Editor’s Note: The author of this post served as the former West Coast Chair of the Securities Enforcement Practice at DLA Piper before founding his own law firm in Los Angeles. He also worked at the Securities and Exchange Commission.
By Nicolas Morgan, Founding Partner of Zaccaro Morgan
When PwC’s Greg Sincoff testified last month during the ongoing criminal trial against three former Dewey & LeBoeuf employees, he drew a distinction between a law firm’s “phantom income” and “fake income.”
That seemingly arcane distinction speaks volumes about an issue larger than the outcome of the Dewey trial: Are big US law firms ready for the transparency and regulatory scrutiny that come with participating in the securities markets?
In a now famous email at the center of the government’s case, Dewey’s former CFO Joel Sanders discussed funds available for distributions to partners: “Keep in mind though that at these levels we will not have the cash to pay the partners by Jan. 31 since $25M is fake income.”
While Mr. Sincoff testified that “phantom income” is indeed a tax accounting term of art describing allocated income exceeding the amount of cash a partner actually received, prosecutors have suggested the “fake income” was an attempt by Dewey to inflate revenues. According to the SEC, which is pursuing a parallel civil case, Dewey allegedly inflated revenues as part of what the SEC called a “grab bag of accounting tricks” used to dupe investors in a $150 million private securities offering.
By odd coincidence, on the same day Mr. Sincoff testified about the difference between “phantom income” and “fake income,” UK law firm Gateley completed an IPO, raising $45 million in the first-ever such IPO for a UK firm. Australian law firm Slater & Gordon famously went public in 2007, raising $30 million. Recently, there has been some interest in allowing US law firms to follow suit.
Earlier this year, Georgetown Law Professor Jonathan Molot suggested in an article that “going public” might move law firms away from what he called “short-termism.” Whether or not publicly traded law firms would adopt longer-term decision making, one thing is certain: securities laws would require a level of disclosure, transparency and internal controls foreign to nearly all large law firms.
The government’s case against Dewey is a stark reminder of the gulf between the legal industry, which has exploded from small and modestly sized partnerships capitalized through partner contributions to international mega-firms with thousands of attorneys funded through massive debt and securities offerings.
With securities offerings come regulatory burdens and expenses. The SEC estimates that “the average cost of achieving initial regulatory compliance for an initial public offering is $2.5 million, followed by an ongoing compliance cost, once public, of $1.5 million per year.” Among many other public company compliance obligations, the disclosure requirements in Regulations S-K and S-X, the certification requirements imposed by Sarbanes-Oxley, and the whistleblower bounty provisions created by Dodd-Frank would present formidable challenges to any law firm seeking to tap securities markets through an IPO.
And the funds available through securities markets can create incentives for wrongdoing (or the appearance of wrongdoing). Even a brief review of the SEC’s recent enforcement actions involving public company financial reporting fraud suggests a host of ways a law firm inclined toward dishonesty could attempt to fleece investors: channel stuffing, bill and hold transactions, fictitious sales or “round-tripping,” artificially inflating the value of receivables, holding books open past the end of a period, sham related party transactions, improper capitalization of expenses, and “cookie jar” reserves.
Whether the Dewey defendants are convicted or acquitted, the criminal trial and parallel SEC action provide a cautionary tale for law firms inclined to dip a toe in the securities markets. A conviction will demonstrate the harsh outcomes for misrepresentations to investors. But an acquittal will provide little comfort. As law firms should well know, in matters involving alleged securities fraud, regulators and criminal prosecutors aggressively pursue charges even when a jury determines those charges were not supported by the facts or the law.