Client Alert

Securities and Exchange Commission Proposes Rules for Attorney Professional Responsibility

12/9/2002
On November 21, 2002, the Securities and Exchange Commission (the "SEC") published a rule (the "Proposed 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.

Summary

The Proposed Rule imposes an "up the ladder" reporting obligation on in-house and outside counsel of public companies to report a material violation of securities laws or a breach of a fiduciary duty by the issuer or any agent thereof that has occurred, is occurring or is about to occur. The reporting attorney is required to report the violation within the organization and document the response he or she receives.

The Proposed Rule also imposes a duty on the reporting attorney to effect a "noisy withdrawal" from the representation of the issuer if the reporting attorney after reporting "up the ladder" to the board level reasonably believes that the issuer has not responded appropriately.

Public comment is being solicited with respect to the Proposed Rule until December 18, 2002. Many have expressed serious concern with a variety of the Proposed Rule's provisions and are preparing comment letters for submission to the SEC.

Who Would Be Covered by the Proposed Rule?

All attorneys "appearing and practicing" before the SEC in any way in the representation of issuers would be required to comply with the Proposed Rule. The Proposed 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 an SEC enforcement proceeding, investigation or inquiry. The definition also includes any conduct involving the preparation of any statement, opinion or other writing incorporated in materials submitted to the SEC irrespective of whether the attorney serves in the legal department of the issuer or is acting in his or her capacity as an attorney. The Proposed Rule also covers attorneys that advise a client that a statement or other writing is not required to be filed or incorporated into an SEC filing or that it is not required to submit or file a registration statement or other SEC filing.

Although this is an area of some ambiguity, foreign attorneys would be covered by the Proposed Rule irrespective of whether they are admitted to practice in the United States. For example, if a foreign attorney is involved in the preparation of a document for use in a foreign jurisdiction that might subsequently be used as the basis for another document used in a SEC filing or submission, with or without the knowledge of the foreign attorney who prepared the original document, the foreign attorney would be covered by the Proposed Rule. Non-practicing attorneys who remained licensed attorneys and who are employed by an issuer or are engaged by the issuer (e.g., an investment banker who is a lawyer) would also be covered by the Proposed Rule. The Proposed Rule would also include an attorney employed by an issuer's subsidiary if he or she is requested to work on the issuer parent's SEC filing.

Duty to Report Evidence of a Material Violation

If an attorney becomes aware of evidence of a material violation, the attorney would have to report the evidence of the material violation to the issuer's chief legal officer ("CLO") or to both the CLO and the CEO. The Proposed Rule broadly defines a "material violation" to include "a material violation of a securities law, a material breach of fiduciary duty, or a similar material violation." The Proposed Rule does not define the scope of a "similar material violation," but the proposing release indicates that the intended meaning was to capture material violations that extend beyond a breach of fiduciary duty or a violation of the securities laws.

The materiality of a violation would be determined by the reporting attorney by considering whether a reasonable investor would consider the information important to an investment decision. The determination of whether an attorney would have to report evidence of a material violation would be based on an objective standard, one that is based on what a reasonable attorney would believe under the circumstances, and not decided on the basis of the subjective belief of the attorney.

"Up the Ladder" Reporting

The Proposed 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 would be required to report the evidence to the issuer's CLO or to both the CLO and the issuer's CEO. If the reporting attorney believes that reporting the evidence of the material violation to the CLO or CLO and CEO would be futile, the reporting attorney would 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.

Once evidence of a material violation is reported, the attorney would have to take reasonable steps under the circumstances to document the report and the CLO's response. Following a report of evidence of a material violation to a CLO or CLO and CEO, the CLO would be required to conduct a reasonable inquiry to determine whether a basis exists for the report.

If the reporting attorney does not receive a timely or appropriate response from the CLO after reporting evidence of a material violation, the attorney would be required to report the evidence of the material violation "up the ladder" to the issuer's audit committee or, in the absence of an audit committee, to another committee of the board of directors consisting solely of independent directors or, in the absence of such a committee, the full board of directors.

Under the Proposed Rule, an issuer upon receiving a report of evidence of a material violation may direct in-house or outside attorneys to investigate a reported material violation. The Proposed Rule would require any attorney retained to do such to report any evidence of a material violation to the issuer in the same manner that a reporting attorney would be required to do so.

Notification to the SEC Where There Is No Appropriate Response

If an attorney reasonably believes an issuer's directors have responded inadequately to reported evidence of a material violation, and the attorney believes that the 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, after properly documenting the events, the reporting attorney must take the steps described below.

In-House Attorneys. An in-house attorney who reasonably believes an issuer's directors have responded inadequately to reported evidence of a material violation and believes that the 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, after properly documenting the events, must:

  • notify the SEC within one business day that he or she intends to disaffirm any opinion, document, affirmation, representation, characterization, or the like in a document filed with or submitted to the Commission, or incorporated into such a document, that the attorney has prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading; and
  • promptly disaffirm to the SEC, in writing, any such opinion, document, affirmation, representation, characterization, or the like.
The Proposed Rule does not require in-house attorneys to resign from employment, and, if the reporting attorney reasonably believed that the material violation that has occurred is not ongoing, the attorney may, but would not be required, to make the disaffirming statements above.

Outside Attorneys. An outside attorney who reasonably believes an issuer's directors have responded inadequately to reported evidence of a material violation and believes that the 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, after properly documenting the events, must:

  • withdraw from representing the issuer, indicating that the withdrawal is based on professional considerations;
  • notify the SEC within one business day of withdrawing that the reporting attorney is withdrawing based on professional considerations;
  • promptly disaffirm to the SEC any opinion, document any opinion, document, affirmation, representation, characterization, or the like in a document filed or submitted to the SEC that the attorney has assisted in preparing and the attorney reasonably believes is or may be materially false or misleading.
In cases where the material violation has already occurred but is not ongoing and the reporting attorney reasonably believes would be likely to have resulted in substantial injury to the financial interest or property of the issuer or investors, the reporting attorney would be permitted, but not required, to disaffirm and withdraw.

In any case where an attorney makes a "noisy withdrawal," the issuer would be obligated to notify any successor attorney that the successor attorney had been retained to replace an attorney who had to withdraw based on professional considerations.

Qualified Legal Compliance Committee

The Proposed Rule permits an alternative reporting provision where companies have previously established a QLCC. A QLCC must be 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 . If the issuer has a QLCC, a reporting attorney would be permitted to report evidence of a material violation directly to the QLCC. Once a reporting attorney has reported evidence of a material violation to the QLCC, the reporting attorney would have no further obligation: the attorney would not have to assess the issuer's response to his or her report or engage in a "noisy withdrawal." The attorney could continue to represent the issuer. A QLCC would assume responsibility for investigating any matter referred to it by a CLO or reporting attorney. This would provide an incentive for issuers to form a QLCC even though there is no requirement to do so.

If the QLCC directs the issuer to take remedial action and the issuer does not, each member of the QLCC, the CLO and the CEO would be individually responsible for notifying the SEC that a material violation has occurred, is occurring or is about to occur and for disaffirming any document submitted to or filed with the SEC that the individual member considers false or materially misleading. The QLCC, CLO and CEO would be required to notify the SEC about a material violation in situations where a reporting attorney would not be required. For example, the QLCC, CLO and CEO would be required to report past material violations and all material violations regardless of the effect on the issuer and investors.

Supervisory and Subordinate Attorneys

The Proposed Rules hold attorneys who supervise other attorneys responsible for their subordinates' compliance. A subordinate attorney would be permitted to satisfy the reporting requirements of the Proposed Rule by reporting evidence of a material violation to his or her supervisory attorney. If a subordinate attorney reports evidence of a material violation to his or her supervisory attorney, the supervisory attorney would be required to comply with the reporting requirements of the Proposed Rule. A supervisory attorney could be held liable for violative conduct by another attorney which he or she knowingly ratifies or which he or she fails to prevent when able to do so.

Liability for Non-Compliance

A violation of the Proposed Rule would constitute a violation of the Securities Exchange Act of 1934, allowing the SEC to commence a civil action seeking injunctive and other appropriate equitable relief, as well as civil money penalties. The SEC would also be permitted to initiate an administrative proceeding against the violator seeking appropriate disciplinary action. The Proposed Rule would not create a private right of action against an attorney who had violated the Proposed Rule, but would not eliminate SEC disciplinary actions under Rule 102(e) to discipline attorneys for unprofessional conduct (e.g. an attorney who lies to the SEC staff).

Conclusion

The Proposed Rule raises a number of controversial issues. Some of these issues include:

  • the breadth of the Proposed Rule's coverage concerning who qualifies as an "attorney," what it means to be "appearing and practicing" before the SEC and what constitutes the "representation of an issuer;"
  • concerns raised by the "noisy withdrawal" or reporting out requirements; and
  • questions about the coverage of the breach of fiduciary duty aspect of a "material violation."
In view of the limited time allowed to prepare and submit detailed comments to the SEC, we encourage readers to seek an extension of the comment period so that comments can later be made to the extent the SEC is not required under the Act to adopt final regulations by January 26, 2003.
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