SEC Adopts Final Rules for Attorney Professional Responsibility | Publications

On January 23, 2003, the Securities and Exchange Commission (the "SEC") adopted rules (the "Rule") implementing Section 307 of Sarbanes-Oxley Act of 2002 (the "Act") regarding professional standards of conduct for all attorneys who appear and practice before the SEC.[fn1]

Summary

The Rule imposes an "up the ladder" reporting obligation on in-house and outside counsel who appear and practice before the SEC to report a material violation of securities laws or a breach of a fiduciary duty by an issuer client or by any of its officers, directors, employees or agents that has occurred, is occurring or is about to occur. The attorney is required to report the violation to the issuer's chief legal officer (the "CLO," usually an issuer's general counsel) or chief executive officer and CLO. If he or she does not receive an adequate response from either, he or she must report the material violation to the issuer's audit committee, another committee of the board of directors or the entire board. The Rule will take effect on August 5, 2003.

Contrary to the SEC's initial proposal, the Rule does not impose a duty on an attorney to effect a "noisy withdrawal" from the representation of the issuer if the attorney receives an inadequate response from the issuer. The SEC postponed consideration of the "noisy withdrawal" requirement pending consideration of additional comment, and the SEC proposed an alternative provision that would require an attorney to withdraw in certain situations but require the issuer, not the attorney, to make public disclosure of the withdrawal. The comment period for the reproposal of the "noisy withdrawal" requirement and its alternative will end on April 7, 2003.[fn2]

Who Is Covered by the Rule?

All attorneys "appearing and practicing" before the SEC who provide legal services to an issuer and who have notice that documents that they are preparing or assisting in preparing will be filed with the SEC are required to comply with the Rule. Lawyers in-house at an issuer, as well as outside counsel, are covered by the Rule. The Rule will also cover an attorney employed by an issuer's subsidiary if he or she is requested to work on the issuer's SEC filing. However, the SEC did narrow the class of lawyers covered by the Rule from what was proposed. Licensed attorneys who are employed by an issuer but who do not have an attorney-client relationship with the issuer will not be covered by the Rule. Therefore, an investment banker who happens also to be licensed as an attorney, but does not practice law in connection with his or her employment, will not be covered by the Rule. In addition, an attorney who prepares a contract which is later filed as an exhibit in connection with a SEC filing would not be covered by the Rule if the attorney never intended or had notice that the contract would be filed with the SEC.

The Rule broadly defines "appearing and practicing" before the SEC and covers attorneys who communicate in any way with the SEC on behalf of an issuer, including representation of an issuer in a SEC enforcement proceeding, investigation or inquiry. The definition also covers any conduct involving the preparation of any statement, opinion or other writing incorporated in materials filed or submitted to the SEC, and it does not matter whether the attorney serves in the legal department of the issuer as long as the attorney is practicing law on behalf of the issuer and intended or knew that the document would be included in the issuer's SEC filing or submission. The Rule covers an attorney who advises a client that a statement or other writing is not required to be filed or incorporated into a SEC filing or that it is not required to file or submit a registration statement or other SEC filing.

Many, but not all, foreign attorneys are excluded from the Rule's coverage. The Rule does not apply to "non-appearing foreign attorneys." A "non-appearing foreign attorney" is defined as an attorney:

who is not licensed to practice law in the United States,
who does not hold himself or herself out as practicing or giving advice on United States law and
who conducts activities that would constitute appearing and practicing before the SEC only incidentally to his or her foreign practice or appears or practices before the SEC only in consultation with United States counsel.

The term "incidentally" is not defined by the Rule, so it is not clear how the SEC will interpret this term. Therefore until guidance is provided, foreign attorneys who advise issuers that file with the SEC should consult with United States counsel in order to avoid being covered by the Rule.

Duty to Report Evidence of a Material Violation

If an attorney becomes aware of evidence of a material violation, the attorney will have to report the evidence of the material violation to the issuer's CLO or to both the CLO and the CEO. The Rule broadly defines a "material violation" to include "a material violation of an applicable United States federal or state securities law, a material breach of fiduciary duty arising under United States federal or state law, or a similar material violation of any material United States federal or state law." The Rule does not define the scope of a "similar material violation of any material United States federal or state law," and the proposing release merely indicated that the intended meaning was to capture material violations that "extend beyond" a breach of fiduciary duty or a violation of the securities laws.

Awareness of a material violation will be determined by an objective triggering standard. The use of an objective standard will prevent an attorney from defending his or her inaction solely on the basis that he or she did not know of the material violation. If the attorney concludes that there is credible evidence that would make it unreasonable for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur, the attorney will have an obligation to report the evidence of the material violation. The use of the qualifier "credible" in the definition was intended in part to make clear that gossip, hearsay or innuendo would not trigger a reporting obligation.

"Up the Ladder" Reporting

The Rule requires an attorney to report within the issuer evidence of a material violation by any officer, director, employee or agent of the issuer. Initially, the attorney will be required to report the evidence to the issuer's CLO or to both the CLO and the issuer's CEO. If the attorney believes that reporting the evidence of the material violation to the CLO or CLO and CEO would be futile, the attorney can report the evidence directly to the issuer's audit committee or board of directors or, alternatively, a "qualified legal compliance committee" ("QLCC"), as discussed below.

If the attorney does not receive a timely and appropriate response from the CLO after reporting evidence of a material violation, the attorney will be required to report the evidence of the material violation "up the ladder" to (a) the issuer's audit committee or, in the absence of an audit committee, (b) to another committee of the board of directors consisting solely of independent directors or, in the absence of such a committee, (c) the full board of directors. An "appropriate response" is defined by the Rule as an issuer's response to an attorney which causes the attorney to "reasonably believe" that:

no material violation has occurred, is occurring or is about to occur,
the issuer has adopted appropriate remedial measures or sanctions to stop, prevent or address any past, present or future material violation and minimize the likelihood of its recurrence, or
the issuer, with the consent of the board of directors, authorized board committee or QLCC, has retained or directed an attorney to investigate the matter[fn3] and the issuer (a) has implemented any remedial measures recommended by the investigating attorney or (b) has been advised by the investigating attorney that a "colorable defense" can be asserted on behalf of the issuer or its affiliates in connection with the material violation.

The phrase "reasonably believe" is ambiguously defined. "Reasonably believes means that an attorney believes the matter in question and the circumstances are such that the belief is not unreasonable." However, the adopting release does provide useful factors that an attorney may consider in assessing the appropriateness of a response: the amount and weight of the evidence of a material violation, the severity of the apparent material violation and the scope of the investigation into the report. The SEC rejected the recommendation that the attorney could rely on the assurances of the CLO. However, the SEC recognized and anticipated that an attorney may rely on reasonable and appropriate factual representations and legal determinations of a person whom a reasonable attorney would rely.

The proposed rules would have required an attorney to document his or her actions and any response received from the issuer and maintain such records for a reasonable period. The Rule eliminated this requirement, so that the reporting attorney need not memorialize any of his or her actions in connection with "reporting up the ladder."

Optional Notification to the SEC Where There Is No Appropriate Response

Unlike the proposed rules, the Rule does not require an attorney under any circumstances to either withdraw from representing an issuer, disaffirm his or her part in a SEC filing or report evidence of a material violation to the SEC. The SEC deferred consideration of this "noisy withdrawal" provision until at least April 7, 2003. The Rule does permit an attorney to provide the SEC with confidential information about evidence of a material violation at an issuer, without the issuer's consent, if the attorney reasonably believes it necessary:

to prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors;
to prevent the issuer, in a SEC investigation or administrative proceeding from committing perjury or other criminal action that is likely to perpetrate a fraud upon the SEC; or
to rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney's services were used.

Qualified Legal Compliance Committee

The Rule permits an alternative method of reporting where issuers have previously established a QLCC. A QLCC must be appointed by an issuer's board of directors and comprised of at least one member of the issuer's audit committee and at least two independent members of the issuer's board of directors. An issuer may designate its audit committee or another existing committee as its QLCC as long as the designated committee has the required composition and is granted the necessary powers of a QLCC. If the issuer has a QLCC, an attorney would be permitted to report evidence of a material violation directly to the QLCC. A CLO could also refer a report of evidence of a material violation to the QLCC. Once an attorney has reported evidence of a material violation to the QLCC, the attorney would have no further obligation to assess the issuer's response to his or her report. The attorney could continue to represent the issuer. The QLCC would assume responsibility for investigating any matter referred to it by the CLO or attorney. If the QLCC directs the issuer to take remedial action and the issuer does not, the QLCC may, but is not required to, notify the SEC about the material violation. Any action taken by a QLCC, including notifying the SEC about a material violation, requires a majority vote of its members.

The SEC indicated service on a QLCC is not intended to increase the liability of any member of the board of directors under state law and expressly stated that it would be inconsistent with the public interest for any court to conclude that QLCC service increases one's liability exposure. The adopting release encourages an issuer to establish a QLCC as a means of effective corporate governance. Establishing a QLCC might also help an issuer comply with the SEC's recently proposed rule that would require a listed public company's audit committee to establish procedures for the receipt, retention and treatment of complaints regarding accounting violations. Depending on the qualifications of its members, a QLCC could possibly serve this function for the audit committee as well as its function under the Rule.

Supervisory and Subordinate Attorneys

The Rules hold senior attorneys who supervise other attorneys responsible for their subordinates' compliance.[fn4] However, a person who reports directly to a CLO (e.g. a Deputy General Counsel) cannot be a subordinate attorney and therefore must comply with the "up the ladder" reporting requirements of the Rule. A subordinate attorney would be permitted to satisfy the reporting requirements of the Rule by reporting evidence of a material violation to his or her supervisory attorney and not more senior members of the issuer's management. If a subordinate attorney reports evidence of a material violation to his or her supervisory attorney, the supervisory attorney becomes obligated for "up the ladder" reporting of the material violation. A supervisory attorney could be held liable for a subordinate attorney's violative conduct if he or she knowingly ratifies or fails to prevent the violation.

Liability for Non-Compliance

The Rule affirmatively states that enforcement of its provisions is vested exclusively with the SEC. A violation of the Rule will constitute a violation of the Securities Exchange Act of 1934, for which the SEC is authorized to seek civil injunctive and other appropriate equitable relief, as well as civil money penalties. The SEC may also initiate an administrative proceeding against the violator seeking appropriate disciplinary action or disciplinary action for unprofessional conduct under Rule 102(e) (e.g. an attorney who lies to the SEC staff). The Rule contains an express safe harbor provision prohibiting a private right of action against an attorney, law firm or issuer for a violation of the Rule.

Interaction with State Ethics Laws

To the extent a state imposes lesser requirements on attorneys, the Rule explicitly preempts state law; however, the Rule does not prohibit states from imposing more rigorous obligations on attorneys that are not inconsistent with the Rule.

"Noisy Withdrawal" Reproposed

The SEC deferred final consideration of the "noisy withdrawal" requirement until at least April 7, 2003. As proposed, an attorney who does not receive an appropriate and timely response from an issuer and believes that the reported material violation is ongoing or is about to occur and is likely to result in substantial injury to the financial interest or property of the issuer or its investors would be required to notify the SEC that he or she intends to disaffirm his or her involvement with the materially deficient filing(s), withdraw from representing the issuer and notify the SEC about the attorney's withdrawal for "professional considerations." In-house attorneys would not be required to quit their employment but would have to notify the SEC that they intend to disaffirm their involvement with the materially deficient filing(s).

Alternative to "Noisy Withdrawal"

Since "noisy withdrawal" was not mandated by Section 307 of the Act, the SEC is not required to adopt this provision. In light of the substantial negative comment that this proposal received, the SEC proposed for comment an alternative reporting requirement. Unlike the "noisy withdrawal" requirement, the alternative would not require a withdrawing attorney to notify the SEC of his or her withdrawal, and it would not require an attorney to disaffirm documents filed with the SEC.

Under this alternative, an attorney retained by an issuer who has reported evidence of a material violation and has not received an appropriate and timely response and reasonably concludes that there is substantial evidence of a material violation that is ongoing or about to occur and is likely to cause substantial injury to the financial interest or property of the issuer or investors must:

withdraw from representing the issuer and
notify the issuer, in writing, that the withdrawal is based on professional considerations.

In the same circumstances, an attorney employed by the issuer would not have to quit but would have to cease participation or assistance in any matter concerning the violation and notify the issuer, in writing, that he or she believes the issuer has not provided an appropriate response.

The alternative also does not require an attorney to withdraw or cease participation or assistance in a matter if he or she would be prohibited from doing so by order or rule of a court, administrative body or other authority with jurisdiction over the attorney. In such a case, though, the attorney would have to notify the issuer, in writing, that the attorney would have withdrawn or taken such action but for this prohibition. If either an in-house attorney or outside counsel reports evidence of a material violation and reasonably believes that he or she has been discharged for doing so, the attorney must notify the CLO.

When an issuer receives written notice in any of the above situations, the issuer would be required to report such notice within two business days on Form 8-K, 20-F or 40-F, as applicable.[fn5]

Conclusion

Unlike many of the other of the reforms of the Act, the full impact of the Rule on issuers and their attorneys will not be immediately apparent. Most of the Rule's requirements are not triggered until an attorney reasonably believes that there is evidence of a material violation. If such a situation develops, compliance with the Rule may test established relationships among outside and in-house counsel. The Rule may also have the effect of increasing the involvement of an issuer's general counsel and chief executive officer in SEC disclosure issues.

Footnotes

1: To see the text of the Rule, go to: http://www.sec.gov/rules/final/33-8185.htm.

2: To see the text of the proposed rule, go to: http://www.sec.gov/rules/proposed/33-8186.htm

3: The Rule requires any attorney retained to investigate evidence of a material violation also to report "up the ladder" any evidence of a material violation that he or she discovers using the same objective standard applicable to all other attorneys.

4: Only an attorney who directs or supervises the actions of a subordinate attorney is considered a senior attorney.

5: Foreign private issuers do not file Form 8-Ks; therefore, the SEC is proposing a "short form" filing on Form 20-F or 40-F lieu of the Form 8-K filing.