Blog & Legal Alerts
Jeremy Pomeroy speaking at ACI summit: “There’s a Mobile App for That: Avoiding Legal Pitfalls While Leveraging New Trends in Mobile Apps and Promotions.”
Jeremy Pomeroy will be speaking at the American Conference Institute’s annual summit on Digital Advertising Compliance: Social Media, Sweepstakes & Promotions, on September 10, 2013 in NYC. Jeremy’s topic: “There’s a Mobile App for That: Avoiding Legal Pitfalls While Leveraging New Trends in Mobile Apps and Promotions.” The conference promises: “Practical tools for maintaining legal and regulatory compliance for all your social media and promotional practices.” For more information, see AmericanConference.com/digitaladvertising.
In an earlier post, The Craigslist Exemption, I described the changes mandated and expected that arise from the new JOBS Act signed into law on April 5. One of those upcoming changes is the ability to engage in general solicitation and general advertising under a Reg D, Rule 506 private offering of securities, so long as all purchasers are accredited investors. The SEC has long allowed companies to sell to sophisticated purchasers who meet the definition of “accredited investor” without going to the expense of a formal SEC-registered public offering, but wouldn’t permit any kind of mass marketing because that might lead to unsophisticated retail investors buying shares in the secondary market or worse, intentional efforts to sell to the general public using accredited investors as willing conduits.
Congress felt that the status quo prohibition on general solicitation and advertising made it overly difficult for companies to connect with sophisticated investors, putting an artificial limit on access to funding by young companies. Without the ability to advertise, companies could only sell to someone already known to the investment community which was effectively shut to outsiders. If you had to ask how to invest in a private securities offering, you were presumptively on the “outside.” In addition to that problem, having a closed network of accredited investors meant that brokers, dealers and others in the financial industry could grant favors and engage in other forms of rent seeking before admitting new accredited investors to the club. So, Congress has directed the SEC to permit general solicitation and general advertising so long as all purchasers are accredited investors. There is now a mini-firestorm in progress about how the SEC should interpret the Congressional directive. Joe Wallin’s Startup Law Blog gives a good overview.
Accredited investor definition
Congress seems to have required a strict binary standard: purchasers are either accredited or not. If they’re not, then your company cannot rely on Rule 506 and may have violated the securities laws. This is a potentially serious problem for anyone trying to use Rule 506 and is also discussed in my earlier post. A large camp of securities practitioners militates for a “reasonable belief” standard: if you reasonably believe that your purchasers are “accredited,” then you should be able to use Rule 506 even if it turns out you were wrong.
This is a vital question but perhaps we lawyers are getting over-excited. The current definition of “accredited investor” (from Rule 501) already incorporates a reasonable belief standard:
“Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:” (my italics).
So, a reasonable belief means that the purchaser is, in fact, an accredited investor even if he or she does not actually fall within the listed categories. Some commentators have pressed the SEC to add an additional reasonable belief standard outside the accredited investor definition. In essence, general solicitation and advertising would be allowed where the company reasonably believes that the company reasonably believes that the purchasers fall within the listed categories. This is probably a non-starter for the SEC because the JOBS Act does require that all purchasers be accredited investors. But there should be no cause for alarm so long as a reasonable belief standard remains right where it is in the definition. Much more interestingly, the JOBS Act has opened up a new boom industry in investor asset verification. Is your dotcom ready to pivot?
Apparently anticipating this whole debate, the JOBS Act further directs the SEC to specify methods that companies can take to verify that purchasers are accredited investors. It seems likely that the SEC will make its verifications mandatory, at least where general solicitation and advertising are used – in other words, a “reasonable belief” will not be warranted unless specific steps are followed. What are those steps?
We don’t know yet, although we do hope that the rule will not be “overly prescriptive” as the New York City Bar Association puts it in their comment letter to the SEC. One clue to SEC thinking comes from a talk given by Lily Brown, SEC Senior Special Counsel to the Director who opined (speaking solely for herself and not for the SEC) that companies will need to do more than they do under current practice. Current practice is essentially twofold: (1) rely on the brokers and dealers to make offers only to their contacts “in the know” and who they have some familiarity with from past transactions, and (2) insist that those investors make a representation to the company (essentially a promise) that they meet the definition of “accredited investor.” Commentators are pressing the SEC to accept current practice as sufficient, but what if more is needed? Leaning again on Joe Wallin, “Presumably this means that issuers are going to have to request documentation from investors demonstrating their incomes or net worth, such as tax returns, net worth statements prepared by third party accountants, bank statements, brokerage account statements, etc.”
And there’s your next pivot. Filtering accredited investors through a third party asset verification service would limit sales to people who first affirmatively sign up and “opt in” to the brave new world of accredited investing where U.S. securities laws afford much more limited protection. The service would take on the tedious and time-consuming process of obtaining client consents, credit reports, bank statements and the like. The existing industries that I see best situated to move into the field are the credit rating agencies, credit reporting services, credit score reporting services, financial aid services, such as The College Board’s CSS service, and any nimble dotcom that can move quickly enough.
Naturally, this remains hypothetical until the SEC issues rules for comment, receives comments and issues final rules. Anything could happen. However, it seems likely that a market that will soon be able to leverage technology to unleash the private offering market at last, will be permitted to rely on a technology-based verification service.
Are you ready to take this on? Feel free to submit your own comment to the SEC here in favor of a technology-based third-party verification system. I’ll even help you write it up.
Click here to try the interactive version of the puzzle (Java required)
Don’t have Java? Then see below for a traditional format.
1. Massachusetts requires that any person or business, wherever located, that owns or licenses “personal information” of a Massachusetts resident maintain this kind of written information security program.
3. Not necessary if you want to enter a sweepstakes or contest.
6. An advantage of registering a copyright with the United States Copyright Office is the ability to recover _____________________.
8. Godfather of soul
9. Re-Tweeting a false, damaging statement that someone else made could give rise to this kind of claim.
10. A state that requires registration of a sweepstakes if prizes totaling over $5,000 are awarded.
12. 10 to the 10 to the 100th power
15. Unsolicited commercial text messages need to comply with this U.S. law (abbrev.).
16. Flash Cookie
19. Prudent businesses do this before branding a product or service.
21. Running a sweepstakes that includes the elements of consideration (e.g., payment), chance and an award could be deemed an illegal one of these.
22. California’s Attorney General recently declared that California law requires that operators of mobile apps that collect personally identifiable information about Californians must display a conspicuous one of these. (2 words)
23. accompany your trademark with this designation when you want to put the world on notice as to your trademark rights but don’t have a federal registration.
24. These need to meet before a contract can be formed.
25. Queen of Soul
5. Courts have not consistently enforced this kind of online agreement.
7. Failing to disclose sponsorship of blog entries may be considered unfair and ____________.
9. THIS CROSSWORD PUZZLE DOES NOT CONSTITUTE THIS (DISCLAIMER).
11. You will need this kind of written agreement if you want to own the copyright in the images or text that a freelancer creates for you (3 words).
13. “The thing speaks for itself.” (Latin)
14. Ideas, know-how, and techniques retained unaided in the memory of a receiving party.
17. There’s no such thing as this kind of clause. (Chico)
18. Registering a copyright agent under this law is required if an Internet service provide wishes to take advantage of a “safe harbor” protecting it from liability for infringing user generated content.
20. A recent UK law prohibits placing or reading these on a computing device without consent.
Jeremy Pomeroy will be speaking on Social Media issues in technology transactions at the Practicing Law Institute’s “Information Technology Law Institute 2012: Innovations in Apps, E-books, Cybersecurity, Mobile Technology, Privacy and Social Media.“ The seminar will take place on April 19-20, 2012 in New York.
For more information, click here.
If you’re like me, you might be having trouble sorting out the new JOBS Act (properly, the Jumpstart Our Business Startups Act) that President Obama signed into law on April 5. The written and online analyses seem to be essentially correct but they are far too sketchy to let us all participate in the discussion. To understand the law and to have a well-thought opinion on what it means, you need to have a basic understanding of how U.S. securities laws function.
I’ll try to keep it brief, but, even so, I’ll need to break this up into sections. In this first section, I look at how the JOBS Act changes the rules on current fundraising techniques. In later sections, I will examine the new crowdfunding rules and the ways the JOBS Act allows companies to delay or avoid complying with Sarbanes-Oxley and other rules.
The Securities Act of 1933 (which is often called the ’33 Act or just the Securities Act) covers the offer and sale of securities while the Securities Exchange Act of 1934 (called the ’34 Act or the Exchange Act) governs the trading of securities on public stock exchanges. A “security” is an investment in a common enterprise, such as a corporation, for a return from the efforts of a third party, such as a corporation’s professional management team. The archetypal securities are stocks and bonds and, to simplify this discussion, let’s just leave it there, even though there are many other financial instruments that fall under this definition.
Broadly speaking, the Securities Act requires companies that issue securities (known as “issuers”) to make minimum disclosures to buyers and the Exchange Act requires them to continue making disclosures to the public generally. The theory is that so long as enough accurate information is available, investors can be left in charge of protecting themselves, whether they are buying directly from the issuer or from other investors on a stock exchange. This disclosure-based, buyer beware approach has been the cornerstone of U.S. securities regulation for almost a hundred years now. It makes sense, but, as with all things, the devil is in the details. The details, some say, tend to stifle markets and startup companies in particular. The two principal targets of the JOBS Act were impediments to startup fundraising and the burdens of Sarbanes Oxley compliance. The fundraising impediments come from the Securities Act while the SOX problems come through the Exchange Act.
Fundraising under the Securities Act
– Public Offerings
The Securities Act forces companies to make disclosures to buyers of their securities. It does this by outlawing all sales of securities unless the issuer has completed a registration with the Securities and Exchange Commission or a specific exemption applies. The registration statement is a complex and expensive document to prepare. It requires a whole team of investment bankers, accountants and lawyers, plus the issuer’s senior management, anywhere from three months to a year to prepare. Each line of text and every table of numbers is painstakingly reviewed for accuracy and potential to mislead investors or generate lawsuits. Accordingly, a registration statement under the Securities Act is quite beyond the resources of most young companies; it is only prepared for the company’s first sale of securities to the public, an “initial public offering” known as an “IPO”.
– Private Offerings
We all know that startups sell securities without registering under the Securities Act. They do this through one or more specific exemptions from registration that are contained in the Act itself. Probably the most well-known exemption is Section 4(2) of the Securities Act, which exempts “transactions by an issuer not involving any public offering.” The next question is, obviously, “What is a “public offering?” Unfortunately, the Securities Act doesn’t tell us and the SEC won’t. They feel that it’s better to keep people guessing and, on the advice of counsel, erring on the side of caution. Even now, the SEC will often settle enforcement actions rather than let the case go to court – a court opinion could upset decades of SEC policy, after all.
Nevertheless, the SEC has used its rulemaking authority to define some things that are not “public offerings.” These so-called “safe harbors” account for most of the unregistered, or “private” offerings of securities in the U.S. In Regulation D, the SEC has created a set of detailed steps that, if followed precisely, mean that an offering will not be a “public offering” and will fall within the Section 4(2) or other exemptions. The JOBS Act essentially forces a change in Reg D to permit advertising even during a supposedly “private” placement of securities that is not a public offering.
– Reg D / Section 4(2)
Regulation D actually includes several different safe harbors that technically fall under different sections of the Securities Act. The JOBS Act modifies Rule 506 which currently allows unlimited offers and sales of securities to so-called “accredited investors” and to no more than 35 non-accredited investors. The term “accredited investor” includes individuals with a net worth exceeding $1 million or with an income exceeding $200,000 (or $300,000 in joint income with a spouse). It is intended to cover sophisticated individuals that are wealthy enough to hire their own advisors and lawyers to protect their interests. These people, the reasoning goes, can demand the same level of information that would be in a registration statement filed with the SEC and so it would be wasteful to force companies to prepare and file one.
As a further condition, Rule 506 prohibits “general solicitation” and “general advertising” such as seminars open to the public and newspaper or broadcast advertisement. The JOBS Act requires the SEC to modify Rule 506 to remove this limitation but only if “all purchasers of the securities are accredited investors.” So, a general advertisement can be made, but only accredited investors can actually purchase.
There are some interesting conundrums for practitioners. Traditionally, a Rule 506 offering is made solely to accredited investors and perhaps a handful (but always less than 35) of specific non-accredited investors who might literally be friends and family. Because the 35-person limit for non-accredited investors applies to both offers and sales, any non-accredited investor who receives an offer “counts” for purposes of computing the limit even if they don’t buy. Most practitioners prefer to avoid non-accredited investors entirely just to avoid the danger of inadvertently going over the limit and also to keep a few in the “back pocket” in case some accredited investors turn out to be too poor to be accredited. In that event an “unused” non-accredited investor slot could save the entire fundraising from violating the Securities Act. By requiring that all purchasers be accredited investors, the JOBS Act takes away some of the safety net.
Perhaps for this very reason, the JOBS Act also mandates that the SEC rule changes require issuers to take “reasonable steps” to verify that purchasers are accredited investors. Going even further, the Act tasks the SEC with identifying these “reasonable steps.” So, the JOBS Act almost places the burden on the SEC to create a very explicit “paint by numbers” system. On the other hand, the SEC could punt on the question by issuing a vague rule calling for some discretion on the issuer’s part.
– Reg D / Section 3(b)
While Rule 506 and Section 4(2) exempt types of transactions, Section 3(b) of the Securities Act, now renumbered as 3(b)(1), allows the SEC to exempt types of transactions so long as the total amount of securities is limited to $5 million. Under that authority, the SEC issued two additional rules as part of Reg D. Rule 504 exempts offerings by issuers of up to $1 million solely in compliance with state securities laws while Rule 505 exempts offerings by issuers of up to $5 million to no more than 35 purchasers and without any general solicitation or general advertising.
Some commentators have implied that the JOBS Act raises the Rule 505 limit of $5 million to $50 million. Actually, the JOBS Act leaves Rule 505 untouched, but adds a new Section 3(b)(2) to the Securities Act which requires the SEC to issue rules for a new exemption for offers of up to $50 million. The statute spells out that public offers, sales and solicitations must be allowed, and that the securities can be freely resold without the need for a Section 4(1) exemption that would apply to most other exempted securities. However, this new exemption is not a free ride. The SEC must require the issuer to publicly file annual audited financials and “may” require that issuers also deliver an offering document to purchasers which must also be publicly filed and “may” require such issuers to also make periodic public filings. Given the SEC’s mission to protect investors, I read “may” as “definitely will.” This all begins to sound very much like the registration statement and annual reports already required of public companies. Presumably, the SEC will generate some form of abbreviated or fast-track version of the current process.
– Section 4(1), the 4“(1½)” exemption, and its future on Craigslist
Most readers who are still following this at all probably did not notice one important part of the 4(2) exemption. Here it is again with some emphasis added: “transactions by an issuer not involving any public offering” do not require registration with the SEC. Okay. So, what happens if I want to sell stock that has never been registered with the SEC and was not purchased under the new Section 3(b)(2) exemption? Remember, the Securities Act outlaws all sales of securities unless the issuer has completed a registration with the SEC or a specific exemption applies. I’m not the issuer, so I can’t use the 4(2) exemption or any SEC safe harbors, such as Reg D, that apply only to issuers of securities.
Some readers will suddenly understand the importance of the “registration rights” that they obtained when they bought shares in their startup company. A registration right is the ability to force a corporation to file a registration statement with the SEC so the investor can legally sell the corporation’s shares to the public. Startup companies commonly grant registration rights to investors when they conduct a large financing round. If you don’t have registration rights or if you decide not to exercise your rights, you probably need to sell under Section 4(1) of the Securities Act.
Section 4(1) exempts transactions by any person other than an issuer, underwriter, or dealer. Unfortunately for would-be sellers, the term “underwriter” is defined to include anyone who purchased securities with the intention of distributing them. Because most investors in fact intend to resell their shares eventually, the definition could include just about everyone who ever bought unregistered securities from the issuer. Luckily, the SEC has created another safe harbor in Rule 144 which, in broad strokes, allows a security holder to sell his or her securities after holding them for at least six months to a year. As usual, there are prickly details that can trip up your plans, but we won’t go through them here. Just be sure to consult a securities lawyer before you hang your hat on Rule 144.
The more interesting approach is to use the Section 4(1) exemption alone, without relying on Rule 144. First, there is the so-called “naked” 4(1) exemption. Just sell the shares and swear on a stack of bibles that you are not an underwriter. Hope fervently that the SEC agrees with you or at least gives you a pass. This is equivalent to walking a tightrope without a net and is not for the faint of heart. It is an act of desperation. The second approach is much better; follow in the footsteps of the elders and clothe yourself in the almost respectable 4 “(1½)” exemption.
The first thing to remember about the 4(1½) exemption is that there is no 4(1½) exemption. The ½ refers to a set of practices developed by securities lawyers that is intended to generate evidence that the seller did not originally purchase the shares with a view to distributing them and so, logically, cannot be an “underwriter” within the meaning of the Securities Act. To cut to the quick, the seller pretends that he is the issuer and wants to use a 4(2) exemption. So, sell only to accredited investors and do not engage in any form of general solicitation or general advertising. This has all been tacitly allowed by the SEC for decades.
Getting back to the JOBS Act, we can speculate that with general solicitation and advertising permissible for issuers, it may become possible for resellers to also solicit and advertise their shares before eventually selling to accredited investors. Conceptually, it seems only fair, but in practice it is far more likely that an individual seller would forego the expense of hiring an attorney to properly document and structure a new-fangled 4(1½) exemption with the result that Craigslist could become as popular for resales of unregistered securities as it is now for cheap apartments, used cars and other low-end purchases.
– Rule 144A
Rule 144A is yet another safe harbor under Section 4(1) which allows investors to avoid becoming “underwriters.” The rule was designed to facilitate a liquid electronic market in unregistered securities among very large institutions known as “qualified institutional buyers” or QIBS. These institutions, like accredited investors, would theoretically not need the full protection of a registration statement filed with the SEC. Rule 144A has become a significant vehicle for large transactions and a mainstay for foreign companies that sell shares into the United States without listing shares on a U.S. stock exchange.
The practice is to prepare a disclosure document under the home country’s regulatory regime (Hong Kong, for example), have a U.S. securities lawyer review and “improve” it to meet or at least approximate the requirements of a U.S. IPO and then add a new cover and additional disclaimers and risk factors based on U.S. practice in order to meet the Rule 144A requirements. The U.S. “wrap” is distributed to QIBS in the U.S. but not circulated to anyone else. The JOBS Act also changes this by requiring rule changes that permit general solicitation and general advertising of Rule 144A offerings and permit offers to any investor. Actual sales, however, are still limited to QIBS.
What it all means
– May Flowers
What will these changes mean? Obviously, we can’t know in advance and certainly not before the SEC issues its rules, due 90 days from the Act’s passage. But it’s always fun to speculate. I put myself in the optimist’s camp here and see this as a way to achieve far greater transparency in the financial markets, and perhaps far more de facto regulation of unregistered offerings than anyone seems to realize.
For starters, if “private” offerings can be advertised, many issuers will be inclined to do so. A greater awareness of an ongoing offering is likely to attract a greater number of accredited investors or QIBS who will bid up the price of the issuer’s securities. As a result, the general public will probably learn a lot more about how the Wall Street world works. Not many non-accredited investors (and not so many accredited investors either) have seen a private placement memorandum and very few have read a 144A PPM, but that will probably change. Under cover of the JOBS Act, a PPM can be circulated freely and receive public comment and analysis to be digested by accredited and non-accredited investors alike. Companies that release their PPMs will, in fact, establish a track record among industry followers that could help support interest and make an eventual IPO a success. Conversely, the market can identify duds early and cut off funding before unworthy companies reach an IPO where they can sell to the general public that will, presumably, be less well-informed. Investors will probably also become more familiar with overseas companies accessing the 144A markets.
Perhaps more importantly, scholars, economists and researchers will also have access to an entire area of the economy that has been essentially hidden from view based on legal restrictions. The conclusions that they reach will be available to us all, including our legislators.
– Rule 10b-5
All this public disclosure of private offerings should be a good thing for everyone. After all, the received wisdom is that “all publicity is good publicity.” Many commentators on the JOBS Act seem to leave it at that, but, as a lawyer, I would point out that Rule 10b-5 still applies to disclosures under private offerings.
For those not in the know, Rule 10b-5 is the rule you already know. This SEC rule was issued under the Exchange Act and prohibits insider trading (you knew that). It is, in fact, much broader. The rule prohibits fraud, untrue or misleading statements or omissions, and anything at all that, “would operate as a fraud or deceit upon any person.” The only way to avoid the rule when buying or selling securities is to also avoid any “means or instrumentality of interstate commerce.” So, if you can do the whole thing without using a telephone, the mail or the internet, you can escape liability. Not gonna happen.
The long term result, as I predict it, will be that companies raising money in a “private” offering will release information designed to comply with Rule 10b-5. The best guidance we have on how to do that is to comply with the spirit, and perhaps even the letter, of the disclosure requirements that would apply to a registered public offering. This is actually the main justification for having a U.S. lawyer review foreign disclosure documents destined for use in a Rule 144A offering. This is what I mean by de facto regulation. The benefit of casting a wider net through general solicitation and advertising will prompt greater public and regulatory attention, thereby forcing stricter compliance with general antifraud rules and resulting in public-offering caliber disclosure. At least for mainstream, reputable companies.
But what about the short term and less reputable companies? In the short term, the pessimists are probably correct – the JOBS Act is a bonanza for practitioners of fraudulent securities offerings.
– April Showers
You’ve probably been imagining this whole rosy regulatory picture in the framework of companies like Apple, Google or even the next Apple or Google (as yet unknown). The pessimists aren’t worried about those companies. Those companies are real, with real products and services that deliver real value to investors and consumers. The pessimists are more worried about the very, very small companies you never heard of. In fact, most of the companies involved either don’t exist yet or, when they do exist, will be phony shell companies that suck in investor dollars and disappear. In short, the pessimists are worried about a fool and his money.
Sadly, the pessimists are right to worry. Securities fraud accounts for several billion dollars in investor losses every year, not even counting the headline acts of recent years like Bernie Madoff. You can read an overview from the SEC here, or you can look at some old articles of my own here and here. The problem is called “microcap fraud” or “penny stock fraud” because the companies involved have very low share prices. Many are not listed on any exchange and even those that are listed have few investors, a single broker that handles all trades and zero to one independent researcher that follows them. This means that it is easy – way too easy – for management, a major shareholder or the securities broker to manipulate the market. It is not an exaggeration to say that often all of the above, aided by associates in organized crime, cooperate to spread rumors, drive up share prices, sell shares to unsophisticated investors and then dump their own shares at a profit. And that’s just the classic “pump and dump” scheme as depicted in season 2 of The Soprano’s. It really happens. A lot.
The SEC enforcement division is hopelessly outnumbered by the crooks. Allowing organized teams of practiced fraudsters to openly invite unsophisticated investors to sales meetings can only add fuel to the fire. If even one accredited investor (planted by the organizers) buys stock, the whole meeting becomes almost untouchable from a legal standpoint. The additional changes that the JOBS Act makes for crowdfunding and delaying application of the Exchange Act become outright terrifying to anyone who knows the shady underside of our financial markets. Hence the widely divergent views on the likely effects of the JOBS Act. An optimist looks forward to seeing a more vibrant private offering market that, through the magic of efficient market theory, will channel money quickly to the most innovative and competitive new companies. The pessimist looks at the already vibrant fraudulent market and sees it booming even more.
The Federal Trade Commission issued a 112-page report on 3/26/12 entitled “Protecting Consumer Privacy in an Era of Rapid Change: Recommendations for Businesses and Policymakers.” While not announcing any new binding legal requirements, the report provides an indication of the FTC’s thinking and the evolving direction of U.S. privacy law.
The FTC report indicates that the agency will be focusing its efforts in the following areas: Do-Not-Track; Mobile; Data Brokers; Large Platform Providers; and Promoting Enforceable Self-Regulatory Codes.
If you have any questions, please contact us at email@example.com.
The FTC will be hosting a workshop: “Advertising Disclosures in Online and Mobile Media” on May 30, 2012 in Washington, DC and via webcast. This could be an opportunity to understand FTC thinking and influence upcoming FTC guidelines in this area.
Most of the corporate lawyers I meet are a fairly sincere bunch. We like solving problems. We actually do like helping people and are never so excited as when we get to work on an interesting problem; and never so enervated as when the drudgery keeps coming and it seems that no-one outside of legal will even talk to us. Why is it that an engineer with the same personality type has the whole “nerd/cool” thing going for him but we lawyers are in a constant battle to just connect outside legal and disprove negative expectations?
The most common reason Counsel stays out of touch is what I call the Absolution Fallacy – and we do it to ourselves.
Following years of training in law school and private practice (and uncounted earlier years of television courtroom dramas), corporate attorneys often buy in to a flawed professional paradigm. The paradigm views the lawyer as impartial and non-judgmental and adhering to these supposed virtues is the highest professional aim. Taken to an extreme, the lawyer becomes disinterested and from there it’s a short step to being disconnected and even noncommittal. This might begin to sound familiar; we have all known lawyers like this and they are never first pick for staffing new matters. Attorneys persist because this “professional code” absolves them from the responsibility of decision-making and absolves them from the consequences of bad decisions.
The Absolution Paradigm arises from our very carefully constructed criminal law system which is founded on the proposition that government is the single greatest enemy of individual freedom. Hence, Blackstone’s famous formulation, “better that ten guilty persons escape than that one innocent suffer.” The system presumes that accused criminals are innocent until proven guilty and requires lawyers to provide a zealous defense, even though many (about ten out of eleven if Blackstone was correct) are probably guilty and deserve to be punished. This is essentially a distasteful task and is morally burdensome for criminal defense attorneys.
To ease the moral burden, we use a divide and absolve approach. We divide criminal trials into three separate tasks – prosecution, defense and judge. Each of these legal professionals is responsible for only a small piece of the puzzle. The prosecution prosecutes within the limits of the law. The defense zealously defends without regard to guilt while the judge administers the legal rules with a view to preserving the integrity of the system. With such a small piece reserved for each, none of the participants bears moral responsibility if a guilty person goes free to inflict more harm. And just to make absolutely certain, we pass the final buck to a jury of laymen. This is a highly engineered solution to a complex moral issue. The weight of the problem is so severe that even with this Absolution Paradigm at work, criminal defense work is exhausting for even the most committed attorneys over time.
In the corporate setting, the Absolution Paradigm is a disaster because it prevents Counsel from actually counseling. In the corporate setting, there can be no absolution from decision-making and its consequences – the Absolution Paradigm, so useful in criminal law, becomes an Absolution Fallacy.
While it is true that corporate law departments refer to “clients,” this terminology is designed to indicate accountabilities and is unhelpful to the current discussion of responsibilities. In the corporate setting, we are the client. Naturally, lawyers are rarely the sole decision-maker but our views need to be expressed and incorporated into the decision-making process. This includes our views about both the merits and risks of any given corporate action and the more fundamental question of whether it’s a good idea or not. We cannot function simply as a super reference-librarian on steroids, we need to have an opinion that we are willing to both express and communicate.
Think about the role that the General Counsel serves. The GC is typically a strategic resource for the company and not just a technician. GCs even move into the CEO suite. Having legal training does not exempt Counsel from the responsibility to contribute fully to the Corporation any more than an MBA gives its holder a monopoly on business sense. Put yet another way, just because Counsel lacks decision-making authority, doesn’t mean that it is absolved from giving the best decision-making advice possible.
In professional terms, we can look to The Lawyer’s Code of Professional Responsibility which intones that we must, “exercise independent professional judgment on behalf of a client.” The Code very cogently states that, “the essence of the professional judgment of the lawyer is his educated ability to relate the general body and philosophy of law to a specific legal problem of a client.” In short, a lawyer must apply the law to the facts. In the corporate setting, the “facts” are that the organization exists to do business, take risks and, hopefully, make money. Drawing a simile to criminal law, telling a corporation that it cannot go forward with a business strategy is like taking away someone’s driver’s license. If the entire law department is overly cautious, the effect is closer to imprisonment. Corporate Counsel has no business imprisoning its own client.
Delivering usable advice is often challenging, but these challenges are overcome every day. It might be useful to look at how the medical profession overcomes a similar problem. Those of us who have visited the doctor recently have probably noticed an amusing “pain chart” on the wall. Doctors have long had trouble communicating about the degree of pain and discomfort that patients experience. Something that is very painful to you or me might be just a small thing to someone else. The obvious example is when the doctor smiles and says, “This will only hurt a little bit.” This statement is well-meaning, but at the same time practically meaningless. The pain chart bridges the communication gap by showing six cartoon faces in a row, each one drawn with increasing amounts of pain from left to right. The face on the left is entirely happy, while the face on the far right shows a downturned mouth, heavy eyes and tears, clearly in a great deal of discomfort. It’s a simple tool, but extremely effective. Counsel needs to try harder at communicating legal concepts, legal pitfalls and degrees of risk. The pain chart is an example of how creativity can overcome technical barriers.
In exercising professional judgment on behalf of our client, Counsel also needs to fully take onboard the responsibility for the results of legal advice. The most pointed example of this is when we kill a proposal. Personally, I think it would be a useful metric to measure how many proposals the legal department “shoots down” in a year. From there, it is a short step to also measure how many man-hours this legal bloodbath costs other departments. We make no friends when we obstruct the efforts of our colleagues who may have worked for most of the year on a project that we label “risky. All business transactions are risky. It behooves us to understand the nature and degree of risk that our organization will comfortably tolerate and to help decision-makers weigh the risks we see against the benefits that will accrue. Sometimes this means we have to step outside our comfort zone. For example, you might need to leave your office and have a talk face-to-face with the person down the hall. Certainly, foreclosing any avenue or business venture should be a last resort after the other possibilities have been discussed both inside and outside the legal department. Remember, it’s about expanding the top line first and controlling costs to improve the bottom line second. Counsel’s worries about inchoate downside risk probably don’t even come in third.
In many negotiations, we see a standard comment come back from the other side – make the indemnities mirror images so each party gives exactly the same indemnity to the other. This may sound like a reasonable proposal and can be hard to resist when you are under pressure to finalize a deal. But before you do, make sure that you understand what you’re giving up. Parties rarely face the same risk.
An indemnity is just a promise to pay someone money. Typically, each party to a contract will indemnify the other for any losses that the other party suffers as a result of the indemnifying party’s breach of the contract, including expenses incurred and reasonable legal fees. The rationale is that it’s only fair that the wrongdoer should bear the resulting costs of both parties. And because everyone who signs a contract bears the same risk that the other party will simply not perform, it’s correct to give mirror-image indemnities here. But what if the risk is not mutual?
This kind of disparity is particularly striking in the B2B context. Imagine a chemical company in Pennsylvania that sells to a diversified materials company in New Jersey. With a standard liability cap, the seller should be able to sleep easy. But the buyer incorporates the chemicals into plastics and specialty materials in the auto, toy, fashion and housewares industries worldwide. When something goes wrong, the buyer’s French customer names both the buyer and the seller in the lawsuit. Let’s assume that neither party is at fault, so the customer will not win. Who should pay the legal fees?
This is probably a risk that the buyer has built into its business; but the seller had no way to predict or insure against a lawsuit in France. Logically, the seller should receive an indemnity from the buyer for third party claims arising from the sale of chemicals to the buyer. This lopsided risk profile arises naturally from the nature of the two businesses. Both companies deal directly with their own customers and can control those relationships, but neither can do anything about risks arising from the other’s customers or business. Given that the seller’s other customers are very unlikely to sue a fellow buyer, a lopsided indemnity is the correct approach.