A recent report that the Securities and Exchange Commission may sue a company's outside lawyer for his role in an internal investigation has put renewed emphasis on the role and risks of "gatekeepers" in the post-Sarbanes-Oxley era.

The move comes as corporate boards and committees are increasingly hiring outside lawyers to investigate accusations of fraud at their companies. Often, the attorneys are hired after the SEC notifies a company of wrongdoing, or sometimes after the board becomes aware of an employee whistleblower complaint.

But experts note that the assignments can bring unintended consequences for companies, due in part to new rules of professional conduct for attorneys.

Meisner

“This is a very sensitive area,” says Derek Meisner, the former branch chief of the SEC's Division of Enforcement in Washington, D.C. “There is a tension between the attorney’s duty not to aid or appear to aid the client in committing a crime or fraud, and the lawyer’s duty of confidentiality to that client,” he adds.

Cutler

The threat that outside counsel might be targeted for enforcement was most recently mentioned by SEC Division of Enforcement Director Stephen Cutler. In a speech made at the UCLA School of Law in Septempber, Cutler stated that the Commission would be focusing on corporate “gatekeepers,” including lawyers that “may have conducted investigations in such a manner as to help hide ongoing fraud, or may have taken actions to actively obstruct such investigations” (see article above, right).

Unintended Consequences

To date, the SEC has not sued an outside attorney for illicit behavior during a corporate investigation, although Cutler noted that the Commission has stepped up scrutiny of the role of lawyers in corporate frauds. "We have named lawyers as respondents or defendants in more than 30 of our enforcement actions in the past two years," he said.

In addition, Bloomberg recently reported that the Commission was considering whether to file a lawsuit against Christopher McGrath, attorney in the San Diego offices of Paul, Hastings, Janofsky & Walker, for his role in an investigation at Endocare Inc.

There is little public information about the allegations or possible charges, and SEC staffers, including Division of Enforcement assistant director Gregory Faragasso, would not comment on the record. However, experts note that such a suit against a lawyer would be meaningful: As the outside counsel turned investigator becomes more common, the lawyer’s duties in this position need to be clarified.

Grail

“The job of the attorney is not just the role of investigator,” says Efrem Grail, partner in the Pittsburgh office of Reed Smith. “You are trying to get to the truth. And then, once you get it, what do you do with it?”

Grail’s comments are particularly relevant in light of new standards of professional conduct for attorneys, which require an attorney to report evidence of a material violation “up-the-ladder” to the CEO or even the board. “The lawyer has the additional obligation of reporting up and out,” says Grail. But that isn’t always the directors’ intent when they hire a lawyer lead internal investigations.

SEC rules allow the attorney to give information to regulators without the company’s consent if he uncovers violations and believes the directors are ignoring what’s wrong.

In addition, lawyers conducting such internal investigations could be held personally liable if they fail to report facts or intentionally conspire to sway the facts. “The SEC’s possible action [against McGrath or other internal investigative lawyers] ups the ante for an attorney who discovers corporate misconduct but continues to advise or assist the company without addressing the misconduct,” says Meisner, now Of Counsel at Kirkpatrick & Lockhart in Boston.

McGrath was a lawyer at Brobeck, Phleger & Harrison—a firm that no longer exists for unrelated reasons—when Endocare’s audit committee hired him in October 2002 to examine the company’s accounting. An investigation by the SEC is still ongoing; the Commission is pursuing civil charges against three directors who sat on the audit committee that hired McGrath. Endocare declined to comment.

Few Best Practices

There is surprisingly little guidance available to companies forced to hire third parties for these types of investigations.

Experts do note, however, that companies should only hire lawyers who have had no previous employment with the company, and have no personal ties to any of the officers or directors at the company. "It is critical that an internal corporate inquiry be entrusted to someone who is completely independent of the company and of the events likely to be investigated," wrote former SEC chairman and Compliance Week columnist Harvey Pitt in an article published in July (see column at right).

If any of connections do exist, the appearance of independence could be compromised. That's because, as The Conference Board recently noted in an report on independent investigations, "In an independent probe, the lawyer acts as a fact-finder, not as an advocate."

For example, the SEC fined Del Global Technologies Corp. $400,000 in June in part because after the accounting fraud was discovered, the audit committee hired a lawyer who was a close friend of the chief executive to conduct an internal investigation. This investigation, the SEC said, sought to shield the chief executive, who orchestrated the fraud.

"The more serious and problematic the charges, the more important it is to have a genuinely independent counsel," says Richard Swanson, partner and co-chair of the corporate and securities litigation practices group at Thelen Reid & Priest in New York.

Experts add that it would be inappropriate for an attorney assigned to such an investigation to subsequently become the company’s defense counsel if regulators pursue legal action. "The attorney's report is going to be an artifact in the defense's argument so he would end up defending the quality of his own work which is inappropriate," says Thomas Morgan, a professor at the George Washington University Law School. "That lawyer hired for an investigation lacks the perspective that a defense lawyer really needs."

We've made resources available in the box at right, and we'll continue to monitor developments in the McGrath case as they develop.