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The Securities and Exchange Commission has a harsh message for in-house lawyers: Fulfill your gatekeeper duties or suffer the consequences. John Isselmann Jr. learned this lesson last fall, when he became the first general counsel in the post-Sarbanes-Oxley era to be penalized for gatekeeper violations. The SEC’s civil case against Isselmann, the former general counsel of Electro Scientific Industries Inc., is a cautionary tale for corporate counsel everywhere. Stephen Cutler, the SEC’s enforcement chief, first put in-house lawyers on notice about the agency’s emphasis on gatekeepers in a speech given on Sept. 20, 2004. Cutler defined gatekeepers as “the sentries of the marketplace” � auditors, directors, and “the lawyers who advise companies on disclosure standards and other securities law requirements.” The agency, he added, was “considering actions against lawyers . . . who assisted their companies or clients in covering up evidence of fraud, or prepared, or signed off on, misleading disclosures regarding the company’s condition.” Four days after Cutler’s speech, the SEC announced that it had settled its allegations against Isselmann. While the agency has gone after a number of lawyers for their alleged role in a financial fraud, Isselmann’s case is unique. The SEC doesn’t claim that he participated in the scheme to fraudulently boost the quarterly financials at ESI, a semiconductor manufacturer based in Portland, Ore. The agency doesn’t even allege that Isselmann knew about the fraud at the company, which reported revenues of $207 million in fiscal year 2004. The SEC says only that the ex-GC failed to communicate material information to ESI’s audit committee and outside auditors � information that would have stopped the accounting fraud. In his settlement with the SEC, Isselmann neither admitted nor denied the agency’s allegations. The 37-year-old lawyer agreed to pay a $50,000 civil penalty and consented to a cease-and-desist order. He left ESI in 2003 � he says that the company asked him to stay on � and currently does consulting work in Portland. (ESI officials did not respond to requests for comment for this article.) “Mr. Isselmann failed in his gatekeeper role,” says Patrick Murphy, an enforcement lawyer in the SEC’s San Francisco office who supervised the ESI probe. “He had information that he should have passed on to the board and the company’s external independent auditor. If that information had been provided, it would have prevented the financial fraud.” Isselmann has a different take on the government’s case against him: “Cutler was out there putting the fear of God into lawyers, and he needed an exclamation point. I was that exclamation point.” Whether the SEC was looking to make an example of Isselmann or not, his case shows how treacherous the GC job can be these days. The agency alleges that former Chief Financial Officer James Dooley and ex-controller James Lorenz III committed several instances of fraud at ESI. But the SEC doesn’t claim that Isselmann was involved in any of the wrongdoing � only that he failed to report a specific incident. According to the SEC’s complaint against Isselmann, Dooley and Lorenz decided late on Sept. 12, 2002, to eliminate $1 million in vested retirement and severance benefits for ESI’s employees in Asia. Dooley and Lorenz then fraudulently applied the savings to ESI’s bottom line by an accounting move called “reversing the accrual,” the SEC claims. Isselmann was not present or consulted when Dooley and Lorenz made their middle-of-the-night decision, according to the SEC’s complaint. But Dooley subsequently asked Isselmann to get a written opinion from the company’s outside counsel in Japan on whether Japanese law permitted eliminating the benefits. Dooley didn’t tell Isselmann that ESI’s books had already been altered, the SEC says. Morrison & Foerster, ESI’s Japanese counsel, e-mailed an opinion to Isselmann, stating that the company could not unilaterally terminate the benefits. According to the SEC’s complaint, Isselmann tried to raise this point at a disclosure meeting right before the company filed its financial statement, but Dooley objected and cut him off. After the meeting, Isselmann provided Dooley with a copy of the written legal advice. Nevertheless, ESI went ahead and filed a fraudulent statement overstating its quarterly income by 28 percent, the SEC says. Five months later, according to the agency’s complaint, ESI’s new CFO told Isselmann how Dooley and Lorenz had decided to eliminate the benefits and reverse the accrual during their Sept. 12 meeting. (Dooley had since been promoted from CFO to chief executive officer.) Isselmann immediately told ESI’s audit committee and outside counsel what had happened, the SEC’s complaint says. But that wasn’t enough for the agency. The SEC faulted Isselmann for failing to stand up to then-CFO Dooley at the disclosure meeting, and for failing to provide the audit committee with Morrison & Foerster’s advice. These failures allowed Dooley and Lorenz to conceal their fraud, the SEC says. The agency didn’t bring a case against ESI, citing the company’s “extraordinary cooperation in the commission’s investigation.” But Dooley and Lorenz didn’t get off so lightly. In September, the U.S. Attorney’s Office filed a 17-count indictment against the two men, who were fired from ESI in 2003. Prosecutors allege that Dooley and Lorenz made a series of accounting reversals and reclassifications that falsely boosted ESI’s earnings by nearly $7 million, allowing the company to hit its financial targets for the first two quarters of its 2003 fiscal year. Dooley’s lawyer, Steven Ungar of Lane Powell Spears Lubersky in Portland, said in a statement that the government’s claims against his client “are false, distorted, and unfairly present only one side of the story. . . . When the facts are fairly and accurately presented, we are confident that [Dooley] will be fully exonerated.” Lorenz, who has also pleaded not guilty, could not be reached for comment. For his part, Isselmann says he didn’t even realize he’d done anything wrong. “I didn’t fully understand the accounting issues,” says Isselmann. He explains that at the time, he was just eight years out of law school and had no accounting experience and only a limited securities law background. “Like many general counsel, I was a generalist � my job was a mile wide and an inch deep. I relied heavily on accounting people like Dooley and outside auditors to flag those issues for me.” Isselmann says he thought of the Japanese benefits matter as an employment issue, not an accounting issue. He adds that as ESI’s only in-house lawyer, “I didn’t have the luxury of focusing on a single e-mail and thinking about it for weeks and weeks.” He says he probably spent an hour and a half in total on the benefits matter. Ultimately, the SEC charged Isselmann under rule 13b2-2 of the Securities Exchange Act of 1934 with failing to provide a material fact to accountants in connection with an SEC filing. According to Isselmann’s lawyer, Melinda Haag, a partner in the San Francisco office of Orrick, Herrington & Sutcliffe, it’s essentially a strict liability offense. “No intent or even negligence needs to be shown,” she says. “They’re saying that [he] should have somehow figured out what was going on.” Haag adds, “It’s a frightening prospect for anyone who holds that gatekeeper position.” William Baker, a former SEC enforcement chief now in the D.C. office of Latham & Watkins, agrees: “The SEC is saying, ‘Too little, too late.’” Baker adds, “Whatever message they’re sending, it’s a scary one for in-house lawyers.” Tamara Loomis is a reporter at Corporate Counsel , the ALM publication where this article first appeared. Her e-mail address is [email protected].

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