH Sec. L. Rep. 82,847 at 84,172 (1981).
8. Id. at 82,847 (1981).
9. Id.
10. Werner Kronstein, SEC Practice: The Carter-Johnson Case: A Higher Threshold for SEC Action Against Lawyers, 9 Sec. Reg. L. J. 293, 295 (1981).
11. Carter and Johson, supra at 82,847.
12. John H. Gutfreund, Exchange Act Release No. 31,554 [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,067.
13. Id.
14. Id. at 83,609.
15. Id.
16. Id. at 83,609 n.26; see Model Rule 1.6 prohibiting disclosure of client confidences.
17. 23 F.3d 452 (D.C. Cir. 1994)
18. Id. at 454.
19. Id. at 454.
20. Id at 458.
21. Id. at 462.
22. SEC Initial Decision, Release No. 62, 1995 SEC LEXIS 1041 (Admin. Proc. File No. 3-8196) (Apr. 11, 1995)
23. Id. at 18.
24. 15 U.S.C. § 78 et. seq.
25. Title III, Section 301, § 10A(a)(1) & (2).
26. Title III, Section 301, § 10A(b)(1).