Refco Collapse Spotlights Trend Of Targeting Lawyers

Federal regulators and plaintiffs’ lawyers are reportedly setting their sights on a prominent Chicago law firm responsible for the loan documents that allegedly allowed the former CEO of the commodities trading firm Refco to hide hundreds of millions in customer losses.

Wycoff

The possible implication of the venerable law firm, Mayer Brown Rowe & Maw, in the Refco collapse exemplifies a growing trend by government regulators, private plaintiffs and even corporations themselves to consider law firms as potential targets for liability when things go wrong for their corporate clients, says William Wycoff, a partner with Thorp Reed & Armstrong in Pittsburgh.

“It was very unusual in the past for the corporation that gets in trouble to turn around and sue its lawyers,” Wycoff says. “But with the SEC and plaintiffs’ lawyers getting such large settlements, some corporations are turning around and saying to their lawyers, ‘What you did was negligent; you failed to stop this rogue member of the board of directors from doing what he was doing.’”

Such legal malpractice actions are in addition to private litigation filed on behalf of shareholders and complaints by the Securities and Exchange Commission.

Henning

“Lawyers are being looked at more closely—the SEC is doing it,” says Peter Henning, a professor at Wayne State University Law School in Detroit. “When the Commission does that, it gets the attention of plaintiffs’ bar.”

No actual suits have been filed against Mayer Brown yet, but the focus on lawyers has been expected. In a September 2004 speech before the UCLA School of Law, former SEC Division of Enforcement Director Stephen Cutler noted that the Commission had stepped up its scrutiny of “gatekeepers,” including lawyers. “We have named lawyers as respondents or defendants in more than 30 of our enforcement actions in the past two years,” he said. According to Cutler, in most cases the lawyers had “gone astray,” and had "twisted themselves into pretzels to accommodate the wishes of company management, and failed in their responsibility to insist that the company comply with the law" (see excerpt below, left).

Cutler also noted that, based on the SEC's investigative docket at the time, additional actions were likely. “We are also considering actions against lawyers, both in-house and outside counsel, who assisted their companies or clients in covering up evidence of fraud, or prepared, or signed off on, misleading disclosures regarding the company's condition,” he said.

Henning at Wayne State notes that the SEC has the power to go after anyone, lawyers included, for aiding and abetting securities fraud, but private plaintiffs can’t sue lawyers for aiding and abetting. Instead, private suits must show that the lawyer or law firm participated in the fraud—a much higher standard.

“Private plaintiffs have to prove that the lawyers are ‘primary violators,’ that there was a higher level of involvement in decisions,” Henning says. “It has to be more than just giving legal advice that was improper or led to a violations. There has to be a much more direct connection between what the lawyer did and a securities violation. It has to be more than advising the client.”

Counsel ‘Needs To Be Concerned’

Refco, once the largest U.S. independent futures and commodities brokerage, filed for bankruptcy protection in October after the company discovered $430 million of hidden debt that was allegedly concealed in a company controlled by former CEO Phillip Bennett. In November, Bennett pleaded not guilty to criminal charges of taking part in a conspiracy to sell stock to the public based on falsified financial statements.

GATEKEEPERS

The excerpt below is from a speech titled, "The Themes of Sarbanes-Oxley as Reflected in the Commission's Enforcement Program," delivered Sept. 20, 2004, by former SEC Division of Enforcement Director Stephen Cutler:

[Gatekeepers are] the sentries of the marketplace: the auditors who sign off on companies' financial data; the lawyers who advise companies on disclosure standards and other securities law requirements; the research analysts who warn investors away from unsound companies; and the boards of directors responsible for oversight of company management. They're paramount in ensuring that our markets are clean. And Congress recognized that when it enacted Sarbanes-Oxley...

As for lawyers, Sarbanes-Oxley required the SEC to set minimum standards of professional conduct for those appearing and practicing before us. And the SEC has done so, requiring attorneys with evidence of material violations of federal securities laws or breaches of fiduciary duty to "report up the ladder" to senior management and, if necessary, the board of directors. I recently read with interest about a new program at Harvard that addresses issues raised by the business of law. The professor who founded the program said in an interview that "[i]f Enron has taught us anything, it ought to be that professionals have a very important role as gatekeepers. We have to understand the market in which the professionals operate and the pressures they are under. We need to develop institutional strategies that allow firms to regulate their members better." As law has become more of a business than a profession, it's gotten that much harder in my view for lawyers to heed the advice of lawyer and statesman, Elihu Root. He said that "[a]bout half the practice of a decent lawyer is telling his clients that they are damned fools and should stop."...

So what have we done in the enforcement area to address the role of gatekeepers and hold them accountable for failing to discharge their legal responsibilities? Quite a lot, in my view. But I have to confess that this isn't a brand new idea for us. For as far back as the early 70s, the Commission's enforcement program has focused on gatekeepers. Actually, Judge Sporkin had his own name for this approach. He called it the "access theory." Ensure good behavior by those who control "access" to our capital markets and you could achieve more than you would by going after every bad actor. In short, pursuing gatekeepers was the most targeted and effective way of using the agency's limited enforcement resources. And limited they are. While we've been the beneficiaries of significant budget increases in the last three years, we're still quite small when you consider the breadth of our "beat" -- more than 12,000 public companies; 7,200 broker-dealers; 8,200 investment advisers; and 35,000 mutual funds.

So on to what we've done [with lawyers]...

...Consistent with Sarbanes-Oxley's focus on the important role of lawyers as gatekeepers, we have stepped up our scrutiny of the role of lawyers in the corporate frauds we investigate. We have named lawyers as respondents or defendants in more than 30 of our enforcement actions in the past two years.

Many of those we charged could have avoided problems if they had heeded Elihu Root's advice. We have seen too many examples of lawyers who twisted themselves into pretzels to accommodate the wishes of company management, and failed in their responsibility to insist that the company comply with the law. These include Warnaco's general counsel, Stanley Silverstein, who recently settled our charges against him for certifying a misleading annual report containing material misstatements that were at the heart of the company's reporting violations; Gemstar-TV Guide's former general counsel Jonathan Orlick, who, we allege, facilitated Gemstar's fraudulent revenue enhancement scheme by providing false certifications to Gemstar's auditors; and Leonard Goldner, the former general counsel of Symbol Technologies, who, we allege, manipulated stock option exercise dates to enable certain senior executives of the company, including himself, to profit unfairly at the company's expense.

While all of these are examples of in-house counsel gone astray, I think it's notable that close to half the Commission's actions against lawyers during the past two years involved outside counsel. Last April, for example, we brought an action against counsel to a Pennsylvania school district based on two unqualified legal opinions he issued regarding a note offering. More recently, we sued another bond counsel who, we allege, issued favorable legal opinions on a series of municipal bond underwritings, despite his knowledge that the bond proceeds were being wrongfully commingled and diverted.

We have more to do in this area. Based on our current investigative docket, I think you can expect to see one or more actions against lawyers who, we believe, assisted their clients in engaging in illegal late trading or market timing arrangements that harmed mutual fund investors. We are also considering actions against lawyers, both in-house and outside counsel, who assisted their companies or clients in covering up evidence of fraud, or prepared, or signed off on, misleading disclosures regarding the company's condition. One area of particular focus for us is the role of lawyers in internal investigations of their clients or companies. We are concerned that, in some instances, lawyers may have conducted investigations in such a manner as to help hide ongoing fraud, or may have taken actions to actively obstruct such investigations.

Source

Ex-SEC Enforcement Chief Stephen Cutler: The Themes of Sarbanes-Oxley as Reflected in the Commission's Enforcement Program (Sept. 2004)

Since Refco’s collapse, lawsuits have been filed against Grant Thornton, Refco’s brokerage auditor, and three firms that served as lead underwriters on Refco’s $583 million initial public offering last August. So far none of the suits have named Mayer Brown—which declined to comment for this article—or any other law firm as a defendant. But Wycoff, of Thorp Reed & Armstrong, says that the conduct of Refco’s legal counsel is surely being looked at by plaintiffs’ lawyers.

“Today, law firms [that] write SEC documents like prospectuses and 10-Ks on behalf of their clients are all being eyed for their deep pockets in shareholder suits,” says Wycoff. “Refco’s SEC counsel needs to be very concerned.”

Wycoff notes, however, that private lawsuits are “not easy” ones. “But the numbers are so large that the potential of going in front of a jury or getting a verdict would just be devastating,” he says. “That’s the problem with law firms. Sure they have insurance, but it’s not anywhere close to what the coverage needs to be [if a suit is successful].”

Difficult or not, shareholder suits against law firms are likely to continue to rise, Wycoff notes. “We’re going to see a lot more allegations against law firms that they were direct participants in the fraud,” he says.

Law Firms As ‘Primary Violator’

Law firms have been in the cross hairs since the collapse of Enron in 2001. Shareholders filed suit against two law firms that represented Enron: Vinson & Elkins and Kirkland & Ellis.

In 2002, a judge dismissed the securities claims against Kirkland & Ellis, noting that any documents the firm drafted were for private transactions, not for public disclosure or shareholder solicitation. However, the suit against Vinson & Elkins—which allegedly assisted Enron in devising the special purpose entities that figured prominently in company’s failure—was allowed to proceed.

The judge in the case agreed with the SEC’s position on liability under Section 10b of the Securities Exchange Act. The SEC had argued that a law firm or other adviser can be a “primary violator” if it “creates” a material misrepresentation with the intent to deceive, even if it does not sign the document containing the misrepresentation or otherwise identify itself to investors.

The litigation against Vinson & Elkins is still in discovery and Henning, of Wayne State Law School, says such suits are unlikely to settle. “Law firms will fight,” he says. “They understand that a finding of liability or even a settlement payment would be a high cost. No lawyer likes to admit they were involved in a securities fraud. And [a settlement] may actually be something they would have to disclose when they work on future deals.”

But Wycoff says he wouldn’t be surprised if Vinson & Elkins settles the Enron suit “rather than taking the chance of it going to trial.” Such a settlement, however, would likely encourage future claims. “People are watching [the Vinson & Elkins suit],” he notes. “Plaintiffs’ lawyers are looking at it.”

Lawyers ‘Under The Radar’

Perhaps unsurprisingly, lawyers do not appear to be eager to talk about efforts to hold law firms responsible for corporate failures. Several law firms contacted by Compliance Week for this article declined to be interviewed on the topic, citing possible conflicts with pending cases and the fear of making themselves targets.

Henning says he understands the reluctance of lawyers to discuss the issue. “Lawyers have been largely under the radar. Aside from Enron, lawyers are pretty happy with the way things are set up at the moment,” he says. “Without aiding and abetting liability, it’s hard to get the outsiders. Proving that a law firm is a primary violator is a difficult standard to meet. Law firms don’t want to wave a red flag saying, ‘Hey, look at me. Here’s how you can go about suing me.’ The less said the better, with law firms.”

According to Wycoff, increased efforts to hold law firms liable for corporate difficulties could make some law firms think twice about taking on certain kinds of companies as clients.

“If it’s some new corporation, a law firm is going to have to do some due diligence and ask, ‘What has the company done? Have they been in bankruptcy? Have they turned over lawyers quickly?’ You’ve got to be very aware of those red flags,” says Wycoff. “Shakier companies may have some problems. But most corporations aren’t going to have any problem finding a lawyer to represent them.”