Why Don’t General Counsels Stop Corporate Crime?

Sureyya Burcu Avci is a Research Scholar and H. Nejat Seyhun is Professor of Finance at University of Michigan Ross School of Business. This post is based on their recent paper.

General Counsels (GCs) are supposed to wear multiple hats and manage these hats efficiently. On the one hand, they are the top legal officer for the firm, working closely with the top management and formulating and executing the firm’s legal strategy. On the other hand, they are the corporate watchdog. Sarbanes Oxley (SOX) imposes a watchdog role for GCs since corporate attorneys must report any potential violation to the chief executive officer and if the response from these officers is inadequate, then to the board of directors to stop any potential wrongdoing. [1] The reasoning behind the SOX-imposed requirement is that GCs have a moral obligation to society at large to set the corporation in the right direction. More than any other executives in the corporation, GCs are well-versed in law and they are expected to understand violations of law and they are expected to use their legal expertise to advise, intervene and stop potential corporate wrongdoing. [2] Logically, these two hats are not only always compatible, and in fact, they may be in conflict with each other.

Evidence shows that in spite of these reforms enacted in SOX and explicit provisions and responsibilities given to corporate attorneys, most of the whistle-blowing in case of corporate fraud comes from employees (17%), non-financial market regulators (13%), and media (13%). [3] Clearly absent from this list are top in-house corporate counsels (GCs). In this paper, we investigate the potential reasons for the failure of corporate counsels to report and prevent corporate crime.

We formulate two mutually exclusive hypotheses to characterize GC’s actions. The first hypothesis is that fraudulent top-level executives intentionally keep the corporate counsel out of the information loop. [4] As a result, in-house lawyers are generally unaware of the developing violations and therefore unable to report and prevent fraud. [5] Thus, the corporate counsels cannot fulfil their gatekeeping role since they simply do not have the information about the potential wrongdoings.

A second hypothesis is that in-house corporate counsels participate in planning, creation, execution or cover-up of the fraud alongside other top management. [6] This hypothesis states that corporate counsels are typically not only present at the scene of the crime, but also they help create the crime and thus they are well aware of the crime and subsequent cover-up. In this case, corporate lawyers would have no incentive to report the fraud since they would be turning themselves in by reporting. [7]

We test these hypotheses by examining insider trading by top level executives as well as general counsels before, during, and after the class period in firms involved in securities class action (SCA) settlements. We use insider trading to understand the information, intent and motivations of each top level executive while the top management is engaged in corporate fraud. We also compare insider trading in firms with Security Class Action (SCA) settlements with those firms that were not involved in SCAs.

If GCs are uninformed about an ongoing-violation until the whistle blowers reveal the fraud, then we would not expect GCs to be heavy sellers of their own firms’ stocks during the class period, as compared to the control periods before and after the class periods. Similarly, if the GCs are outside the fraudulent group and they are only marginally aware of some of the violations, they are not likely to know the full extent of the fraud. In addition, they may be afraid to report it due to fear of retaliation. In this case, we would again not expect the GCs to sell their own firms’ stock. However, if the second hypothesis is correct and GCs are part of the fraudulent group, we would expect the GCs to behave similarly to the other top level executives and sell their own firm’s stock before the fraud is revealed, and thus benefit from the fraudulent cover-ups.

Our evidence shows that GCs generally behave similar to other top-level executives. They are heavy sellers of their own firm’s stocks during the class periods and they profit abnormally by avoiding the stock price declines upon revelation of the fraud at the end of the class periods. Our evidence is consistent with the hypothesis that the GCs are part of the fraudulent group and therefore they should be treated the same.

Our evidence strongly suggests that SOX assumption that GCs would serve as a good watchdog is misplaced. Hence, participating in top level decision making or being given access to important policy decisions of the firm does not necessarily make GCs good watch dogs. Our evidence in fact suggests that GCs are already part of the top management and they should not be expected to police themselves.

We suggest that policy responses to corporate fraud should include creating of a separate gatekeeper counsel reporting directly to independent board members instead of the CEO. The hiring, compensation and promotion of this gatekeeper counsel should be determined by the independent board members. Second, additional penalties including potential disbarment and allowing for private right of action for fraud against general counsels would be sensible steps in the right direction. A third policy response can include mandated hiring of outside legal-audit firms similar to financial audit firms.

The full paper is available for download here.


[1] 15 U.S.C. § 7245; 17 C.F.R. Part 205 (Securities and Exchange Commission’s Standards of Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an Issuer). Rule 17 C.F.R. § 205.3 states:

If an attorney, appearing and practicing before the Commission in the representation of an issuer, becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney shall report such evidence to the issuer’s chief legal officer (or the equivalent thereof) or to both the issuer’s chief legal officer and its chief executive officer (or the equivalents thereof) forthwith.

17 C.F.R. § 205.3(b)(1).
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[2] Dyke, Morse and Zingales estimate that in the 1996-2004 period, one out of seven large publicly traded company was engaged in fraud, while the average cost of fraud was set at $380 billion a year. See Alexander Dyck, Adair Morse & Luigi Zingales, How Pervasive is Corporate Fraud, 2014 working paper.
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[3] Alexander Dyck, Adair Morse & Luigi Zingales, Who Blows the Whistle on Corporate Fraud?, 65 J. Fin. 2213, 2226 (2010) (discussed on the Forum here).
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[4] As a case in point, according to the Examiner’s Report, WorldCom CEO Bernard Ebbers simply lied to the general counsel Michael Salsbury that the board approved Intermedia merger agreement when in fact the board had not approved it. See Third and Final Report of Dick Thornburgh, Bankruptcy Court Examiner at 399, In re WorldCom, Inc. et al., 377 B.R. 77 (S.D.N.Y. Oct. 15, 2007).
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[5] WorldCom attorneys Michael Salsbury and Bruce Borghardt appear to fall in this category. Id. at 278 (“The legal function at WorldCom was decentralized, with no in-house counsel, including former General Counsel Michael Salsbury and Bruce Borghardt, former General Counsel for Corporate Development, charged with responsibility to ensure that proper corporate governance processes were followed. The Examiner concludes that an institutional and organizational defect, rather than failings by particular individuals, contributed to the Company’s injuries in this area.”).
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[6] A third in-between possibility is that some corporate lawyers do become marginally aware of the violations but they either have incomplete information or they worry about retaliation in case they report the violation, and thus they prefer to keep silent or do not escalate their suspicions. Since this category places the corporate lawyers outside the fraudulent group, we combine them with the first group since they do not have sufficient information about the true extent of the corporate wrongdoing.
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[7] Corporate Counsels can also take part in illegal activity independently of top management. On February 5,2016, Herbert Sudfelt, an attorney for Fox-Rothchild was convicted of insider trading after he purchased Harleysville stock prior to a merger announcement and made approximately $79,000 in illegal profits.
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