New England Biz Law Update
Recent action taken by the Securities and Exchange Commission against two Massachusetts individuals has in-house counsel and workers alike wondering whether there are limits to the extent employees can rely on their company’s attorneys.
In September, the SEC filed a complaint against two Boston-based employees of State Street Bank, John Flannery and James Hopkins.
The agency accused the men of misleading investors about their exposure to subprime investments in their marketing of a State Street bond fund. The SEC settled similar charges with State Street earlier in the year, with the firm repaying fund investors more than $300 million.
Both men plan to defend their actions by arguing that they depended on the advice of their in-house counsel.
“Our position is that it is unfair for the SEC to bring an action against a person who sought and relied on legal advice in good faith. That is what you would expect a client seeking legal advice to do,” said Mark W. Pearlstein, an attorney for Flannery and a partner at McDermott, Will & Emery in Boston.
By filing the complaints, the SEC forces employees to second-guess their in-house counsel, Pearlstein said, and possibly seek a second opinion.
“It puts an employee in a very difficult spot because it would be unrealistic to expect that every employee dealing with an issue of external communications would be required to retain their own disclosure counsel in order to advise them,” he said.
Hopkins’ attorney, John F. Sylvia, a partner at Mintz, Levin, Cohn, Ferris, Glovsky & Popeo in Boston, said in a statement that his client is disappointed that the SEC chose to bring the administrative action but is “justifiably proud of his distinguished 34-year career built on personal integrity and the highest ethical standards and fully expects to be exonerated once the true facts are presented.”
Misleading communications?
During the subprime mortgage crisis in 2007, Hopkins and Flannery “engaged in a course of business and made material misrepresentations and omissions that misled investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management,” the SEC complaint alleges.
State Street’s Limited Duration Bond Fund was almost entirely invested in subprime mortgage-backed securities and derivatives, but Hopkins, a product engineer, and Flannery, State Street’s chief investment officer of the Americas, described the fund as “less risky” than a typical money market fund, and the extent of its concentration in subprime investments was not disclosed to investors, the SEC claims.
Even when some investors and client service personnel expressed their belief that the fund had just one relatively small subprime investment, the complaint alleges, Hopkins did nothing to correct investors’ misunderstanding.
The miscommunications continued throughout the summer of 2007, the SEC claims, as State Street’s internal advisory groups recommended to their clients that they withdraw from those funds, while Flannery and Hopkins continued encouraging others to stay invested and to continue to invest. Clients of the internal advisory groups then redeemed from the fund, and State Street sold the fund’s mostly liquid holdings and used that cash to meet the redemption demands of those better informed investors, the SEC says, leaving the fund and its remaining investors with largely illiquid holdings.
State Street settled in February with the SEC and the offices of the Massachusetts secretary of state and attorney general. The company paid more than $300 million to investors as part of the settlement, and an additional almost $350 million to investors to settle private suits.
But the settlement included a limited privilege waiver, the SEC says, under which State Street provided information to the agency to investigate the potential liability of company individuals.
In the administrative proceedings, the SEC is seeking a ban that would prevent both Flannery and Hopkins from future employment with an investment company, as well as a civil penalty.
David P. Bergers, the regional director of the SEC’s Boston office, would not comment on the administrative proceedings against Flannery and Hopkins except to say that their hearing is scheduled to start on Feb. 28.
The company’s lawyer
While the facts of the complaints are based in securities, a similar situation could arise in other contexts, noted employment lawyer William E. Hannum, a partner at Schwartz Hannum in Andover, Mass.
Government agencies investigating wage and hour violations, OSHA compliance, health-care related regulations or immigration issues could result in similar circumstances, with employees wondering if they are insulated from later prosecution by relying on advice from company lawyers.
“Employees should remember that in-house counsel aren’t lawyers for the employee,” said Richard M. Gelb, a business litigator at Gelb & Gelb in Boston.
Even sophisticated executives can forget that an in-house lawyer does not have their personal best interests at stake, Hannum said.
If there is a mutuality of interest, then employees and company attorneys should be on the same page, Gelb said. But if there is a potential for a conflict of interest, employees may need independent counsel in order to analyze or understand their situation, he said.
In a perfect world, employees could retain “counsel on a quiet basis,” who they can turn to for advice or help when making certain decisions, Gelb suggested.
But not all employees are capable of hiring, at their own expense, back-burner counsel available for consultation.
For employees, the tipping point of when their interests diverge from the employer’s can be unclear.
One definite line in the sand, Gelb said, is when a governmental agency, such as the SEC, undertakes an investigation. At that point, employees should contact their own lawyer.
If the matter at hand is a black-and-white area and a commonplace practice, there is clearly less chance of a complaint being filed down the road where an employee relies on in-house counsel, Hannum said.
But the grayer the area of law, the more careful an employee should consider future ramifications, he said.
“If an employee goes to their in-house counsel for advice but disagrees with the advice given or is unsure,” then the employee may want to seek outside counsel for further information, Hannum said, especially if the employee works in a regulated industry, like securities, or has a professional license to maintain.
“Don’t assume that because the company lawyer blesses the action, then the employee is OK,” he said. “If the employee is not comfortable, then he or she should get some advice from their own lawyer who has their own interests at stake.”
Lessons for in-house counsel
With Flannery’s and Hopkins’ hearing approaching in February, the impact of the SEC complaints on an employee/in-house counsel relationship may become more evident as the two clarify their defense.
“It is very clear that the involvement of counsel in Mr. Flannery’s good-faith adherence to their advice is going to be a central issue in the litigation. This is a very important issue, because it puts employees who seeks out counsel from their company and relies on that advice in a very difficult position,” Pearlstein said.
Reliance on counsel must be reasonable, Gelb said, so the defendants will need to establish that they presented State Street lawyers with all the necessary information about the fund and its investments.
Flannery and Hopkins will need to argue that “they made full and accurate disclosure to the lawyers, who then gave advice based on that disclosure, and they conducted their activities based on that advice,” Gelb said.
In-house counsel can also learn from the case, lawyers said. Company attorneys must understand the scope of the advice being given to employee clients and should be clear with employees — particularly during an investigation — about whose interest they represent and who their client is.
And Hannum noted that the SEC has been increasingly aggressive in enforcing securities regulations in the wake of the financial crisis.
“This is an agency enforcing laws that weren’t as aggressively enforced under the prior administration, which raises the stakes and the risks,” especially for the employees relying on their in-house counsel, he said.
