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SECURITIES ANDEXCHANGE COMMISSION
lashinlt , D. c. 20548(202) 272.-2850
REMARKS TOTHE FOURTEENTH ANNUAL SECURITIES
kEGULATION SEMINARLos Angeles, California
December 4, 1981
RELIANCE ON ADVICE OF COUNSELAS A DEFENSE TO SECURITIES LAW VIOLATIONS
Reliance on Advice of Counsel as aDefense to Securities Law Violations
Today I want to ~bare with-you my views on the difficultquestion whether, and to what extent, reliance on advice ofcounsel is, or should be, a r~levant factor in defending againsta securities law violation? .
Despite years of case law development, law review arti-cles and panel discussions among learned observers and prac-titioners, clear rules remain elusive.
I became interested in this subject shortly after start-ing with the Commission in July of this year. The Office ofthe General Counsel was seeking authorization from the Commis-sion to file an amicus brief in a case on appeal before theThird Circuit. I want to briefly describe a hypotheticalset of facts, derived from the issues in that case but muchsimplified, to pose the question that attracted my interest.
Imagine yourself as counsel to the issuer of convertibledebentures publicly traded on the New York Stock Exchange.Debentureholders are entitled to convert into the issuer'scommon stock, which is privately held. The issuer, a rail-road with non-rail assets, seeks to spin off those assetsinto a corporation not subject to ICC regulation. It trans-fers the assets to a wholly-owned SUbsidiary and proposes topass ownership of the subsidiary to the issuer's commonstockholders by means of a dividend payable in the stock ofthe subsidiary.
You are asked whether, under applicable law, including,of course, the terms of the debentures and the indentureunder which they were issued, it is necessary to notify thedebentureholders of the proposed dividend, and thereby affordthem an opportunity to convert. Management is aware that,if a significant number of the public debentureholders con-vert, a registration statement will have to be filed, invol-ving delay and extra cost. Management also recognizes that,if there are no conversions, ownership of the non-rail assetswill pass to the issuer's stockholders, without dilution.
The views expressed in this paper are my own and do notnecessarily represent those of the Commission, my fellowCommissioners, or the staff.
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The issuer's ability to repay the debentures will in nosense be impaired by the spin off. While not all debenture-holders will necessarily convert, some -- perhaps many -- will.Notice of the plan is clearly material to the debentureholders.Management is willing to notify the debentureholders andfile an S-l if a legal duty requires it to do so. You areasked whether such a duty exists.
You research the indenture, the issuer's listing agreementand the applicable rules of the New York Stock Exchange and ofthe Commission. After careful research, you conclude that nosuch duty exists and so advise your client. Acting in re-Lf.ance upon that opinion, the dividend is paid. Later, indefending a IOb-5 action brought by debentureholders, theissuer asks you why its reliance on your professional judg-ment as to the question of duty isn't enough to dispose ofthe case by motion for summary jUdgment. Since Hochfelder,hasn't Rule IOb-5 required scienter, which the Supreme Courtdefined as "a mental state embracing intent to deceive,manipulate 'or defraud", or in the context of Section IO(b),"knowing or intentional misconduct?" How, management asks,could we have engaged in misconduct, knowing or intentional,when we came to you -- the best securities lawyer in theland -- precisely to avoid doing anything wrong --even accidentally?
Before answering, you had best look carefully at thelaw and think through the possible implications. You mightbe surprised at what you find. For example:
Were you to defend on the ground of good faithreliance on counsel's opinion, expect to have SECv. Savoy, a D.C. Circuit case, decided in September,thrown at you. Here, the court made the unexceptionalpoint that "[c]ompliance with the federal securitieslaws cannot be avoided simply by retaining outsidecounsel to prepare required documents," but thenwent on to suggest, in dicta, that reliance onadvice of counsel is not a defense to liabilityunder IOb-5 but only one factor to be consideredin fashioning the appropriate remedy. Other cases,perhaps rooted in the notion that "ignorance ofthe law is no excuse," would be added to lendsupport for the D.C. Circuit Court's dicta.
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There are two other implications, which I will justnote because they are worth remembering, but without furtherdiscussion today.
In asserting the reliance defense, you should beprepared to bow out of the case as counsel forthe defendant issuer. One consequence of assertingthe reliance defense may be an implied waiver ofthe attorney-client privilege. Cases have so held,forcing counsel for the party asserting the defenseto submit to discovery on that subject. UnderS5-102 of the Disciplinary Rules of the Code ofProfessional Responsibility, this situation mighteven call for your withdrawal as counsel, due tothe likelihood of your becoming a witness, eitherfor your client or for the plaintiff.If reliance on your opinion turns out to be irrel-evant to the question of lOb-5 liability, be preparedfor your client to complain, perhaps even sue,over your failure to advise, in advance, as to:
(a) whether your opinion was qualified orunqualified,
(b) whether reliance on the 0plnlon would berelevant at all to defending against a IOb-5 suit,and
(c) if relevant, whether the requisites for areliance defense were fully satisfied in this case.Commentators have suggested that a lawyer has aduty to give his client advice on these matters.
Should reliance on advice of counsel ever be a factorrelevant in establishing a defense to securities law viola-tions? At the outset I should stress that the "reliancedefense,n as justifiable reliance on advice of counsel issometimes referred to, is not really a defense at all butsimply some evidence tending to support a defense based ondue care or good faith.
Now, as suggested in Savoy, there are those who believethat reliance on advice of counsel is irrelevant to any ofthose violations. I am not among that group. Nor, indeed,is the Commission. In a recently filed amicus brief involving
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Rule IOb-s, it expressed the view that under appropriatecircumstances, defendant's reliance on advice of counsel isa relevant factor in determining whether the requisite scienterexists.
There are a few cases, the most recent of which is Savoy,suggesting that the reliance defense is irrelevant to substan-tive violations. However, a close reading of those caseswill establish that they do not, in fact, stand for thatproposition at all -- in the earlier cases because they simplydon't make that suggestion, and in the later ones becausethey rely on a misreading of the earlier ones.
Of course, viewed as a question of policy, some haveargued that there are sound reasons for permitting a defensebased upon reliance on advice of counsel. The existence ofthis defense should serve to encourage the use of competentcounsel on difficult questions of law, thereby fosteringimproved disclosure to investors. As the Commission statedin its recent decision, In re Carter:
Significant public benefits flow from theeffective performance of the securitieslawyers' role. The exercise of independ-ent, careful, and informed legal judgmenton difficult issues is critical to theflow of material information to the se-curities markets.
And as the Second Circuit recognized in SEC v. Spectrum, Ltd.:The legal professional plays a uniqueand pivitol role in the effectiveimplementation of the securities laws.Questions of compliance with the in-tricate provisions of these statutesare ever present, and the smooth func-tioning of the securities markets willbe seriously disturbed if the publiccannot rely on the expertise profferedby an attorney when he renders an opin-ion on such matters.
On the other hand, there are legitimate and even powerfulpolicy arguments against the defense. It is clear the defensecould serve to foster abuses. There is, understandably, afear that the reI iance defense might encourage unscrupulous
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clients to buy immunity from securities law violations byopinion-shopping. Accommodating lawyers will spring up, eagerto provide the protection afforded by reliance on a formal,yet clearly erroneous opinion. Critics of the defense oftenask why those injured by a defendant should bear the risk ofhis counsel's mistakes. Here one must recognize that thelawyer has seldom been held liable for the consequencesof his erroneous opinion. Some see the reliance defense asgiving to the lawyer a judge-like power to declare what thelaw is. And, finally, one may argue that we foster the develop-ment of better lawyers by putting a higher premium on theirbeing correct. Why add value to their role when they perform itinadequately?
It is these concerns that in the past have made theCommission and others uneasy about the reliance defense.The fact is, however, that we are not writing new laws, butinterpreting old ones, many of which involve questions ofdue care and state of mind. The reliance defense can berelevant to these questions. The trick is to determine whenit ought to be available, keeping in mind the concerns justvoiced and seeking to deal with them through careful limita-tions on the use of the defense.
Now, let us turn to this difficult question of when.Perhaps the best way to get one's arms around this subjectis to start with what we can say with some certainty andthen move on to the less certain,