Breaking past the parallax: finding the true place of lawyers in securities fraud.

• Author: Adams, Marianne C.

Introduction I. Background A. Cast in Dual Roles: The Role of the Lawyer 1. Professional Rules Governing Attorney Conduct 2. Attorneys as Gatekeepers B. The World Before Central Bank C. Central Bank and the Congressional Response it Prompted. D. Enron and Sarbanes-Oxley E. The Supreme Court Weighs In Again: Stoneridge v. Scientific-Atlanta F. Recent Congressional Action II. The Parallax View: Too Much, Or Not Enough, Liability On Lawyers Is A Matter Of Perspective A. Arguments for Liability 1. The Gatekeeper Argument 2. The Deterrence Argument 3. The Compensation Argument 4. The Client Protection Argument B. The Anti-Liability Side: "Clients [W]ant [C]hampions, [N]ot [C]haperones" 1. The Strict Reading of Statutory Text Argument 2. The Attorney-Client Privilege/Confidentiality Argument 3. The Floodgates of Litigation Argument 4. The Bubble Theory and Increased Costs for Gatekeeper Services Arguments III. In Search of the Middle: What Role Should a Lawyer Really Play, And What Level Of Liability Meets the Goals of Fairness? A. Proposed Solution 1. Strengths of the Proposal 2. Weaknesses of the Proposal B. Existing Proposals 1. Return to pre-Central Bank 2. Restoring a Private Right of Action with a Cap on Liability 3. Professional Rules Solution 4. Other Proposed Solutions Conclusion INTRODUCTION

In October 2005, investors discovered that Refco, Inc., a popular brokerage firm, had for years engaged in fraudulent transactions designed to create a semblance of financial success. (1) To cover up, rather than write off, poorly made loans that became uncollectible, Refco engaged in a series of complex "round-trip" transactions in which it made loans to third-parties and then had the third-parties make loans to its entities. (2) As a result of this scheme, the appearance of Refco's balance sheets improved dramatically. No one was the wiser when the company went public until months later when Refco stated that its balance sheets should not be relied upon. (3) As it turned out, Refco's financial situation, covered up by the fraud, left it on the precipice of collapse, which imminently followed, (4) causing tremendous losses to investors and forcing Refco to declare bankruptcy. (5)

In the course of its "round-trip" fraud, Refco used a well-known law firm to help it prepare key documents (6) and explain the structure of the "round-trip" transactions to third-party participants in the scheme. (7) The law firm was also involved in the creation of a series of securities offerings in which the prospectuses contained information that it knew to be false. (8) Not surprisingly, investors sued the law firm claiming that it knew or should have known about the fraud, and thus ought to be held liable. (9) The firm moved for dismissal. (10) Granting the motion to dismiss, United States District Court Judge Lynch wrote that, given the present state of the law, he had no choice but to dismiss the action against the law firm. (11) In dicta, however, Judge Lynch expressed his concern with the laws under which he had to decide the case, as well as his opinion that the system is ripe for a change so that such actions could, at a minimum, be heard in court. (12)

Lawyers often play an integral part in business transactions and securities offerings. This puts lawyers on the sidelines of not only great business successes, but also, every so often, tremendous failures. (13) Because they are viewed by many as gatekeepers, and in that role provide a degree of assurance (with their reputational capital) that gross illegalities will not occur, (14) a series of questions arise in the minds of many when illegalities do happen on attorneys' watch. (15) This Note analyzes the legal standards that are in play and those that should be imposed when lawyers aid or abet a fraud.

Part I sets out the historical and theoretical background against which the analysis of attorney liability is undertaken. This Part traces the relevant underlying principles and defines the unique position that a lawyer occupies under securities laws as he or she plays the dual role of client advocate and corporate gatekeeper. It then discusses the changes to attorney liability that were brought about by judicial decisions and legislative actions over the past two decades. Part II discusses the contrasting views on the issue, both those calling for the reintroduction of aiding and abetting liability and those calling for a continuation of the status quo. Finally, Part III offers a new approach for resolving the debate, proposing a statutory amendment that balances competing policy considerations; specifically, the need for liability and the need to curb the potential explosion of litigation such liability may cause.

1. BACKGROUND

   The discussion that follows in this section provides the background information which forms the basis for the current debate on whether to impose aiding and abetting liability on attorneys. Part I.A provides a brief overview of the ethical and professional rules governing attorneys' conduct and then discusses attorneys' status as gatekeepers. Part I.B reviews the history of aiding and abetting liability in the United States prior to the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver. (16) Part I.C discusses the limits placed on aiding and abetting liability by Central Bank and the following congressional expansion of such liability with the passage of Private Securities Litigation Reform Act of 1995. (17) Thereafter, Part I.D reviews the changes to attorneys' gatekeeper role brought about by the Sarbanes-Oxley Act of 2002 (18) in the wake of the Enron scandal, and Part I.E discusses the Supreme Court's decision in Stoneridge Investment Partners v. Scientific-Atlanta, Inc. (19) and its elimination of scheme liability (20)--one of the options used by investors as an alternative to the overruled aiding and abetting liability claim. Lastly, Part I.F discusses the congressional response to the Stoneridge decision and the frauds that accompanied the recent recession via the proposed bill entitled Liability for Aiding and Abetting Securities Violations Act of 2009. (21)

   1. Cast in Dual Roles: The Role of the Lawyer

      Much of the impetus to impose aiding and abetting liability on lawyers stems from their gatekeeper role in securities law and corporate contexts, (22) and the belief that there is a need to ensure that they continue in that function. (23) It is therefore helpful to begin the discussion of attorney aiding and abetting liability with an overview of the dual roles that lawyers play.

      As counsel, an attorney is both a corporate gatekeeper thereby possessing a set of responsibilities to the general public, (24) and an advocate constrained by a duty to the client and responsibilities that come with client representations. (25) The dual roles that attorneys play are governed by different standards. On the one hand, attorneys must abide by professional rules governing their obligations to clients (26) and the profession; (27) on the other hand, they must meet certain expectations associated with their gatekeeper role. (28) The attorney-client relationship is further complicated by an important interest at stake for the attorney: continued client representation and thereby continued financial benefit, which, in turn, is important for both a law firm's reputational capital (29) and its financial well-being. This goal of client retention, however, in spite of its benefits, (30) can impair an attorney's judgment of what is ethically necessary, (31) increasing the need for appropriately tailored rules governing attorney conduct.

      1. Professional Rules Governing Attorney Conduct

      Many of the existing ethical and professional principles that guide attorney behavior are reflected in the American Bar Association Model Rules of Professional Conduct (the "Rules"), which have been adopted in one form or another in over forty states. (32) These and other attorney conduct rules take into account attorneys' dual roles and contain guidelines designed to help attorneys meet both obligations to their clients and any obligations they may have to the public as a result of their clients' actions. The main obligation of a lawyer, however, is the one owed to the client, which the Rules reflect through their explicit imposition of such duties. (33) By contrast, the obligation to the public is more theoretical and stems from general ethical principles rather than specific relationships. (34)

      Because of the overarching significance of the duty to the client, any outside obligations that may conflict with this duty inevitably complicate client representation. In the case of gatekeeper obligations, the chief complicating factor, apart from the duty of confidentiality, is the doctrine of attorney-client privilege. (35) The purpose of the doctrine is to protect communications between clients and their attorneys in the course of legal counseling, thus fostering more open communication. (36) The privilege, however, is deemed waived upon disclosure of protected information that is not meant for the general public, (37) which, in turn, also raises concerns for client confidentiality. (38) Absent an exception, in the fulfillment of his or her gatekeeper obligations, the lawyer is restricted to avenues not involving disclosure. To allow for circumstances where attorneys may need to reveal certain information, and to spare attorneys from necessary noncompliance with their broader ethical obligations, the Rules allow for disclosure in cases where it is necessary in order 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." (39) The duty to the client thus comes with exceptions that assist attorneys in their functions as officers of the court and...