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Guest post: More evidence piles up on the role of in-house counsel in preventing scandal

News of Tesco’s Deferred Prosecution Agreement promises me another day combing through meticulously negotiated documents to see if in-house, or outside, lawyers were involved in the latest corporate scandal.The reason I am on the lookout is I have been reading several studies that look at the macro picture examining the impact of appointing lawyers to senior executive positions in US listed companies. Earnings management (which the false accounting was an attempt at) is one of the ones that crops up.

In broad terms the studies are good news for in-house lawyers. They tend to show a positive impact on corporate governance where lawyers are in very senior roles in listed corporates in the US. One such study finds significantly reduced compliance breaches (related to accounting and insider training) and monitoring breaches (general failures of legal risk management related to contract, antitrust, disclosure and so on) associated with senior lawyer appointments to companies (Morse et al, ‘Executive Lawyers: Gatekeepers or Strategic Officers?’). Another that companies with senior lawyers in the top management, ‘are more likely to issue forecasts, particularly bad news forecasts, than other firms.’ (Kwak et al ‘The Composition of Top Management with General Counsel and Voluntary Information Disclosure’).

Interestingly too, share price reaction to disclosure from companies with senior lawyers in top positions is stronger (claims Kwak et al): either markets take disclosures from companies with lawyers more seriously or these are companies to whom the markets pay more attention. Although there is also evidence that credit risk analysts are sensitive to gatekeeping risk and think in-house legal teams become less effective gatekeepers as lawyers are promoted to senior management positions (Ham and Koharki, ‘The Association between Corporate General Counsel and Firm Credit Risk’). Ham and Koharki found credit ratings dropped quickly, and the riskiness of corporate debt increased significantly, in companies that promoted lawyers to their senior team. One question this raises might be, who is more astute, investors or credit risk analysts?

A further study shows that that, ‘the presence (and proportion) of directors with legal backgrounds on the audit committee is associated with higher financial reporting quality.’ (Krishnan et al, ‘Legal Expertise on Corporate Audit Committees and Financial Reporting Quality’) It is this study that suggests that legal expertise and accountant’s expertise each benefits from the presence of the other in this context. The presence of a lawyer on the audit committee reduces earnings management.

The evidence supports the idea that lawyers have an impact independent of a board’s other strategies to improve governance, ‘individual lawyers matter’. (Morse et al again). Such attempts to disentangle and measure the influence of individual lawyers appointed to seniority are necessarily crude and difficult to disentangle from other possible influences on compliance. It is not possible to say, for instance, whether such data tells us something about lawyers in companies generally, or lawyers in senior roles in companies, or companies that appoint lawyers to senior positions. Often the studies only focus on those lawyers who are in the top five earners in a company. The studies do a decent job of trying to disentangle these factors, but more work would be required to be certain they had succeeded. The indicators of success are also quite general: is reduced enforcement against a company because there are fewer breaches or because they are better defended in the early stages? Nonetheless, there is a gathering set of studies, albeit quite similar methodologically, suggesting in-house lawyers in senior roles can and do improve corporate governance in certain circumstances.

The evidence also suggests that one influencing behaviour might not be seniority per se but accentuated personal responsibility for gatekeeping functions. Jagolinzer et al look at corporate policies on insider trading, and find requiring GC approval for potential insider trades is associated with, ‘a substantial reduction in informed trading by insiders’ (Jagolinzer et al, Corporate Governance and the Information Content of Insider Trades). Their results also suggest that Sarbanes-Oxley may have amplified the positive effects of legal expertise in this process. Similarly, requiring GC sign-off was an important factor driving SEC compliance in Morse et al’s results.

Conversely, the way in-house lawyers are managed and incentivised appears to be important. ‘Contracting of lawyers into strategic activities’ (through higher levels of equity-based remuneration) can reduce that gatekeeping effort in relation to monitoring (Morse et al). They estimate that, ‘on average the hiring of a [senior] lawyer implies a 31.4% reduction in securities fraud …[but] when the lawyer is hired with high equity incentives, she only reduces fraud by 6.6%.’ And Hopkins et al suggest gatekeeping behaviour is moderated by senior lawyer compensation structures: firms with highly compensated GCs had, ‘lower financial reporting quality and more aggressive accounting practices’ but also that, ‘GCs play an important gatekeeping role in keeping the firm in compliance with generally accepted accounting principles’ (Hopkins et al, Corporate General Counsel and Financial Reporting Quality (2015) 61 Management Science 129). The implication they draw is that, ‘GCs appear to tolerate moderately aggressive behaviour but constrain it such that it would not result in violation of securities laws and jeopardize their standing within the firm’.

Thus the risk of compliance being personally attributable to them by regulators is in tension with incentives, some of which may be economic and some reputational. Looked at in this way Goh et als finding that, ‘the inclusion of general counsel in top management is associated with a firm’s tax avoidance’ looks less contradictory (Goh et al, ‘The Inclusion of General Counsel in Top Management and Tax Avoidance’). GCs do not need to personally certify tax compliance to regulators, the risks of advising on tax policy can be more easily shared with external advisers (see, Rostain and Regan, Confidence Games: Lawyers, Accountants, and the Tax Shelter Industry), and the potential for significant commercial benefits from tax minimisation alter the reputational calculus. The result? Where lawyers are part of the top management team those firms, ‘have lower GAAP effective tax rate, more uncertain tax positions, a higher likelihood of engaging in tax shelter activities, and more tax haven countries in which the firm reports a significant subsidiary, relative to firms without a general counsel in top management.’ Also, ‘tax avoidance is greater when (1) the general counsel has tax-related expertise, (2) the firm hires an external auditor with tax expertise or purchases more tax services from its external auditor, and (3) the CEO has more power over the general counsel.’ Increases in tax avoidance are also shown to be related to certain GCs who move from one firm to another (they appear to carry the strategy with them). The potential for diffusion of responsibility by engaging external consultants on matters of law is further emphasised by evidence that the retention of ‘top-tier’ outside lawyers reduced the completeness of SEC mandatory disclosures (see, Choudhary et al, ‘Boards, Auditors, Attorneys and Compliance with Mandatory SEC Disclosure Rules’ (2013) 34 Managerial and Decision Economics 471). So, as a parting shot, that study suggests that, while private practitioners like to hold themselves out as more ethical than in-house lawyers, the evidence suggests a more complicated picture.

Richard Moorhead is professor of law and professional ethics at UCL Faculty of Laws and director of the Centre for Ethics and Law. He blogs at Lawyer Watch. Follow Richard on Twitter.