Today the art of lawyering for a financial institution client is increasingly complicated and challenging. Understanding the reasons why and learning lessons from situations of difficulty can help lawyers overcome complexity and meet the challenges. As always, the lawyer serves as an advisor, but now the lawyer is also a key part of the financial institution's control infrastructure. If the lawyer does not understand this new function and embrace the expanded role, the lawyer will be ineffective and the control structure of the financial institution will be weakened. The expansion of the scope of activities has made the traditional advisory role more complex for lawyers in today's financial institutions. A study of corporations where major problems have been encountered show four basic flavors of lawyer failure, with every one constituting a control failure. This is the "new" challenge.

In my position as General Counsel of the Federal Reserve Bank of New York, I have watched lawyers work in all kinds of financial institutions—small community banks, large foreign and domestic banking organizations, financial and bank holding companies and their regulated and nonregulated subsidiaries and affiliates. The work of different lawyers for such diverse clients yielded mixed results. Some lawyers executed masterful maneuvers while a few committed incredible blunders. Generally, lawyers acquitted themselves with distinction in assisting their financial clients in the management of legal, compliance and reputational risk. In some specific cases, financial institutions sustained serious injuries from mistaken decisions and in some cases their decisions were the result of poor legal judgment or ineffective controls for legal and reputational risk.

The fact that counsel's task is more challenging and important today results from several different conditions. The first is speed. Information moves at a greater velocity today than it did 25 years ago. The lifeblood of the financial services industry is information, which is delivered today through voicemail, snail mail, paper, email, BlackBerry, telephone and even the occasional meeting.

The next condition deals with the complexity of our subject matter, which results from the nature of the supervisory process. We in the supervisory community develop a response to a particular problem and those that are supervised and regulated react to what we have done. That reaction prompts us to amend our approach in a more nuanced manner. As nuances cumulate, so does complexity.

Thirdly, one must consider the Internet and its ability to process vast quantities of information. Not only do money and information move more quickly, both are processed more rapidly. The Web will not only present the offers for a vacation in Cabo San Lucas, it will analyze them by price, hotel rating, and favored vendor.

Another noteworthy condition is the expansion in scope of activities. When I started my legal career more than 25 years ago, banks were engaged in banking. Now a financial holding company may include the traditional bank, a broker dealer, an unregulated nonbanking subsidiary, an insurance company, and a multitude of foreign organizations involved in a wide variety of financial and merchant banking activities. Banks are not just banks anymore.

The final condition is the rise in importance of a company's reputation and the discipline of reputational risk management. Last year one of the more astute bankers of the modern era, Sanford Weill, stated that reputational risk has become as important in financial institutions as credit risk, a remarkable and telling observation. Weill's view is consistent with the "evidence." Several prominent companies have seen compliance, legal and reputational risks work together to place their companies in danger of failing or even cause their companies to fail. Many prominent industry commenters are now characterizing these risks collectively as a franchise risk.

There are lessons to be learned from situations where financial institution lawyers performed well and situations where they foundered. Failure comes in four different flavors. The ones discussed here are caricatures. If a particular lawyer comes to mind, this is simply a coincidence. Each flavor is a blend of many different ingredients—some very good lawyers and some very fine institutions have tasted the flavor of failure. This can happen when a good lawyer has a bad client or when a good person is caught up in a bad culture.

In a famous case involving a failed thrift institution, Lincoln Savings and Loan Association, Judge Sam Sporkin asked an apocryphal question: "Where were the lawyers?" In many situations the lawyers simply cannot be found. Not because the lawyers present were either hiding or sleeping, but rather they are not there at all. The lawyer uninvolved will be the ineffective lawyer. Because the lawyer is part of the financial institution's system of internal control, the uninvolved lawyer represents a failure of that system.

Consider this situation. A young and highly intelligent trader working at a nonbanking subsidiary of a U.S. bank holding company in Frankfurt, Germany is concerned when he returns from his summer holiday in France. Because of adverse market events, profit for his division is down substantially this year. He does a rough calculation of his year-end bonus compensation and the amount spent on the recently ended summer holiday. Then it comes to him. There is a fantastic profit opportunity in a new derivative transaction he had been thinking about.

You know where this story is going. Other traders share our trader's interest in the success of this derivative prospect because the rising tide of financial success will float all their boats. All partake in a common bonus pool. The pooling arrangement incents the group to take risk, especially given people's tendency to live on last year's financial success and not save for a rainy day. The group approves the hypothetical derivative transaction. The strategy is executed and works as planned—a significant profit is realized and everyone in the unit celebrates the brilliance of the young trader. But the celebration is soon dampened by news reports the windfall profit comes at the expense of a handful of powerful bank customers. Once these customers learn the details of the trades that harmed them, the bank becomes the object of their ire. They complain to the bank's senior management and the traders soon learn a powerful lesson about reputational risk. It seems there are some other highly profitable sections of the bank that enjoyed a close relationship with the injured customers. The injured customers quickly sever those relationships, earning our traders some strong intra-bank enmity. Worse yet, the business press reports customers are complaining to the government about the bank's "market manipulation." Had an experienced lawyer with an understanding of markets been involved, that lawyer would likely point out the risk of trying to "rig" a market result, whether or not the behavior meets the legal definition of "market manipulation." The absence of the lawyer results in the group taking a decision that is not cognizant of this risk.

The consequence is the taste of the first flavor of failure—lawyers uninvolved. This story will ordinarily not have a happy ending for the bank or its traders. The traders and the supervisor will likely face adverse action by their employer. Even if the bank is successful in a market manipulation investigation and no charges are filed, the bank will sustain reputational injury and lose several important customers. There is also the prospect of significant penalties if the governmental investigation turns into an enforcement action. Cases like this hypothetical situation tend not to occur in well controlled organizations where legal review is an embedded part of the corporate culture.

Lawyers themselves are usually involved in every aspect of a financial institution's business and sometimes there is too much work and not sufficient time to get it all done. All financial institutions strive to be efficient or they will be noncompetitive in a market economy. This basic law of competition means the law department needs to be "right" sized. If the department is too fat, then the financial institution will not be efficient. If the department is too lean, then its lawyers can become overtaxed—our second flavor of failure.

One mistake overtaxed lawyers make is in the assessment of the facts about a particular transaction. In my experience, lawyers tend to make more mistakes in understanding the facts than they do in understanding the applicable law. In a typical scenario, a lawyer becomes proficient at a particular kind of banking transaction—such as the sale of mortgage loans that originate with the bank. Yet the lawyer is surprised to hear that questions are being raised about whether some of the sales are "true sales." The lawyer has always depended on a checklist to review loan sale transactions, which he has used successfully for years. But he then hears about an undisclosed side letter between a loan officer at the bank and the transferee receiving the loans, which contains certain recourse rights of the buyer against the seller in the event some of the loans go into default. This letter represents a new "fact." Our lawyer has made the elementary mistake of the overtaxed lawyer—he has not conducted a sufficient inquiry into the facts of the specific transaction, but assumed the current deal was just like the last one. It takes time to know whether the facts of this deal match the facts on a checklist and shortcuts can be treacherous.

Another situation common to the overtaxed lawyer is the accretion of subtle changes to a well-established deal structure over time, which can radically reform the substance of the transaction. An overtaxed lawyer will have little time to think and no time to reflect. Such a lawyer may be so transfixed on getting the transaction processed that the evolving change in substance is just missed. Later, when the wisdom of hindsight makes the change in substance so obvious, many of these lawyers will struggle to understand why the change in substance slipped past them.

The overtaxed lawyer, like the uninvolved lawyer, is a control problem for the financial institution. The lawyerly function in the presented hypothetical is purposeful—to make sure the institution will achieve the desired result, a "true sale." The overtaxed lawyer caused that client intention to be frustrated, since the recourse rights in the side letter may transform the intended sale into something else, most likely a secured lending. The consequences of this transformation can go beyond defective accounting. The institution may sustain financial loss, as the asset it thought was sold is now collateral for a loan to a borrower that might not be creditworthy. Accordingly, this flavor can be very bitter.

An equally important and sour taste of failure is from the incompetent lawyer. I use "incompetent" in its legal sense and not as a pejorative. Because of today's complexity, lawyers tend to specialize in particular substantive areas. A lawyer acting outside of his or her area of competence may make the right judgments for the wrong reasons, acting correctly but not competently.

The competency issue usually shows itself when the judgment made is not quite correct. Take the hypothetical case of a busy law department experiencing a heavy demand for its services. One member of the law department has earned an excellent reputation in the area of secured lending, a reputation earned through hard work across a series of transactions. This lawyer learns from a loan officer that several federal grand jury subpoenas have been served on the bank and sent to the chief legal officer. The subpoenas relate to a number of loans made by the bank to a group of Russian companies. The lawyer feels this is an area he knows, such as lending, and senses an overburdened legal chief would certainly appreciate if he "volunteered" to handle these subpoenas. He contacts the chief legal officer and offers to help her. She accepts the offer with a sense of relief.

The subordinate lawyer then makes a series of errors. He fails to notice the grand jury subpoenas are nondisclosure subpoenas and mistakenly tells the loan officer that he may inform the borrower. He turns the document assembly process over to the loan officer, realizing afterward that the officer is one of the bank officials who approved the loans to the Russian companies under suspicious circumstances. The lawyer also does not realize he personally approved the legal work on the transactions under investigation, which was done by an outside firm. When asked later by the U.S. lawyer if he had any involvement in the subject lending, he answers the question with an exculpatory, "No," even though he was involved in the review process. Our lawyer, while well intentioned and trying to help, has tasted the third flavor of failure—lawyer incompetent. These mistakes will reflect adversely on the top legal officer, who bears ultimate responsibility for the work of associate counsel.

The problem is our well-intentioned junior lawyer lacks the requisite expertise to handle a federal criminal investigation where the bank may be a subject or a target. A criminal investigation touching the business of a financial institution is always serious. Today, like so many areas in the practice of law, corporate criminal investigations are highly specialized and fraught with peril. This is not the kind of assignment for a rookie. While the lawyer may be proficient commercially, he is not competent to handle a criminal matter.

The increasing complexity of legal practice is particularly noteworthy. When I began my legal career over 25 years ago, there were lawyers who focused on finance. Now there are lawyers who specialize in project finance, consumer finance, and even Islamic finance. The incompetent lawyer is a person who, for whatever reason, cannot say to himself or his client, "I am not the right person for this engagement."

Only one step removed from the incompetent lawyer is the compromised lawyer, the most egregious form of lawyerly failure. The compromised lawyer is one whose personal interests conflict with the interests of the client. As much as we like to think these individuals are few and far between, the compromised lawyer has shown himself in recent years with some regularity.

Let us start with the most egregious form of compromise. A lawyer is asked for advice regarding a transaction between the bank and a special purpose vehicle (SPV). The transaction is being done by the bank for tax reasons and the purpose is to push gains into another tax year through a complex structured financial transaction with the SPV. The vehicle will record a small but certain profit on the overall transaction. One of the business people has an interest in the vehicle and when asked about it by the lawyer, the business person says the interest has been fully disclosed and by the way, "Would you also like to be an investor?" There have been cases where company insiders, including lawyers, have been shareholders of SPVs established to achieve some company objective, such as creating a bankruptcy remote vehicle.

For a more tangible, real-world example, compromised company lawyers have rationalized their personal interest in SPVs as being for the good of the company, with their own personal interest being incidental. This kind of behavior marks our fourth flavor of failure—when the personal interest of the lawyer stands in the way of disinterested legal advice to the client. The problem with the compromised lawyer is the lawyers' obligation to have judgment "independence." The task, as set forth in one of our disciplinary rules, is to provide "independent judgment" on behalf of the client. Perhaps this is the principal reason why corporate lawyers serve so well as control persons. They are not independent of management but a part of it, and yet, unlike all of the nonlawyer management members, the lawyer is duty bound to exercise independent judgment. The compromised lawyer cannot provide such judgment.

The example of the lawyer who is interested in a SPV is an extreme example of the compromised lawyer. There are less obvious situations raising similar concerns. Consider the case of a lawyer in a decentralized law department within a financial institution. This lawyer is located in a trading area and his bonus compensation is determined as a percentage of what the traders in that area earn. If one of the traders should come up with an idea that may add a considerable sum to the bonus pool, would this lawyer be capable of expressing independent judgment? Compensation is surely a factor with respect to independence, but how much of a factor?

A few years ago there was a situation where a lawyer was involved in preparing legal agreements conferring special emoluments to two very senior corporate officers. He later prepared a similar contract for himself and got senior officers to approve it. One might look at this situation and say, "This lawyer had in his head when he prepared the first set of compensation documents that you will get yours now and I will get mine later." If so, this lawyer was not exercising his independent judgment when he prepared the first set of documents. Further, if members of the board were counting on him to perform a control function, their reliance was misplaced because they were unaware of the lawyer's hidden motive.

There is no debate that a compromised lawyer is a control problem. But how and whether the judgment of the lawyer is compromised are much more difficult issues. In the most deliberate of cases, such as the lawyer with shares of the SPV, the answer will be clear. The difficult cases are those involving variable nonsalary compensation. As a general guide, if you find yourself wondering whether you are independent, you probably are not.

Understanding and recognizing the taste of the different four flavors of failure is critically important. Avoiding each flavor will strengthen the processes within a financial institution for managing legal, reputational and franchise risks. If lawyers are involved in all material parts of a financial institution's business, stay within their areas of competence, are not overtaxed and work without conflicting personal interests, then the control structure will be robust and strong. This will yield a safer and sounder banking system—the bedrock of a sound economy.