Conflicts of Interest

1. General introduction

Financial institutions are among the most heavily regulated entities in the US. Despite the weight of such regulation, damaging allegations of widespread conflicts of interest in the industry have of late been front-page news with distressing regularity. Many of these issues have emerged not far behind – and sometimes hand-in-hand with – the collapse of major companies such as Enron and WorldCom following discovery of massive financial fraud.

A broad range of financial institutions has recently been the subject of regulatory investigations, enforcement action and lawsuits. The targets have included investment banks, ranging from traditional “underwriter” firms to full-service financial institutions, commercial banks, mutual funds and investment advisers. In the most recent wave, insurance and reinsurance companies have become targets, first relating to allegations concerning bid-rigging and other anti-competitive practices, and thereafter in respect of claims relating to the improper use of “finite” or non-traditional products that allegedly were used improperly to smooth financial results.

As financial institutions in the US continue to face regulatory scrutiny, as regulators impose additional obligations on financial institutions to address potential conflicts of interest and to play a more active role as “gatekeeper” and as legal and compliance staff play a far more prominent role in the day-to-day operations of investment banks, it would be difficult to characterise the regulatory landscape as settled or stable.

2. Historical background

The earliest concerns with conflicts of interest would involve the potential conflicts between commercial banking and securities trading. Although legislation in the late 1920s explicitly permitted commercial banks chartered by the federal government to deal in securities, which in turn led to an expansion of investment banking activities, the permissive era proved to be short-lived. In the wake of the stock market crash of 1929 and the subsequent Great Depression, the US Congress enacted various laws aimed at increasing consumer confidence in banks as well as preventing bank failures by curtailing banks’ use of funds deposited by customers. Among these laws, was the Glass-Steagall Act (GSA) of 1933, which mandated separation between commercial and investment banking and ushered in a regime that would last 70 years.

In the 1950s, the Bank Holding Company Act (BHCA) was enacted to prohibit bank holding companies, which were not subject to the GSA, from acquiring direct or indirect control over a company that was not a commercial bank. One exception to this rule allowed the Federal Reserve Board to permit a bank holding company to acquire or control a non-banking company if its activities were “so closely related to banking or managing or controlling banks as to be a proper incident thereto”. This exception allowed bank holding companies in some instances to conduct securities-related activities.

The GSA regime came under attack by the banking industry in the mid-1960s, when commercial banks pushed to expand their purview. That push was stopped temporarily by the US Supreme Court in 1971, in Investment Co Institute v Camp 401 US 617, 639 (1971). In Camp, the court upheld the GSA’s separation of commercial and investment banking activities, finding that commercial banks should not be able to offer mutual funds.

Through the 1980s and into the 1990s, as the capital markets supplanted the bank lending market as the preferred source of capital, commercial banks resumed their push to meet the competitive threat posed by investment banks. In 1999, Congress passed the Gramm-Leach-Bliley Act (GLBA), also known as the Financial Modernization Act of 1999, finally bringing the GSA era to an end. The GLBA repealed the GSA’s restrictions on banks affiliating with securities firms. In supplanting the GSA, the GLBA permitted financial services providers (including commercial banks, securities firms, and insurance companies) to affiliate with each other and enter each other’s markets.

As the twentieth century came to an end, and with it a highly regulated, compartmentalised regime that was built on the separation of insurance operations, commercial banking operations and the underwriting of securities, one could reasonably ask whether the industry was headed for trouble. From a regulator’s perspective the answer turned out to be “yes”, but for a different reason. Within two years, regulators’ concerns with the industry would focus on conflicts of interest, but not those inherent in the conduct of various disparate businesses under one roof (except perhaps for the possible set of conflicts that full service firms face when one part of the firm, for example, is trying to sell a banking product, and another is pitching a capital markets product, to the same company). The focus would instead be on conflicts within the various divisions of investment banks.

3. Recent areas of regulatory focus

As the technology bubble burst and financial scandals began to dominate the headlines, the media and the investing public, followed by the regulators, turned their attention to Wall Street. These developments came at a time when investing in the stock market had become a broad-based, and extremely popular, activity in the US, and media attention (including the advent of financial news networks providing round-the-clock coverage of the markets), coupled with the vast array of financial information available electronically, and instantly, had dramatically raised the public profile of research analysts.

From mid-2001 to the present, the public and regulatory scrutiny of analysts would lead to a broader focus on financial service firms generally, with parallel investigations into various specific products, services and practices ripe for scrutiny.

Research analysts

The financial institution conflicts of interest that received the most public attention involved research analysis by investment banks, and the tension they face when serving both corporate and individual clients. Investment firms have information barriers – so called “Chinese walls” – separating the research (ie analyst) and the investment banking sides of the business. These barriers were not specifically mandated by law or regulation. They serve principally to prevent the flow of non-public information to analysts on the other side of the “wall”, which would put analysts at risk of violating insider-trading laws, and to satisfy implied obligations under insider-trading sanctions legislation.

Information barriers were not designed to address conflicts of interest, and in a system where there is an absolute wall, the potential for conflicts among different parts of an institution and among clients serviced by different parts of an institution is likely to be exacerbated. As multi-service financial institutions evolved and encompassed a wider range of businesses, as competition for mandates increased and as the capital markets boom got underway offering investment banks opportunities to earn tremendous fees from a range of services (from M&A advisory, the underwriting of debt and equity, to derivatives structuring), so too did the potential for conflicts.

Financial institutions typically provide research through their analysts, sales through their brokers and underwriting services to corporate clients. The desire to please corporate clients with favourable analyst reports came into conflict with the goal of providing objective information to the market in these analyst reports. Potential conflicts were inherent in the following:

1 the firm may have underwritten a company’s public offering or be seeking future investment banking business, and the analyst may have been part of the team that brought in the business;

2 favourable reports by brokerage firm analysts could trigger higher trading volumes, resulting in greater commissions;

3 an analyst’s salary and bonus may have been linked to the profitability of the firm’s investment banking business; and/or

4 the analyst, other employees of the firm and the firm itself or its affiliates might own an equity stake in the companies the analyst covers.

The analyst may have participated in employee stock pools that invest in companies that the analyst covers or might have a direct investment. At the time these conflicts came into sharp focus, the existing rules provided little in terms of procedural constraints or of disclosure. Broker-dealers were required to disclose whether they made a market in, and whether they had recently underwritten a public offering of, a subject company’s securities. Of the two principal self-regulatory organisations (SROs), the NASD had rules requiring member firms, and/or their officers and partners (but not the analysts), to disclose ownership in a subject company’s options, warrants and other rights (but not common stock), and the New York Stock Exchange (NYSE) had rules requiring the firm and the analyst to disclose whether they “may” have an ownership interest in a subject company’s securities (common stock and options) and whether any employees of the firm were directors of a subject company.

In their investigations of securities research in the summer of 2001, regulators highlighted the following: 1 analysts provided significant assistance to investment bankers; 2 analysts often were involved with start-up companies before the investment banking team developed a relationship; 3 analysts often covered companies whose securities the firms underwrote; 4 analysts sometimes provided investment bankers with prior notice of changes in recommendations; 5 most firms did not prohibit analysts from having stock positions in the companies they covered; 6 compliance with SRO rules that required firms to monitor employees’ investments in private equity vehicles was poor;

7 disclosure of firm and analyst stock ownership in recommended securities varied widely and disclosure of underwriter and market-maker status conveyed little useful information;

8 analysts routinely recommended securities in public appearances
without any disclosure of conflicts to investors;

9 some analysts issued “booster-shot” reports (reiterating buy recommendations) around the time an underwriter lock-up expired enabling the firm, firm clients and the analyst to sell into an inflated market; and

10 rating terminology was unclear and confusing. In recognition of the potential limitations and bias of research analyst reports, in June 2001, the US Securities and Exchange Commission (the SEC) issued an investor alert urging investors not to rely solely on analyst recommendations when deciding to buy stock. SEC Commissioner Laura S Unger was quoted as saying that: “[f]inancial analysts have been the focus of intense public scrutiny in recent months, and I am hopeful the industry will eliminate the conflicts of interest that threaten the fairness and objectivity of analyst recommendations.” Investors were urged to consult multiple sources of information while considering their own investment goals and tolerance for risk.

Market timing

In late 2003, New York Attorney-General Eliot Spitzer and the SEC announced investigations into, and enforcement action concerning, a series of improprieties by publicly traded mutual funds. These included a practice known as “market timing”, whereby certain favoured investors were permitted to make rapid purchases in and out of funds in order to capitalise on information known to the market at large but, due to their unique structure, not yet reflected in the price of the mutual funds.

Market timing is not illegal, although the prospectuses of many mutual funds prohibit it. The rapid trading in and out of mutual funds by a small number of fund shareholders comes at a cost to longer-term investors as transaction and processing costs are borne by a fund as a whole and therefore come out of the pockets of all shareholders. By the same token, periodic profit-taking by market timers comes at the expense of long-term shareholders whose investment in the funds is potentially diminished each time a market timer seeks to buy low or sell high in the fund. There is thus an inherent tension between permitting aggressive, savvy investors to use mutual funds for market timing and preserving the funds as a haven for shareholders seeking a long-term nest egg rather than short-term profits.

That tension was exacerbated – and transformed into an outright conflict of interest – by the agreement by some fund complexes to permit market timing activity in certain funds, provided that market timers invested a sizeable portion of their assets for a long-term period in other investment vehicles owned by the same financial institution. This practice became known as soliciting “sticky assets”. This conflict of interest formed the backbone of Eliot Spitzer’s complaints against a number of mutual fund complexes in late 2003 and 2004.

In its response, the SEC moved to bolster the effectiveness of independent directors of funds and to solidify the role of the board of directors of funds as the ultimate advocate for fund shareholders. Registered investment advisers became subject to codes of ethics requirements. Action was taken to address conflicts of interest between mutual funds and brokers who distribute fund shares and to improve disclosure about fees, conflicts of interest and sales incentives. In a related move, hedge fund advisers (long able to operate beyond regulatory scrutiny and to function with little disclosure to fund investors) were subjected to SEC registration.

Other potential sources of conflicts

Following the mutual fund inquiries, the then director of the SEC’s division of enforcement took broader aim at Wall Street generally. In a series of speeches, the director started from the premise that conflicts of interest are “inherent in the financial services industry”. He continued: “When you are paid to act as an intermediary, like a broker, or as another’s fiduciary, like an investment adviser, the groundwork for conflict between investment professional and customer is laid.” Conflicts could arise between the firm’s interests and a client’s, between different parts of the same firm and between clients in one part of the firm and clients in another part of the firm.

In late 2003 and again through much of 2004, he called upon the financial services firms to undertake a “top-to-bottom” review of their business operations, with the goal of addressing conflicts of every kind. The firms were urged to search for practices that had the potential to sacrifice the interests of one set of customers in favour of the interests of another. They were to identify any situation in which the firm could place its interests or its employees’ interests ahead of customers. Both types of conflicts, he posited, had to be eliminated or be disclosed. He cited as examples of recent SEC enforcement actions:

1 the analyst that failed to disclose in research concerning a public merger ownership of stock in the target;

2 the securities firm that had policies in place calling for disclosure of the fact that the firm offered different classes of mutual funds shares with different discounts but that failed to adopt a sufficient supervisory regime to determine whether the policies were being followed;

3 the investment adviser that failed to advise clients referred to it by full service brokerage firms (with the understanding that those clients’ trades would be routed back to those brokers) that they were paying higher commissions than its other clients that were referred to a discount broker;

4 the investment adviser that allocated IPO shares only to certain of its clients, which were paying the adviser a performance-based fee; and

5 the investment banking firm whose investment management arm switched proxy votes on behalf of its advisory clients (without advising them about a potential conflict) from a vote against, to a vote in favour of, a merger in which the investment bank was advising one of the parties to the merger, and went on, after pointing out that the focus was shifting from analysts to other business areas of full service firms, to highlight some of the cases the SEC staff was evaluating:

6 a firm’s research department avoids downgrading a buy recommendation on a company’s securities after selling a large block of the company’s stock to a major institutional customer;

7 a firm provides research coverage for a company in which the firm and its senior managers have an interest; 8 a firm provides research coverage for a company whose pension assets are managed by the firm’s asset management division;

9 a pension consultant retained to advise pension funds in selecting advisers has a relationship with a broker and thus has an incentive to recommend advisers that will direct brokerage business to the broker;

10 a prime broker has the discretion to allocate redemptions among its accounts that hold callable securities that may be tempted not to allocate redemptions to preferred customers; and

11 a firm provides execution to a hedge fund while recommending that fund to its customers. Firms were urged to be proactive, systematically to identify conflicts and then inform the SEC staff of any violative conduct. The consequences would be worse, the director was on record as saying, if the SEC found the conduct on its own.

Evolving trends related to accountability

One major fall-out from the financial scandals and the lawsuits that followed was a move by the courts and regulators to impose greater accountability on the so-called gatekeepers: financial institutions, accountants and lawyers. For financial institutions, this has manifested itself in a number of ways, including the imposition (or threat) of liability by courts and regulators on investment banks for allegedly aiding and abetting fraud by their public company clients. Courts and the SEC have focused on new theories of primary liability, aiding and abetting liability and liability for causing violations of the securities laws by others to impose penalties on financial institutions.

Guidelines were also proposed (but have not yet been promulgated) that would have been applicable to regulated financial institutions in respect of so-called complex structured financial transactions, which guidelines were designed to shift the policing function to the investment banks that structured and sold these products, so as ultimately to protect the shareholders of the banks’ clients and the general investing public.

4. Regulatory responses to conflicts of interest

In response to growing concern about conflicts of interest in the financial industry, regulators (and the SROs) were galvanised to act and did so by focusing on various types of conduct.

Regulation FD (Fair Disclosure)

Regulation FD, which is designed to prevent selective disclosure by US public reporting companies, was adopted by the SEC in August 2000. Under this regulation, public companies must refrain from intentional selective disclosure and must cure unintentional selective disclosure by publicly disclosing material non-public information that has been so disclosed selectively. Regulation FD treats as selective disclosure those disclosures made to broker-dealers, investment advisers, hedge funds and shareholders that are likely to trade on the basis of the disclosure. The principal targets of the regulation were research analysts who through one-on-one meetings or attendance at analyst conferences were given the benefit of material insights into a public company’s results and prospects that were not available to the general public.

Although the SEC had in the past sought to combat the perceived advantage accorded analysts through enforcement action for insider trading, its poor track record in the courts led it to focus instead on the source of the information – the public companies themselves. Violations of Regulation FD do not create new liability under the anti-fraud rules of the federal securities laws. However, the regulation has served as a basis for a series of high-profile SEC enforcement actions against companies, chief executive officers, chief financial officers and heads of investor relations departments.

The Sarbanes-Oxley Act

On 30 July 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (SOA). Broadly, the SOA covered six principal initiatives:

The SOA required the SEC, either directly or acting through the SROs – the NASD and the NYSE, to address conflicts of interest involving research analysts. The rules include establishing safeguards to separate research analysts from review, pressure or oversight from investment banking personnel and limit company influence.

Action by the self-regulatory organisations

In May 2002, the SEC approved rule changes filed by the SROs governing research analyst conflicts. In July 2003, in response to the legislative mandate set forth in the SOA, the SEC approved amendments to a series of SRO rules regarding research analyst conflicts of interest. These rules, which have been issued by the NYSE and the NASD and apply to their member firms (members), are among a series of recent regulatory steps designed to address research analyst conflicts of interest. Other recent initiatives affecting research analysts include Regulation AC, adopted by the SEC in February 2003, and the global settlement of enforcement actions relating to research analyst conflicts of interest brought against ten financial institutions, both of which are described below.

The SRO rules are designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and public appearances, to improve the objectivity of research, to provide investors with more useful and reliable information and to require disclosure in public appearances and research reports of conflicts of interest that are known, or should have been known, by the securities analyst or the broker-dealer to exist at the time of the appearance or the date of distribution of the report. Specifically, the SRO rules:

1 restrict the review of research reports prior to distribution, by prohibiting any review of a research report by investment banking personnel or any other employee of the member who is not directly responsible for investment research, unless such review is for the purpose of the verification of the factual accuracy of information in the report or identification of any potential conflict of interest;

2 prohibit any research analyst from participating in efforts to solicit investment banking business, such as involvement in solicitation or “pitches” to prospective investment banking clients or other communications that are made for the purpose of soliciting investment banking business;

3 require procedures for review and approval of the compensation of a research analyst primarily responsible for the preparation and substance of a research report, at least annually, by a committee that reports to the board of directors or a senior executive of the member, and prohibit any employee of a member’s investment banking department from participating on this committee;

4 contain trading restrictions for research analysts that prohibit the trading of securities of companies close in time to the publication of research reports regarding an issuer, as well as trading contrary to the recommendations of the member firm, and extend such restrictions by prohibiting any person who supervises research analysts, or a member of a committee, who has direct influence and/or control with respect to

(i) preparing the substance of research reports or (ii) establishing or changing a rating or price target of a subject company’s equity securities, from effecting trades in securities of a company that is the subject of such research reports, or ratings or price target changes, without the prior approval of the member’s legal or compliance personnel;

5 require disclosure by a member in research reports, to the extent the member knows or has reason to know, and by a research analyst in public appearances, to the extent the analyst knows or has reason to know, of whether the member or any affiliate of the member, received compensation during the past 12 months from the subject company;

6 require members to prepare a final research report prior to
terminating coverage of a subject company, which must be made
available using the means of dissemination equivalent to those
ordinarily used to provide customers reports on the same subject
company;

7 impose quiet periods on research during which a member may not publish or otherwise distribute research reports regarding an issuer and research analysts may not recommend or offer an opinion on an issuer’s securities in a public appearance;

8 prohibit members and employees of members who are involved in the member’s investment banking activities from directly or indirectly retaliating against or threatening to retaliate against any research analyst as a result of an adverse, negative or otherwise unfavourable research report written or public appearance made by the research analyst that may adversely affect the member’s present or prospective investment banking relationship with the subject company of the research report; and

9 require research analysts and supervisory analysts to be registered with, qualified by and approved by, the relevant SRO.

Regulation AC (Analyst Certification)

Regulation AC was adopted by the SEC in April 2003 with the intent to require that “brokers, dealers, and certain persons associated with a broker or dealer include in research reports certifications by the research analyst that the views expressed in the report accurately reflect his or her personal views, and disclose whether or not the analyst received compensation or other payments in connection with his or her specific recommendations or views”. The regulation requires research reports to include two different statements by the research analyst: (1) the analyst must certify that the research being provided truly reflects his or her opinion; and (2) the analyst must disclose to what extent his or her compensation is directly or indirectly dependent on a specific recommendation tied to investment business. If the analyst’s compensation could be directly or indirectly affected by the specific recommendations or views contained in the research report, “the statement must include the source, amount, and purpose of such compensation, and further disclose that it may influence the recommendation in the research report”. Regulation AC also requires the maintenance and retention of records related to public appearances by research analysts.

Like Regulation FD, Regulation AC lacks a private right of action.

The Global Settlement

In April 2003, ten Wall Street securities firms agreed to pay $1.4 billion in fines to settle charges arising from the production of biased research that supported their investment banking businesses while misleading ordinary investors. This was commonly referred to as the Global Settlement, and it was based on an enforcement action brought by the SEC against ten brokers for “failing to ensure that the research they provided their customers was independent and unbiased by investment banking interests”. The terms of the settlement also included policy changes, such as the increased insulation of research analysts from investment banking pressure, a complete ban on the “spinning” of initial public offerings and an obligation for firms to furnish independent research. Some of the undertakings are similar to the SRO rules described above, while others go further. Among other things, the subject firms agreed to:

1 a physical separation of research and investment banking departments to prevent flow of information between the two groups (not required by the SRO rules);

2 the determination of the research department’s budget by senior management without input from investment banking and without specific revenues derived from investment banking (not required by the SRO rules);

3 the determination of research analysts’ compensation and evaluation of their job performance without regard to investment banking revenues or input from investment banking personnel;

4 the making of all company-specific, termination-of-coverage decisions by research management (not required by the SRO rules);

5 prohibit research analysts from participating in efforts to solicit investment banking business;

6 create “firewalls” between investment banking and research; 7 a commitment on the part of the firms to furnish independent researchto customers for a period of five years (not required by the SRO rules); and 8 a requirement to disclose publicly their research analysts’ historical ratings and price target forecasts.

SRO prohibitions on certain IPO allocation abuses

In August 2002, the NYSE and the NASD, at the request of the SEC, established an IPO advisory committee to address abusive practices in the IPO process, such as spinning, unlawful quid pro quo arrangements, inequitable imposition of penalty bids and allocations based on agreements to pay excessive commissions. The committee in May 2003 proposed 20 recommendations, including various proposals for SRO action. The NYSE and the NASD have rule-making proposals pending before the SEC responding to the recommendations directed at the SROs.

Separately, in April 2005, the SEC approved SRO rule changes that to a certain extent overlap with the Global Settlement, but that apply to all member firms. These changes prohibit analysts from participating in roadshows related to an investment banking transaction, in effect prohibiting three-way conversations among analysts, customers and investment banking as well as those involving research, customers and issuers; prohibit investment banking personnel from directing analysts to engage in marketing efforts with customers relating to investment banking transactions; and require that any communications from analysts to customers relating to investment banking services be fair, balanced and not misleading.

1. General introduction

The investing public’s belief in auditor independence is critical to instilling confidence in the integrity of financial statements that public companies must provide. But major corporate scandals have exposed the limits of auditor independence and eroded that confidence.

2. History

Since the 1930s, federal securities laws have required an independent public accountant to attest to financial statements filed with the SEC. In 1933, the Federal Trade Commission established the function of accountants as independent auditors for the purpose of reducing information costs to investors and strengthening their trust both in the information that they were receiving from issuers and in the financial system as a whole.

With the passage in 1933 and 1934 of legislation that resulted in the creation of the SEC and has since formed the basis for the regulation of the securities markets, accounting became a profession recognised as crucial to the viability of the securities markets. Public companies are required to submit independently audited financial statements to the SEC in registration statements in order to conduct public offerings and in their annual reports. Users of these financial statements, such as investors, rely on the accuracy of the financial information to evaluate myriad factors such as the probable future performance of a company and to evaluate the general risks of their investment. To ensure comparability, reliability and materiality of the financial statements of a company, the statements must be prepared by an independent auditor.

Under the federal securities laws, the SEC was responsible for making sure the accountant-as-auditor was “independent” of the client, so as to be able to render an objective and accurate opinion. In practice, however, the SEC generally delegated much of its authority to establish accounting methods to the private sector. Between 1936 and 1959, the Committee on Accounting Procedure of the American Institute of Certified Public Accounts (AICPA) established the first financial reporting and accounting standards. Beginning in 1959, the Accounting Principles Board, which is also a part of the AICPA, assumed the role of standard-setter. In 1973, the AICPA gave its authority to a newly created independent private sector body called the Financial Accounting Standards Board (FASB). The SEC endorsed the establishment of the FASB and formally recognised it as the accounting standards-setter in the US. To this day, the SEC has largely adopted the accounting methods established by FASB, referred to as (US) generally accepted accounting principles (GAAP). The objectivity, accuracy, and conformity of financial statements for publicly listed companies must adhere to GAAP.

3. The 1990s conflicts of interest

Because auditors are paid by the companies they audit, there is an inherent conflict in the relationship. That conflict had always been recognised and tolerated. The degree of conflict in the auditor-client relationship, however, changed dramatically in the 1990s as auditing firms began providing non-audit services to the same companies, which proved to be more lucrative than auditing. Using statistics provided by the SEC, the Senate Report accompanying the bill that eventually became the SOA estimated that the percentage of average revenue at the then Big Five accounting firms arising from accounting and auditing services fell from 55 per cent in 1988 to 31 per cent in 1999. By comparison, the percentage of average revenue coming from management consulting services increased from 22 per cent to 50 per cent during that same period.

Because a critical audit could hinder the relationship with the audited company, an auditor’s potential desire to maintain favourable relationships with its client to ensure the flow of the more lucrative non-audit work, potentially threatened the auditor’s independence and impartiality. Moreover, by auditing the same companies for which they provided consulting, auditors were essentially reviewing their own work, further compromising their independence and objectivity.

4. Passage of the Sarbanes-Oxley Act

Some details of the SOA have already been discussed in the section regarding financial institutions. This discussion will be limited to the changes the SOA has had on auditors.

The SOA overhauled the self-regulatory structure that had existed previously and mandated the creation of the Public Company Accounting Oversight Board (PCAOB). All US and non-US public accounting firms that audit SEC reporting public companies must register with the PCAOB. The PCAOB has the power to discipline firms and individual accountants for violations of SEC rules and regulations, and to impose penalties such as fines, censures, removal from client arrangements, limitations on activities and suspension from audit functions on a temporary or permanent basis.

The SOA also included other safeguards against auditor conflicts of interest. The SOA attempts to correct the balance in the auditor-client relationship by prohibiting an auditor for a public company from providing a variety of services to the audit client, such as: bookkeeping; design and implementation of financial information systems; appraisal or valuation services; actuarial services; management functions or human resources; investment adviser or investment banking services; and legal services and expert services. All audit services and permitted non-audit services must be pre-approved by the audit committee, and companies must provide in their annual proxy statements a breakdown of fees paid for audit services and various classes of permitted non-audit services.

Moreover, auditing firms must now rotate the lead auditing partners in charge of a corporate client every five years. Lead and concurring partners are subject to a five-year rotation and a five-year time-out requirement. Other audit partners are required to rotate every seven years and observe a two-year time-out period. An audit firm will not be deemed independent if the lead partner, the concurring partner, or any other member of the audit engagement team who provides more than ten hours of audit, review or attest services accepts a position with an audit client in a “financial reporting oversight role” within the one year period preceding the commencement of the current audit engagement.

The auditors are also now required to discuss with the audit committee: all critical accounting policies and practices used by the issuer; all alternative accounting treatments of financial information within GAAP related to material items that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm; and other material written communications between the accounting firm and management of the issuer.

The rules governing public company audit committees have also changed as a result of the SOA. Under stock exchange listing standards adopted as a result of the SOA, audit committees now have the sole responsibility of hiring, firing and compensating the company’s outside auditors. Each member of the audit committee of a listed company must now be an independent director, meaning he or she may not accept any consulting, advisory or other compensatory fee from the issuer or be an affiliated person of the issuer. In effect, the audit committee has replaced management as the auditor’s client.

5.The current impact

The full effects of the auditor independence rules remain to be seen. What has clearly changed is the nature of the relationship among the audit committee, the auditor and management. Where the relationship pre-SOA tended to be a bilateral one between management and the auditor, the post-SOA relationship is dominated by the audit committee. The auditor independence rules are but one part of the new landscape that includes the audit committee independence requirements, as well as a number of new duties undertaken by audit committees as a result of stock exchange listing standards and other SEC rule-making. If there is one single lesson learned from the enforcement actions and litigation that followed the scandals, it is the importance of effective oversight by the board and its committees, in particular the audit committee. Although ultimately one cannot legislate against fraud, increased sensitivity to controls and procedures, coupled with the proper tone at the top, can go a long way towards reducing the likelihood of corporate fraud.

One interesting effect of these regulations has been an increase in the audit costs for companies. In an article for the Financial Times, Peter Bruce notes that, due to additional money US-registered public companies are now spending on auditing services, audit fees in the US are thought to be increasing by about 20 per cent. He notes as an example that after keeping audit fees with KPMG consistent for the past several years, Prudential considered a potential rate increase of 100 per cent. Additionally, some corporations will go beyond the new legal requirements, setting more stringent internal control standards to avoid any potential scandals. The costs to public companies have increased even more significantly in the past year as a result of the lead-up to, and now effectiveness of, new internal control rules, and related audit requirements, mandated by the SOA.

1. Conflicts generally

“Few precepts in law are more firmly entrenched than that, once a client retains a lawyer to handle a matter, and until that matter is at an end, a relationship exists between them which is of the highest character.” When groups of lawyers practice together in law firms or other associations, these client relationships are often even more complex given the representation of many clients. The lawyer’s task of juggling multiple clients and various ethical duties is not getting simpler. Coupled with an increasing global economy, the explosion of international firms has greatly enhanced the probability of conflicts, the difficulty of their detection and the complications of their resolution. The lawyer’s obligation to each individual client must be preserved, and so, lawyers must actively confront the issues concerning conflicts of interest among multiple clients.

There are myriad circumstances under which a lawyer may be said to have a conflict of interest. For lawyers in large law firms, issues often arise concerning the firm’s ethical obligations in resolving the representation of differing client interests. For instance, attorneys must deal with practical issues such as (1) whether the firm may represent more than one client, either concurrently or jointly, in connection with a particular matter and (2) whether the firm may undertake a particular representation implicating the interests of another existing client of the firm or a former client of the firm. This latter “industry” conflict may not result in a direct conflict but none the less presents issues particularly for the firm that has developed an industry speciality only to find that its success in doing so prevents it from fully taking advantage of that speciality.

We have identified two of the most common conflicts of interest a lawyer may face. These examples are illustrative, but certainly not exhaustive.

Multiple representation

Multiple representation refers to the situation where a lawyer concurrently represents several parties in the same matter. This topic has been the subject of much commentary and regulation. Virtually all states except California follow one of the two model ethics codes developed by the American Bar Association (ABA): the Model Rules of Professional Conduct (1995) (adopted in 1983), and the Model Code of Professional Responsibility (1979). Commentators have generally agreed that the Model Rules’ formulation of conflict-of-interest regulation is an advance over the less sophisticated Model Code provisions. Accordingly, most US jurisdictions have adopted some form of Model Rule 1.7, which addresses issues concerning multiple representation.

The Model Rules contain two rules governing conflicts of interest among current clients. Model Rule 1.7(a) provides in pertinent part: “A lawyer shall not represent a client if the representation of that client will be directly adverse to another client.” Model Rule 1.7(b) provides: “A lawyer shall not represent a client if the representation of that client may be materially limited by the lawyer’s responsibilities to another client.”

Multiple representation is not always forbidden, and some clients may in fact benefit from this arrangement if their interests are aligned, or if it is more cost-efficient to retain only a single lawyer or firm. One common example of this is in a case where one lawyer represents multiple minority shareholders. In a circumstance like that, courts have found that the shareholders may benefit financially from shared counsel.

The most frequent reason a client would want to consent to multiple representation is cost. “Using a single lawyer jointly can save clients the expense of duplicative representation. Even when clients are antagonists, the potential benefits that an aggressive, unconflicted lawyer might achieve on behalf of a client may be less than the expense of the additional representation.” Likewise, multiple clients may wish to retain a known and trusted lawyer or one with a specialised practice area. In these situations, to the extent the professional codes allow the clients to consent to the conflicted representation, courts have generally permitted multiple representation, in the spirit of honouring client autonomy.

Client autonomy is not always protected, however, in the context of a criminal case. Courts have found that the dangers associated with multiple representation are much greater in criminal cases, and have accordingly been less willing to allow a lawyer to represent more than one client in a criminal proceeding.

Adverse representation

It is generally well settled that a lawyer may not represent one client in a manner that is adverse to the interests of another current client in an unrelated manner. This is referred to as a “direct adversity conflict” or “adverse representation”. Rule 1.7(a) of the ABA Model Rules of Professional Conduct provides that a lawyer shall not represent a client as an advocate if the representation of that client will be directly adverse to another client the lawyer represents in some other matter, even if the other matter is wholly unrelated. Representation of one client with interests adverse to the interests of another current client is generally prohibited not only in litigation, but also in transactional matters.

This rule is more straightforward in the context of current clients of the lawyer or the law firm. The situation is more complex when a lawyer attempts to represent a new client with opposing interests to a former client. While courts tend to be extremely sceptical of these type of attorney relationships, there is no rule that prohibits such representation. The danger, however, is that a lawyer may (perhaps inadvertently) divulge client secrets in the process of adverse representation. The rules that have been established in respect to representation of interests adverse to those of a former client are generally concerned with ensuring that any disclosure of confidential information (whether intentional or inadvertent) is prevented. The secondary goal of the rules seems to be preventing an attorney from gaining unfair advantage through use of previously communicated confidential information.

Model Rule 1.9 is explicit in limiting a lawyer’s ability to enter into a new attorney-client relationship that may encourage him or her to disclose former client confidences. The rule provides that a lawyer who has formerly represented a client in a matter shall not thereafter: (a) represent another person in the same or a substantially related matter, in which that person’s interests are materially adverse to the interests of the former client, unless the former client consents in writing after consultation, and with knowledge of the consequences, and a full disclosure of the material facts or (b) use information relating to the representation to the disadvantage of the former client. For a lawyer to be disqualified under Rule 1.9, four requirements must be met: (1) the lawyer must have had an attorney-client relationship with the moving party;

(2) the current matter must involve either the same subject matter as the lawyer had previously worked on for the former client, or be substantially related; (3) the interests of the present client must be materially adverse to those of the former client; and (4) the former client must not have consented to the representation.

Although courts and professional codes are reluctant to allow adverse representation, before they will disqualify a lawyer on the motion of a former client, that client must demonstrate that in the course of the former relationship with the lawyer, confidences were disclosed and that that information is relevant to the pending matter. Even after a former client has made this showing, however, the ultimate decision is still within the discretion of the court.

The nation’s courts have devised various approaches to assist them in determining whether two matters (one involving the former client and the potentially conflicting representation an attorney hopes to undertake) are substantially related so as to disqualify the attorney. The approaches range from very liberal to much more strict. For example, in the Second Circuit, a former client who invokes the substantial relationship test must establish that issues involved in the two representations are essentially the same as, if not identical to, the issues raised in the present case. In contrast, in the Third Circuit, most district courts have found that the fact that two representations involved similar or related facts is not sufficient to warrant a finding of a substantial relationship, and instead, they can be substantially related only if the allegedly conflicted lawyer might have acquired confidential information in one matter which is relevant to, or could be used to the detriment of, a former client in the subsequent action. In some cases, the difference in approach from one jurisdiction to another could be significant to the ultimate decision of whether a lawyer should be disqualified.

There are, of course, exceptions to the adverse representation rule. For example, courts have recognised that exceptions must be made for lawyers working in large law firms – finding that one lawyer’s knowledge is not necessarily imputed to the entire firm. Since a lawyer in a large law firm may not have had access to any client confidences, some courts have found that a movant in a disqualification action must demonstrate that the challenged attorney had access to confidential information. The touchstone of the analysis for most courts is protecting the former client confidences at all cost. With this principle as their guide, most courts are willing, however, to find practical solutions that more accurately reflect the nature of law firm representations today.

Other developments

As is the case with our other “gatekeepers”, lawyers (both in-house and outside counsel) have been impacted by the fall-out from the financial scandals. In a closely followed speech in September 2004, the then director of the SEC’s enforcement division laid out his themes of enforcement, the first of which was the importance of “gatekeepers” – in his words the:

“sentries of the marketplace: the auditors who sign off on companies’ financial data, the lawyers who advise companies on disclosure standards and other securities law requirements; the research analysts who warn investors away from unsound companies; and the boards of directors responsible for the oversight of company management. They’re paramount to ensuring our markets are clean. And Congress recognised that when it enacted Sarbanes-Oxley.”

So, lawyers too, like the financial institutions (and in particular their analysts), auditors and outside directors, are part of the solution. The SOA required the SEC to set minimum standards of professional conduct for lawyers “appearing and practicing” before the SEC, which resulted in the promulgation of rules requiring lawyers with evidence of material violations of the federal securities laws or fiduciary duty to “report up the ladder” to senior management and, if necessary, to the board of directors.

In the meantime, the SEC has stepped up its scrutiny of lawyers and has brought enforcement action against in-house counsel and outside counsel. Enforcement has targeted lawyers involved in market-timing arrangements, in covering up evidence of fraud or signing off on misleading disclosure and, most recently, in conducting internal investigations where their actions may have obstructed the investigations or covered up fraud.

In the past two years, we have witnessed a flood of regulatory responses (from new rules and standards, to new institutions, to enforcement action and investigations) to a host of activities, some clearly (and massively) fraudulent, others part of the pre-Enron landscape of acceptable behaviour which for better or worse in today’s environment have become at best unacceptable and at worst against the law. Many of these responses have targeted activities the essence of which represented some form of conflict of interest: between managers and public shareholders; between funds and their investors; between gatekeepers and the constituents they were supposed to serve.

A number of the responses, on balance, are healthy and positive. Others may have gone too far. Are financial institutions so cautious that the spirit that drove financial product innovation (from high yield bonds that financed the leveraged buy-outs of the 1980s and the early telecommunications boom to derivative instruments) has been banished into exile? Are accountants so cautious that companies are forced to restate earnings due to differences of opinion over interpretations of accounting standards and are paying the price in the lawsuit that follows, or so cautious that private companies that should have a shot at the public markets are deferring or shelving plans to go public because of accounting concerns? Are senior executives choosing not to seek legal advice for fear of triggering a possible “reporting up” obligation? Has the market suffered because of constraints on the flow of information to the marketplace? Are public companies spending too much time and money on compliance-related policies and procedures which in the final analysis will not prevent fraud? These are all worthy of consideration.