Where to turn for legal advice? Both inside and outside corporate counsel play an important role in advising the board of directors.

OVER THE LAST TWO YEARS, corporate governance has become front-page news. Following some spectacular failures by corporate boards to oversee properly the senior officers of public companies, the oversight role of corporate directors has been widely debated. Many commentators argue that directors have broken faith with the stockholders by not being sufficiently skeptical of the managers, and that many boards are, in effect, the lapdogs of unscrupulous officers. These challenges to boards come at the same time as the heightened regulations imposed by Sarbanes-Oxley, the Securities and Exchange Commission, and the NYSE and Nasdaq listing requirements.

The confluence of these events has led many boards to reconsider the role they should play in managing the corporation and its officers. As boards grapple with these issues, some have questioned to whom they should turn for objective legal counsel and whether inside counsel is able to give the directors the objective advice they must have.

The role of the board

The stockholders are the owners of the public corporation but cannot themselves directly oversee the actions of management or, for that matter, the board of directors. Instead, stockholders must rely on others to manage their assets on their behalf. It is a bedrock principle of corporate law that the business of the corporation is managed by or under the direction of the board of directors. (Others, including the independent auditors, the SEC, and institutional investors, obviously also play important roles in this effort.) However, direct operational control must, as a practical matter, rest with the full-time managers, the senior officers. This is especially true for a public corporation with hundreds or thousands of stockholders.

The separation between ownership of the business and its day-to-day management inevitably gives rise to potential conflicts of interest, ranging from outright self-dealing by officers at the corporation's expense to sugarcoating bad news or to rushing into poorly considered business ventures. The board of a public company should take an active role in managing the corporation so as to minimize the potential for these conflicts.

However, in many well-publicized cases this did not happen. For example, the special investigative committee of the board of directors of WorldCom Inc. reported that:

"[WorldCom's] Board and its Committees did not function in a way that made it likely that they would notice red flags. The outside Directors had little or no involvement in the Company's business other than through attendance at Board meetings. ... [The Chief Executive Officer] controlled the Board's agenda, its discussions, and its decisions. He created, and the Board permitted, a corporate environment in which the pressure to meet the numbers was high, the departments that served as controls were weak, and the word of senior management was final and not to be challenged."

A well-functioning board should look to the company's lawyers to help it meet its oversight responsibilities and manage these potential conflicts. The lawyers should play an especially important role in helping the board to oversee the corporation's compliance with laws, including Sarbanes-Oxley and the related rules and regulations, and in establishing effective whistleblower and other preventative programs. In addition, counsel's active involvement in the board's processes and discussions can improve its deliberative process and help the board establish that it has acted on a fully informed basis, and with due care. For example, the company's lawyers should be directly involved in (among other matters) the board's review of legal compliance programs, evaluations of new initiatives, and any material legal matters, including regulatory compliance, litigation and legal issues associated with international operations, acquisitions, and divestitures.

The role of legal counsel

Because the company's outside directors are not directly involved in the day-to-day operations of the business, they must rely on the managers to make them aware of the factual and other considerations necessary for the board to function properly. As was noted by the American Bar Association's Task Force on Corporate Responsibility, the board needs the active involvement of the general counsel in order to provide the board with the information and analysis necessary for it to discharge its oversight responsibilities with respect to legal and other matters (Report of the American Bar Association Task Force on Corporate Responsibility, March 31, 2003).

However, inside counsel can sometimes find themselves in a difficult position when called upon by the board to evaluate, from a legal perspective, a management initiative. Corporate counsel advises management and often works closely with the chief executive officer and other senior officers of the company. Having a good working relationship with officers and being considered an integral part of the business function is important to being an effective inside counsel. Likewise, if inside counsel is viewed as a practical business adviser rather than a "deal breaker" management will probably consult with counsel earlier in the development of an initiative. This permits the lawyers to have more effective input than when the legal staff is consulted at the last minute, with a fully defined project.

These considerations can make it difficult for in side counsel to criticize a management proposal in front of the board, particularly if the criticism could be seen as undermining management or as too skeptical of management's plans or motivations.

At the same time, the directors may be concerned that if they rely on inside counsel's advice, they could be criticized for not being more independent of management, even if the advice given is, in fact, completely independent and unbiased. Relying on inside counsel to advise the board is, some say, like asking a fox's opinion about whether the foxes should be guarding the henhouse. These commentators suggest that the board should turn principally to its own counsel, or at the least should use outside counsel that is not overly involved with management.

As with other board responsibilities, there is not a "one size fits all" answer to this issue. Inside counsel generally has a depth and breadth of information and experience that can be invaluable to the board, so long as there are free and open lines of communication with the legal staff. And, because the board, as the body that most directly acts for the corporation, is the inside counsel's client, the board should be able to rely without question on the integrity and legal judgments of inside counsel. If the directors have any doubts on that score, they should probably look for a new inside lawyer, rather than keeping that counsel in place and looking for advice from someone who inevitably is less knowledgeable about the corporation and its business.

However, in some situations, the board probably should turn to outside counsel, either the corporation's regular outside lawyers or, in some cases, counsel with no other relationship with the company. The decision whether to use inside counsel or look to outside lawyers should, however, be made by the board, on a case-by-case basis so as to offer the board the best legal advice available.

Recommended policies

The board's corporate governance policies should be designed to enhance internal counsel's ability to advise the board without unnecessarily undermining counsel's relationship with management. The policies should also allow the board to call on outside counsel whenever appropriate and should encourage the development of a good working relationship with both inside and outside counsel. In most cases, the board should look first to its inside counsel. This is almost always the most effective way to enable directors to receive the legal advice and information needed to effectively carry out their oversight responsibilities. In many cases, when a corporation encounters problems related to conflicts between the interests of management and the interests of the corporation and its stockholders, the problem is not that the board did not have early access to objective legal advice, but that it was not informed of the relevant factual information. This problem can be avoided by fostering an environment of open and close communications between inside counsel and the board.

The American Bar Association's Report included some thoughtful guidelines for corporate governance policies and the role that counsel should play in implementing and enforcing such policies. Those guidelines include the following recommendations:

* "The general counsel should have primary responsibility for designing, implementing and maintaining a legal compliance system under the oversight of the board. The system should require the general counsel to meet regularly with the board and in executive sessions with the independent directors to establish lines of communication between the general counsel and the board of directors and communicate concerns regarding legal compliance matters."

Inside counsel should attend the regular board meetings and should actively participate in those meetings. This will help establish an expectation of ongoing reporting that can help avoid disrupting counsel's relationships with senior management and should also help to overcome any reluctance to frankly communicate problems to the board. The board of directors should charge a committee of independent directors, such as a legal compliance committee or the audit committee, to meet separately with inside counsel about legal and compliance affairs, including whistleblower policies and any reports about material violations of law.

* "The legal compliance system should establish reporting relationships of internal and external counsel so that there is a direct line of communication through the general counsel for reports of material violations of law."

The company should have a legal compliance system that provides a method for bringing any violations or potential violations of law to the attention of the appropriate person at the corporation so that an appropriate investigation can be conducted. The standards of professional conduct for attorneys proposed by the SEC require that an attorney who becomes aware of evidence of a material violation of law or a material breach of fiduciary duty by the corporation or any of its directors or officers report such evidence to the corporation's chief legal officer or to both the chief legal officer and the chief executive officer.

The corporation should adopt a policy that directs the general counsel of the company to mandate that all inside and outside counsel report directly to the general counsel if they conclude that there has been or may be a material violation of law. The policy should also require that the general counsel conduct an investigation and, if a material violation has occurred or is about to occur, take all reasonable steps to ensure that the company responds appropriately. A report on any such violation should be a part of the general counsel's ongoing reporting to the board. Alternatively, the general counsel may refer a report of evidence of a material violation of law to a qualified committee of the board if such a committee was established before the report of evidence of a material violation.

Role of outside counsel

The board should call on outside counsel for advice if the board or internal counsel decides that expertise in a particular area of law or type of transaction is needed, or if there is potential for internal counsel's disinterested judgment to be compromised as a result of relationships with management or otherwise. The board should also feel free to call on outside counsel so as to avoid even the appearance of conflict, particularly in sensitive areas such as executive compensation, antitakeover protections, and affiliate transactions.

Some have suggested that outside counsel should attend all board and committee meetings on a regular basis to advise the board of directors, or even that the board should engage its own counsel that is independent of the corporation's regular outside counsel. These commentators have suggested that the outside lawyers are, of necessity, more independent of management than inside counsel and could play a role similar either to a lead independent director, by setting the legal agenda for the board, or to the independent auditors, by reviewing the decisions of internal counsel. However, in most cases this approach would not be necessary or desirable.

Although outside counsel may be more independent or objective than inside counsel (an assumption that is subject to debate), they generally do not have nearly as much grounding in the company and its business as do the corporation's inside lawyers. Moreover, as the external lawyers be come more familiar with the details of the company and its day-to-day operations, the same concerns arise about their degree of independence from management. Having external counsel attend all board meetings may even engender additional tension within the corporation by creating the appearance or even the reality of separately counseled factions, resulting in less communication between directors and officers, contrary to the goal of corporate governance policies.

In any event, it is probably useful for the company's regular outside corporate counsel to meet with the board of directors one or two times a year. Attending regularly scheduled meetings of the board allows the outside lawyers to remain familiar with the directors and helps the board to establish a relationship with outside counsel without unduly interfering with the relationship between the board and its inside counsel. Outside counsel may also be able to advise the board and internal counsel on the "best practices" of its other clients in the area of corporate governance. By establishing this sort of working relationship, it will be easier for the board to call on outside counsel when the need arises, as when there are actual or potential conflicts of interest, or if the board desires a second opinion on some issue. Outside counsel can also be a good resource for helping the board meet its ongoing obligations for director education.

It is, of course, appropriate and in many instances will be prudent for the board to engage independent outside counsel for special investigations or disinterested advice in connection with matters involving a potential conflict. In any situation where there are concerns about actual conflicts of interest, the board should consider whether to engage outside counsel that does not have any relationships with the interested parties and their affiliates that could perhaps influence their advice, and in these situations the board should select outside counsel without any recommendation by or influence from the interested parties. The company's governance policy should clearly provide that such counsel report directly to the board or a special committee in order to ensure its independence.

A relationship of confidence

Both inside and outside corporate counsel play an important role in advising the board of directors. In most cases the board should turn first to its inside counsel for legal advice. The general counsel's active involvement is necessary to design, implement, and maintain a legal compliance system that will enable the board to discharge its responsibilities. The board should have a strong working relationship with the company's general counsel, based on its confidence in the general counsel's integrity and ability to exercise independent judgment. If the board does not have that confidence, the directors should look for a general counsel on whom they can rely.

Finally, the directors and the general counsel should together review the corporation's governance policies and practices to make sure that they encourage the flow of information to the board by establishing clear lines of communication that enable directors to receive sufficient and timely information and analysis from senior executive officers.

F. Douglas Raymond III is a managing partner of the law firm of Drinker Biddle LLP and head of the firm's Corporate and Securities Group (www.drinkerbiddle.com). His practice focuses on acquisitions and divestitures as well as on securities offerings. In addition, he counsels corporations and their boards of directors on matters relating to corporate governance under the Pennsylvania and Delaware corporation laws. He is based in the firm's Philadelphia office. Deanne Dissinger, an associate in the Corporate and Securities Practice Group, assisted in the preparation of this article.