Professor Bainbridge...on law, politics, religion, culture & food

Use and Abuse of Sarbanes-Oxley § 307

I've blogged on the problems with SOX § 307 and I've written law review articles on them. Yet, now we have a new thing to worry about; namely, overeager application by the SEC. The NY Times is reporting that SEC Commissioner Harvey "I never saw a problem that didn't need a new law" Goldschmid is threatening to use § 307 against mutual fund lawyers (link via Mike O'Sullivan):

"An attorney who is aware of credible evidence of a material violation of the securities laws, or a material breach of fiduciary duty, must report this evidence up the chain of command," if necessary to independent members of the fund's board, said Harvey J. Goldschmid, the S.E.C. commissioner, in a speech before the Investment Company Institute, the mutual fund trade group, in Washington.

What's wrong with that? Well, number one, there is no evidence any fund lawyers knew anything about the problematic trades:

No one has yet asserted that specific lawyers representing particular funds knew of possibly unethical behavior by managers, said Paul Schott Stevens, a partner in the Washington office of Dechert. What is more, Mr. Stevens said, no one has charged that a lawyer knew that fund managers permitted after-hours trading by certain favored investors or that the managers allowed some investors to buy and sell fund shares rapidly.

In my work on § 307 I have repeatedly argued that:

Managers who intentionally commit fraud or breaches of fiduciary duty will only rarely consult their legal counsel, of course. Instead, counsel will be consulted by a manager who is pursuing an aggressive course of conduct or one who has inadvertently strayed over the line into illegality. Unfortunately, SOX 307 likely will discourage even those contacts. Even corporate managers not engaged in actual misconduct will not welcome the investigation that an attorney’s “reporting up” would engender, especially where there is a possibility that counsel will go over their heads. Managers therefore may withhold information from counsel, so as to withhold it from the board, especially when the managers are knowingly pursuing an aggressive course of conduct. Indeed, in many of the recent corporate scandals, the misconduct was committed by a small group of senior managers who took considerable pains to conceal their actions from outside advisors such as legal counsel.

Bringing the sort of marginal cases Commissioner Goldschmid is proposing will only strengthen those incentives. Hence, it becomes even less likely that managers will consult lawyers. At the same time, juries and regulators acting with the benefit of hindsight may infer the lawyers must have known what was going on, imposing liability. Being a corporate practitioner is likely to get a lot more stressful, which means being a corporate client is likely to get a lot more expensive.