Corporation, Securities
& Business Law Forum
March 1999 Vol. 44, No. 2
Statements or expressions of opinion or comments appearing herein are those of
the editors or contributors, and not necessarily those of the association or section.
Contents
* Staying out of trouble with the SEC: Tips for the brokerage firm
* Y2K for the business manager who has no time to deal with Y2K
* Sample Year 2000 readiness disclosure statement
* American Bar Association issues guidelines for attorneys serving on corporate boards of directors
Our second issue of the newsletter was developed by council member, Donna Cunningham, and includes our regular columns and some interesting new ones. Of special interest to the section council is our pro bono initiative, highlighted in Chairman Jim Moylan's column and the subject of a feature article by Bill McGrath, executive director of the Illinois Pro Bono Center. In addition to the articles highlighted in Donna's column, this issue also features an article by Jim Moylan on ABA guidelines for attorneys serving on corporate boards of directors. As always, we welcome your comments and suggestions, as well as material for the next issue of the newsletter.
Robert C. Knuepfer, Jr.
Baker & McKenzie, Edtor
In addition to our usual columns, this issue contains articles by Dexter Johnson on how to Stay Out of Trouble with the SEC, and Brent Gwillim on Piercing the Corporate Veil. Also included is my Y2K article in three parts, which has been directed to the business manager rather than the business lawyer. The hope is that you will be able to pull out the article and send it to your clients. There is much in it for which they may seek your advice. Also enclosed is a sample Disclosure Statement sent to me by my bank, which I though was rather well done. This Y2K edition was a more ambitious project than I thought, and so it is later than usual, but worth (I hope) waiting for.
Yours,
Donna J. Cunningham
By James J. Moylan, Arnstein & Lehr, Chicago
The section council decided to move forward with our pro bono initiative.
One aspect of being a professional is providing service to those in need without charge. Business lawyers have typically been reluctant to render pro bono services in traditional pro bono areas due to concerns over unfamiliarity with the areas of law involved, malpractice coverage, and other legitimate issues.
In response to those concerns, we sought to identify pro bono projects that would lend themselves to our areas of concentration. We located the Community Economic Development Law Project ("CEDLP") in Chicago and the Illinois Pro Bono Center ("IPBC") in Champaign. Debra Osborn of the CEDLP and Bill McGrath of the IPBC attended our September 11, 1998, section council meeting in Chicago to discuss their programs.
Briefly, business lawyers will have opportunities through CEDLP to assist low income individuals in forming a business or providing business law help to businesses being operated by low income individuals. The beauty of the CEDLP program is that the CEDLP staff screens the projects and works with the individuals to develop the business plan, budget, fees, etc. before calling in the volunteer lawyer to prepare and file the formation documents or engage in other substantive legal representation.
In addition to such traditional "one on one" pro bono services, CEDLP provides other pro bono opportunities in the nature of sponsoring seminars where business lawyers can speak on topics such as forming a business, negotiating a lease, qualifying for not-for-profit status, etc. CEDLP also needs lawyers to author articles for CEDLP's newsletter, which also qualifies as a pro bono activity.
Please read Bill McGrath's article in this newsletter which contains a more detailed discussion of the pro bono opportunities available to our section council members.
A volunteer form is enclosed with this newsletter. If you have a desire to perform pro bono services but were uncomfortable with traditional pro bono practice areas, we believe the CEDLP and IPBC programs are for you. Please complete the form and return it to Mary McClain Grant at the ISBA's Chicago Regional Office. We will compile the applications and forward them to CEDLP for Chicago area practitioners and IPBC for downstate practitioners.
We hope you will volunteer for just one project per year to help advance this section council's goal of promoting the theme of professionalism this year.
Thank you.
By William D. McGrath, Executive Director, Illinois Pro Bono Center, Champaign
There are many reasons why attorneys in Illinois do pro bono legal work; it is rewarding, it provides needed help for clients with legitimate legal problems; it furthers the profession's standards of ethics and it gives volunteers experience and training. Across the state, thousands of dedicated volunteers help families facing illegal evictions, improper collection activities, domestic violence and wrongful termination from benefit programs. These volunteers often work with organized pro bono programs which serve an important role as a conduit to get clients in need in touch with willing volunteers. These pro bono projects also provide substantial backup, support and mentoring services for volunteer attorneys, so the lawyers can put their time to work on solving the clients' legal problems.
Attorneys who primarily practice in corporate, securities or business law settings must find challenging and rewarding pro bono opportunities that provide meaningful avenues for volunteer activity. One such opportunity is offered by the ISBA Corporation, Securities and Business Law Section's new pro bono project. This effort, the first official pro bono project initiated by any ISBA section or committee, matches the vast talents and experience of section members with needed work for community nonprofit corporations who are engaged in economic development activities in Cook County. The Community Economic Development Law Project (CEDLP, Law Project) has been in operation since 1985 as a project of the Chicago Lawyers' Committee for Civil Rights.
The Law Project provides free legal services to community-based organizations working in areas of housing, community and economic development. These groups get help with incorporation and other start-up issues, such as application for tax-exemptions, drafting of documents and assistance with bylaws and corporate board development. The Law Project recruits volunteer attorneys who concentrate in corporate, tax, real estate and zoning law. The volunteer lawyers help these community groups who are beginning projects to help community development in low income parts of Chicago.
The Law Project believes that the cost of not having an attorney when a group is venturing into new and unfamiliar territory of economic and housing development can be very high. On the other hand, legal advice can make the difference between the success or failure of a project. This approach to assisting with community development has attracted nearly 500 volunteer attorneys to the Law Project.
In addition, the Small Business Program has been initiated to provide legal help to low income entrepreneurs who are starting small, for profit businesses. These entrepreneurs are in need of vital legal assistance with issues regarding business structure (corporation v. partnership), obtaining licenses, dealing with employment law matters, leases and loan documents.
Volunteers should devote the time necessary to accomplish each assigned project; however, a variety of time commitments are available to volunteers, ranging from relatively simple tasks to more intensive long-term projects. Staff at the Law Project work with the community group, sometimes for years, until they are truly ready for a volunteer attorney to step in and get the case. Once a volunteer is recruited for a particular client, a specific retainer agreement is drafted; one which clearly articulates the responsibility of the volunteer attorney. This is important to make sure that a volunteer who is experienced in incorporation matters is not expected to provide tax assistance to the community group, or some other legal work beyond that which is specified in the agreement. The distribution of incidental costs, such as duplicating and messenger services, is also detailed in the retainer. An attorney volunteer who accepts a referral from the Law Project will be covered for that case by the Law Project's professional liability insurance. Volunteers are not expected to provide "costs" or otherwise advance expenses to clients.
In addition to specific work with eligible client groups, ISBA Corporation, Securities and Business Law Section members can also provide important assistance in other ways. The Law Project would like to institute a regular newsletter to update individual clients and client community groups about legal and legislative changes which impact on their businesses and organizations. This newsletter would serve an important role in providing a vehicle for the exchange of information among these community groups, and small businesses, but is a project that is currently beyond the means of the Law Project. Staff and volunteers at the Law Project simply do not have the time to put together a quality newsletter on a regular basis. Members of the section, however, could help with the production of a newsletter and that service would be a big benefit to both the community groups involved and the Law Project.
Likewise, participation in community legal education seminars is an area where section members can provide a great benefit to this effort. Community nonprofit groups often lack the resources to subscribe to all the current news publications necessary to keep up with changes in tax rules, corporate law and other important business matters. The members of the section are uniquely qualified to help with this type of effort.
Outside the Chicago and Cook County areas, volunteers can still help. The Law Project works with eligible clients in the collar counties. Working with a number of local pro bono programs (covering virtually the entire state), pro bono assistance on business and corporate legal issues is needed. Interested volunteers will be placed with local pro bono efforts to match your interest to available services in your community.
This important and unique opportunity for pro bono involvement demonstrates the commitment of attorneys, like yourself, to provide quality, uncompensated voluntary civil legal services to the income eligible and to organizations who serve the income eligible. To join this effort, please sign the pro bono volunteer form found on page two of this newsletter and return it to the ISBA. Your pro bono effort will be greatly appreciated.
Staying out of trouble with the SEC: Tips for the brokerage firm
By Dexter B. Johnson, Mallon & Johnson, PC, Chicago
Over four years ago, the Securities Exchange Commission ("SEC") caused considerable consternation within the management ranks of some of the nation's largest brokerage firms when, through a series of high profile cases, it began to dramatically increase the number of administrative actions and sanctions against brokerage firm supervisors and managers.
Whether it was the SEC holding officers at Salomon Brothers' trading department liable for its employee submitting false bids in an auction of Treasury securities, Paine Webber and its management being sanctioned stiffly for its failure to supervise sales-related activities in its branch offices, or supervisors at Kidder, Peabody & Co. being sanctioned by the SEC for failure to supervise a senior trader conducting "phantom" trades, lawyers and the industry alike believed that executives from the branch manager level to the highest echelons of broker-dealer firms would move quickly to curb the behavior of renegade brokers who violated the securities law. Many of these firm supervisors did take decisive remedial action to deter future violations in response to increased regulatory investigations, sanctions, and arbitration decisions targeting the firm and its supervisory personnel. Unfortunately, for varying reasons, including lax practices, some firms, their supervisors, and managers have not gotten the message.
As a whole, these cases have forced brokerage firm management to take a more expansive view of their responsibility to supervise brokers to prevent wrongdoing. The question where that responsibility for supervision, and the liability for failing to do so, begins and ends might be subject to debate. However, there is little argument that it does not always end with a wrongdoing broker's immediate boss or supervisor. For proof, one need look no further than Frederick Joseph, Drexel Burnham Lambert's former CEO. Joseph was sanctioned for his failure to supervise Michael Milken. Despite Joseph's lack of knowledge about what Milken did, the SEC concluded that Joseph should have recognized Milken's actions as red flags, and investigated his activity. Nor, despite the SEC's somewhat amorphous standards for imposing liability for failure to supervise, does it have to end at the top of the brokerage firm's hierarchy.
One thing is certain: The current SEC is intensely focused on sales practice issues and, in particular, brokerage firms and their managers. Along with increased administrative actions against firms and their managers, the SEC is meting out stiffer sanctions against those supervisors who fail to supervise registered representatives who violate the federal securities laws. The SEC's rationale appears to be that by focusing its resources on firms and their managers, its administrative efforts will have a greater impact on firm culture and how firms conduct their business.
Theories of liability? The legal theories underpinning brokerage firm and supervisory liability for the wrongful conduct of its brokers include:
* Failure to supervise;
* Controlling person;
* Aiding and abetting; and
* Respondeat superior.
There is no shortage of cases in which the SEC, National Association of Securities Dealers ("NASD"), and state securities regulators have not successfully tested these theories. Unfortunately, examples abound and a few are summarized below.
Failure to supervise
Since the Salomon Brothers treasury action and the Paine Webber sales practices administrative actions, the SEC has brought administrative actions against numerous retail brokerage firms, their officers, and employees based on its determination that the broker-dealer or supervisory person "has failed reasonably to supervise, with a view to preventing violations of ...[the Securities Act of 1933 ['1933 Act'], the Securities Exchange Act of 1934 ['1934 Act'], the Investment Advisers Act of 1940, the Investment Company Act of 1940, the Commodity Exchange Act, or the rules or regulations thereunder, or the rules of the MSRB]...another person who commits such a violation, if such other person is subject to his supervision." 15 U.S.C. section 78o(b)(4)(E).
Basis of the theory
The SEC's more aggressive posture toward supervisors, whether CEO or branch manager, holding them responsible for failing to supervise those who commit securities law violations derives from sections 15(b)(4)(E) and 15(b)(6) of the 1934 Act, 15 U.S.C. section 78o(b)(4)(E) and 78o(b)(6). Section 15(b)(4)(E) also provides a safe harbor against a failure to supervise charge if the broker-dealer or individual can show that:
* There were established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect violations; and
* The supervisor reasonably discharged his duties under the system without reason to believe that the procedures and the system were not being satisfied.
No better example exists of the SEC's use of section 15(b)(6) of the 1934 Act, which incorporates by reference section 15(b)(4)(E) of the 1934 Act, than the SEC's bar of Frederick Joseph, Drexel's CEO, for life from acting as the chairman or CEO of a broker-dealer and from association in a supervisory capacity with any broker-dealer for a period of three years. The SEC found that Joseph failed reasonably to supervise Michael Milken who at the time was manager of Drexel's high-yield bond department in the mid-80s. The SEC determined that, while Joseph did not supervise Milken directly (and probably had little knowledge of Milken's activities), he bore personal responsibility for not bringing questionable purchases made by a group controlled by Milken to legal and compliance personnel for advice to determine whether those activities violated the law.
Continuing problem
The number of recent administrative enforcement actions in which the SEC and other regulators have imposed liability upon supervisors, throughout the management chain, since the Salomon Brothers and Paine Webber administrative actions is extensive. A steady stream of brokerage firm supervisors have continually failed to grasp lessons for what has become now a familiar chorus of sanctions imposed for their failure reasonably to supervise brokers.
First Capital
On August 13, 1997, as part of a settlement, the SEC and the CFTC ordered First Capital Strategists and four of its partners to pay $2.6 million to colleges and universities who invested through The Common Fund, a nonprofit corporation that manages $17 billion for 1,300 educational institutions. As a result of a trader's unauthorized trading, The Common Fund lost approximately $137.6 million over a period of approximately three years.
The SEC and CFTC argued that the partners failed to adequately supervise the trader, overstated actual performance, and misrepresented the firm's internal controls. The regulators further concluded that First Capital should have known about the trader's unauthorized day trading which exposed The Common Fund to an unauthorized level of risk. In a separate criminal action, the trader pled guilty and was sentenced to 34 months in prison and ordered to pay $237,465 in restitution for losses he sustained in the unauthorized trading.
The SEC suspended the partners from doing securities business for one year and barred them from acting as supervisors in the securities industry, with a right to reapply in five years. The SEC also revoked First Capital's registration as an investment adviser.
In the Matter of Orlando Joseph Jett and Melvin Mullin
The SEC suspended Melvin Mullin, a supervisor of Orlando Joseph Jett, a trader and one-time head of Kidder, Peabody & Co.'s Government Securities Trading Desk. Mullin was suspended for three months, and given three months supervisory suspension from association with any broker, dealer, investment company, investment advisor, or municipal securities dealer, and was subject to a civil penalty of $25,000 for failure to reasonably supervise Jett. In the Matter of Orlando Joseph Jett and Melvin Mullin, Exchange Act Release No. 34-37226, 61 SEC Docket (CCH) 2440 (May 20, 1996).
The SEC alleged that Mullin failed reasonably to supervise Jett when for approximately three years, Jett utilized an anomaly in the broker-dealer trading and accounting system when trading U.S. Treasury bonds issued pursuant to the treasurer's program of Separate Trading of Registered Interest and Principal ("STRIPs") to create the appearance of large trading profits when in fact Jett was continually losing large amounts of money. The SEC determined that Mullin failed reasonably to supervise Jett in that he did not monitor Jett's trading in sufficient detail to prevent and detect Jett's violations of the federal securities laws.
Paine Webber's BOM: In re James Warren
Less publicized recent violations include the branch office manager ("BOM") of Paine Webber's Omaha, Nebraska, office being suspended from association in supervisory capacity with any broker-dealer, investment advisor, investment company, or municipal securities dealer. The SEC found that the BOM failed to supervise a registered representative in the Nebraska office. The SEC alleged that the BOM failed to conduct a reasonable inquiry into the apparent over-concentration of customer accounts in illiquid and unsuitable direct investments. The SEC determined that the over-concentration was readily apparent from a review of the registered representative's customer account records, and that the BOM's failure to detect the over-concentration constituted a failure to supervise. In re James Warren, 62 SEC Docket (CCH) 2447, 1996 WL 539165 (N.A.S.D. Sept. 24, 1996).
In re Refco Securities, Inc.