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Benefits: A reactive lawyer-monitoring regime would likely generate fewer benefits, however, than those generated by a proactive lawyer-monitoring regime. Lawyers simply would not spot as many financial information failures, though it is impossible to quantify how many failures would be missed.

Balancing costs and benefits of a reactive lawyer-monitoring regime: The benefits of a reactive lawyer-monitoring regime hence would be low, but its costs likewise would be low. Without empirical data, it is difficult to determine precisely whether those benefits would exceed those costs.

Pragmatically, though, that precise determination is inconsequential. Lawyers should want to perform at least some monitoring role, not only because lawyer monitoring is seen as a social good138 but also because it could help to blunt criticism and possible liability in the event of a financial information failure.139 Accordingly, it is a given that some lawyer monitoring regime will develop.140 The relevant normative

138See supra note 40 and accompanying text (observing the strong public perception, corresponding to a norm, that lawyers should have some monitoring responsibility). See also supra notes 43-49 and accompanying text (discussing commentator arguments urging lawyer monitoring). Cf. Coffee, The Attorney as Gatekeeper, supra note 118 (advocating a “gatekeeper” function for securities lawyers so as to diminish the harm of defective disclosures to the investing public).

139See, e.g., In re Enron Corp. Securities, Derivative & ERISA Litigation, 235 F.Supp. 2d 549 (S.D. Tex. 2002) (denying a law firm’s motion to dismiss complaint); Nathan Koppel, Wearing Blinders, supra note 10, at 166 (quoting Professor George Cohen of University of Virginia Law School as proposing that, whatever the accountant’s role in a transaction, “it is the lawyers’ obligation to ask, ‘Is this fraudulent? Is this deal designed to mislead investors?’”). See also Lincoln Sav. & Loan Ass’n v. Wall, supra note 5 (referencing Judge Sporkin’s clarion call, “Where … were the outside … lawyers when these transactions were effectuated?”).

140This article is indifferent as to whether lawyer monitoring develops in a top-down fashion, such as by government imposing regulation requiring monitoring or by courts imposing liability for failure to adequately monitor; or in a bottom-up fashion, such as by lawyers fostering norms for monitoring through bar association pronouncements or by law firms internally adopting policies on monitoring.

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question for this article, therefore, is which lawyer monitoring regime—one that is proactive, or one that is reactive—is superior.

Part III: Comparison of Proactive and Reactive Lawyer-Monitoring

At first glance, comparison appears difficult: a proactive lawyer-monitoring regime would be more beneficial but also more costly, a reactive one less costly but also less beneficial. Even the most proactive lawyer-monitoring regime probably would do little in absolute terms, however, to curb financial information failures. This is because lawyer monitoring would likely reduce information failure only marginally in the event of fraud, mistake, or misinterpretation, and would produce no benefits when GAAP itself causes the information failure.141 Thus, although proactive lawyer-monitoring would produce relatively more benefits than a reactive regime, the benefits differential would likely be slight in absolute terms.

In contrast, the differential in costs between proactive and reactive lawyermonitoring would likely be significant in absolute terms. A proactive lawyer-monitoring regime would be very costly. To become skilled in GAAP, lawyers would require extensive and continuous training.142 Teaching technical accounting principles would be insufficient; lawyers also would have to become indoctrinated in accounting lore.143 Furthermore, lawyer monitoring time presumably would be billable.144 Lawyers engaged in proactive monitoring also may have to raise their billing rates to compensate for higher liability insurance premiums.145 Other cost increases might include aggravated legal uncertainty about corporate governance responsibilities.146

141See supra notes 87-105, 136 and accompanying text (discussing, among other things, that GAAP may well be the most likely reason for financial information failure).

142See supra notes 54-57 and accompanying text.

143See supra notes 57-78 and accompanying text.

144See supra notes 78-79 and accompanying text.

145See id.

146See supra notes 80-86 and accompanying text.

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The costs of a reactive lawyer-monitoring regime, though, would be relatively small. Lawyers would be required to perform an inquiry only when it is likely to produce benefits, and the little monitoring time this entails should rarely be billable.147 Nor would a reactive regime result in liability-insurance premium increases as high as those of a proactive regime or necessarily aggravate legal uncertainty about corporate governance responsibilities.148

The benefits differential between proactive and reactive lawyer-monitoring thus would likely be slight, whereas the costs differential between these regimes would likely be significant. Accordingly, the amount saved by choosing a reactive, as opposed to proactive, lawyer-monitoring regime should exceed the absolute value of any benefits lost.149 A reactive lawyer-monitoring regime therefore should be economically superior to a proactive regime.150

147See supra note 136 and following text.

148Id.

149Correlatively, the costs added by choosing a proactive, rather than reactive, lawyermonitoring regime should exceed the benefits gained. Of course, if one of the marginal cases where proactive (though not reactive) lawyer-monitoring catches financial information failure is a future “Enron,” the consequences would not be marginal. Catching a future Enron through lawyer monitoring, however, is unlikely. Even proactive lawyer-monitoring would not have caught Enron since most of the dubious Enron transactions technically appeared to comply with GAAP. See supra note 105 and accompanying text. Moreover, the possibility of catching a future Enron must be balanced against the certainty that a proactive lawyer-monitoring regime would itself impose consequential costs.

150A slightly analogous debate can be found in the corporate governance literature, over whether members of a corporation’s board of directors should have a proactive duty to monitor employees for possible wrongdoing or whether board members should only have a reactive duty to monitor employees when on notice of misconduct. The Delaware Supreme Court took the latter position in Graham v. Allis-Chalmers, 188 A.2d 125 (Del. 1963), in which a company pled guilty for price fixing by mid-level employees. Plaintiff argued that board members should be liable for failing to implement a compliance program that would have detected and prevented this type of wrongdoing. The court disagreed, reasoning that directors may rely on the honesty of subordinates until they are put on notice of a problem (i.e., until there are warning signs). Professor Bainbridge has

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The comparison of proactive and reactive lawyer-monitoring still needs to address Professor Cunningham’s query whether lawyers should be responsible for accounting as the functional equivalent of law.151 Lawyers, after all, advise clients in complying with law, so why shouldn’t they also have an obligation to advise clients in complying with accounting “law”?

There are potentially two answers. The first is that accounting may not be the functional equivalent of law or, if it is, that the obligation of lawyers to advise on law may not extend to matters that are merely law’s functional equivalents. I need not examine this answer because the second answer, below, is dispositive of the question. That answer is that, in highly specialized areas of law, non-expert lawyers are not, and should not be, obligated to monitor expert lawyers on matters of their expertise. Thus, a corporate lawyer working on a complex tax transaction would not be expected to proactively second-guess tax advice rendered by specialized tax counsel.152 Tax law is simply too complex and different from other areas of law for non-tax lawyers to be

argued in that context, as I do in this article’s context, that this reactive approach is sensible because monitoring is costly. WILLIAM A. KLEIN, J. MARK RAMSEYER, &

STEPHEN M. BAINBRIDGE, TEACHERS MANUAL FOR BUSINESS ASSOCIATIONS 230 (5th ed.

2003). In contrast, the Delaware Chancery Court has favored a more proactive monitoring regime in In re Caremark Int’l Inc. Derivative Litigation, 698 A.2d 959 (Del.Ch. 1996), involving court approval of a settlement of alleged criminal violations of a federal statute banning kickbacks for medical patient referrals. In approving the settlement, the court stated that board members have an affirmative duty to monitor employees regarding important aspects of a corporation’s business, even absent notice of misconduct (i.e., absent warning signs). Irrespective of how this debate should be resolved, it is very different from, and thus only indirectly informs, the debate in my article. A board of directors manages the corporation, and management inherently involves initiative. Moreover, corporate compliance programs typically do not involve, as would lawyer monitoring of accounting, the high costs and only marginal benefits of nonexperts monitoring experts. For these reasons, I strongly doubt that even the Caremark court would find that board members have a duty to hire lawyers to second-guess accounting determinations by certified public accountants.

151See supra notes 46-47 and accompanying text.

152[cite]

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efficient monitors. By the same token, the tax counsel’s expertise mitigates the need for such monitoring.

Similarly, even if accounting were the functional equivalent of law, that alone should not obligate lawyers to engage in proactive monitoring. Such an obligation would (as shown in this article) create economic inefficiencies, whereas an accountant’s expertise mitigates the need for such monitoring. This approach is even more compelling for accountants than for tax lawyers because accountants are subject to a duty of independence and thus less subject to capture than tax lawyers.153 Accordingly, to the extent accounting is the functional equivalent of law, accountants are at least the functional equivalents of specialized counsel (as to accounting matters).

On balance, then, a reactive lawyer-monitoring regime should be superior to one that is proactive. Lawyers at most should be watchdogs, not bloodhounds.154 No lawyer monitoring regime, however, can be a full solution to the problem of financial information failure. Even the most proactive such regime would likely do little to curb information failure because lawyer monitoring only indirectly affects the primary actors giving rise to the failure—the firm, its accountants, and investors.155 An optimal solution should directly address these actors or the underlying accounting system that permits financial information failure.

This article therefore finally explores—albeit briefly because the boundary between lawyer and accountant responsibility is not involved—possible optimal solutions to the problem of financial information failure. Although not itself optimal, lawyer

153See supra notes 91-92 and accompanying text.

154Cf. In re Kingston Cotton Mill Co. (No. 2), 2 Ch 279 (Ct. App. 1896) (Eng.) (in the

context of preventing accounting fraud, describing a watchdog’s role as reacting only when there is something to “arouse [its] suspicion,” contrasted with a bloodhound’s role of “approach[ing] [its] work with suspicion or with a foregone conclusion that there is something wrong”).

155 See supra notes 87-105, 136 and accompanying text.

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monitoring can supplement these other solutions. Where lawyer monitoring is employed, this article has shown that a reactive monitoring regime should be superior to one that is proactive. This article will not examine, however, whether lawyer monitoring should supplement other solutions; that is almost inevitable, given that lawyer monitoring is presently seen as a social good.156

Part IV: Seeking Optimal Solutions

Optimal solutions to the problem of financial information failure should, as observed, directly address the primary actors giving rise to the failure—the firm, its accountants, and investors—or the underlying accounting system that permits the failure. My examination below therefore starts with the firm, effectively meaning its management.

Regulating the firm: Recall that financial information failures can be divided into three categories, the first of which is fraud.157 Members of management are almost always the primary movers, if not the sole persons responsible, in this category.158 Regulation to prevent fraud therefore should focus primarily on management. Pursuant to powers delegated under the Sarbanes-Oxley Act,159 the SEC has now taken this approach, promulgating rules and regulations aimed at reducing agency costs.160

156See supra notes 138-139 and accompanying text.

157See supra note 88 and accompanying text.

158See supra note 90 and accompanying text (explaining why it is rare for CPAs to engage in or tolerate fraud).

159Public Company Accounting Reform and Investor Protection Act of 2002 (“SarbanesOxley”) (Pub. L. No. 107-204, 116 Stat. 745 (2002), codified at scattered sections of 15 U.S.C.).

160[Briefly discuss SOX §§ 303, 307, SEC Rule 13b2-2, and other applicable regulations. cite]

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To some extent, the increasing complexity of financial and business transactions has made it easier for management to disguise fraud,161 a problem that may require its own solutions. One possible solution is to limit complex financial or business transactions, although this would be inefficient.162 Another solution, though itself secondbest,163 is to prohibit the conflicts of interest that (as in Enron) increase the likelihood that management may be engaging in overly complex transactions for ulterior motives.164

Regulating the firm’s accountants: Accountants are primarily responsible for the secondary category of financial information failures—those caused by mistake or misinterpretation of GAAP.165 In this regard, accountants play two separate roles: helping to structure transactions to achieve accounting goals under GAAP (and, in that connection, preparing financial statements to reflect those goals), and auditing financial statements to confirm GAAP compliance.166

161See supra notes 27-36 and accompanying text. My claim that the increasing complexity of financial and business transactions has made it easier to disguise fraud

should not be confused with unrelated observation (made by Professor Cunningham) that the greater the complexity of a fraud, the more likely it is to be caught. Cf. Cunningham,

Sharing Accounting’s Burdens, supra note 45, at 1426.

162Rethinking the Disclosure Paradigm in a World of Complexity, supra note 30, at 21-

163Id. at 37 & 37 n. 227 (suggesting that there may be no first-best solution to the

problem of financial complexity).

164Id. at 31-36. The theory of this approach is that complexity undermines the disclosure paradigm in which sophisticated investors and securities analysts bring market prices into line with disclosure. Therefore continued reliance on disclosure would be justified only absent cost-effective supplemental protections. Although these protections might include governmental or private-sector certifications of securities quality or even direct or indirect guaranties of securities value, prohibiting these management conflicts of interest would be more optimal because, in the face of complexity, investors must rely not only on disclosure but also on the business judgment of management in setting up complex transactions for the company’s benefit. To that end, the law similarly should focus, in addition to disclosure, on requiring management to be free of conflicts of interest that would affect management’s judgment in those transactions. Id. at 36-37.

165See supra note 88 and accompanying text.

166Cf. supra note 22. This article has not previously emphasized these separate roles. Although accountants bear responsibility in both these roles, they more often face

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Accountants engaged in the first role act to some extent like managers,167 and thus their regulation may be informed by analyzing regulation of a firm’s managers.168 Sarbanes-Oxley also requires managers to impose internal corporate controls over the firm’s financial reporting.169

Accountants engaged in the latter role, as auditors, already are closely regulated.170 Auditing failures nonetheless could be addressed through non-traditional approaches, such as requiring firms to have two separate auditors—a system in which accountants watch the accountants.171 Although this could be as costly as (if not costlier than) proactive lawyer-monitoring, accountants at least would have the requisite expertise to second-guess one another about GAAP.172

liability in their role as auditors. [cite] This might appear to make it even more incongruous that lawyers are being subjected to liability for accounting failures, since their role—effectively helping to structure and document transactions—is more akin to structurers and preparers than to auditors. I do not suggest, however, that lawyer liability should turn on this distinction because I believe its premise is flawed: accountants as structurers and preparers should face greater liability than accountants as auditors because one who causes a problem is at least as culpable as, if not more culpable than, one who fails to catch it—even where there is a duty to try to catch it. Actual experience may be contra because of the technical legal hurdles to imposing aider-and-abettor liability (discussed supra note 14).

167Cf. e-mail from Professor Cunningham, supra note 66 (suggesting that any regulation of management “should include accounting managers”).

168See supra notes 157-164 and accompanying text.

169Sarbanes-Oxley § 404.

170See supra notes 90-91 and accompanying text.

171This approach was suggested by Professor Bill Widen in his e-mail, supra note 28.

172Professor Widen argues that “[w]hen put this way, proactive monitoring by lawyers is seen in a dim light. The only reason to suggest such monitoring is that the lawyers are already on the scene and, thus, such monitoring might not seem to add the same degree of cost as a second accounting firm. However, if lawyers were to perform this monitoring task at all well (as they should want to for liability avoidance reasons), then the lawyers would need to become accountants and perform additional procedures (which might better be done by a second accounting firm).” Id.

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More traditional regulatory approaches, such as imposing even stricter liability regimes or greater penalties for mistakes or failures, could also be applied to accountants in either of these roles. Sarbanes-Oxley already has taken steps in that direction.173

Fixing the accounting system: Most instances of financial information failure likely occurs in the third category—where GAAP itself fails.174 Sarbanes-Oxley again has taken steps to correct this failure by requiring a firm’s management to certify, without reference to GAAP, that financial statements are fairly presented.175 Another possible solution is to improve GAAP, perhaps by transforming it into more of a principles-based, as opposed to rules-based, accounting regime, like International Accounting Standards (IAS). The costs and benefits of such a transformation are currently being hotly debated.176

Educating the firm’s investors: Notwithstanding these solutions, some financial information failures inevitably will occur because investors are human. Government can mitigate the likelihood and impact of these failures, however, by educating investors to take into account all relevant sources of financial information. Ironically, the most important source for this information is the footnotes to financial statements. GAAP requires firms and their accountants to disclose, in these footnotes, most material financial information not already embodied in the financial statements themselves.177 The ultimate financial information failure is that of investors to read, much less study,

173[cite and explain]

174Supra note 102 and accompanying text.

175Sarbanes-Oxley § 302.

176See, e.g., James D. Cox, Regulatory Duopoly in U.S. Securities Markets, 98 COLUM. L. REV. 1200 (1999); Study on Adoption of a Principles-Based Accounting System, supra note 66, at _[cite]_ (observing that “[r]ules-based accounting standards exacerbate the problems created by the complexity of business transactions”). See also G. Bennett Stewart III, Why Smart Managers do Dumb Things, WALL ST. J. A16 (June 2, 2003) (arguing that accounting standards reform is the most appropriate regulatory response to corporate accounting failures).

177[cite]

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footnotes.178 The footnotes to Enron’s financial statements, for example, revealed many (if not all) of the troublesome potential liabilities that ultimately caused Enron to collapse.179

Simply educating investors to read these footnotes carefully can contribute significantly to solving the problem of financial information failure.180 The good news is that, post-Enron, “no reasonable investor can claim ignorance of financial statement footnotes.”181

CONCLUSIONS

In recent years, the increasing complexities of financial and business transactions, as well as changes to generally accepted accounting principles, have blurred the boundary between the roles of lawyers and accountants. As a result, there is a strong public perception that lawyers should have some responsibility for preventing information failures that can arise from these transactions, most notably misleading financial statements. This article examines what that responsibility should be.

178Benjamin A. Templin, Expensing Isn’t the Only Option: Alternatives to the FASB’s Stock Option Expensing Proposal, 30 IOWA J. CORP. L. 357, 363-64 (2005)(decrying that “few investors read the detailed financial disclosures” in footnotes, and that “[c]onsequently, an investor might make a decision to buy or sell a stock based on imperfect information”).

179See Anne Tergesen, The Fine Print: How to Read Those Key Footnotes, BUS. WK., Feb. 4, 2002, at 94, 94-95 (noting that investors “could have had a heads-up that all was not quite right at [Enron] long before the bad news broke in October. The source of this information? The footnotes companies are required to publish with their financial statements….”).

180See supra note 59.

181Steven L. Schwarcz, Securitization Post-Enron, 25 CARDOZO L. REV. 1539, 1556 n.

87(2004).