Ethics and “Accounting for Lawyers” Annual Business Law Seminar Utah State Bar Business Law Section May 20, 2014 Professor Christian Johnson S.J. Quinney

Christian Johnson copyright 2014

Ethics and “Accounting for Lawyers”

Annual Business Law SeminarUtah State Bar Business Law Section

May 20, 2014Professor Christian JohnsonS.J. Quinney College of Law

(C.P.A. – inactive Texas)


Laundry List – Rules of Professional ConductEthical Issues for the Transactional Lawyer

• Who do they apply to?– Outside counsel– In-house counsel– Attorney’s that aren’t members of Utah bar– Attorney’s that are “inactive” or don’t practice

• Conflicts of Interest• Compensation• Failing to Act Competently• Confidentiality and Failing to disclose• Work product (transactional documents) or legal opinions (closing opinions)

– Used to commit fraud or crimes– Result in false disclosures or misrepresentations

• When to resign• Who to tell (“up the ladder” reporting)• Reporting the misconduct of others• Multi-jurisdictional issues


Case StudyCharles Keating & Lincoln S&L

• Lincoln Savings & Loan Association v. Wall• D.C. U.S. District Court – 1990 – 743 F.Supp.

901• Revenue Recognition Problem• $2.6 Billion cost to taxpayers


Parties

• Litigation: Seeking to regain operational control of Lincoln Savings & Loan Association

• Plaintiffs– American Continental Corporation – Ohio

Corporation based in Phoenix– Lincoln Savings & Loan Association

• California chartered S&L• Wholly owned subsidiary of ACC• Deposits insured by FSLIC (cousin of FDIC)

• Defendant: OTC (Office of Thrift Supervision)


BackgroundLincoln is placed in Conservatorship

• Regulator appointed a conservator in April 1989• Basis for appointment:– Lincoln was in a “safe and unsound condition to

transact business”– There was a “substantial dissipation of assets or

earnings due to . . . violations of law, rules or regulations, or to any unsafe or unsound . . . practices.”

• Conservator is appointed ex parte• May seek judicial review of appointment


Defendant’s Position

• Lincoln was at all times managed and operated on a sound financial basis

• Regulators’ actions were arbitrary and capricious

• Regulators’ actions precipitated Lincoln’s severe financial crisis


History

• Charles Keating acquired Lincoln in 1984• Moved business to Phoenix– Reduced single family loans in California– Made direct investments in equity securities– Purchased “high yield-high risk” bonds– Equity participations in emerging businesses– Loans to individuals in speculative activities– Keating negotiated deals even though not an

officer


Wescon Transaction

• Direct investment by Lincoln• Development of Estrella Project– 20,000 acres outside Phoenix– 8,500 acres called Hidden Valley

• Lincoln sold 1000 acres of Hidden Valley to West Continental Mortgage and Investment Corporation (“Westcon”)


Lincoln(seller)

WesCon(Buyer)

One thousand acres of Hidden Valley raw land

$3.5 Million Down payment +Non-recourse Note $10.5 million

Loan from Garcia$3.5MM Loan from Lincoln to Garcia

$3.5 MM Loan from Garcia to Wescon


Gain on Sale for Lincoln for Wescon Transaction

• Sales Proceeds - $14 million• Less: Cost of 1000 acres - $3 million

Gain on Sales $11 million


(Short Term) Advantages of Gain

• Boosts profitability of Lincoln and consolidated entities

• Boosts Lincoln’s “regulatory capital” for regulatory purposes

• Artificially Boost “Fair Market Value” of remaining property

Bank Balance SheetCapital Ratios

• Cash 20MM• Perf Assets 800MM• Troub Assets 150MM– (may not get repaid)

• Other Assets 30MM• Totals 1 Billion

• Deposits 800MM• Other Liabilities 100MM• Capital 100MM

• Totals 1 Billion

• 100/1,000 = 10%


Loans Require Write-OffEffect on Ratios

• Cash 20MM• Perf Assets 800MM• Troub Assets 150MM• Write Off (70MM)=– Net 80MM

• Other Assets 30MM• Totals 930MM

• Deposits 900MM• Capital 100MM• Loss (70MM)• Net Cap 30MM• Totals 930MM

• 30/930 = 3.22%


Increasing and Decreasing Bank Capital

• Increases to Capital– Shareholder contributions of capital– Income from operations– Gains from selling property

• Decreases to Capital– Dividends (pay out of earnings)– Distribution of Capital– Losses from operations– Losses from selling property



Problems with Sale(Find the Fraud)

• Lincoln Appraisal - $9 million versus $14 million • Wescon– Net worth of only $31,000– No intention of developing property– Testimony: acting as “straw man” for Garcia (head of E.C.

Garcia & Co.)– $3.5 million came from loan by Garcia to Wescon– Garcia assumed Wescon’s obligations

• Neither Wescon nor Garcia made any payments to Lincoln


Problem with Garcia

• Garcia was a heavy borrower from Lincoln• $30 million outstanding loans from Lincoln• Garcia not interested in developing Hidden

Valley• Didn’t want to jeopardize $20 million loan

being negotiated with Lincoln• $20MM loan and Wescon Transaction closed

on the same day


Lincoln(seller)

Wescon(Buyer)

One thousand acres of Hidden Valley raw land

$3.5 Million Down payment +Non-recourse Note $10.5 million

Loan from Garcia$3.5MM Loan from Lincoln to Garcia

$3.5 MM Loan from Garcia to Wescon


Problems with Non-recourse Sale

• Only recourse is to foreclose on property• No personal recourse to Wescon or Garcia • Property is not income producing– no rentals to pay interest– Other costs (taxes, improvements, etc.)

• Could sell “lots” to meet interest payments– (no intention to develop property)– Time lags – development difficulties


Critique of Accountants by Court

• Blindly followed abstract accounting principles• Should determine if transaction makes

economic sense• Must look for economic substance• Skeptical if audit trail is lacking• Skeptical if audited entity has failed to comply

with record keeping requirements


How are Transactional Lawyers Involved in Ethical Concerns?

• Lawyer Work Product/Services– General counsel (in house) and Outside Counsel– Property Sales Documentation– Loan documentation– “Closing” Legal Opinions

• Transaction Approvals– Board of Director Meetings & minutes

• “Water Cooler” Knowledge• Questions from the Accountant• Right Hand knowing the Left Hand


Ethical Issues for Transactional Lawyer

• Utah Rules of Professional Conduct– Obligations to Client (i.e. the Company)– Obligations to third party

• Sarbanes Oxley - Publicly Traded Entity– Obligations to SEC– Obligations to Utah Securities Commission


Banking Regulator

• If state chartered – Utah Department of Financial Institutions

• If Federally Chartered – Office Comptroller of the Currency

• If Insured Deposits (state or Federal) - FDIC • Possible Actions• Civil Penalties• Criminal referral to justice department (derivative action)• Banned for life from practice with banks


Utah Rule 4.1. Truthfulness in Statements to Others

• In the course of representing a client a lawyer shall not knowingly:

• (a) Make a false statement of material fact or law to a third person; or

• (b) Fail to disclose a material fact, when disclosure is necessary to avoid assisting a criminal or fraudulent act by a client, unless disclosure is prohibited by Rule 1.6.


Utah Rule 1.6. Confidentiality of Information

• (b) A lawyer may reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary:

• (b)(2) to prevent the client from committing a crime or fraud that is reasonably certain to result in substantial injury to the financial interest or property of another and in furtherance of which the client has used the lawyer’s services;

• (b)(3) to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or has resulted from the client’s commission of a crime or fraud and in furtherance of which the client has used the lawyer’s services;


Utah Rule 1.13. Organization as a Client (“Up the ladder”)

• (b) If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law that reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization. Unless the lawyer reasonably believes that it is not necessary in the best interest of the organization to do so, the lawyer shall refer the matter to higher authority in the organization, including, if warranted by the circumstances, to the highest authority that can act on behalf of the organization as determined by applicable law.

• (c) Except as provided in paragraph (d), if,• (c)(1) despite the lawyer's efforts in accordance with paragraph (b), the highest authority that

can act on behalf of the organization insists upon or fails to address in a timely and appropriate manner an action, or a refusal to act, that is clearly a violation of law, and

• (c)(2) the lawyer reasonably believes that the violation is reasonably certain to result in substantial injury to the organization, then the lawyer may reveal information relating to the representation whether or not Rule 1.6 permits such disclosure, but only if and to the extent the lawyer reasonably believes necessary to prevent substantial injury to the organization.


Utah Rule 1.16. Declining or terminating representation

• (a) Except as stated in paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if:

• (a)(1) the representation will result in violation of the rules of professional conduct or other law; . . .

• (b) Except as stated in paragraph (c), a lawyer may withdraw from representing a client if: . . .

• (b)(2) the client persists in a course of action involving the lawyer’s services that the lawyer reasonably believes is criminal or fraudulent;

• (b)(3) the client has used the lawyer’s services to perpetrate a crime or fraud;

Documents

Ethics and “Accounting for Lawyers” Annual Business Law Seminar Utah State Bar Business Law Section May 20, 2014 Professor Christian Johnson S.J. Quinney