Risk Management

In Your Own Defense

Why representing finance executives in lawsuits is both an art and a science.
Lori CalabroMay 1, 2005

You aren’t paranoid. There really is a target on your back that says “Sue Me.” A recent study by PricewaterhouseCoopers LLP concludes that 203 private securities class-action lawsuits were filed against U.S. companies and their directors and officers in 2004 — a 16 percent increase over 2003. In 8 out of 10 of those cases, the CFOs of the companies being sued were named as defendants (see “The Blame Game,” at the end of this article).

“Now more than ever, these cases implicate the CFO,” says Steve Skalak, a partner at PwC and leader of its U.S. corporate-investigations practice. “That’s not surprising; the law, the government, and the public at large are very focused on personal responsibility for accounting fraud.”

Private class-actions are not the only arrows aimed at finance executives, of course. The Securities and Exchange Commission routinely names CFOs in its investigations of accounting malfeasance. So does the Department of Justice (DoJ). In many government cases, both departments may be investigating the same CFO simultaneously.

Indeed, at this juncture, “it is almost guaranteed that a CFO will face some sort of legal investigation” in his or her career, says Skalak. “Not every CFO will be in the eye of the storm,” he admits, “but today’s minor whistle-blowing case may easily be tomorrow’s class action if left unattended.”

Meet Your New Best Friend

To protect themselves against these multiple assaults, many CFOs have had to hire defense lawyers, either for their companies or for themselves. In fact, lawyers specializing in the defense of finance executives have created something of a cottage industry.

A specialty is certainly required. “It’s much more difficult to defend CFOs, because it’s harder for them to use the ‘Sergeant Schultz’ defense,” says Stephen Poss, chair of the Securities Litigation and SEC Enforcement Practice Group at Boston-based Goodwin Procter LLP (see “What Does Your CEO Really Know?“). “You need to know the accounting issues as well as the legal issues, and you need to understand how to deal effectively with [the regulators],” says Poss, whose firm represents more than a dozen current or former CFOs in cases that range from SEC investigations to securities class actions to federal grand jury probes. “Saying that a financing or transaction was beyond the understanding of the CFO,” says Skalak, is not a defense “that will succeed under current law.”

While in-house corporate counsel will not themselves represent finance executives when they are sued in shareholder lawsuits, in-house counsel can provide recommendations for outside counsel. Directors-and-officers-liability insurance companies also will recommend lawyers, or may require that the CFO pick lawyers from a panel of preapproved law firms. CFOs who have weathered similar cases are also an excellent resource. “Word-of-mouth should not be underestimated,” says Brian E. Pastuszenski, a senior partner in Goodwin Procter’s securities litigation practice.

In any event, he says, finding legal representation may involve a “bake-off” in which several law firms are interviewed by the company named in a suit. When an internal investigation becomes necessary, he adds, the audit committee likely will become involved as well.

The Wrong Instincts

Lawyers with experience in government cases against companies say that tailoring the search according to the agency in charge is often a must — especially if the SEC is involved. Given that body’s current focus on cooperation with companies, for example, “the instincts a general commercial litigator has may be wrong in an SEC investigation,” says Poss. “You need to know the rules of the game.” Taking an abrasive stance during investigative testimony may not be the best approach with the SEC, adds Derek M. Meisner, a former SEC lawyer based in Boston for Kirkpatrick & Lockhart Nicholson Graham LLP. In those cases, acting “more deferential and cordial may be in the best interests of the client” (see “The Limits of Mercy.”).

Pay attention to accounting expertise, too. “You don’t want a lawyer who cannot do the math,” says Poss. “He or she must be able to look at annual reports and know how revenue recognition works — as well as know how the SEC is likely to think revenue recognition works.”

Moreover, says Pastuszenski, a good attorney must be able to appreciate the complexities of the accounting rules and, where an error has been made, help a judge distinguish between “alleged manipulation by the CFO of earnings or revenues and what may have been a good-faith mistake.” This ability takes on new importance, says Meisner, because regulators lately have blurred the lines “between reckless conduct and negligent conduct.”

A lawyer who “considers all the collateral consequences of the investigation” is also a better choice, in the view of Ellen Podgor, professor of law at Georgia State University. The attorney must know if the defendant could lose a license or be barred from doing further business with the government, for example.

Experts disagree about the importance of an attorney actually residing in a certain jurisdiction. Pastuszenski, for example, does as much work in California as in Boston. He points out, though, that it behooves any counsel to be familiar with the judge before whom counsel will appear. Pastuszenski typically associates with a local lawyer in a particular jurisdiction to educate himself about such nuances as the judge’s pet peeves.

In the end, overall experience rules. “You do not want a first-timer representing you,” says Pastuszenski, and you should ask about the lawyer’s track record handling similar matters. You should also ask if the attorney you’re hiring will remain involved as the case progresses, will be available to discuss important decisions that need to be made, and will be there for you in important hearings or at trial, if necessary. “You don’t want someone who is just there for the pitch,” he adds.

Seeking Separate Counsel

When Joan Brubacher, CFO of Scottsdale, Arizona-based Mobility Electronics Inc., was hit with an earnings-misguidance class-action suit early last year — along with her CEO, Charles Mollo — it was the first time she had ever had to legally defend herself. The two moved quickly to retain counsel, she says, “even though we were comfortable we had done nothing wrong.”

Brubacher and Mollo interviewed several law firms, explaining to each that the allegations stemmed from the firm’s failure to hit its fourth-quarter revenue target, which prompted the stock price to drop by 21 percent. Ultimately, they turned to Palo Alto, California-based Wilson Sonsini Goodrich & Rosati, because they knew the firm from an earlier SEC investigation that involved a company Mobility had acquired.

The class-action suit was dismissed last November. But that case — and the $350,000 in legal fees Mobility had to pay — left a lasting impression on Brubacher. “It was a real eye-opener about how much more careful I need to be about documentation,” she says. “For example, I’ve changed my methodology for filing E-mail.” Although Brubacher chose not to retain her own personal counsel, she says the option was always open. “It never came to that,” she says, “but the culpability of a CFO can be very different from that of a CEO. You have to look after yourself as an individual.”

Says Skalak, “Everyone hopes that it doesn’t get to the point where an individual’s interests diverge from the company’s.” But that certainly happens. In the case of a restatement, for example, “often the CFO has ‘resigned,’ and wants his own counsel because of tensions with his former company,” says Pastuszenski. If the CFO remains with the company, there may be “some benefit for the CFOs and the company to present a united front.”

SEC and DoJ investigations may automatically call for separate counsel, notes Derek Meisner. Those agencies “have made it clear that cooperation is critical, and one way for a company to cooperate is to retain separate counsel for the CFO or any other executive who may have interests adverse to those of the company,” he explains. In many cases, directors-and-officers insurance policies allow legal fees to be reimbursed by the company. On the other hand, CFOs hiring a “shadow counsel” — one dedicated to protecting their own interests, while the lead counsel is retained by the company — may raise questions concerning who should pay legal fees. Standard D&O policies do not pay for such counsel.

A Pattern of Property

The vast majority of securities class-action lawsuits, including cases involving the CFO, do not go to trial, but are either thrown out or are settled, according to Pastuszenski. “But because of changes in the law,” he says, “getting to the settlement stage takes much longer today than it did 10 years ago.”

Could the high-profile courtroom dramas of recent months usher in changes, either in the mix of settlements and cases that go to trial or in the style of defense adopted by CFOs? “More and more, the allegations made by plaintiff lawyers follow a common theme: How could the board of directors and the officers not have known?” says Pastuszenski. “It’s too early to say what the impact of recent headline-grabbing cases, if any, will be,” he says. But the burden of proof will remain on the plaintiff or the government to show an executive’s participation in wrongdoing. “Legally,” he says, “it is not enough for the plaintiff to simply say that the CFO knew about a fraud. That rule isn’t going to change.”

No matter what the specific allegations, says Skalak, the best defense for a finance chief involves demonstrating “a pattern of behavior that shows he or she acted properly in certain instances.” Ideally, “the CFO should create a documented trail that shows GAAP was followed, that the proper controls were in place, that the board was informed of problems when necessary, and that the external auditors were brought in when needed.”

And if the CFO happens to be guilty? Then, “none of these tactics will protect people,” says Skalak. “But the regulators at the Department of Justice and the SEC are not looking to punish executives who act properly and set the right tone at the top.” Neither are the shareholders.

Lori Calabro is a deputy editor of CFO.

Who Hired Whom?
Legal choices of some high-profile CFOs.
CFO (Company) Case Summary Lawyer(s)
Andrew Fastow
Pleaded guilty to wire and securities fraud. Will serve a 10-year sentence after testifying againstformer CEO Kenneth Lay and former president Jeffrey Skilling. John W. Keker: Keker & Van Nest LLP; San Francisco
Richard Hawkins
Faces 25 years in prison if convicted on charges of conspiracy, fraud, and lying to company auditors in a scheme to inflate earning at the pharmaceutical distributor. Melinda Haag: Orrick Herrington & Sutcliffe; San Francisco
Timothy Rigas
Will be sentenced June 1 along with his father for misleading investors and poketing some $2 million for personal use. Was found guilty of securities fraud, bank fraud, and conspiracy after four-month trail. Paul R. Grand: Morvillo, Abramowitz, Grand, Iason & Silberberg PC; New York
Michael Sears
Currently serving a four-month sentence for illegally recruiting a top Air Force official fo a Boeing job. Theodore T. Poulos: Cotsirilos, Tighe & Streicker Ltd.; Chicago
Howard Smith
Fired by AIG (whose lawyers were trying to cooperate) for taking the Fifth Amendment when asked about AIG’s relationships with several reinsurers. Andrew Lawler, New York
Scott Sullivan
Pleaded guilty to three counts of securities fraud in the largest bankruptcy in history.Was the star witness in the trial and subsequent conviction of CEO Bernard Ebbers. Roy Black: Black, Srebnick, Kornspan & Stumpf P.A.; Miami
Mark Swartz
(Tyco International)
On trial in the New York Supreme Court for the second time for larceny and fraud along with former CEO L. Dennis Kozlowski.. Charles A. Stillman: Stillman & Friedman PC; New York
Source: Various news reports