December 19, 2019 Articles

Critical Steps in Protecting the Attorney-Client Privilege While Interfacing with Compliance Consultants in SEC Investigations and Litigation

The commission and the courts have been clear that the defense of reliance on advice of counsel is of great importance to facilitating compliance efforts. They have not been as clear when it comes to reliance on consultants.

By Brent R. Baker and Joseph D. Watkins

The infamous remark by Dick the butcher, the “plotter of treachery” in Shakespeare’s King Henry VI—“The first thing we do, let’s kill all the lawyers”—was a message from Shakespeare that really means don’t kill the lawyers; they may be our last line of defense. The same idea holds true for broker-dealers and investment advisors seeking to avoid overbearing regulatory oversight by seeking advice from third-party compliance consultants (CCs) rather than traditional legal counsel: Do not get rid of the lawyer; the lawyer may be your last line of defense. This article acknowledges the utility of CCs to create economic efficiencies for financial services firms (FSFs) but suggests that careful adherence to the traditional elements of the attorney-client privilege are still required to preserve important client protections and defenses.

In the place of legal counsel, and in the name of efficiency, third-party CCs are commonly used to conduct due diligence and internal investigations and to achieve regulatory compliance. These efficiencies have caused FSFs, such as broker-dealers and investment advisors (also known as registered investment advisors), to use the services of CCs as opposed to in-house or outside legal counsel. The benefits of engaging third-party consultants are many (e.g., effectiveness, cost efficiencies, and other targeted applications). However, the benefits derived from properly interfacing with legal counsel can provide the same return while maintaining the almost priceless protections related to the attorney-client privilege. Hence, the relevance of Shakespeare’s advice—properly engaging legal counsel in compliance efforts provides significant value.

During periods of uncertainty—like a financial crisis or a recession, administrative changes, or policy shifts—FSFs turn to CCs to better understand changing markets and to relieve regulatory reporting burdens. Often the advice that management relies on from these CCs can help in fulfilling management’s fiduciary responsibilities, while providing valuable insight into complex regulatory matters. CCs can assist directors and officers by effectively fulfilling specific regulatory requirements. There are, however, some legal pitfalls arising from the blanket use of CCs rather than legal counsel. We have routinely seen FSFs encountering these pitfalls with the U.S. Securities and Exchange Commission (SEC), through either examination requests from the Office of Compliance Inspections and Examination or enforcement subpoenas directed toward CCs and their communications with the FSFs.

In a 2016 SEC decision, In re The Robare Group, Ltd., the commission cast doubt on whether firms may rely on an “advice of consultants” defense to violating the law. The decision has compromised the value-add CCs bring to the table and may have increased areas of liability for FSFs. Indeed, the Robare decision has cast a shadow over engaging CCs for corporate due diligence, internal investigations, contract management, and corporate compliance initiatives, because firms seeking to limit their legal liability need to know for sure that they can rely on the advice of consultants if the advice they receive proves to be wrong or insufficient for SEC enforcement staff.

At its core, the attorney-client privilege’s safety net attaches only to communications that are in fact for legal advice. In such cases, the privilege masks both the client’s communication and the corresponding legal advice. While the legal protections of the privilege are typically waived when information is disseminated to third parties, which is often the case with CCs, the legal advice exception keeps the privilege and the safety net intact.

Proper use of legal compliance interfacing can position FSFs to meet the strict SEC disclosure requirements while still preserving the attorney-client privilege. If done incorrectly, the use of CCs can inadvertently chart a detailed course for SEC enforcement staff to air an FSF’s “dirty laundry” or question its sincere attempts to achieve regulatory compliance. Currently, violations discovered by the SEC during good-faith efforts to review and implement corporate compliance functions are often the first source of information sought by the SEC.

Accordingly, properly interfacing with CCs, non-legal specialists, and other advisors is vital to FSFs maintaining privilege and reliance defenses. A properly implemented legal compliance interface is critical to accomplishing this goal and maintaining both the value-add that CCs bring and the benefits derived from the privilege and associated reliance defenses.

Issues That Financial Services Firms Encounter in Engaging Compliance Consultants

FSFs seeking assistance from CCs can open themselves up to significant legal jeopardy in their efforts to comply with the SEC’s and self-regulatory organizations’ disclosure demands. FSFs regularly hire and rely on CCs to obtain advice concerning regulatory requirements. Without correctly interfacing with consultants, FSFs can lose or waive both the attorney-client privilege and the reliance on counsel defense, if it exists, and may end up with an independent compliance consultant (ICC) imposed on them involuntarily at the request of the commission or a court.

The Robare decision casts doubt on whether a firm may rely on CCs as a defense to violating the law. Moreover, neither the commission nor the D.C. Circuit’s recent review of Robare have clarified whether or not the defense of reliance on CCs is valid. Although these decisions may be lacking in clarity, they provide valuable insight into how the commission views the reliance defense and how to perfect such a defense for the future.

While the Robare decision may lead some readers to believe that the commission is discouraging reliance on CCs, such a reading of the case would seem to miss the SEC’s true intentions. Rather than discouraging the use of CCs, the commission may simply be clarifying that such reliance does not provide the same legal protections as reliance on legal counsel. The decision states that if a reliance on consultants defense exists, it will look almost exactly like the reliance on counsel defense. To take advantage of such a defense, a firm must make sure that it can demonstrate that a complete disclosure was made to counsel, legal advice was sought and received about the relevant conduct, and reliance on the advice was in good faith.

The Robare decision puts FSFs in a compromising situation. They find themselves needing to preserve privilege and retain CCs for their industry expertise and economic efficiency, all while being able to use the reliance on counsel defense if needed. The SEC and self-regulatory organizations, such as the Financial Industry Regulatory Authority, Inc. (FINRA) and Municipal Securities Rulemaking Board, acknowledge that firms benefit greatly from having access to CCs. They provide needed expertise in monitoring FSF activities, perform specific tasks related to internal investigations, and ensure corrective actions are taken. As evidence of this, the SEC will step in and require firms to hire an ICC when their compliance efforts fail. With proper planning and correct interfacing mechanisms between CCs, FSFs can avoid being in this situation altogether, preserve privilege, and comply with regulatory requirements.

The Basic Tenets of the Attorney-Client Privilege

The general principle illustrated in In re Kellogg Brown & Root, Inc., 756 F.3d 754 (D.C. Cir. 2014), holds that communications in internal investigations involving in-house compliance departments can be protected by the privilege if a “primary” or “significant” purpose of the internal compliance investigation is to obtain legal advice. When determining if the attorney-client privilege will protect both the client’s communication and the corresponding legal advice, courts typically assess three factors. The privilege protects communications (1) between a client and the client’s attorney (2) that are intended to be, and in fact were, kept confidential (3) for the purpose of obtaining or providing legal advice. The black-letter law regarding the privilege says that the presence of an outside, or third, party on an otherwise privileged communication will waive privilege.

There are two exceptions to this rule:

  1. where the third party is assisting an attorney in understanding and interpreting complex principles (also known as the Kovel doctrine, which gets its name from United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), which extended the privilege to an accountant retained by an attorney); and
  2. where the third party is so thoroughly integrated into the company that he or she should be treated as functionally equivalent to an employee (or in-house legal counsel).

Our focus is directed at the first of these two exceptions—third parties assisting clients in understanding and interpreting complex principles—and how it relates to FSFs.

As noted above, not all communications with an attorney are privileged. Consulting an attorney in a capacity other than as a lawyer—for example, as “policy advisor, media expert, business consultant, banker, referee or friend”—can remove the privilege. The Kovel court recognized that the inclusion of a third party in attorney-client communications does not destroy the privilege if the communication is “to improve the comprehension of the communications between attorney and client.”

The foundation for attaching the privilege to communications with third parties, or CCs, is based on the attorney’s need to interpret information in an attempt to better inform his or her legal opinions. If a corporation retains an outside CC to head up an internal investigation and the consultant retains outside counsel to assist with its legal analysis, the advice of that outside attorney would likely not be privileged. This is because the attorney is providing legal advice to the consultant, not to the corporation. If, on the other hand, the corporation itself hires the outside counsel to conduct the investigation and that outside counsel then retains a CC pursuant to a Kovel agreement, the client, through the client’s counsel, can preserve the privilege.

Properly interfacing with compliance professionals is vital to protecting the attorney-client privilege. If a firm chooses to divulge privileged communications to a third party and wishes to retain the privilege, it must show that the third party enabled counsel to interpret aspects of the client’s own communications that could not otherwise be appreciated in the rendering of legal advice. The Kovel court made the point that “accounting concepts are a foreign language to some lawyers in almost all cases, and to almost all lawyers in some cases.”

The same translation need arises for FSFs. The statement above could just as easily be read to say that the SEC’s filing requirements are a foreign language to some lawyers in almost all cases, and to almost all lawyers in some cases. It is not enough, however, to simply state the necessity of such third-party input; proof of the third party’s necessity is required. The assistance need not be considered absolutely essential to the ordinary performance of legal services for the individual providing such assistance to fall within the scope of the privilege.

Several other courts have extended the privilege in analogous situations to cover investment bankers and public relations firms as long as they are assisting in litigation or formal SEC investigations.

It is also important to note that under the amended Rule 206(4)-7 of the Investment Advisers Act, the SEC asserts that the attorney-client privilege and the work-product doctrine do not apply to books and records that the commission requires a registrant to maintain. In its release accompanying the final rule on compliance programs in 2004, the commission stated that “[a]ll reports required by our rules are meant to be made available to the Commission and the Commission staff and, thus, they are not subject to the attorney-client privilege, the work-product doctrine, or other similar protections”—for example, annual reports that registrants are required to keep and that CCs help to prepare. A properly implemented legal compliance interface should consider the intersection of the required books and records provisions and how they may or may not be affected by privilege. We suspect this adopting release applies to work done internally by general counsel as well.

The common thread is that each communication must be for legal advice, not for business purposes or for the purpose of strictly preserving the privilege. Similarly, courts commonly maintain privilege claims in cases involving consultants, accountants, investigators, public relations firms, and non-testifying experts retained for legal advice. Mere convenience and economic efficiency may not justify maintaining the Kovel claim for confidential firm communications.

The Attorney-Client Privilege Value-Add

The privilege allows clients to seek legal advice without the worry of additional liability from being open and frank with their legal counsel. The privilege also permits FSFs to prevent, look for, and resolve compliance issues without legal retribution. When correctly interfacing with legal professionals, FSFs can use the privilege as a safety net to improve compliance functions without incurring additional liability, something the SEC should encourage.

Critical compliance operations (such as mock audits, corporate due diligence, internal investigations, contract management, and corporate compliance initiatives), in which privilege arrangements are used by FSFs, are vital. SEC examinations can be a painful process for any firm that has not properly interfaced with CCs. The “road map theory” presents a real threat to compliance efforts and can be used as fodder against FSFs after the fact.

The SEC may bring an action against a firm, and as part of that action, the SEC may require that the firm appoint an ICC. In such a case, the firm loses the ability to maintain the privilege and the SEC can gain access to the ICC’s findings and information. Thus, by improperly interfacing with CCs or other third parties, or by waiting for the SEC to find some reason to conduct a review, FSFs will likely lose the ability to maintain the privilege when it is most needed.

The value provided by the privilege is multifaceted. First, it provides firms the ability to perform a good-faith review of SEC filings and reporting requirements to the best of their ability without the threat of providing a “road map” for SEC enforcement officers. Second, the value-add of properly interfacing with CCs provides firms with the added level of privilege and maintains a proper reliance on counsel defense when needed.

It should be noted that asserting formal affirmative defenses or reliance on legal advice can impliedly waive privilege protection for FSFs. Most courts allow clients to withdraw such affirmative defenses if they wish to avoid this implied waiver.

The Courts’ and the SEC’s View on Relying on Compliance Consultants

The commission and the courts have been clear that the defense of reliance on advice of counsel is of great importance to facilitating compliance efforts. They have not been as clear when it comes to reliance on consultants. As Bevis Longstreth, a former SEC commissioner, put it in a 1981 securities regulation seminar, “the reliance defense . . . is not really a defense at all but simply some evidence tending to support a defense based on due care or good faith.” Encouraging frank communications between clients and attorneys is important to remedy wrongdoing and can be evidence of one’s due care or good-faith efforts.

The courts, the commission, and regulators know and understand the benefit of providing a due care or good-faith defense. For example, in Howard v. SEC, 376 F.3d 1136, 1148 n.20 (D.C. Cir. 2004) (citing In re William R. Carter and Charles J. Johnson Jr., 47 S.E.C. 471, 504 (1981)), where a broker reasonably relied on a lawyer’s improper advice, the courts held that “although such a securities professional should have been familiar with the rudiments of securities law, they are not expected to display finished scholarship in all of the fine points.”

Legal counsel plays a “critical role in the functioning of securities transactions.” Id. The courts have also noted that there are significant public benefits flowing from the “effective performance of the securities lawyer’s role. The exercise of independent, careful, and informed legal judgment on difficult issues is critical to the flow of material information to the securities markets.” Id. The Second Circuit has expressed a similar view of the compliance roles legal counsel fulfills. Stating that the “smooth functioning of the securities markets [would] be seriously disturbed if the public cannot rely on the expertise proffered by an attorney when he renders an opinion on such matters.” SEC v. Spectrum, Ltd., 489 F.2d 535, 541–42 (2d Cir. 1973).

There is a difference, however, between the role CCs play and that of legal counsel, especially in the securities arena where the law permeates all aspects of the corporate structure. The Robare decision has shown that reliance on CCs does not have the same amount of deference as reliance on legal counsel, unless they are virtually identical.

Robare is not the only case firms have to guide their analysis. While there is little information available about how the commission or the courts treat the “reliance on consultant” defense, knowing that such a defense is functionally equivalent to the reliance on counsel provides a more defined path. For example, in In the Matter of Edgar R. Page & PageOne Financial Inc., the commission found that a firm failed to disclose a significant conflict of interest and later made false and misleading statements about the conflict. The firm argued that its conduct was not egregious because the compliance responsibilities had been delegated to compliance professionals. The commission did not agree. In a decision remarkably similar to Robare, the commission stated that “[a]ssuming that engagement of compliance professionals—as compared to counsel—might under some circumstances mitigate the egregiousness of a wrongdoer’s misconduct, Page’s argument is not persuasive.” The firm’s argument failed because it did not make a full disclosure and thus failed to meet the elements of the privilege.

The question not fully answered in Robare and Page is what the reliance on counsel defense would actually look like if it existed and was tested in court. In these two cases, there was either no actual reliance or not a full and fair disclosure of relevant facts to justify the application of the defense.

In a case that should cause almost any FSF to stop and pause, SEC v. Alderson, 390 F. Supp. 3d 470 (S.D.N.Y. 2019), the commission brought an action against two former investment advisors, alleging that they made misrepresentations. They asserted the attorney-client privilege and work-product protection over tax opinions and communications between the employer and attorneys at a compliance consulting firm, asserting the good-faith reliance defense. The commission, and more importantly Judge Caproni in the Southern District of New York, disagreed with the firm. While many of the CCs were attorneys, the firm had not engaged the CCs in a typical Kovel-styled agreement through counsel. Due to the direct communications between the consultants and the investment advisors, the privilege was destroyed. The Alderson case is a recent and classic example of what can happen when FSFs do not correctly engage consultants.

The foundational principle illustrated above is that the courts’ and the commission’s views on the reliance defense for CCs has created industry uncertainty. When a reliance on consultants defense can be used to show due care and good faith, it should fulfill the basic elements of a reliance on counsel defense. For that reason, the most effective way to engage a CC would be to do so through the conduit of legal counsel and engaging CCs through a proper compliance interface.

Market Demand for Proper Interfacing with Compliance Consultants and Solutions

Due to the time-tested value of the attorney-client privilege, the market has a strong desire for solutions analogous to Kovel agreements, in which FSFs hire counsel and then counsel hires consultants to assist in translation efforts to better inform legal advice. The privilege covers both the attorney and the consultants, and if the privilege is maintained up to that point, the client still can maintain reliance on counsel if later needed. A Kovel letter solution for FSFs would be appropriate, thus extending the privilege to CCs retained by counsel. Under this type of arrangement, it should be clear that the consultant is hired by the attorney for purposes of making a “literal translation” of information conveyed by the client to the attorney and to remind the consultant that he or she is working for the attorney and not the client.

The lesson from Robare is that FSFs should be cautious about relying on the advice of consultants when they have not been engaged through a proper compliance interface. There are limitations to the protections of due care and good faith that firms hoped to secure in retaining a consultant directly. In contrast, the reliance on counsel defense is still the foundation of the privilege and provides for a consistent legal basis to assert a reliance defense. To assert such a defense, it is critical that FSFs properly interface with CCs through legal counsel and sufficiently demonstrate that they (1) made complete disclosure to counsel, (2) sought advice as to the legality of their conduct, (3) received advice that their conduct was legal, and (4) relied on that advice in good faith.

In theory, the privilege would cover the CC’s work to prevent laying out a road map for enforcement officials while simultaneously incentivizing compliance. Although this approach has not been fully tested in the courts, the underlying elements have been, and it would be logical that such a solution would provide significant a value-add to FSFs.

Conclusion

While there is uncertainty for FSFs seeking to better understand how they should interface with CCs, there are solutions. FSFs have reacted to this uncertainty by seeking to properly implement these solutions. The Robare opinion has provided insights into how to better accomplish this goal. FSFs should take comfort in the fact that seeking legal advice from counsel who interface with CCs for legal advice will preserve the privileges and defenses. In addition, the SEC should take comfort in the fact that providing incentives to properly engaging CCs prior to a regulator’s mandate only increases compliance. The value-add described above makes one think long and hard about Dick the butcher’s advice to “kill all the lawyers.”

Brent R. Baker is a director and shareholder and Joseph D. Watkins is an associate with ClydeSnow, P.C., in Salt Lake City, Utah.

Entity:
Topic:

Copyright © 2019, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).