What Public Comments on the SEC’s Proposed Climate-Related Rules Reveal—and the Impact They May Have on the Proposed Rules

On March 21, 2022, the Securities and Exchange Commission (“SEC”) published for comment its much-anticipated proposed rules on climate disclosures, entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors.”[1]  The SEC invited public comments on these rules, and the response was overwhelming—nearly 15,000 comments were published on the SEC’s website over the course of three months, from individuals and organizations representing all aspects of modern American society.  Few, if any, of the SEC’s rule proposals have ever received such voluminous, significant, and diverse comments.  And the comments themselves range from brief statements to complex legal arguments either in support or in opposition, as well as detailed proposals for further changes to the proposed climate disclosures.  The comment period closed on June 17, 2022, and further action by the SEC to finalize the proposed rule is anticipated this fall.

This article provides a brief summary of the comments, and analyzes and summaries the key points the comments conveyed.

Statistical Analysis of Form and Individualized Submissions

Since the beginning of the public comment period, the SEC has received 14,645 comments on the proposed climate disclosure rules.[2]  To provide some context for how massive that figure is, the SEC has only received 144 comments on its proposed cybersecurity risk management rules, which were announced two weeks before the proposed climate disclosures and have also been the subject of extensive commentary in the press.  Yet despite the prominence of the SEC’s cybersecurity proposal, it has received fewer than 1% of the comments offered on the climate disclosure rule.

Of the 14,645 comments, approximately 12,304, or 84% of the total, are form letters.  This includes 10,589 comments that the SEC itself identified as form letters, and another 1,715 apparently individualized comments that were actually form letters.  However, even when removing these form letters from consideration, fully 2,341 individualized comment letters remain—a substantial number, and a significant percentage (16%) of the volume.[3]

The form letters are worth exploring in more detail.  Of the 12,304 comments, fully 10,861 (88%) broadly express support for the proposed climate disclosure rule, and only 1,443 (12%) are in opposition.  This disparity in the level of support for the two positions is best conveyed by the chart below.

Positions for and against the new SEC Disclosures

Notably, it has been possible to identify some, although not all, of the organizations that sponsored the form letter writing campaign.  In particular, form letters proposed by the Union of Concerned Scientists in support of the proposed climate disclosures were submitted 6886 times—more than 55% of the total volume of form letters.  Additionally, the form letters proposed by the Climate Action Campaign and the National Wildlife Federation in support of the SEC’s proposed disclosures were also quite voluminous among the submissions—1208 and 956 comment letters, respectively.  The most frequent form letters submitted in opposition to the proposed climate disclosure rules—e.g., those proposed by FreedomWorks (348 letters) and the Club for Growth (172 letters)—did not achieve nearly the same volume of submissions.

But the apparent overwhelming majority in favor of the proposed SEC climate disclosure rules, as conveyed by the form letters, is belied by the individualized submissions, which were far more closely divided.  Of the 2341 individualized comment letters submitted, approximately 53% (1238 comment letters) expressed support, about 43% (1015 comment letters) were opposed, and a handful—around 4% (88 comment letters)[4]—did not express a position.  The below chart demonstrates the levels of support expressed by the individualized submissions:

Individual submissions supporting, opposing, and neutral to the new SEC Disclosures

Besides the mere volume of submissions, however, the most noteworthy aspect of the individualized submissions are the substantive arguments—both factual and legal—that these comment letters articulate, whether in support or opposition to the proposed rules, as well as the identity of those making these submissions.

Arguments in Support of the Proposed SEC Climate Disclosure Rules

The organizations and individuals that chose to offer support for the SEC’s proposed climate disclosures represent a wide swathe of society.  Broadly speaking, these proposed climate disclosures attracted support from, among others: Democratic politicianscivil society organizations (such as environmental NGOs), individual corporationsprofessional services organizations, and academics. While the rationales offered by these different groups varied considerably, in part due to their varying perspectives (e.g., environmental NGOs were more concerned with the impact on the transition to a clean-energy environment, while corporations often focused on the consequences of particular aspects of the rules), the individualized comments in support of the proposed disclosures nonetheless shared some common features.

Specifically, there are a number of common arguments that are frequently featured among the 1239 individualized submissions in support of the SEC’s proposed climate disclosures.  Six arguments appear in over 10% of the submissions.  In order of prevalence, these are:

  1. Environmental Protection (347 submissions, 28%): that the proposed rules will help protect the environment
  2. Investor Choice (280 submissions, 23%): that the proposed rules will enable investors to make more informed choices
  3. Investor Protection (263 submissions, 21%): that the proposed rules will enable investors to protect themselves and their investments from climate-related risk
  4. Standardization of Climate Disclosures (259 submissions, 21%): that the proposed rules will enable the standardization of climate disclosures, making data comparable
  5. Increased Transparency (171 submissions, 14%): that the proposed rules will increase transparency and hold companies accountable for their emissions
  6. Alignment with International and Foreign Regulatory Frameworks (169 submissions, 14%): that the proposed rules will bring the United States into alignment with both international frameworks and other countries (e.g., the EU)

No other argument appeared in more than 6% of the individualized submissions in support of the SEC’s proposed climate disclosures.

Notably, the most common arguments in favor of the proposed climate disclosures share a common feature: these are all policy arguments, focusing on the benefits to investors and the broader economy from the adoption of the SEC’s proposed disclosures.  Only a single argument among the top ten most frequent arguments in support was a legal argument—namely that the proposed rules fall within the SEC’s statutory authority—and that argument appeared in only around 3% of the submissions (41 submissions).[5]  This focus on policy benefits among supporters of the SEC’s proposed climate disclosures is unsurprising, as these public policy rationales were a key factor in encouraging the Biden Administration to pursue this regulatory agenda.  However, the reluctance to engage with critics of the proposed climate disclosures on a legal basis may signal the difficulties that the SEC’s proposed climate disclosures may encounter in future court challenges.

Arguments in Opposition to the Proposed SEC Climate Disclosure Rules

Those entities and individuals that submitted individualized comment letters opposing the SEC’s proposed climate disclosures also represent a broad range of American society, albeit with a somewhat different focus.  Generally, individualized letters in opposition to the SEC’s proposed climate disclosures tended to be submitted by, among others: Republican politiciansindividual corporationstrade industry groups, and NGOs. (Unsurprisingly, the fossil fuel industry and extractive industries were particularly well-represented among the commenters.)  These individualized submissions—frequently lengthy and extensively analyzing the SEC’s regulatory practices and authority—shared a number of common themes.

In particular, there are a number of common arguments that featured frequently among the 1014 individualized submissions to the SEC in opposition to these proposed climate disclosures.  Three (3) arguments appeared in more than ten (10) percent of these submissions:

  1. Ultra vires (322 submissions, 32% ): that the SEC lacks the ability to issue these disclosures as the proposed rule is beyond the scope of the SEC’s legal authority
  2. Compliance Costs (218 submissions, 21% ): that compliance with the proposed rule will impose unreasonable and extensive costs on businesses
  3. Climate Science Skepticism (123 submissions, 12%): that the science concerning climate change is unsettled and therefore the proposed rule is inappropriate

Although no other common argument appeared in more than 7% of the individualized letters in opposition, it should still be noted that there were a large number of letters that objected to the increased burdens placed on particular types of businesses, whether farmers (53 submissions, 5%), fossil fuel companies (49 submissions, 5%), or small businesses (36 submissions, 4%).

Overall, it is striking that around a third of the comments submitted in opposition stated that the SEC had acted beyond its authority (ultra vires) in proposing this new rule.  While this critique is hardly novel—it has been a frequent refrain of the Republican SEC Commissioners ever since this topic was first broached—the prevalence of this argument among the individualized comments suggests that both the public and sophisticated market actors perceive this issue as a key vulnerability in the SEC’s proposal, and that this legal argument will likely be emphasized in the inevitable legal challenge to this SEC rule.  And, based on recent decisions by the Supreme Court, it is altogether likely that this line of attack may find a sympathetic audience in the courts.

Potential Changes to the SEC Climate Disclosure Rules Resulting from Public Comments

Despite the differences between the advocates and opponents of the SEC’s proposed climate disclosures, both sides submitted proposals to the SEC to change or adjust the proposed rules.  Although there was often substantial disagreement about the content of these proposed changes, there were also significant areas of convergence.

Some of the changes to the SEC’s proposed climate disclosures frequently submitted by supporters of the rule included:

  1. ISSB: that the SEC should further align its proposal with the ISSB and help create a global standard (76 comments);
  2. Extended Phase-In Period: to extend the phase-in period for these new disclosure requirements (72 comments);
  3. Alignment with International and Foreign Standards: that the SEC should further align its proposal with international and foreign standards, such as the EU or TCFD (66 comments);
  4. Enhance Scope 3 GHG Emissions: to eliminate exemptions so that all companies must disclose Scope 3 GHG emissions (55 comments);
  5. Principles-Based Approach to Materiality: to adopt a principles-based approach to materiality rather than bright-line rules (53) comments;
  6. Remove Scope 3 GHG Emissions: to remove the requirement that Scope 3 GHG emissions be disclosed (36 comments);
  7. Furnish, Not File: that the disclosures be provided in a document that is “furnished” to the SEC, rather than filed (which impacts potential liability) (26 comments).

Although certain proposed changes by proponents of the SEC’s proposed climate disclosure rule are undeniably expected (e.g., removing exemptions for disclosure of Scope 3 GHG emissions), there are others that seem somewhat surprising on initial review (e.g., extending the phase-in period or removing Scope 3 GHG emissions entirely).  This can most easily be explained by the fact that supporters of the SEC’s proposed rule include corporations and other business interests, which will resist certain burdensome regulations even if generally offering support for the overall thrust of the proposal.  There are also academics and others who continue to express skepticism concerning the utility of disclosing Scope 3 emissions, or even whether it can be adequately measured.

It should be emphasized that these changes proffered by supporters of the SEC’s proposed rule, many of which are designed to render the proposed rule less onerous, may indicate that the support for the proposed rule—or at least the most stringent aspects of it—is relatively weak (or at least among the corporate interests nominally aligned with the SEC).

The most frequent changes suggested by opponents of the rule included:

  1. Remove Scope 3 GHG Emissions: to remove the requirement that Scope 3 GHG emissions be disclosed (69 comments);
  2. Principles-Based Approach to Materiality: to adopt a principles-based approach to materiality rather than bright-line rules (35 comments);
  3. Extended Phase-In Period: to extend the phase-in period for these new disclosure requirements (25 comments);
  4. Furnish, Not File: that the disclosures be provided in a document that is “furnished” to the SEC, rather than filed (which impacts potential liability) (18 comments).

These proposed changes (and others) advanced by opponents of the SEC’s proposed rule are generally designed to make the rules less stringent and also to reduce costs and potential legal liability.

As can be seen by comparing the above lists, there are certain areas where suggested changes to the proposed rule converged.  In particular, there are issues where both opponents of the SEC’s proposed rule and some of its supporters would try to render it less intrusive or impactful, particularly with respect to the elimination of the requirement to report Scope 3 GHG emissions and to extend the phase-in period further.  (Although, as noted, this apparent convergence between opponents and supporters of the SEC’s proposed rule may be due to divergent interests among the supporters of the SEC’s proposed rule with respect to its implementation.)

But, regardless of the specific content of the particular proposed changes, what is undoubtedly significant is that these proposed changes have highlighted the aspects of the SEC’s proposed climate disclosure rule that are likely most sensitive to regulated corporations.  Such an insight reveals not only the areas where active lobbying is most likely to take place, but also previews probable priorities for corporate compliance departments.  In effect, focusing on the aspects of the proposed rule where changes were proposed is a means to identify the key issues from the perspective of the regulated entities and the public at large.

Conclusion

The level of engagement with the SEC’s proposed climate disclosures, as demonstrated by the number and detail of the public comments offered, is extraordinary. This degree of attention indicates the significant impact that is expect to result from the ultimate promulgation of these rules (or a revised version thereof).

Of course, the key question here is what changes, if any, are likely to be made to the SEC’s proposed rule based upon the public comments submitted to the SEC.  In this context, it is noteworthy that a handful of key issues have been identified by both proponents and opponents of the proposed disclosures as especially ripe for potential revision.  As noted above, these include, among others, the length of the phase-in period and the disclosure of Scope 3 GHG emissions.  If any changes are to be made to the SEC’s proposed climate disclosure rule, it is likely that such changes will be related to these issues.

However, given the relative lack of forward momentum with respect to other aspects of the Biden Administration’s climate agenda, there may well be political pressure not to weaken or otherwise rollback the SEC’s proposed rule, as this is one of the few areas where significant—and publicly-recognized—progress has been made with regulations designed to address the issue of climate change.  Further, the Biden Administration’s SEC has certainly recognized the inevitability of a legal challenge to these proposed climate disclosures, and, since no degree of alteration would suffice to preempt such a lawsuit, the SEC may conclude that it is better to seek to implement all aspects of the proposed regulation for the political benefit that can be achieved in the short term, since the substantive aspects of the proposed disclosure may not ultimately survive judicial scrutiny.  The SEC may also prefer to send a strong signal to the market by maintaining its original proposed rule.  Recognizing these pressures, it seems unlikely that the public comments submitted to the SEC will have a significant impact on the final rule promulgated in the coming months—and improbable that the SEC will make the proposed disclosures less robust.


FOO​TNOTES

[1] These proposed rules are discussed more fully in our prior publication:  https://www.mintz.com/insights-center/viewpoints/2451/2022-03-30-brief-summary-secs-proposed-climate-related-rules

[2] Although the total number of comments, when including both form letters and individualized letters, is 14,739, there are 94 comment letters on the SEC website that are duplicates, and have thus been removed from the calculation.

[3] For comparison, the proposed SEC rule on disclosing compensation ratios drew about 300,000 form letters and around 1500 individualized comment letters.  In this case, the individualized comment letters represented only about 0.5% of the total volume.  https://www.sec.gov/comments/s7-07-13/s70713.shtml

[4] The eighty-eight comment letters that did not adopt an express position on the proposed climate disclosure rules instead conveyed a number of different points, including proposing narrow changes to the proposed rule without taking a stance on the rule as a whole, or offering further context for the SEC’s actions (e.g., comparing the SEC to other regulators, whether domestic or international).  This category also includes a number of early comments that simply requested that the SEC extend the deadline for submitting comments.

[5] There are public comments in support of the proposed rule that focus on the legal issues.  In particular, the submission of Prof. John Coates of Harvard Law School, a former SEC official, is devoted exclusively to defending the legal authority of the SEC to issue the proposed climate disclosure rule. https://www.sec.gov/comments/s7-10-22/s71022-20130026-296547.pdf

©1994-2022 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

A Fool in Idaho; SEC Sues Idahoans for Insider Trading Scheme

In July 1993 two brothers, David and Tom Gardner, and a friend, Erik Rydholm, founded a private investment advisory firm in Alexandria, Virginia. They named that firm Motley Fool after the court jester in “As You Like It,” a play written by William Shakespeare (it is believed in 1599). The Motley Fool, or Touchstone as he is known in the play, was the only character who could speak the truth to Duke Frederick without having his head cut off. Similarly, Motley Fool, the advisory firm, sought to give investors accurate advice, even if it flew in the face of received wisdom. For example, in advance of April Fool’s Day 1994, Motley Fool issued a series of online messages promoting a non-existent sewage-disposal company. The April Fool’s Day prank was intended to teach investors a lesson about penny stock companies. The messages gained widespread attention including an article in The Wall Street Journal.

Over time Motley Fool grew into a worldwide subscription stock recommendation service. It now releases new recommendations every Thursday, and subscribers receive them through computer interfaces provided by Motley Fool. The terms of service in a Motley Fool subscription agreement (in the words of the May 3, 2022 Complaint brought by the U.S. Securities and Exchange Commission [“SEC”] in the Federal Court for the Southern District of New York) “expressly prohibit unauthorized access to its systems.”  David Lee Stone of Nampa, Idaho (southwest of Boise), is a 36-year-old computer design and repair person with a degree in computer science.  Since June 2021, he and his wife have lived periodically in Romania, a fact cited in the Complaint, suggesting, perhaps, some involvement with Romania-based computer hackers. In any event, Stone is alleged in the Complaint to have used deceptive means beginning in November 2020 to obtain pre-release access to upcoming Motley Fool stock picks. Using that information, Stone and a co-defendant made aggressive investments, typically in options, which generated more than $12 million in gains. Stone, his codefendant, and his family and friends all benefited financially from knowing in advance the Motley Fool picks.

The SEC seeks injunctions against Stone and his co-defendant, as well as disgorgement with interest and civil penalties, for violating the antifraud provisions of federal law. The Commission also seeks disgorgement with interest from the family and friends. In addition, the U.S. Attorney for the Southern District of New York has filed criminal charges against Stone.

This case is in many ways reminiscent of the 1985 federal prosecution by the U.S. Attorney for the Southern District of New York (who happened to be Rudolph Giuliani at the time) of R. Foster Winans. Winans was, from 1982 to 1984, the co-author of “Heard on the Street,” a column in The Wall Street Journal. Winans leaked advance word of what would be in his column to a stockbroker who then invested with the benefit of that information, sharing some of the profits with Winans. Winans argued that his actions were unethical, but not criminal. He was found guilty of insider trading and wire fraud and was sentenced to 18 months in prison. He appealed his conviction all the way to the U.S. Supreme Court, which upheld the lower court rulings.

Attempting to profit on market sensitive information can be both a civil and a criminal offense. The SEC Enforcement Division and the relevant U.S. Attorney are prepared to introduce a perpetrator to those consequences.

©2022 Norris McLaughlin P.A., All Rights Reserved

CFTC Wades Into Climate Regulation

On June 2, 2022, the Commodities Futures Trading Commission (CFTC) issued a Request for Information (“RFI”) for “public comment on climate-related financial risk to better inform its understanding and oversight of climate-related financial risk as pertinent to the derivatives markets and underlying commodities markets.”  According to the RFI, the CFTC is contemplating “potential future actions including, but not limited to, issuing new or amended guidance, interpretations, policy statements, regulations, or other potential Commission action within its authority under the Commodity Exchange Act as well as its participation in any domestic or international fora.”

Specifically, the RFI issued by the CFTC is quite wide-ranging, and engages with numerous aspects of the CFTC’s authority, focusing on both systemic and narrow issues.  For example, the CFTC has, among other things, issued a broad request for comment on how “its existing regulatory framework and market oversight . . . may be affected by climate-related financial risk” and “how climate-related financial risk may affect any of its registered entities, registrants, or other market participants, and the soundness of the derivatives markets.”  It is hard to imagine a broader request by the CFTC–it is effectively asking for input on how “climate-related financial risk” may impact any portion of its regulatory purview.  Conversely, the CFTC has also posed very specific questions, including as to how the CFTC “could enhance the integrity of voluntary carbon markets and foster transparency, fairness, and liquidity in those markets,” and how it could “adapt its oversight of the derivatives markets, including any new or amended derivative products created to hedge-climate-related financial risk.”  In short, based upon the RFI, the CFTC could conceivably adopt a narrow or broad view of how it should adjust its regulations to account for climate-related financial risk.  Notably, however, the CFTC also asked if there were “ways in which updated disclosure requirements could aid market participants in better assessing climate-related risks,” which suggests that the CFTC may echo the SEC’s recent proposed rule for mandatory climate disclosures.

Most significantly, the fact that yet another financial regulatory agency is focused on “climate-related financial risk” suggests that the Biden Administration is willing to expend significant resources and energy in engaging in this type of regulation to advance its climate agenda.  When considered in tandem with the SEC’s recent proposed rules for mandatory climate disclosures and to combat greenwashing, it is apparent that there is a significant regulatory focus on climate issues and the financial markets.  This move by the CFTC also suggests that the Biden Administration will fully support the SEC’s proposed rules against the inevitable legal challenge.  (And, based upon the concurrences of the Republican CFTC commissioners to this RFI, it is likely that any climate-related regulation proposed by the CFTC will also be subject to legal challenge, likely on the grounds that such a regulation exceeded the CFTC’s authority.)  Most importantly, this move by the CFTC–that seeks to “understand how market participants use the derivative markets to hedge and speculate on various aspects of physical and transition [climate] risk”–demonstrates that the regulatory focus on climate and the financial markets will remain a top priority for the foreseeable future.

The Commodity Futures Trading Commission today unanimously voted to release a Request for Information (RFI) to seek public comment on climate-related financial risk to better inform its understanding and oversight of climate-related financial risk as pertinent to the derivatives markets and underlying commodities markets.

©1994-2022 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

Constitutionality of FTC’s Structure and Procedures Under SCOTUS Review

Both the Federal Trade Commission (FTC) and the Antitrust Division of the Department of Justice (DOJ) have authority to enforce Section 7 of the Clayton Act by investigating and challenging mergers where the effect of such transaction “may be substantially to lessen competition or tend to create a monopoly.”

However, the enforcement paths of these two federal agencies differ markedly. DOJ pursues all aspects of its enforcement actions in the federal court system. The FTC, on the other hand, only uses the federal district courts to seek injunctive relief, but otherwise follows its own internal administrative process that combines the investigatory, prosecutorial, adjudicative, and appellate functions within a single agency.

Whether a transaction is subjected to DOJ or FTC review is determined by a “clearance” process with no public visibility. To many, including entities in the health care industry—and, in particular, parties to hospital mergers that are now routinely “cleared” to the FTC (exemplified by two recently filed enforcement actions against hospitals in New Jersey and Utah)—this process appears to be arbitrary. It is also particularly daunting because the FTC has not lost an administrative action in over a quarter-century. Because of the one-sided nature and duration of these administrative proceedings, most enforcement actions brought against merging hospitals rise or fall at the injunctive relief stage. This process also appears to embolden the FTC into taking unprecedented actions, including the pursuit of enforcement remedies against parties to abandoned transactions.

However, this may soon change. The Supreme Court of the United States has agreed to hear a case that raises a forceful constitutional challenge to the FTC’s structure and procedures. The Supreme Court recently agreed to combine the briefing schedule of this case with a similar case that successfully challenged the constitutionality of the administrative process of the Securities and Exchange Commission. The outcome of these cases may fundamentally alter the FTC’s enforcement process.

©2022 Epstein Becker & Green, P.C. All rights reserved.

Hackers Go Phishing in Beeple’s Deep Pool of Twitter Followers

“Stay safe out there, anything too good to be true is a … scam.” Beeple, a popular digital artist, tweeted to his followers, addressing the phishing scam that took place on May 23, 2022, targeting his Twitter account. The attack reportedly resulted in a loss of more than US$400,000 in cryptocurrency and NFTs, stolen from the artist’s followers on the social media website.

After hacking into Beeple’s Twitter account, perpetrators tweeted links from the artist’s page, promoting a fake raffle for unique art pieces. The links would reportedly take the user to a website that would drain the user’s cryptocurrency wallet of their digital assets.

Phishing scams for digital assets, including NFTs or non-fungible tokens, have steadily increased, with funds as large as $6 million being stolen. Various jurisdictions have adopted privacy and security laws that require companies to adopt reasonable security measures and follow required cyber incident response protocols. A significant part of these measures and protocols is training for employees in how to detect phishing scams and other hacking attempts by bad actors. This incident is a reminder to consumers to exercise vigilance, watch for red flags and not click on links without verifying the source.

The remaining summaries of news headlines are separated by region for your browsing convenience. 

UNITED STATES

Relaxed Deaccessioning COVID-19 Exemptions Expire

The global COVID-19 pandemic brought many changes, including dire financial consequences of the shutdowns for museums. In April 2020, the Association of Art Museum Directors (AAMD) made a decision to ease the rules that dictate how museums may use proceeds from art sales. Until April 2022, museums were permitted to use the funds for “direct care of collections” rather than to procure new artworks for their collections.

This relaxed policy and some of the museums that followed it met with backlash on more than one occasion; others, however, advocate for its continuation, citing considerations of diversity and inclusion. Some further argue that a policy born out of financial desperation should be continued to provide museums with the means to overcome any future financial issues that may arise.

Given that “direct care” is vague and open to interpretation, opponents of the relaxed rules counter giving museums such latitude to decide on the use of the proceeds, as it can lead to abuses and bad decisions. While AAMD has returned to its pre-pandemic regulations, and museums have followed suit, it appears that the public debate around deaccessioning is far from over.

Inigo Philbrick Sentenced to a Prison Term

Former contemporary art dealer Inigo Philbrick was sentenced by a federal court in New York to serve seven years in prison for a “Ponzi-like” art fraud, said to be one of the most significant in the history of the art market, with more than an estimated US$86 million in damages. Philbrick stood accused of a number of bad acts, including forging signatures, selling shares in artworks he did not own and inventing fictitious clients.

New York Abolishes Auction House Regulations

As the U.S. government is studying whether the art market requires further regulations to increase transparency and to combat money laundering, New York City repealed its local law that required auctioneers to be licensed and required disclosures to bidders, including whether an auction house had a financial stake in the item being auctioned. While the abolition of the regulation was ostensibly to improve the business climate after the pandemic, some commentators note that the regulations were outdated and not serving their purpose in any event. As an illustration, a newcomer to an auction will likely struggle to understand the garbled pre-action announcements or their significance. Whether the old regulations are to be replaced with new, clearer rules remains to be seen.

EUROPE

Greece and UK to Discuss Rehoming of Displaced Parthenon Marbles

The Parthenon marbles, also known as the Elgin marbles, have been on display in London’s British Museum for more than 200 years. These objects comprise 15 metopes, 17 pedimental figures and an approximately 250-foot section of a frieze depicting the birthday festivities of the Greek goddess Athena. What museum goers might not know is that these ancient sculptures were taken from the Acropolis in Greece in 1801 by Lord Elgin.

Previously, the British government, seeking to retain the sculptures, relied on the argument that the objects were legally acquired during the Ottoman Empire rule of Greece. However, for the first time, the UK has initiated formal talks with Greece to discuss repatriation of the Parthenon sculptures. These discussions are expected to influence future intergovernmental repatriation negotiations.

ASIA

Singapore High Court Asserts Jurisdiction over NFTs after Ruling Them a Digital Asset

The highest court in Singapore has granted an injunction to a non-fungible token (NFT) investor, Janesh Rajkumar, who sought to stop the sale of an NFT that once belonged to him and was used as collateral for a loan. The subject NFT from the Bored Ape Yacht Club Series is a rarity, as it depicts the only avatar that wears a beanie. Rajkumar now is seeking to repay the loan and have the NFT restored to his cryptocurrency wallet. The loan agreement specified that Rajkumar would not relinquish ownership of the NFT, and should he be unable to repay the loan in a timely manner, an extension would be granted. Instead of granting Rajkumar an extension, the lender, who goes by an alias “chefpierre,” moved to sell the NFT. The significance of the Singapore court’s decision is two-fold: the court has (1) recognized jurisdiction over assets cited in the decentralized blockchain, and (2) allowed for the freezing order to be issued via social media platforms.

THE MIDDLE EAST

Illegal Trading Leads to Raiding of Antique Dealer by the Israeli Authorities

A recent raid on an unauthorized antiquities dealer in the city of Modi’in by the Israel Antiquities Authority recovered hundreds of artifacts of significant historical value, including jewelry, a bronze statue and approximately 1,800 coins. One the coins is a nearly 2,000-year-old silver shekel of great historical significance. The coin is engraved with the name Shimon, leader of the 132–136 C.E. Bar Kokhba revolt.

Investigations are ongoing to determine where the antiquities were obtained. The Antiquities Robbery Prevention Unit intends to charge the dealer and their suppliers upon obtaining this information.

© 2022 Wilson Elser

Suing Attorneys In Texas For Participating in Fiduciary Breaches

It is not uncommon for an attorney to execute all or part of his or her client’s wishes, which may be in breach of a fiduciary duty owed by the client to a third party. The third party can certainly sue the client for breaching fiduciary duties. But can the third party also sue the attorney for participating in the client’s actions?

An officer or director of a company may set up a competing business and direct company business to the new competing business. If the officer or director uses an attorney to set up this business and the attorney knows that new business will be used to usurp opportunities, can the company sue the attorney for facilitating the creation of the new business? What if the attorney is an owner of the new company or works for the new company in a nonlegal position?

Certainly, Texas has legal theories that can hold a party liable for participating with a fiduciary in breaching duties owed by the fiduciary. There is a claim for knowing participation in a breach of fiduciary duty. See Kinzbach Tool Co. v. Corbett-Wallace Corp., 138 Tex. 565, 160 S.W.2d 509, 514 (1942); Paschal v. Great W. Drilling, Ltd., 215 S.W.3d 437, 450 (Tex. App.—Eastland 2006, pet. denied) (holding wife liable for knowing participation in employee’s embezzlement where funds were placed in joint account and wife benefitted from stolen funds). See also Westech Capital Corp. v. Salamone, 2019 U.S. Dist. LEXIS 143577, 2019 WL 4003093, at *1 (W.D. Tex. Aug. 23, 2019) (collecting cases that explain that “Texas appellate courts have routinely recognized the existence of a cause of action for knowing participation in the breach of fiduciary duty.”). The general elements for a knowing-participation claim are: 1) the existence of a fiduciary relationship; 2) the third party knew of the fiduciary relationship; and 3) the third party was aware it was participating in the breach of that fiduciary relationship. D’Onofrio v. Vacation Publ’ns, Inc., 888 F.3d 197, 216 (5th Cir. 2018); Meadows v. Harford Life Ins. Co., 492 F.3d 634, 639 (5th Cir. 2007). There is also a recognized civil conspiracy claim in Texas. The essential elements of a civil conspiracy are (1) two or more persons; (2) an object to be accomplished; (3) a meeting of the minds on the object or course of action; (4) one or more unlawful, overt acts; and (5) damages as the proximate result. Juhl v. Airington, 936 S.W.2d 640, 644 (Tex. 1996). Finally, there may be an aiding-and-abetting breach-of-fiduciary-duty claim. The Texas Supreme Court has stated that it has not expressly adopted a claim for aiding and abetting outside the context of a fraud claim. See First United Pentecostal Church of Beaumont v. Parker, 514 S.W.3d 214, 224 (Tex. 2017); Ernst & Young v. Pacific Mut. Life Ins. Co., 51 S.W.3d 573, 583 n. 7 (Tex. 2001); West Fork Advisors v. Sungard Consulting, 437 S.W.3d 917 (Tex. App.—Dallas 2014, no pet.). Notwithstanding, some Texas courts have found such an action to exist. See Hendricks v. Thornton, 973 S.W.2d 348 (Tex. App.—Beaumont 1998, pet. denied); Floyd v. Hefner, 556 F.Supp.2d 617 (S.D. Tex. 2008). One court identified the elements for aiding and abetting as the defendant must act with unlawful intent and give substantial assistance and encouragement to a wrongdoer in a tortious act. West Fork Advisors, 437 S.W.3d at 921. Some courts have held that here is no aiding and abetting breach of fiduciary duty claim. Hampton v. Equity Trust Co., No. 03-19-00401-CV, 2020 Tex. App. LEXIS 5674 (Tex. App.—Austin July 23, 2020, no pet.). See also Midwestern Cattle Mktg., L.L.C. v. Legend Bank, N.A., 2019 U.S. App. LEXIS 36966, 2019 WL 6834031, at *7 (5th Cir. Dec. 13, 2019); In re DePuy Orthopaedics, Inc.Pinnacle Hip Implant Prod. Liab. Litig., 888 F.3d 753, 782, 781 (5th Cir. 2018)  For a discussion of these forms of joint liability for breach of fiduciary duty, please see E. Link Beck, Joint and Several Liability, STATE BAR OF TEXAS, 10TH ANNUAL FIDUCIARY LITIGATION COURSE (2015).

It is clear that at least under some theories, that third parties can be held liable for participating in fiduciary breaches with the party owing fiduciary duties. Can the third party be an attorney? Prior to Cantey Hanger, LLP v. Byrd, 467 S.W.3d 477 (Tex. 2015), it was unclear in Texas whether a party could assert a claim against an attorney not representing the party, such as for negligent misrepresentation or aiding and abetting fraud or breaches of fiduciary duty. Some courts allowed the claim if the attorney was committing or participating in fraud. Others did not.

The plaintiff in Cantey Hanger alleged that the attorneys who represented her husband in a divorce proceeding had committed fraud by falsifying a bill of sale to shift tax liabilities from the sale of an airplane from her husband to her. Id. at 479-80. The Texas Supreme Court held that attorney immunity barred the claim because “[e]ven conduct that is ‘wrongful in the context of the underlying suit’ is not actionable if it is ‘part of the discharge of the lawyer’s duties in representing his or her client.’” Id. at 481. The following are key excerpts from the opinion:

Texas common law is well settled that an attorney does not owe a professional duty of care to third parties who are damaged by the attorney’s negligent representation of a client. Barcelo v. Elliott, 923 S.W.2d 575, 577 (Tex. 1996); see also McCamish, Martin, Brown & Loeffler v. F.E. Appling Interests, 991 S.W.2d 787, 792 (Tex. 1999) (explaining that a lack of privity precludes attorneys’ liability to non-clients for legal malpractice). However, Texas courts have developed a more comprehensive affirmative defense protecting attorneys from liability to non-clients, stemming from the broad declaration over a century ago that “attorneys are authorized to practice their profession, to advise their clients and interpose any defense or supposed defense, without making themselves liable for damages.” Kruegel v. Murphy, 126 S.W. 343, 345 (Tex. Civ. App. 1910, writ ref’d). This attorney-immunity defense is intended to ensure “loyal, faithful, and aggressive representation by attorneys employed as advocates.” Mitchell v. Chapman, 10 S.W.3d 810, 812 (Tex. App.—Dallas 2000, pet. denied).

….

In accordance with this purpose, there is consensus among the courts of appeals that, as a general rule, attorneys are immune from civil liability to non-clients “for actions taken in connection with representing a client in litigation.” Alpert v. Crain, Caton & James, P.C., 178 S.W.3d 398, 405 (Tex. App.—Houston [1st Dist.] 2005, pet. denied); see also Toles v. Toles, 113 S.W.3d 899, 910 (Tex. App.—Dallas 2003, no pet.); Renfroe v. Jones & Assocs., 947 S.W.2d 285, 287-88 (Tex. App.—Fort Worth 1997, pet. denied). Even conduct that is “wrongful in the context of the underlying suit” is not actionable if it is “part of the discharge of the lawyer’s duties in representing his or her client.” Toles, 113 S.W.3d at 910-11;

….

Conversely, attorneys are not protected from liability to non-clients for their actions when they do not qualify as “the kind of conduct in which an attorney engages when discharging his duties to his client.” Dixon Fin. Servs., 2008 Tex. App. LEXIS 2064, 2008 WL 746548, at *9; see also Chapman Children’s Trust v. Porter & Hedges, L.L.P., 32 S.W.3d 429, 442 (Tex. App.—Houston [14th Dist.] 2000, pet. denied) (noting that “it is the kind of conduct that is controlling, and not whether that conduct is meritorious or sanctionable”).

Because the focus in evaluating attorney liability to a non-client is “on the kind—not the nature—of the attorney’s conduct,” a general fraud exception would significantly undercut the defense. Dixon Fin. Servs., 2008 Tex. App. LEXIS 2064, 2008 WL 746548, at *8. Merely labeling an attorney’s conduct “fraudulent” does not and should not remove it from the scope of client representation or render it “foreign to the duties of an attorney.” Alpert, 178 S.W.3d at 406 (citing Poole, 58 Tex. at 137); see also Dixon Fin. Servs., 2008 Tex. App. LEXIS 2064, 2008 WL 746548, at *9 (“Characterizing an attorney’s action in advancing his client’s rights as fraudulent does not change the rule that an attorney cannot be held liable for discharging his duties to his client.”).

….

Fraud is not an exception to attorney immunity; rather, the defense does not extend to fraudulent conduct that is outside the scope of an attorney’s legal representation of his client, just as it does not extend to other wrongful conduct outside the scope of representation. An attorney who pleads the affirmative defense of attorney immunity has the burden to prove that his alleged wrongful conduct, regardless of whether it is labeled fraudulent, is part of the discharge of his duties to his client.

Id. at 481-484.

Based on the holding in Cantey Hanger, if an attorney is performing duties that a lawyer would typically perform, the attorney immunity defense would apply. This defense would likewise apply to aiding and abetting fraud and breaches of fiduciary duty. See Kastner v. Jenkens & Gilchrist, P.C., 231 S.W.3d 571, 577-78 (Tex. App.—Dallas 2007); Span Enters. v. Wood, 274 S.W.3d 854, 859 (Tex. App.—Houston [1st Dist.] 2008).

In Bethel v. Quilling, Selander, Lownds, Winslett & Moser, P.C., the Court extended the Cantey Hanger holding to allegations of criminal conduct. 595 S.W.3d 651, 657-58 (Tex. 2020). There, the plaintiff had urged the Court “to recognize an exception” to attorney immunity “whe[n] a third party alleges that an attorney engaged in criminal conduct during the course of litigation.” Id. The Court rejected the invitation to adopt an exception or state a categorical rule because doing so would allow plaintiffs to avoid the attorney-immunity defense through artful pleading—”by merely alleging that an attorney’s conduct was ‘criminal.’” Id. The Court eschewed a categorical exception for criminal conduct because such an exception would defeat the purposes of the attorney-immunity defense. Instead, the Court held that conduct alleged to be criminal in nature “is not categorically excepted from the protections of attorney civil immunity when the conduct alleged is connected with representing a client in litigation.” Id. As we explained there, a lawyer who is doing his or her job is not more susceptible to civil liability just because a nonclient asserts that the lawyer’s actions are fraudulent, wrongful, or even criminal. Id.

In 2021, the Texas Supreme Court further clarified the holding in Cantey Hanger to state that “When an attorney personally participates ‘in a fraudulent business scheme with his client,’ as opposed to on his client’s behalf, the attorney ‘will not be heard to deny his liability’ because ‘such acts are entirely foreign to the duties of an attorney.’” Haynes & Boone, LLP v. NFTD, LLC, 631 S.W.3d 65, 77 (Tex. 2021) (quoting Poole v. Hous. & T.C. Ry. Co., 58 Tex. 134, 137 (1882)). The Court in Haynes & Boone, LLP, also expanded the Cantey Hanger holding to extend to transactional work that the attorney performs, in addition to litigation work covered in the Cantey Hanger opinion:

Today we confirm that attorney immunity applies to claims based on conduct outside the litigation context, so long as the conduct is the “kind” of conduct we have described above. We reach this conclusion because we see no meaningful distinction between the litigation context and the non-litigation context when it comes to the reasons we have recognized attorney immunity in the first place. We have recognized attorney immunity because attorneys are duty-bound to competently, diligently, and zealously represent their clients’ interests while avoiding any conflicting obligations or duties to themselves or others.

Id. at 79.

Most recently, in Taylor v. Tolbert, the Court reviewed whether there was an exception to immunity for private-party civil suits asserting that a lawyer has engaged in conduct criminalized by statute. No. 20-0727, 2022 Tex. LEXIS 385 (Tex. May 6, 2022). The court discussed the immunity defense as follows:

The common-law attorney-immunity defense applies to lawyerly work in “all adversarial contexts in which an attorney has a duty to zealously and loyally represent a client” but only when the claim against the attorney is based on “the kind of conduct” attorneys undertake while discharging their professional duties to a client. Stated inversely, if an attorney engages in conduct that is not “lawyerly work” or is “entirely foreign to the duties of a lawyer” or falls outside the scope of client representation, the attorney-immunity defense is inapplicable.

In determining whether conduct is “the kind” immunity protects, the inquiry focuses on the type of conduct at issue rather than the alleged wrongfulness of that conduct. But when the defense applies, counsel is shielded only from liability in a civil suit, not from “other mechanisms” that exist “to discourage and remedy” bad-faith or wrongful conduct, including sanctions, professional discipline, or criminal penalties, as appropriate.

Conduct is not the kind of conduct attorney immunity protects “simply because attorneys often engage in that activity” or because an attorney performed the activity on a client’s behalf. Rather, the conduct must involve “the uniquely lawyerly capacity” and the attorney’s skills as an attorney. For example, a lawyer who makes publicity statements to the press and on social media on a client’s behalf does “not partake of ‘the office, professional training, skill, and authority of an attorney’” because “[a]nyone—including press agents, spokespersons, or someone with no particular training or authority at all—can publicize a client’s allegations to the media.” Immunity attaches only if the attorney is discharging “lawyerly” duties to his or her client.

A corollary to this principle is that attorneys will not be entitled to civil immunity for conduct that is “entirely foreign to the duties of an attorney.” “Foreign to the duties” does not mean something a good attorney should not do; it means that the attorney is acting outside his or her capacity and function as an attorney. For that reason, whether counsel may claim the privilege turns on the task that was being performed, not whether the challenged conduct was meritorious.

This is so because the interests of clients demand that lawyers “competently, diligently, and zealously represent their clients’ interests while avoiding any conflicting obligations or duties to themselves or others.” To prevent chilling an attorney’s faithful discharge of this duty, lawyers must be able to pursue legal rights they deem necessary and proper for their clients without the menace of civil liability looming over them and influencing their actions. Attorney immunity furthers “loyal, faithful, and aggressive representation” by “essentially . . . removing the fear of personal liability,” thus “alleviating in the mind of [an] attorney any fear that he or she may be sued by or held liable to a non-client for providing . . . zealous representation.” In this way, the defense protects not only attorneys but also their clients, who can be assured that counsel is representing the client’s best interests, not the lawyer’s.

Id. The Court acknowledged that “there is a wide range of criminal conduct that is not within the ‘scope of client representation’ and [is] therefore ‘foreign to the duties of an attorney,’” and that “when that is the case, the circumstances do not give rise to an ‘exception’ to the immunity defense; rather, such conduct simply fails to satisfy the requirements for invoking the defense in the first instance.” Id. “[O]ur approach to applying the attorney-immunity defense remains functional, not qualitative, and leaves an attorney’s improper conduct addressable by public remedies.” Id.

The Court then held that the common-law defense of attorney immunity would still apply to state statutes (unless the statute specifically abrogated that defense). Id. The Court stated:

That does not mean that all conduct criminalized by the wiretap statute is immunized from civil liability or free of consequences. As we explained in Bethel, while criminal conduct is not categorically excepted from the attorney-immunity defense, neither is it categorically immunized by that defense. Criminal conduct may fall outside the scope of attorney immunity, and even when it does not, “nothing in our attorney-immunity jurisprudence affects an attorney’s potential criminal liability if the conduct constitutes a criminal offense.”

Id. However, regarding federal statutes, the Court concluded “that attorney immunity, as recognized and defined under Texas law, is not a defense under the federal wiretap statute because, quite simply, a state’s common-law defense does not apply to federal statutes.” Id.

In light of the foregoing authorities, it appears claims against attorneys merely doing work for a client (whether fraudulent, tortious, or even criminal) would be covered by attorney immunity and bar any participation in breach of fiduciary duty claim. However, if the misconduct relates to the attorney personally benefitting from the transaction, or having been a party to the transaction (as opposed to merely the attorney for a party), such an immunity would not apply. See, e.g., Olmos v. Giles, No. 3:22-CV-0077-D, 2022 U.S. Dist. LEXIS 77134 (N.D. Tex. April 28, 2022) (refused to dismiss breach of fiduciary duty claim and misrepresentation claim against attorneys where it was unclear whether the defendant attorneys were a part of the transaction).

Another issue that should be discussed is the impact on the attorney client privilege when an attorney participates in fraud or criminal activities. The attorney-client privilege cannot be enforced when “the services of the lawyer were sought or obtained to enable or aid anyone to commit what the client knew or reasonably should have known to be a crime or fraud.” Tex. R. Evid. 503 (d)(1). As one court describes:

The exception applies only when (1) a prima facie case is made of contemplated fraud, and (2) there is a relationship between the document at issue and the prima facie proof offered. A prima facie showing is sufficient if it sets forth evidence that, if believed by a trier of fact, would establish the elements of a fraud or crime that “was ongoing or about to be committed when the document was prepared.” A court may look to the document itself to determine whether a prima facie case has been established.…

We begin our analysis by examining the scope of the fraud portion of the crime/fraud exception. The Texas Rules of Evidence do not define what is intended in Rule 503(d)(1) by the phrase “to commit . . . [a] fraud.” Black’s Law Dictionary defines fraud as: “A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.” The Texas common law tort of fraud also requires proof of misrepresentation, concealment, or non-disclosure. The legal concept of fraud therefore has at its core a misrepresentation or concealment. This definition also dovetails with the apparent reasoning behind inclusion of fraud in the exception: by keeping client communications confidential–pursuant to the attorney-client privilege –the attorney whose client intends to make a misrepresentation or concealment helps prevent the injured party from learning the truth about the misrepresentation or concealment. Thus, in that situation, the attorney’s silence affirmatively aids the client in committing the tort. This is not generally true of other torts (not based on misrepresentation or concealment) and explains why the exception is not the crime/tort exception.

In re Gen. Agents Ins. Co. of Am., Inc., 224 S.W.3d 806, 819 (Tex. App.—Houston [14th Dist.] 2007, orig. proceeding). Moreover, the Texas Court of Criminal Appeals has held that this exception includes the work-product in the proper circumstances. Woodruff v. State, 330 S.W.3d 709, 2010 Tex. App. LEXIS 9569 (Tex. App. Texarkana Dec. 3, 2010), pet. ref’d No. PD-1807-10, 2011 Tex. Crim. App. LEXIS 749 (Tex. Crim. App. May 25, 2011), pet. ref’d No. PD-1807-10, 2011 Tex. Crim. App. LEXIS 770 (Tex. Crim. App. June 1, 2011), cert. denied, 565 U.S. 977, 132 S. Ct. 502, 181 L. Ed. 2d 347, 2011 U.S. LEXIS 7788 (U.S. 2011).

So, though an attorney may be immune from civil liability, the crime/fraud exception may open up attorney/client communications to the light of day. Regarding crimes involving breaches of fiduciary duty, in addition to theft crimes, the Texas Legislature has created the following crimes: (1) Financial Abuse of Elderly Individual in Texas Penal Code Section 32.55; 2) Financial Exploitation of Vulnerable Individuals in Texas Penal Code Section 32.53; (3) Misapplication of Fiduciary Property in Texas Penal Code Section 32.45; and (4) Failure to Report of the Exploitation of the Elderly or Disabled Individuals in the Texas Human Resources Code Section 48.051.

© 2022 Winstead PC.

The Unredeemable Debtor

The law is the witness and external deposit of our moral life. Its history is the history of the moral development of the race.

– Oliver Wendell Holmes

Bankruptcy law decisions are replete with references to the “worthy debtor.”  In re Carp, 340 F.3d 15, 25 (1st Cir. 2003); In re BankVest Capital Corp., 360 F.3d 291 (1st Cir.2004); In re Institute of Business and Professional Educ., Inc., 79 B.R. 948 (Bankr. S.D. Fla. 1987); In re Nickerson, 40 B.R. 693 (Bankr. N.D. Tex. 1984); In re Marble, (Bankr. W.D. Tex. 1984); In re Doherty, 219 B.R. 665 (Bankr. W.D. N.Y. 1998).

These decisions typically employ the “worthy debtor” nomenclature in the context of the entitlements that are afforded by the provisions of the Bankruptcy Code.  It is always the “worthy debtor” that is entitled to a discharge of debts, a “fresh start”,  or to reject cumbersome contracts. This usage bespeaks a universe that also contains the “unworthy debtor,” a party whose behavior does not merit the statutory benedictions of the Bankruptcy Code. The identity of these parties is most often examined in the context of the discharge of debts and the behavior or actions that merit a denial of discharge or the finding that a particular debt is non-dischargeable.

There is a larger and more amorphous question though that also merits consideration, namely are their industries, companies, enterprises whose function and purpose is so odious and inconsistent with the precepts of good citizenship and the “moral development of the race”, to quote Justice Holmes, that they should be denied the benefits of reorganization afforded by the Bankruptcy Code.

If there is an argument to be made to prevent such enterprises from receiving the benefits of the Bankruptcy Code, to deny them the colloquial label of “worthy debtor”, that recourse likely lies within the provisions of the Bankruptcy Code that require that a plan of reorganization be “proposed in good faith and not by any means forbidden by law.”  11 U.S.C. § 1129(a)(3).  The “not forbidden by law” requirement is of limited utility in situations where the behavior is recognizable as immoral or intrinsically evil to most but has not yet been sanctioned by any legislative authority. Notably, and perhaps inversely, enterprises engaged in the sale and growing of cannabis are without access to the Bankruptcy Code because they act in contravention of the federal Controlled Substances Act, 21 U.S.C. §§ 801 et seq., which has been found to take precedence over state laws allowing the sale of cannabis. SeeGonzales v. Raich, 545 U.S. 1, 12 (2005).  As a result, bankruptcy being a creature of federal law, cannabis cases are generally being dismissed at the outset for cause in accordance with 11 U.S.C. § 1112(b) and not making it as far as the confirmation standard. See, In re Way To Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018).

If “forbidden by law” is unavailable as a source of relief, the last best hope to prevent the sanctioned reorganization of the unworthy debtor lies within the requirement that a plan be proposed in “good faith.”

“Good faith” is not defined by the Bankruptcy Code, a fact that makes it more likely that our  understanding of good faith may be transitory and that as the ‘moral development of the race’ proceeds, so might our understanding of ‘good faith.’  In other words, what was good faith yesterday might not, in light of our communal experience and growth as citizens, be good faith today.

In the first instance, we can understand from the ordering of the words within section 1129(a)(3) that the good faith standard exists independently of the ‘forbidden by law’ standard.  A plan of reorganization may describe a course of action not forbidden by law, but may still not meet the ‘good faith’ standard.

The good faith standard as used within section 1129(a)(3) is most commonly described as proposing a plan that fulfills the purposes and objectives of the Bankruptcy Code.  Those purposes and objectives within the context of Chapter 11 are most commonly understood as being “to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources.”  NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1983);  see alsoBank of Am. Nat. Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 452 (1999) (“[T]he two recognized policies underlying Chapter 11 [are] preserving going concerns and maximizing property available to satisfy creditors”)

This case law, which is by far the most consistent usage of the term, emphasizes paying back creditors and preserving an ongoing enterprise. It does not suggest the existence of anything more amorphous beyond those standards and it supports the idea that the ‘good faith’ standard is not meant to be an existential inquiry into the moral worth of a particular industry.

Bankruptcy courts have, however, recognized that the absence of a definition of good faith leaves courts without “any precise formulae or measurements to be deployed in a mechanical good faith equation.”  Metro Emps. Credit Union v. Okoreeh–Baah (In re Okoreeh–Baah), 836 F.2d 1030, 1033–34 (6th Cir.1988) (interpreting good faith in context of Chapter 13).

Any successful collateral attack under section 1129(a)(3) on the ‘good faith’ of the immoral enterprise must likely follow the path of connecting the good faith standard to the “public good.”  Bankruptcy Courts have invoked the ‘public good’ in refusing to enforce certain contracts and have followed the dictates of some courts that “while violations of public policy must be determined through “definite indications in the law of the sovereignty,” courts must not be timid in voiding agreements which tend to injure the public good or contravene some established interest of society. Stamford Bd. of Educ. v. Stamford Educ. Ass’n., 697 F.2d 70, 73 (2d Cir.1982).

The concept of the ‘public good’ is not a foreign one in bankruptcy courts.  Seeking relief for debtors that are the only providers of a service within their geographic area is an immensely easier task, no court, and no bankruptcy judge, likes to see a business fail and when the business is important to the community, support for reorganization from the bench often works to make reorganization easier.  Bankruptcy courts, although restrained by a statutory scheme, are as a matter of practice courts of equity.  Employing those equitable arguments to support a reorganization is both achievable and a reality of present practice.

Whether equitable arguments can be inversely employed to graft a sense of the ‘public good’ onto the good faith requirement within section 1129(a)(3) is decidedly uncertain and is not directly supported by the case law as it exists.

Somewhere out there though in one of those small border towns between the places of unelected legislators and the judicious and novel application of historical precedent lies the “moral development of the race” and the bankruptcy court that finds that incumbent within the concept of good faith is fair consideration of the public good.

Copyright ©2022 Nelson Mullins Riley & Scarborough LLP

SEC Commissioner Signals Need to Fulfill Mandate of Sarbanes-Oxley Act and Develop “Minimum Standards” for Lawyers Practicing Before the Commission

In remarks on March 5, 2022, on PLI’s Corporate Governance webcast, Commissioner Allison Herren Lee of the Securities and Exchange Commission stated that 20 years after its enactment, it is time to revisit the “unfulfilled mandate” of Section 307 of the Sarbanes-Oxley Act of 2002 and establish minimum standards for lawyers practicing before the Commission.1  Commissioner Lee, who announced that she will not seek a second term when her current one ends this month, took issue with what she called the “goal-directed reasoning” of some securities lawyers—that is, focusing primarily on the outcome sought by executives, rather than the impact on investors and the market as a whole.  Such lawyering, Commissioner Lee observed, has a host of negative consequences, including encouraging non-disclosure of material information, harming investors and market integrity, and stymying deterrence.  The solution, Commissioner Lee opined, is to fulfill the mandate of Section 307, which empowered the Commission to “issue rules, in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers.”2

Over the last 20 years, the Commission has declined to adopt enhanced rules of professional conduct for lawyers appearing before the Commission.  There are good reasons for the Commission’s inaction, including the attorney-client privilege, the goal of zealous advocacy, the fact-specific nature of materiality determinations, and the traditionally state-law basis for the regulation of attorney conduct.  Commissioner Lee, moreover, did not propose specific new rules and recognized that the task was difficult and should be informed by the views of the securities bar and other stakeholders.  Nor did she say that action by the Commission was imminent; it is unclear whether the Commission has authority to promulgate new rules under Section 307 given a 180-day sunset under the statute that occurred in 2003.  Indeed, neither Commissioner Lee nor any of the other SEC commissioners have issued statements on this topic since the PLI webcast.  SEC Enforcement Director Gurbir Grewal has, however, indicated an increased emphasis on gatekeeper accountability in order to restore public trust in the market.3  Nonetheless, given the Commission’s existing authority to impose discipline under its Rules of Practice, practitioners should be mindful of the potential for increased scrutiny moving forward.

Background

In the wake of corporate accounting scandals involving Enron, Worldcom, and other companies, Congress enacted the Sarbanes-Oxley Act in 2002 “[t]o safeguard investors in public companies and restore trust in the financial markets.”4  The Act was aimed at “combating fraud, improving the reliability of financial reporting, and restoring investor confidence,”5 including by empowering the SEC with increased regulatory authority and enforcement power.6  To that end, the Act includes provisions to fortify auditor independence, promote corporate responsibility, enhance financial disclosures, and enhance corporate fraud accountability.7

The Sarbanes-Oxley Act was passed just six months after the collapse of Enron in December 2001, and neither the House nor Senate bills originally contained professional responsibility language.8  Hours before the Senate passed its version of the Act, however, the Senate amended the bill to include language that would eventually become Section 307.9  Around the same time, 40 law professors sent a letter to the SEC requesting the inclusion of a professional conduct rule governing corporate lawyers practicing before the Commission.10  The letter picked up on a 1996 article by Professor Richard Painter, then of the University of Illinois College of Law, which recommended corporate fraud disclosure obligations for attorneys similar to those imposed on accountants by the Private Securities Litigation Reform Act of 1995.11  Senator John Edwards, one of the sponsors of the Senate floor amendment of the bill, emphasized the importance of including professional conduct rules for attorneys in such a significant piece of legislation, stating that “[o]ne of the problems we have seen occurring with this sort of crisis in corporate misconduct is that some lawyers have forgotten their responsibility” is to the companies and shareholders they represent, not corporate executives.12

In its final form, Section 307 imposed a professional responsibility requirement for attorneys that represent issuers appearing before the Commission.  Specifically, Section 307 directed the Commission, within 180 days of enactment of the law, to “issue rules, in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers,”13 and, at minimum, promulgate “a rule requiring an attorney to report evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by the issuer or any agent thereof to appropriate officers within the issuer and, thereafter, to the highest authority within the issuer, if the initial report does not result in an appropriate response.”14

Since the enactment of Section 307, however, the Commission has promulgated only one rule pursuant to its authority, commonly known as the “up-the-ladder” rule.15  The up-the-ladder rule imposes a duty on attorneys representing an issuer before the Commission to report evidence of material violations of the securities laws.  When an attorney learns of evidence of a material violation, the attorney has a duty to report it to the issuer’s chief legal officer (“CLO”) and/or the CEO.16  If the attorney believes the CLO or CEO did not take appropriate action within a reasonable time to address the violation, the attorney has a duty to report the evidence to the audit committee, another committee of independent directors, or the full board of directors until the attorney receives “an appropriate response.”17  Alternatively, attorneys can satisfy their duty by reporting the violation to a qualified legal compliance committee.18  To date, the SEC has never brought a case alleging a violation of the up-the-ladder rule.

Commissioner Lee’s Remarks

In her remarks, Commissioner Lee stated that it is time to revisit the “unfulfilled mandate” of Section 307 and consider whether the Commission should adopt and enforce minimum standards for lawyers who practice before the Commission.  Commissioner Lee criticized “goal-directed reasoning” employed by sophisticated counsel in securities matters, and cited as an example Bandera Master Fund v. Boardwalk Pipeline,19 a recent decision in which the Delaware Court of Chancery rebuked the attorneys involved for their efforts to satisfy the aims of a general partner instead of their duty to the partnership-client as a whole.  The Court, specifically, stated that counsel “knowingly made unrealistic and counterfactual assumptions, knowingly relied on an artificial factual predicate, and consistently engaged in goal-directed reasoning to get to the result that [the general partner] wanted.”20  Bandera and cases like it, according to Commissioner Lee, are emblematic of a “race to the bottom” caused by pressure on securities lawyers to compete with each other for clients, while failing to give due consideration to the potential impact on investors, market integrity, and the public interest.

In Commissioner Lee’s view, “goal-directed” lawyering not only falls short of ethical standards but causes harm to the market and reduces deterrence.  Commissioner Lee expressed concern that, in an effort to give management the answer it wants, lawyers may downplay or obscure material information.21  Although recognizing that materiality determinations are fact-intensive, Commissioner Lee said that should not provide blanket cover for legal advice aimed at concealing material information from the public.  Non-disclosure has a host of negative consequences, including distorting market-moving information, interfering with price discovery, misallocating capital, impairing investor decision-making, and eroding confidence in the financial markets and regulatory system.  Further, such lawyering diminishes deterrence by creating a legal cover for inadequate disclosure, making it more difficult for regulators to hold responsible individuals accountable.  This type of legal counsel, in Commissioner Lee’s view, “is merely rent-seeking masquerading as legal advice, while providing a shield against liability.”

Commissioner Lee stated that the existing framework governing professional conduct is not adequate to hold lawyers accountable for such “reckless” advice.  According to Commissioner Lee, state bars—the principal source for lawyer discipline nationwide—are not up to the task because they lack resources, expertise in securities matters, and the ability to impose adequate monetary sanctions.  Additionally, Commissioner Lee noted that state law standards focused mostly on the behavior of individual lawyers, assigning few responsibilities to the firm for quality assurance.  Indeed, state law standards are mostly drafted in a “one-size-fits-all fashion” according to Commissioner Lee, and do not take into account the different issues faced at large firms that represent public companies, which are quite different from a solo practitioner handling personal injury or estate law matters.  Likewise, although the SEC has the power under Rule 102(e) of its Rules of Practice to suspend or bar attorneys whose conduct falls below “generally recognized norms of professional conduct,” there has been little effort to define or enforce that standard.22  Nor has the SEC rigorously enforced standards of attorney conduct under the one rule it has issued under Section 307, the “up-the-ladder” rule.

Commissioner Lee stated that it was time for the Commission to fulfill its mandate under Section 307.  Although not proposing any specific rules, Commissioner Lee offered the following concepts as a starting point:

  • Greater detail on lawyers’ obligations to a corporate client, including how advice must reflect “the interests of the corporation and its shareholders rather than the executives who hire them”;
  • Requirements of “competence and expertise” (as an example, disclosure lawyers should not opine on materiality “without sufficient focus or understanding of the views of ‘reasonable’ investors”);
  • Continuing education for securities lawyers advising public companies (similar to requirements set by the Public Company Accounting Oversight Board for minimum hours of qualifying continuing professional education for audit firm personnel);
  • Oversight at the firm level (similar to quality-control measures implemented at audit firms);
  • Emphasis on the need for independence in rendering advice (similar to substantive and disclosure requirements implemented in Rule 2-01 of Regulation S-X for auditors);
  • Obligations to investigate red flags and ensure accurate predicates for legal opinions (similar to the obligations that an auditor must perform to certify to the accuracy of their client’s financial statements); and
  • Retention of contemporaneous records to support the reasonableness of legal advice.

Commissioner Lee noted that the content of any specific rules or standards will require “careful thought,” as well as assistance from the securities bar, experts on professional responsibility, and other interested parties and market participants.  She invited input from the legal community and other stakeholders and noted that she appreciated the complexity of the task and concerns of the American Bar Association and others regarding protection of the attorney-client privilege.  Indeed, outside auditors are generally regarded as “public watchdogs” and such communications between the corporation and an auditor are not entitled to the affirmative attorney-client privilege afforded to legal counsel.  Accordingly, regulating the legal profession using a similar framework to that applied to the accounting profession has sparked more controversy.  Nonetheless, in Commissioner Lee’s view, those concerns should be weighed against “the costs of there being few, if any, consequences for contrived or tortured advice.”

Implications

The Commission has declined to adopt enhanced rules of professional conduct for lawyers appearing before it in the 20 years since the enactment of the Sarbanes-Oxley Act.  Commissioner Lee’s call for minimum standards, however, potentially signals increased scrutiny by the SEC with respect to lawyers who “practice before the Commission.”  As Commissioner Lee noted, that means “counsel involved in the formulation and review of issuers’ public disclosure, including those who address the many legal questions that often arise in that context.”23  Nonetheless, Commissioner Lee cautioned that she did “not intend with these comments to address the conduct of attorneys serving as litigators or otherwise representing their client(s) in an advocacy role in an adversarial proceeding or other similar context, such as in an enforcement investigation.”24

Although framing her call for standards in terms of Section 307 of the Sarbanes-Oxley Act, it is not clear that the Commission will—or even can—promulgate any further rules under that authority.  Commissioner Lee did not state that she was speaking on behalf of the Commission or indicate that the Commission would be taking concrete, imminent steps to adopt such standards.  The Commission has not put its imprimatur on the remarks by incorporating them into a formal release or statement of policy.  Moreover, the text of Section 307 appears to foreclose the possibility of further rulemaking, as it provides that the Commission shall issue any such rules “[n]ot later than 180 days after the date of enactment of this act,” i.e., January 27, 2003.  Consistent with that constraint, the SEC proposed the up-the-ladder requirements on November 21, 2002, in Release No. 33-8150, and the rule became final on January 29, 2003.25  But the SEC has not issued any other rule under Section 307 to date.

Even if official action under Section 307 may not be forthcoming, Commissioner Lee’s call for action should not be discounted.  Setting aside the up-the-ladder requirements, the SEC has authority under Rule 102(e) of the SEC’s Rules of Practice to censure or bar a lawyer from appearing or practicing before the Commission if found, among other things, “[t]o be lacking in character or integrity or to have engaged and unethical or improper professional conduct.”26  Commissioner Lee cited prior SEC guidance to indicate that Rule 102(e) may apply to attorney conduct that falls below “generally recognized norms of professional conduct,”27 a standard that has been left undefined to date.28  In practice, the SEC “will hold attorneys who practice before it to the standards to which they are already subject, including state bar rules.”29  At a minimum, then, Commissioner Lee’s objective of greater accountability may be achieved through a more aggressive application of Rule 102(e), which, as she noted, has generally only been applied as a follow-on penalty for primary violations of the securities laws by lawyers.

Commissioner Lee’s term expires on June 5, and she has announced that she intends to step down from the Commission once a successor has been confirmed.30  Should the Commission nonetheless take up her call to action in the future, it will be no easy task to adopt clear standards that can be implemented in a predictable manner.  In particular, Commissioner Lee’s focus on the role of lawyers in advising issuers on determinations of materiality and disclosure does not lend itself well to oversight or enforcement.  The well-established standard for materiality—whether “there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote”—is far from clear-cut.31  The Supreme Court, moreover, long has recognized that materiality “depends on the facts and thus is to be determined on a case-by-case basis.”32  As such, and as evidenced by the sundry cases concerning disclosure issues reversed on appeal, disagreement between litigants—as well as jurists—on matters of materiality and disclosure are par for the course.  If that is so, how can a lawyer’s advice on such matters (which will inevitably turn on the facts and the lawyer’s judgment and experience) be subject to oversight in any objective sense?

Even if lawyers’ materiality advice could be evaluated under objective standards, there are other difficulties.  First and foremost is that oversight of legal advice implicates the attorney-client privilege and the underlying benefit of candid advice from securities disclosure and corporate counsel.  As the Supreme Court has observed, the attorney-client privilege “is founded upon the necessity, in the interest and administration of justice, of the aid of persons having knowledge of the law and skilled in its practice, which assistance can only be safely and readily availed of when free from the consequences or the apprehension of disclosure.”33  Aside from situations in which the client has voluntarily waived privilege (as sometimes occurs in SEC investigations) or where another exception to the privilege applies, it is unclear how the SEC could evaluate legal advice without invading privilege.  Such attempts could have led to an increase in corporate wrongdoing as corporate executives could be more reluctant to seek expert legal advice.  In addition, it is unclear how regulators assessing materiality advice would—or could—balance an assessment of whether a lawyer has given the “correct” advice with a lawyer’s ethical obligations of zealous representation of the client.34  The divide between overreaching “goal-directed” reasoning and permissible zealous advocacy for the client is often murky, and reasonable minds can differ depending on the circumstances.  Moreover, it is already well-accepted that a corporate lawyer’s obligation is to the corporation as its client, not to any individual officer or director.35  That obligation carries with it ethical duties to “proceed as is reasonably necessary for the best interest” of the corporation, including when the lawyer is aware of violations of the law or other misconduct by senior management.36  In that sense, Commissioner Lee’s proposal could be viewed as a call for the SEC to take on enforcement of existing ethical rules, rather than for the development of novel “minimum standards.”

Ultimately, there are good reasons for the Commission’s reluctance to date to formally adopt minimum standards of professional conduct for lawyers appearing before it, including the attorney-client privilege, the goal of zealous advocacy, and the fact-specific nature of materiality inquiries.  The manipulation of facts and bad reasoning targeted by Commissioner Lee are not only the exception, and difficult if not impossible to eliminate completely, but are largely covered by existing rules and practices.  Nonetheless, Commissioner Lee’s call for lawyers to strive for higher legal and ethical standards in their counsel should be welcomed.  Sound legal advice is not only important for issuer clients, but also for the financial well-being of investors, the integrity of the markets, and public confidence in the regulatory system and capital markets.  Enhancements in ethical standards for the legal profession could also lead to reputational benefits and greater integrity in the profession.  It remains to be seen whether Commissioner Lee’s remarks will serve as an aspirational goal for securities lawyers, or translate into concrete action by the Commission.


1 Commissioner Allison Herren Lee, Send Lawyers, Guns and Money: (Over-) Zealous Representation by Corporate Lawyers Remarks at PLI’s Corporate Governance – A Master Class 2022 (Mar. 4, 2022), [hereinafter “Commissioner Lee Remarks”].

See Sarbanes‑Oxley Act, § 307, 15 U.S.C. § 7245 (2002).

3 Gurbir Grewal, Director, Division of Enforcement, Remarks at SEC Speaks 2021 (Oct. 13, 2021).

Lawson v. FMR LLC, 571 U.S. 429, 432 (2014).

5 Stephen Wagner and Lee Dittmar, The Unexpected Benefits of Sarbanes-Oxley, Harvard Bus. Rev. (Apr. 2006).

See Sarbanes–Oxley Act, § 3, 15 U.S.C. § 7202 (2002).

See Sarbanes–Oxley Act, § 1, 15 U.S.C. § 7201 (2002).

8 Jennifer Wheeler, Securities Law: Section 307 of the Sarbanes-Oxley Act: Irreconcilable Conflict with the ABA’s Model Rules and the Oklahoma Rules of Professional Conduct?, 56 Okla. L. Rev. 461, 464 (2003).

Id.

10 Id. at 468-69.

11 See generally Richard W. Painter & Jennifer E. Duggan, Lawyer Disclosure of Corporate Fraud: Establishing a Firm Foundation, 50 SMU L. Rev. 225 (1996).

12 Wheeler, supra note 8, at 465 (quoting 148 Cong. Rec. S6551 (daily ed. July 10, 2002) (statement of Sen. Edwards)).

13 See Sarbanes‑Oxley Act, § 307, 15 U.S.C. § 7245 (2002).

14 Final Rule: Implementation of Standards of Professional Conduct for Attorneys, Securities Act Rel. No. 8185 (Sept. 26, 2003).

15 17 C.F.R. §§ 205.1-205.7.

16 17 C.F.R. § 205.3(b)(1).

17 17 C.F.R. §§ 205.3(b)(3), (b)(4).

18 17 C.F.R. § 205.3(c).

19 Bandera Master Fund LP v. Boardwalk Pipeline Partners, LP, No. CV 2018-0372-JTL, 2021 WL 5267734, at *1 (Del. Ch. Nov. 12, 2021).  In Bandera, plaintiffs brought suit against a general partner for breach of a partnership agreement stemming from the general partner’s exercise of a call right without satisfying two requisite preconditions.  The court held for the plaintiffs and found the general partner had engaged in willful misconduct.  Id. at *51.  Contributing to the misconduct was the general partner’s outside counsel, who drafted an opinion letter justifying the general partner’s exercise of the call right.  Id.  Throughout the drafting process, the court found, that the outside counsel manipulated the facts in order to achieve the general partner’s desired conclusion.  Id. at *18-*47.

20 Id. at *51.

21 Commissioner Lee specifically cited, among other matters, environmental, social, and governance (“ESG”) disclosures.  The Commission is currently considering additional climate change-related disclosures to Regulation S-K and Regulation S-X.  See Jason Halper et al., SEC Proposes Climate-Related Changes to Regulation S-K and Regulation S-X, Cadwalader, Wickersham & Taft LLP (Mar. 23, 2022); see also Paul Kiernan, SEC Proposes More Disclosure Requirements for ESG Funds, The Wall Street Journal (May 25, 2022, 6:26 pm ET).

22 Rule 102(e) states, in relevant part:

(1) Generally. The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter:

(i) not to possess the requisite qualifications to represent others; or

(ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct; or

(iii) to have willfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder.

17 C.F.R. § 201.102(e)(1).

23 Commissioner Lee Remarks, supra note 1.

24 Id.

25 Proposed Rule: Implementation of Standards of Professional Conduct for Attorneys, Securities Act Rel. No. 8150 (Nov. 21, 2002); Final Rule: Implementation of Standards of Professional Conduct for Attorneys, Securities Act Rel. No. 8185 (Sept. 26, 2003); see also 2 Legal Malpractice § 14:114 (2022 ed.).

26 17 C.F.R. § 201.102(e).  The Rules of Practice generally “govern proceedings before the Commission under the statutes that it administers.” 17 C.F.R. § 201.100.  The SEC has the authority to administer and enforce such rules pursuant to the Administrative Procedures Act, 5 U.S.C. § 551 et. seq. See Comment to Rule 100, SEC Rules of Practice (July 2003).

27 In the Matter of William R. Carter Charles J. Johnson, 47 S.E.C. 471 (Feb. 28, 1981) (“elemental notions of fairness dictate that the Commission should not establish new rules of conduct and impose them retroactively upon professionals who acted at the time without reason to believe that their conduct was unethical or improper.  At the same time, however, we perceive no unfairness whatsoever in holding those professionals who practice before us to generally recognized norms of professional conduct, whether or not such norms had previously been explicitly adopted or endorsed by the Commission.  To do so upsets no justifiable expectations, since the professional is already subject to those norms.”).

28 In the past, the Commission has sought to discipline lawyers for violating securities laws with scienter, rendering misleading opinions used in disclosures and engaged in otherwise liable conduct, but not for giving negligent legal advice to issuers. See In the Matter of Scott G. Monson, Release No. 28323 (June 30, 2008) (collecting cases).

29 In the Matter of Steven Altman, Esq., Release No. 63306 (Nov. 10, 2010).

30 Statement of Planned Departure from the Commission (Mar. 15, 2022).

31 TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

32 Basic Inc. v. Levinson, 485 U.S. 224, 250 (1988).

33 Upjohn Co. v. United States, 449 U.S. 383, 389 (1981) (quoting Hunt v. Blackburn, 128 U.S. 464, 470 (1888)).

34 Rule 1.3: Diligence, American Bar Association, (last visited Mar. 18, 2022) (“A lawyer shall act with reasonable diligence and promptness in representing a client.”); Rule 1.3 Diligence – Comment 1, American Bar Association,  (last visited Mar. 18, 2022) (“A lawyer must also act with commitment and dedication to the interests of the client and with zeal in advocacy upon the client’s behalf.”).

35 See, e.g.Upjohn, 449 U.S. at 389.

36 Rule 1.13: Organization As Client, American Bar Association, cmt. 2  (last visited April 19, 2022).

© Copyright 2022 Cadwalader, Wickersham & Taft LLP

Preparing to Testify in Response to an SEC Subpoena

When investigating companies, brokerage firms, investment advisors, and other entities and individuals, the U.S. Securities and Exchange Commission (SEC) relies heavily on its subpoena power. Once the SEC launches a formal investigation, it can issue administrative subpoenas to the company executives, brokers, and others. These subpoenas may be a subpoena duces tecum which compels the person to whom it is addressed to produce documents in his possession or control, or a subpoena ad testificandum which compels the person to whom it is addressed to appear at a specific time and place and testify under oath or affirmation. Crucially, while these subpoenas do not require judicial approval, they are subject to judicial enforcement.

With this in mind, receiving an SEC subpoena is not a matter to be taken lightly. Individuals who have been subpoenaed to testify must thoroughly prepare their testimony, and they need to make sure they know what to expect when the day arrives.

Testifying before the SEC is fraught with potential risks. It is imperative that subpoena recipients devote the necessary time to their preparations, and that they work with their counsel to proactively identify and address all potential areas of concern.

Understanding Why You Have Received an SEC Subpoena

When preparing to testify before the SEC, a key first step is to understand why you have been subpoenaed. Broadly speaking, the SEC focuses its enforcement efforts on two areas: (i) protecting U.S. investors, and (ii) preserving the integrity of U.S. capital markets. As a result, most SEC investigations target allegations of fraud, misrepresentation, conspiracy, and other offenses in one (or both) of these areas.

The SEC’s subpoena should provide at least some insight into the focus and scope of the SEC investigation. However, gathering the information you need to make informed decisions may require examination of other sources as well. For example, it will be helpful if you can identify anyone else who has received a subpoena or Wells Notice related to the investigation, and it may be prudent to conduct an internal compliance audit focused on uncovering any issues that could come to light.

Questions You Should Be Prepared to Answer During Your SEC Testimony

When preparing SEC testimony, it is important to keep in mind that you could easily be fielding questions for six hours or longer. While this can seem overwhelming, SEC subpoena recipients can generally expect to be asked questions in seven main categories. These main categories are:

  • Preliminary Matters
  • Background and Personal Information
  • Your Role Within Your Company or Firm
  • The Scope of Your Duties
  • Investors
  • Due Diligence
  • Clarifying and Closing the Record

1. Questions Regarding Preliminary Matters

SEC subpoena recipients can initially expect a series of questions that are designed to provide the SEC with insight into the steps they took to prepare their testimony. While these questions are largely procedural, some can present traps for the unwary. At the beginning of the session, you should be prepared to succinctly and confidently answer questions such as:

  • Did you get the opportunity to review the Formal Order associated with this matter?
  • Do you have any questions regarding the Formal Order?
  • Did you complete the Background Questionnaire by yourself?
  • Are the contents within the Background Questionnaire truthful and accurate?
  • Is there any information you wish to add to the Background Questionnaire?
  • Do you understand the rules and procedures of the SEC testimony process?
  • Do you have any questions on the rules and procedures of the SEC testimony process?

2. Questions Regarding Background and Personal Information

After dispatching these preliminary matters, the focus will shift to the SEC subpoena recipient’s background and personal information. Keep in mind that the SEC likely has much (if not all) of this information already—so if you omit information or provide misleading answers, this will not go unnoticed. During this phase of your testimony, you can expect to be asked questions such as:

  • What is your educational background?
  • Do you hold any professional or financial licenses?
  • Have you ever worked for a financial firm or investment advisory firm?
  • When did you first meet the other individual(s) involved in this matter?
  • Who introduced you?
  • What was the purpose of your first meeting (e.g., social meeting or business planning)?
  • Do your families know each other?
  • Where are you employed now?

3. Questions Regarding Your Role Within Your Company or Firm

If the SEC is investigating your company or firm (perhaps in addition to investigating you personally), you can expect several questions regarding your role within the organization. Depending on your position, the SEC’s investigators may ask you questions regarding the company or firm itself. Some examples of the questions you should be prepared to answer (as applicable) include:

  • When did you start working at the company?
  • What is your position at the company?
  • Can you describe the company’s corporate structure?
  • What are your title and position at the company?
  • Have your title and position changed over time?
  • What are the duties at the company?
  • Have your duties changed over time?
  • How is the company funded?
  • What is your salary at the company?
  • Who makes the majority of the decisions for the company?
  • Does the company sell securities?
  • Does the company pay dividends?
  • Does the company have voting rights?

4. Questions Regarding the Scope of Your Duties

After gaining an understanding of your role within your company or firm, the questioning will likely shift toward examining the scope of your duties in greater detail. In most cases, this is where the questions asked will begin to focus more on the substance of the SEC’s investigation. During this phase of your testimony, potential questions may include:

  • Can you describe your access to investor funds, financial statements and records, and investor details?
  • Are you aware of or do you have access to the sources of the company´s income?
  • What are the sources of the company´s revenue and projected revenue?
  • Can you describe or do you have access to the sources of the company´s expenses?
  • Who is responsible for preparing the company´s financial statements?
  • Do you have any role in preparing or compiling the company´s financial statements?
  • Who is responsible for preparing the company´s projected financial statements, including projected capital contributions, projected expenses, and projected revenues?
  • Do you have any role in preparing or compiling the company´s projected financial statements?
  • Does the company have its financial statements audited on an annual basis?
  • Did you ever act as a point of contact or intermediary between the company and third parties, such as investors or banks?
  • Do you ever serve as a representative of the company?
  • Are you involved in any of the company’s promotional efforts to the public?
  • Do you know or do you have access to details of the company’s anticipated monetization plans?
  • Are you aware of any complaints against the company?

5. Questions Regarding Investors

Once the scope of your duties has been established, the SEC’s investigators may next focus on your company’s or firm’s communications and relationships with investors. Here too, the investigators’ questions are likely to be tailored to the specific allegations at issue—and you could get yourself into trouble if you aren’t careful. To the extent of your knowledge, you should be prepared to accurately answer questions such as:

  • Does the company have investors?
  • Who are the investors?
  • What types of customers and/or investors do the company target or appeal to?
  • Do you communicate with investors?
  • How did the company attract capital contributions for its formation, project funding, and subsequent business plans?
  • Does the company adopt targeted marketing strategies, or does the company engage in general advertising?
  • What is the average contribution of the company’s investors?
  • Did you create, or do you have access to, a cap table?
  • Did you assist in the preparation of a cap table?
  • Did the company issue stock certificates or provide any other proof of equity ownership to investors?
  • Did the company register any of its investments?
  • Did the company issue a private placement memorandum or file a Form D?
  • Do you know if any investors already knew the company´s directors and officers before investing?
  • Does the company solicit investors or advertise to the general public (e.g., retail investors)?
  • Are you aware of what the company does with investor funds?
  • Can you describe your role in preparing any promotional or marketing materials?
  • Has the company distributed any investor documents or marketing/solicitation materials to the public?
  • Does the company have any plan to show, or did it show, promotional documents to investors?
  • Does the company hold regular investor calls?

6. Questions Regarding Due Diligence

Due diligence is often a key topic of discussion. SEC investigators are well aware that many company executives, brokers, and others are not sufficiently familiar with their companies’ and firms’ due diligence obligations, and charges arising out of due diligence violations are common. With this in mind, you should be prepared to carefully navigate inquiries such as:

  • Does the company have any identity verification procedures in place?
  • What kinds of identity verification procedures does the company use for its investors?
  • Can you describe the company´s know-your-customer (“KYC”) policies?
  • Do you assist with verifying investors or capital contributions?
  • Does the company maintain a compliance program?

7. Questions to Clarify and Close the Record

Finally, at the end of the session, the SEC’s investigators will ask if you want to clarify or supplement any of the answers you have provided. It is important not to let your guard down at this stage. While your testimony is nearly over, you need to remain cognizant of the risk of providing unnecessary information (or omitting information) and exposing yourself to further scrutiny or prosecution. With this in mind, it is best to consult with your counsel before answering questions such as:

  • Is there anything you wish to clarify from today´s testimony?
  • Is there anything you wish to add to your testimony before we close and go off the record?

Practicing your answers to these questions (among others) in a mock interview with your legal counsel or SEC defense attorney will help ensure that you are prepared for the SEC as possible.

Oberheiden P.C. © 2022

SEC Targets Companies Conducting Cryptomining

The SEC recently doubled the size of its Crypto Assets and Cyber Unit.  Since its inception in 2017, the SEC’s Crypto Assets and Cyber Unit has launched more than 80 investigations resulting in over $2 billion in monetary penalties.  With more dedicated investigative attorneys, trial counsel, and fraud analysts, the SEC’s cryptocurrency-related investigations are expected to substantially rise in the months and years ahead.

The tip of the spear will include the areas that the SEC said would be its focus moving forward:

  • crypto asset offerings
  • crypto asset exchanges
  • crypto asset lending and staking products
  • decentralized finance (DeFi) platforms
  • non-fungible tokens (NFTs); and
  • stablecoins

View SEC press release here.

Given the heightened scrutiny, however, even companies outside of the traditional cryptocurrency industry may find themselves subject to enforcement actions and penalties.  For example, the SEC recently announced that it reached a $5.5 million settlement with technology company NVIDIA Corporation for the company’s alleged failure to disclose on its Form 10-Q for fiscal year 2018 that cryptomining was a significant element of its revenue growth. View release here.

NVIDIA is not a cryptocurrency-related company, but rather is a technology company that markets and sells accelerated computing technologies, including graphics processing units (GPUs) for PC gaming, the company’s largest specialized market.  The SEC alleged that, as interest in cryptocurrencies began to increase in 2017, NVIDIA customers increasingly began using gaming GPUs for cryptomining of Ether (ETH), which rose in price from under $10 to nearly $800 between 2017 and 2018.

In its Form 10-Q for fiscal year 2018, despite knowledge (discerned by the SEC from internal company documents and communications) of cryptomining as a significant driver of its GPU sales growth in its gaming division, the SEC alleged that NVIDIA failed to disclose that this growth was largely driven by demand for gaming GPUs to use in cryptomining.  The SEC further alleged that this failure to disclose misled investors about the growth of NVIDIA’s gaming business in violation of Section 17(a)(2) and (3) of the Securities Act of 1933 and the disclosure provisions of the Securities Exchange Act of 1934.

As the SEC steps up its cryptocurrency related investigation and enforcement actions, publicly traded companies must exercise increased diligence in disclosure of activities that touch cryptocurrency assets.   Even internal dialogue about revenues or other disclosable material that touches cryptocurrencies, as happened to NVIDIA, could subject companies to increased scrutiny and significant monetary penalties.

Copyright ©2022 Nelson Mullins Riley & Scarborough LLP
For more articles about cryptomining, visit the NLR Financial Institutions & Banking section.