General Counsel Caught in SEC Crosshairs.

The SEC’s 2016 complaint against RPM and its general counsel (No. 1:16-cv-01803, District of Columbia) shows that GCs can become targets under circumstances that are neither “extraordinary” nor unprecedented, but they are far from common. In that case, the allegations that led to civil charges included:

• Investigation Management: RPM and its general counsel allegedly acted too slowly to gather, preserve, and disclose relevant information.
• Corporate Disclosure Decisions: RPM and its general counsel allegedly violated the securities laws by neither disclosing the investigation promptly nor updating previously filed reports.

The litigation ended in December 2020. The parties entered into a settlement that ended the case without trial and without an adjudication of liability.

Does Insider Trading Liability Ever Attach to Corporate Executives Who Are Not “Insiders”?

Yes, in many cases. Under the federal insider trading laws (which are enforced on an “abuse of trust” theory), insider trading liability requires a showing of (i) material nonpublic information plus (ii) a breached duty. That second element, the breach of duty, can be satisfied in two different ways:

• Classical Insider Trading: In the classical insider trading scenario, an executive or an employee trades shares of his or her own employer’s securities on the basis of nonpublic information. This triggers insider trading liability because the executive or employee breached the duty he or she owed to the company (and its shareholders).
• Misappropriation Liability: Under the insider trading laws’ misappropriation theory, an individual can become liable for insider trading when he or she trades on information that is material and nonpublic, but that was obtained in breach of a duty owed to the source of the information. This form of insider trading does not involve trading shares of the individual’s employer’s securities.

When Does a Disclosure Judgment Become Securities Fraud?

The distinction between an actionable violation of the securities laws and an unfortunate decision is rarely clearly defined. It falls to the SEC to make that call, and it falls to the defense counsel to challenge the SEC’s conclusions. For a general counsel, there are two major risks: (i) personal civil or criminal liability and (ii) reputational harm.

From a personal liability perspective, GCs must be concerned with three separate types of securities fraud liability under the U.S. federal law:

• Primary Liability Under Section 10(b) of the Securities Exchange Act: This form of liability requires showing that the defendant personally took “actionable” conduct and that he or she acted with requisite scienter.
• Aiding and Abetting Liability Under Section 20(e) of the Exchange Act: This form of liability requires showing that the defendant (i) knowingly or recklessly “substantially assisted” the primary liability actor in executing the fraudulent conduct in question.
• Controlling Person Liability Under Section 20(a) of the Exchange Act: This form of liability is generally focused on “insiders” at the top of the organizational structure. If the company takes an action that triggers liability, the controlling person can become liable as well, though a “good-faith” defense is available in this context.

None of these sections seem to be concerned with professional negligence, and there are no provisions in the securities statutes that allow the SEC to bring federal tort claims based on a GC’s professional negligence.

• Scheme Liability Under Section 10(b) of the Exchange Act (and Rule 10b-5): Recently, in Lorenzo v. SEC, the Supreme Court affirmed the lower court’s ruling that “scheme liability” is possible under Section 10(b), even if the defendant did not make a false statement. That means that knowingly disseminating a false statement made by someone else triggers Section 10(b) liability.
• Scheme Liability Under Section 17(a) of the Securities Act: The RPM complaint invoked antifraud provisions in both the Securities Act and the Exchange Act, and it included a variety of complex claims as well.

How Can a General Counsel Establish the Required Mental State to Avoid Securities Fraud Liability?

Under Rule 10b-5, “scienter” is defined as “a mental state embracing intent to deceive, manipulate, or defraud.” That doesn’t necessarily mean that the defendant must have intentionally violated the law. Scienter is also defined as “recklessness.” However, it is not defined to include mistaken judgment, or negligence, which can be the result of being rushed into taking action. While this is the standard for a Rule 10b-5 case, the SEC has a broader set of tools available under Sections 17(a)(2) and 17(a)(3) of the Securities Act. These sections permit SEC negligence claims.

When Must General Counsel Escalate a Possible Disclosure Violation?

The issue of escalation for general counsel is handled by the American Bar Association’s Model Rules of Professional Conduct. Model Rule 1.13(b) addresses the issue by stating:

“If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law that reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization.”

Model Rule 1.4(a)(3) notes that “keep the client reasonably informed about the status of the matter.”

However, Congress intervened in the aftermath of the corporate accounting scandals of the early 2000s. As a result of the Sarbanes-Oxley Act, the SEC was directed to establish minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of issuers which are (i) “reasonable,” (ii) “consistent with the requirements of the securities laws,” and (iii) “ consistent with the requirements of any applicable rules of professional conduct.”

In doing so, the SEC issued Rule 205, which applies to “Attorneys Representing Entities Before the Commission, for Issuers. Attorneys Who Represent Issuers under this Section shall report evidence of a material violation to the chief legal officer (or equivalent) within the entity. It also requires that, if the chief legal officer does not respond appropriately within a reasonable time, the attorney report the evidence of a material violation to the issuer’s audit committee, to another committee of the board consisting solely of independent directors, or to the full board of directors.

When Must an Attorney Escalate Evidence of Material Violations beyond the Chief Legal Officer or Entity’s Counsel?

Under Rule 205, an attorney may not “take an inadequate response from the chief legal officer” with respect to any evidence of a material violation of the securities laws. An adequate response to “evidence of a material violation” involves (i) taking sufficient corrective action to prevent the material violation from occurring, (ii) taking steps to investigate the material violation fully and accurately, and, (iii) promptly disclosing the material violation.

If the attorney takes an inadequate response to the material violation, he or she must promptly report the matter to “one or more independent members of the entity’s board or an independent audit committee.” This rule also provides that if “The chief legal officer does not adequately respond, the attorney shall report the material violation to a committee of independent directors.”

Unlike several other rules that the SEC has issued, Rule 205 does not create a private right of action against attorneys for failing to respond to material violations.

With respect to the RPM case, RPM had the bad luck of employing two different outside law firms. One law firm was representing RPM before the DOJ in the underlying investigation. The other law firm had been retained to advise the company with respect to its securities disclosure obligations. According to the RPM complaint, both the law firm that was assisting with the DOJ investigation had not fulfilled its professional-negligence-related duties, and RPM’s own general counsel had failed to adequately assess the need to disclose the underlying investigation.

Spodek Law Group, led by managing partner Todd Spodek, defends clients in federal criminal and white collar matters.

How Should Counsel Analyze Investigation Losses Under ASC 450?

According to the RPM complaint, the facts in the case were as follows:

• By September 2012, both internal and external counsel alleged to have known that the investigation is related to overcharges totaling “at least $11 million.”
• When RPM filed its Quarterly Report on Form 10-Q for the first quarter of fiscal year 2013, the quarter ended August 31, 2012, on October 4, 2012, it did not make any disclosure relating to the investigation, and it did not make an accrual for the losses related to the investigation. Counsel allegedly signed this filing, which omitted any related disclosure.

Regarding the first point, sealed qui tam claims and other investigation matters are examples of pending-litigation loss contingencies.

Regarding the point about sealed qui tam claims, courts and the parties will issue sealing orders that preclude any disclosure of the existence of the qui tam claim. In most cases, sealing orders will apply not just to disclosure of the existence of the qui tam claim. They will also preclude disclosure to auditors. If a court grants a motion to seal, companies must be careful before disclosure to auditors. With respect to the first point, while GCs can negotiate a deferred prosecution agreement (DPA) on behalf of their company, they should not assume that this means they do not have a disclosure obligation. While a DPA will generally avoid the need for a “disclosure of an investigation” on the company’s securities filings, companies must still account for investigation-related losses in accordance with ASC 450.

Accounting for Losses Subject to ASC 450-20, ASC 450-20-50

If an investigation triggers ASC 450-20, then an accrual for an amount must be reflected as a liability on the company’s balance sheet. When will a loss contingency require an accrual? ASC 450-20 says:

“ A loss contingency shall be accrued if:

• It is probable that a liability has been incurred at the date of the financial statements,
• The amount of loss can be reasonably estimated.”

The latter does not mean “accurately,” but rather “reasonably.”

If an investigation or other matter does not trigger ASC 450-20, the company should check if the investigation or matter triggers ASC 450-20-50. If ASC 450-20-50 is triggered, then a loss disclosure must be included in the footnotes to the company’s financial statements. When will a loss contingency trigger an ASC 450-20-50 disclosure? “ The financial statements shall disclose a contingent loss if:

• There is a reasonable possibility that a loss may have been incurred,
• Disclosure is reasonably possible that it will result in a material amount of loss.”

The footnote disclosure must estimate the possible loss exposure or state “ That to no extent the estimated amount of the loss” or explain that an estimate is not possible.

Summary Advice for Companies, Directors, and Officers Facing a Federal Investigation

• Immediately Hire Independent Defense Counsel
• Conduct an Attorney-Client Privilege-Privileged Assessment
• Engage a Financial Professional to Assess Potential Financial Exposure
• Develop a Plan for Responding to the DOJ or SEC
• Be Prepared to Address Disclosure Obligations
• Be Prepared to Document All Decisions and Judgments
• Keep Records Separate from the Company’s Records
• Seek Outside Counsel to Avoid Allegations of a Conflict of Interest
• Ensure Independent Representation to Protect Personal Interests

When Does General Counsel Need Independent Legal Representation?

As seen in the SEC’s RPM complaint, the federal government can and will use information obtained from corporate counsel when corporate counsel is not represented by independent defense counsel. For example, the RPM complaint relied heavily on the General Counsel’s own admissions to DOJ investigators. Here are key points regarding corporate counsel’s potential and actual need for independent legal representation:

Privileged Communication and Self-Defense

Under Model Rule 1.6(b)(5), a lawyer is permitted to make reasonable disclosures to the extent necessary to “avail himself of a right or defense.” This includes disclosures in “ a legal proceeding, in which the lawyer is a defendant.” This exception does not apply in general. It is narrow, and lawyers who disclose information must be very careful, as they can still be accused of an ethical violation if the disclosure is not justified under these circumstances.

Generally, corporate counsel’s client is the corporation, acting through its board of directors. Model Rule 1.13(a) states, “A lawyer employed or retained by an organization represents the organization.” In other words, the corporation is the lawyer’s client.

When an investigation or lawsuit involves the personal conduct of an executive or another employee, there is a question of whether the corporate counsel also represents that individual. Generally, the corporation may engage separate outside counsel to represent an executive or employee. When this happens, corporate counsel is generally not the executive’s or employee’s lawyer. He or she will still be entitled to act as an assistant to the executive’s or employee’s outside counsel.

Under the privilege exception for self-defense, a lawyer may be entitled to disclose privileged information about his or her client to protect himself or herself against a criminal prosecution or civil litigation. If a lawyer decides to rely on this exception, he or she should consult with independent counsel.

Attorney-Client Privilege and Legal-Advice Privilege

Privilege is often raised in the context of federal investigations. But privilege does not protect the underlying facts discussed in a legal communication. When an attorney is copied on correspondence that is otherwise purely factual or business-oriented, this communication is not necessarily privileged. The attorney’s role as a recipient of the communication must be relevant to the issuance of legal advice, or the communication must contain advice that makes the communication privileged.

Joint Representation and Conflict of Interest

Under Model Rule 1.7(a), “ A lawyer shall not represent a client if the representation involves a concurrent conflict of interest.” While Model Rule 1.7(b) allows joint representation “if the lawyer reasonably believes he or she can provide competent and diligent representation,” in some cases, this is too broad. Especially when an executive or employee’s personal or financial interest in a matter could conflict with that of the company, general counsel or outside counsel should not represent both sides. This may be necessary in the context of an SEC enforcement proceeding, and general counsel should be prepared to instruct his or her company’s outside counsel to step down.

Waiver of Privilege and the “Upjohn Warning”

When corporate counsel conducts an internal investigation or otherwise gathers information from an executive or employee, he or she is entitled to disclose the information to the corporation’s board. The corporation controls the privilege, and the corporation can waive the privilege at its discretion. This means the corporation can waive the privilege even if the executive or employee whose conduct is being investigated objects. An “Upjohn Warning” is used in this context to identify the corporation as the client and explain the corporation’s right to waive the attorney-client privilege over the employee’s objections.

What Should General Counsel Do After SEC Contact?

Regardless of the circumstances, when the SEC or DOJ contacts corporate counsel or a company’s outside lawyers, the immediate response should be to assume that litigation is reasonably foreseeable. This creates a duty to preserve evidence. Under the Federal Rules of Civil Procedure, companies must preserve all forms of “relevant” evidence, including ESI (electronically stored information). This means that companies must stop any automatic or routine deletion of any documents, texts, emails, files, or other forms of ESI that could be relevant to the investigation. If there is a subpoena for information, it requires the recipient to suspend routine deletion and destroy efforts as well.

If the recipient of a subpoena is an individual, there is a question of whether that individual may refuse to produce records that might be incriminating. Individuals have the right to assert the Fifth Amendment privilege against self-incrimination. However, the Fifth Amendment privilege is personal. Corporations possess no self-incrimination privilege. So, if an individual is subpoenaed to produce records, the response from the individual’s attorney must be carefully considered.

What is the Significance of an SEC Wells Notice?

The issuance of an SEC Wells notice (which is a formal notification that SEC staff intend to recommend an enforcement proceeding) does not end the window for presenting arguments to the SEC. The “Wells process” is a form of informal, non-adversary negotiation prior to an enforcement action. Even after a Wells notice is issued, prospective defendants may still be able to request a meeting with the SEC staff, and they may still be able to present oral or written arguments. This possibility is affirmed in SEC Rule 202.5(c).

With respect to Wells notices, the notice itself specifies the time that the recipient of the notice has to respond. According to the SEC Enforcement Manual, “ The staff should respond to a Wells submission as soon as possible, generally within two weeks of the deadline for Wells submissions.”

Can an SEC Enforcement Case Be Settled Prior to Civil Trial?

The final recommendation with respect to a proposed enforcement action is a matter of internal review within the SEC. Only the Commission can authorize enforcement action against a company, individual, or group of individuals. The Commission reviews the staff’s recommendations, and then, if approved, the Commission issues a formal order authorizing SEC enforcement staff to bring a case in civil court.

The SEC also accepts settlement proposals. Generally, companies seek to resolve their potential liabilities before civil trial. This will often involve substantial investigation and extensive negotiations. The SEC’s Seaboard framework lists the factors that will be considered when evaluating whether to give credit for a company’s self-reporting, remediation, or cooperation.

While the SEC takes self-reporting, remediation, and cooperation into consideration when evaluating whether to file a lawsuit against a company, corporate cooperation will not necessarily shield a company’s employees and officers from facing enforcement action, or from facing potential liability in civil litigation. Even if an employee’s or executive’s conduct was fully disclosed to the SEC, the SEC staff may still target that employee or executive in an enforcement action.

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