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American Bar Association

ABA Section of Business Law

Volume 12, Number 1 - September/October 2002

What do you do when confronted with client fraud?
To disclose or not to disclose is becoming a very public question
    By Abraham C. Reich and Michelle T. Wirtner

It's hard to avoid corporate scandal in the news. But what's the business lawyer's role in all this?

Over the past decade, the meteoric rise (and fall) of the business environment has brought the role of professional advisers under heightened scrutiny. In just a few short months, a growing list of corporate accounting scandals — involving such entrenched and venerable giants as Enron, WorldCom, Xerox, Tyco, Adelphia, Global Crossing, K-Mart and Merck — have shaken the public faith in corporate America and sent the stock market into a nose-dive.

In the wake of these scandals, all of the "Big Five" accounting firms are currently defending civil lawsuits, government probes or both. In remarks addressing the economy, President Bush vowed to regulate the accounting profession and strengthen penalties against corporate executives who commit wrongdoing. Now, lawyers are bracing for an attack.

Lawyers, along with accountants and other business advisers, are considered "deep pockets," who can be held accountable when a business runs afoul of the law. Both in-house and outside counsel for business clients are susceptible to potentially devastating liability. The growing number of professionals who have become entangled in the Enron debacle demonstrate the magnitude of this threat. The prevailing sentiment about lawyers is illustrated by a recent statement by Tom Stickel, chairman of the California Chamber of Commerce: "Until we see a CEO and general counsel march off to jail together – for a long, uncomfortable and noncountry club sentence – capitalism is at risk, because people are losing confidence."

With talk like this from business leaders and our Republican president, one has to wonder whether the events of the past few months are only the tip of the iceberg.

Let us be frank about the situation: the legal profession is in danger of losing its right of self-governance.

  • The Arthur Andersen-Enron accounting scandal prompted Congress to introduce accounting reform legislation. S. 2004, 107th Cong., 2d Sess. (2002); H.R. 3970, 107th Cong., 2d Sess. (2002); H.R. 3763, 107th Cong., 2d Sess. (2002).
  • On April 24, 2002, the House of Representatives passed the "Corporate and Auditing Accountability, Responsibility and Transparency Act" to create an oversight board to regulate the auditing and consulting activities of accountants. H.R. 3763, 107th Cong., 2d Sess. (2002).
  • On July 16, 2002 the Senate unanimously passed its own stricter version, the "Public Company Accounting Reform and Investor Protection Act." S. 2673, 107th Cong., 2d Sess. (2002), which features an amendment directing the Securities and Exchange Commission to draw up "Rules of Professional Responsibility for Attorneys" for lawyers who practice before the SEC. On July 24, 2002, the House and Senate reached a compromise in the form of H.R. 3763, the Sarbanes-Oxley Act, which includes the Senate amendment. On July 30, President Bush signed it.
Now that the Sarbanes-Oxley Act has become law, the SEC must produce a rule requiring lawyers to report evidence of a material violation of securities law or breach of fiduciary duty by a representative of a company to the company's general counsel or CEO. If those parties failed to respond, the lawyer would be required to report the evidence to the board of directors.

During Senate debate over the amendment to S. 2673, its sponsor, Sen. John Edwards of North Carolina, said it would not create a new private cause of action, and only the SEC could enforce the proposed rules. But he also stated, "[w]ith Enron and WorldCom, and all the other corporate misconduct we have seen, it is again clear that corporate lawyers should not be left to regulate themselves no more than accountants should be left to regulate themselves."

Although some might argue that administrative agencies have previously set standards for professionals who appear before them, in the current environment the Sarbanes-Oxley Act sets a dangerous precedent. The ease with which Congress passed this legislation demonstrates how eager politicians are to combat the public harm caused by the collapse of Enron and accounting scandals involving other large, publicly held companies.

Would Congress hesitate to regulate lawyers even beyond what has been enacted to date? Hardly. Sen. Richard Shelby of Alabama attempted (albeit unsuccessfully) to attach an amendment to S. 2673 that would have restored a private cause of action for aiding and abetting in securities cases. 148 Cong. Rec. S6658-01, 6673 (daily ed. July 11, 2002) (amendments SA 4261 and SA 4262).

It is worth reminding ourselves that nearly 20 years ago, Sen. Arlen Specter of Pennsylvania introduced legislation (that never was enacted into law) titled "Lawyer's Duty of Disclosure Act of 1983" that would have obligated lawyers to disclose prospective crimes of their clients — as well as prior crimes in the commission of which the client misappropriated legal advice — to law enforcement authorities. Under that proposed legislation, lawyers who failed to make the requisite disclosures would have faced federal criminal liability.

Given Congress' demonstrated desire to prevent the type of public harm created by Enron, WorldCom, etc., it is not difficult to imagine that an Arthur Andersen-style legal scandal would provoke new calls for further government regulation of the legal profession. Indeed, many legal ethicists are already recommending it. See, for example, Marcia Coyle, "Congress May Get Tough With Corporate Lawyers," in the National Law Journal, July 15, 2002 at A4.

Negative publicity surrounding the role lawyers played in the Enron debacle has not helped matters. The highly publicized transactional work of the blue chip law firms, Vinson & Elkins and Kirkland & Ellis, has thrust the issue of the duty of disclosure into the spotlight. From 1997 through 2001, Vinson & Elkins handled transactions involving, among other things, certain off-balance sheet Enron partnerships that are now at the heart of the dispute surrounding Enron's collapse. See Ellen Pollack, "Lawyers for Enron Faulted its Deals, Didn't Force Issue," in The Wall Street Journal, May 23, 2002 at 1,18.

In representing Enron, Vinson & Elkins lawyers were reportedly openly critical of Enron's strategies, and challenged both in-house counsel and Enron's then-CFO, Andrew Fastow. Among the strategies Vinson & Elkins challenged was Enron's practice of forming off-balance sheet partnerships controlled by Fastow in order to mask debt and losses. The firm reportedly refused — more than once — to issue opinion letters.

At various times the firm raised its concerns with Fastow and lawyers from Enron's legal department, but never with Enron's general counsel or its board of directors because the firm did not believe that doing so was necessary.

It has been suggested that Vinson & Elkins should have raised a number of concerns with Enron's board of directors, including concerns about Fastow's conflict of interest in both managing and investing in certain Enron partnerships created to keep several hundred million dollars of debt off Enron's balance sheet, as well as concerns about certain highly complex, off-balance sheet transactions involving various partnerships. In addition, it has been suggested that Vinson & Elkins accommodated Enron too easily in offering an opinion supportive of Enron's decision not to disclose Fastow's $45 million compensation from partnerships in a footnote under "related-party transactions" on Enron's 2001 proxy statement.

The firm was also criticized for its investigation of Enron staffer Sherron Watkins' now-infamous memorandum to former CEO Kenneth Lay warning of potential "accounting scandals" associated with the partnerships. In this regard, Vinson & Elkins was reportedly retained to conduct a limited inquiry and, just before Enron collapsed, the firm returned a nine-page memorandum raising no serious alarms.

A report following a special investigation performed for Enron's board of directors criticized the law firm for an "absence" of "objective and critical professional advice." Worse still, Vinson & Elkins now faces multiple lawsuits from Enron shareholders and employees. For its part, Vinson & Elkins noted that Enron engaged it for limited and discrete tasks in connection with offering advice, structuring transactions and preparing SEC filings. See Miriam Rozen, "V&E Responds to New Enron Claims," in the National Law Journal, June 11, 2002 at A25. Vinson & Elkins believes that Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) — which holds that private plaintiffs cannot sue lawyers and other professionals for allegedly aiding and abetting securities fraud by assisting with a transaction — shields it from liability.

Kirkland & Ellis did not represent Enron, but rather, certain of the off-balance sheet partnerships at issue. See, "Kirkland & Ellis is Not Counsel to Enron," in the New York Law Journal, June 11, 2002 at 2. Although Kirkland & Ellis' involvement with Enron was minor in comparison to Vinson & Elkins', Kirkland & Ellis also faces lawsuits by shareholders and investors who allege, among other things, that these partnerships involved sham transactions and parties designed to conceal Enron debt.

It is alleged that although Kirkland & Ellis represented the partnerships, the firm took its direction from Fastow. The firm maintains that it had no responsibility for determining accounting treatments or shareholder disclosures that form the basis for the lawsuits.

Who among us — the lawyers for WorldCom, Xerox, Tyco, etc. — will be the next targets? Texas and 20 other states want to subject lawyers to the same legal scrutiny that other professional advisers of Enron are facing. See, "States Want Liability Extended for Firms with Links to Enron," in the Houston Chronicle, June 11, 2002 at 3. The Texas attorney general has said that a jury should decide whether law firms are responsible for Enron's fall because they "participated in what was happening."

Giving lawyers greater latitude to disclose a client's transgressions would help to curb the tide of government regulation, and place lawyers in a better position to protect themselves from financial or criminal exposure. But just how counsel should respond when faced with evidence of a client's wrongdoing is a topic that has long divided the bar. Lawyers who suspect or discover misconduct may be constrained from disclosing such wrongdoing by the lawyer-client privilege and their duty of confidentiality to the client. The fact that client confidentiality rules do not protect counsel from lawsuits initiated by third parties (or prosecutors) makes the issue particularly frustrating.

Prior to the ABA's adoption of the Model Rules of Professional Conduct in 1983, and the subsequent state incarnations, existing ethical rules allowed lawyers to disclose any prospective crime of a client, regardless of its degree. The Code of Professional Responsibility provided that "[a] lawyer may reveal the intention of his client to commit a crime and the information necessary to prevent the crime." Model Code of Professional Responsibility DR 4-101 (c)(3) (1980). The ABA's 1983 adoption of Model Rule 1.6 over Model Code of Professional Responsibility DR 4-101 (c)(3) was accompanied by heated debate and controversy.

Ultimately, ABA Model Rule 1.6 limited disclosure "to prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent death or substantial bodily harm." ABA Model Rule of Professional Responsibility 1.6(b) (1983).

Over the past few years, the extent to which lawyers may disclose the fraudulent or criminal conduct of clients to prevent or rectify financial injury to third parties has once again become a hotly debated topic within the organized bar (such as the ABA House of Delegates).

In August 2001, the ABA Ethics 2000 Commission recommended that ABA Model Rule 1.6, Confidentiality of Information, be revised to permit disclosure of client confidences "to prevent the client from committing a crime or fraud that is reasonably certain to result in substantial injury to the financial interests or property of another and in furtherance of which the client has used or is using the lawyer's services," and "to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or that has resulted from the client's commission of a crime or fraud in furtherance of which the client has used the lawyer's services." Commission on Evaluation of Rules of Professional Conduct, ABA, Report with Recommendation to the House of Delegates (Aug. 2001). The House of Delegates rejected both revisions.

On July 24, 2002, the ABA Task Force on Corporate Responsibility issued a preliminary report recommending changes to several of the Model Rules. The report aims to encourage corporate lawyers to act on discovery of misconduct by corporate officers, employees or agents. See 18 Law. Man. Prof. Conduct 457-459 (7/31/02); http://www.abanet.org/buslaw/corporateresponsibility. The task force's proposed modification to ABA Model Rule 1.6 takes the Ethics 2000 Commission's proposal a step further by making disclosure to prevent financial harm to third parties mandatory. The task force will make its report final by year's end and will present it to the ABA House of Delegates next year.

In August 2002, an amendment to ABA Model Rule 1.6 permitting discretionary disclosure of financial harm to third parties was proposed at the ABA Annual Meeting, but ultimately was withdrawn. The amendment will be presented again at the ABA's February 2003 meeting in Seattle. Meanwhile, debate at the state level will continue, as each state evaluates the ABA's recommended changes to the Model Rules.

In Connecticut, Maryland, Pennsylvania, New Hampshire, New Jersey, New Mexico, North Dakota, Texas, Utah or Wisconsin, disclosure to prevent a client from committing a criminal or fraudulent act that is likely to cause substantial injury to the financial interests or property of another is discretionary. The permissive disclosure provision of Pennsylvania Rule of Professional Conduct 1.6(c), which has been in effect since April 1, 1988, is used as a weapon to protect the public from dishonest clients.

By contrast, ABA Model Rule 1.6 (b) only permits a lawyer to reveal confidential client information to the extent necessary to prevent the client from committing an act that is likely to result in death or substantial bodily harm. This rule does not authorize a lawyer to blow the whistle on a client who perpetrates, or plans to perpetrate, fraud likely to result in substantial financial injury to third parties.

In those states that adhere to the ABA Model Rule 1.6(b) restrictions on disclosure, how do you handle a client who has crossed the line? What do you do with the client whose misconduct threatens the financial interests of third parties? Assuming the lawyer has offered appropriate advice, which the client has rejected, the lawyer has several options under the current ABA Model Rules of Professional Conduct.

Without running afoul of the ethical duty of maintaining client confidentiality, a lawyer who suspects or becomes aware of a client's fraud may advise the client, the court or his or her opponent that, because of a disagreement with the client, he or she can no longer continue the representation. Although no disclosure of confidential client information takes place, the "noisiness" of the withdrawal usually raises red flags all around. The lawyer who withdraws noisily hopes that his or her client will rectify the problem; or the noisiness of the withdrawal will provoke an investigation by interested parties, who will then uncover the illegal conduct.

Withdrawing or declining representation is not optional when a lawyer knows his or her work will be used for illegal or ethically improper purposes. ABA Model Rule 1.16(a) requires a lawyer to decline or withdraw from representation if it would result in a violation of the law or the rules of professional conduct. This rule applies unless a tribunal refuses to grant a lawyer leave to withdraw from pending litigation.

In the transactional setting, if a lawyer reasonably believes that a silent withdrawal will not prevent the client from using the lawyer's work product to accomplish an unlawful purpose (for example, an opinion letter), the lawyer may disaffirm the work product — even if this entails disclosure of confidential information. However, such action should be a last resort, and should go no further than necessary to avoid assisting the client's fraud. ABA Comm. On Ethics and Professional Responsibility, Formal Op. 92-366 (1992).

A lawyer should disaffirm even a factually or legally correct opinion if he or she reasonably believes it will be used for a fraudulent transaction. See, for example, Association of the Bar of the City of New York, Report by the Special Committee on Lawyers' Role in Securities Transactions, 32 Bus. Law 1879, 1887 (1977).

In the litigation setting, a lawyer must generally seek leave of court to withdraw if representation would result in violation of the law or ethics rules. ABA Model Rule 3.3 offers the lawyer a bright-line rule: the duty of candor toward the tribunal trumps the ABA Model Rule 1.6 duty of confidentiality to one's client.

ABA Model Rule 3.3(a)(3) requires a lawyer who discovers that his or her client has offered false evidence to take "reasonable corrective action." "Reasonable corrective action" includes remonstrating with the client and, if that fails, advising the court of the client's deception – even if this means disclosing the client's confidential information. Comment 10 to ABA Model Rule 3.3. Ordinarily, the court should accept the lawyer's statement that professional considerations require termination of the representation as sufficient justification for the request to withdraw. Comment 3 to ABA Model Rule 1.16.

ABA Model Rule 1.16(b) creates an optional right to withdraw from representation if a client:
  • persists in a course of action involving the lawyer's services that the lawyer reasonably believes is criminal or fraudulent;
  • has used the lawyer's services to perpetrate a crime or fraud; or
  • insists on taking action that the lawyer considers repugnant or with which the lawyer has a fundamental disagreement. But withdrawal for these reasons is permissible only if it can be accomplished without a material adverse effect on the client's interests. ABA Model Rule 1.16 (a)(1)-(4).
ABA Model Rule 1.13 allows a lawyer to break the confidence of a representative of an organization by reporting the wrongdoing of the highest authorities within the organization. But the lawyer still cannot blow the whistle on the organization. If no one within the organization is willing to heed the lawyer's advice, his or her only option is to withdraw from representation.

For the in-house lawyer, nothing short of resignation will suffice. Paradoxically, courts in certain jurisdictions have refused to recognize a cause of action for retaliatory discharge in the case of in-house lawyers who are terminated after blowing the whistle on improper conduct. See, for example, Balla v. Gambro Inc., 584 N.E. 2d 104 (Ill. 1991); Willy v. Coastal Corp., 647 F. Supp. 116 (S.D. Tex. 1986), rev'd. in part on other grounds (5th Cir. 1988), 855 F.2d. 1160, aff'd. on other grounds, 503 U.S. 131 (1992).

Given the risks of failing to disclose potential fraud, shouldn't all states allow optional disclosure of client confidences to prevent or rectify financial injury to third parties? Or do the disclosure options currently available under the ABA Model Rules sufficiently obviate the need for revisions to ABA Model Rule 1.6 permitting broader disclosures, at the risk of undermining the attorney-client privilege?

We suggest that the ABA House of Delegates erred in rejecting the Ethics 2000 Committee's proposal to expand a lawyer's right to disclose confidential client information to prevent financial injury to third parties. The reason is simple: Without the threat of disclosure, it can be difficult to persuade miscreant clients not to break the law. Lawyers opposed to self-regulation beware: If the profession fails to adequately police itself, our government will enact legislation that not only polices lawyers, but extends liability for corporate governance fiascos.

States around the country should adopt directives like Pennsylvania Rule of Professional Conduct 1.6(c) in order to permit lawyers to disclose client confidences to prevent or rectify substantial financial injury to third parties. Since Pennsylvania adopted Rule of Professional Conduct 1.6(c) in 1988, there has been no evidence of an erosion of the attorney-client privilege. Instead, Pennsylvania lawyers use Rule 1.6(c) to shield the public from dishonest clients.

With such a rule, the case for government regulation of the bar is exponentially weaker. Moreover, it would place lawyers in a better position to protect themselves from financial or criminal exposure.

Few would argue that a lawyer should substitute his or her own business judgment for that of a client. But lawyers who take no action when confronted with a client's fraud face significant liability, and potentially expose members of the public to preventable losses. Although the ABA Model Rules and the rules of many states do not allow a lawyer to disclose confidential client information to prevent or rectify financial injury to third parties, in this political climate, the failure to do so may nevertheless result in prosecution by regulatory authorities and civil suits by third parties who have suffered damages.

Each time this occurs, the public trust in our profession is further damaged, and we become more vulnerable to governmental regulation.

With the exception of only a few states, the regulation of lawyers has traditionally been the exclusive province of state supreme courts. As lawyers, we must ask ourselves: Do we want to survive as a self-governing profession? Of course we do. Clearly, the more latitude we allow lawyers in trying to prevent injury to the public — including financial injury — the better our chances of remaining so.

Reich is managing partner and Wirtner an associate at the Philadelphia office of Fox Rothschild O'Brien & Frankel, LLP. Reich's e-mail is areich@frof.com; Wirtner's is mwirtner@frof.com.

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