The Securities and Exchange Commission (SEC or Commission) is considering proposals that would require public companies to disclose reliable and complete information about the risks of climate change. The Commission’s efforts will fall short, however, unless it addresses the role of lawyers in the disclosure process.
Under the federal securities laws, legal obligations for accurate disclosure of material information rest with the company and are typically the responsibility of executive management. Yet in making these determinations, management relies on lawyers. Few public companies would file periodic reports with the SEC without providing them to counsel for review. Lawyers are particularly important in reviewing materiality determinations made by management.
Lawyers sometimes get the analysis wrong, however, and management sometimes benefits from the incorrect advice. Particularly where the securities violation has a state of mind requirement, management may avoid liability by pointing to the presence of lawyers in the process. At the same time, lawyers are rarely held accountable.
Mistakes may occur because lawyers lack adequate expertise or have an insufficient understanding of the facts. In a new paper, however, we argue that they may also occur because of a fundamental misconception about the role lawyers, implicitly or explicitly, play in the disclosure process. Lawyers are often under extraordinary pressure to merely justify or confirm management decisions about disclosure. Particularly in grey areas such as materiality, this goal of management confirmation results in an approach that focuses more on assessing litigation risk of nondisclosure and amassing factors that support a finding of immateriality than on determining the importance of the information to reasonable shareholders and investors.
Lawyers take this approach because management benefits from the advice, and there is little accountability where the advice ultimately proves incorrect. The lack of accountability has a number of sources. The SEC does not bring actions for bad legal advice, and state disciplinary agencies are not equipped to deal with the issue. Even where a regulator is willing to address the concerns, the existing set of professional standards, usually states’ rules of professional conduct, are not adequate. Reflecting an historical bias for focusing on the conduct of litigators rather than transactional lawyers, the Model Rules do not set out meaningful requirements for securities lawyers providing disclosure advice to public companies.
This management confirmation bias, coupled with a lack of accountability, will have the same effect on the system of climate change disclosure proposed by the SEC. The proposed rules would mandate climate-change related disclosure, relying on determinations about what is material, including the assessment of climate-change related risks and the impact of those risks on the company’s business. Particularly where this information will not be welcome by the investing public, management has an incentive to avoid disclosure. To the extent lawyers contribute to this goal by employing a management confirmation approach in assessing materiality, investors and the public will end up with an inaccurate view of the company’s contribution to climate change.
The problem we identify is different from the familiar, if unresolved, discourse about the gatekeeping role of lawyers in companies’ wrongdoing. The gatekeeping discourse is about what the job of corporate lawyers should be. Our article, in contrast, is about what the task of securities lawyers is. Put differently, the management confirmation bias with respect to corporate disclosure is not a theoretical one about what lawyers should or should not do. Rather, it is about what happens when lawyers do not do their job under existing securities laws and regulations.
There is, we assert, a solution to the problem of lawyers’ poor disclosure advice. The SEC has the authority to address the role of lawyers in the disclosure process. Congress in the Sarbanes-Oxley Act (SOX) instructed the SEC to adopt and enforce “minimum standards of professional conduct” applicable to attorneys appearing before the SEC in the representation of public companies. With one exception, the SEC has never used this authority, and in that one case no lawyers were punished. The Commission should reconsider and put in place and enforce standards applicable to securities lawyers practicing before it and providing advice to public companies.
Our article proposes seven such standards.
First, the SEC’s standards already specify that securities lawyers representing public companies must operate in the interests of the corporation, not its management. This standard, however, provides no insight into how this should be accomplished. It should.
Second, the standards should embody a concept of completeness with respect to advice. This means a lawyer should convey any significant uncertainties in the analysis. Particularly with respect to materiality determinations, this would include discussing the risk that certain information may be later viewed as material and what the consequences of that would be.
Third, the standards should clarify the obligation to have an adequate factual predicate for the advice. Before providing disclosure advice, lawyers should be required to employ some type of process to make sure that the facts they have considered are sufficient to render an opinion or provide the requisite advice. Where they know the information may not be accurate, either because of red flags or because of a rapidly changing environment, they should have an obligation to investigate.
Fourth, much as auditors do with respect audit evidence, lawyers making determinations should keep sufficient contemporaneous records to support the reasonableness of their legal advice.
Fifth, lawyers providing disclosure advice should have a minimum level of training and expertise making relevant assessments, particularly with respect to grey areas such as materiality. This should require more than a general understanding of the federal securities laws or the belief that, because lawyers also invest, they inherently understand the informational needs of institutional and other investors. Disclosure lawyers opining on the informational needs of “reasonable shareholders” should have adequate expertise to make these determinations.
Sixth, standards should require policies and procedures at the law firm level that are designed to ensure the quality of advice. Much as auditing firms must have a system of quality control with respect to the audits of public companies, law firms should have a similar system when giving opinions to public companies.
Finally, standards should require disclosure to entities outside of the company in limited circumstances where management refuses to follow the advice of disclosure counsel and insists on acting in a manner which will make the corporation liable.
While these recommendations may seem bold in the sense that they deviate from the traditional state-based approach to the regulation of lawyers, they may not be bold enough. Almost two decades of experience with the oversight of auditors that represent public companies has shown the benefits of a dedicated regulator with the authority to write and enforce relevant standards. If the Commission does not promulgate and enforce rules designed to address the role of lawyers in the disclosure process, it may make sense to create an oversight board like the Public Company Accounting Oversight Board (PCAOB) for accountants.
This post comes to us from professors J. Robert Brown and Eli Wald at the University of Denver’s Sturm College of Law. It is based on their recent article, “Chilling Climate Change Disclosure: The Enabling Role of Corporate Counsel in Management Misstatements of ESG Matters,” available here.