The SEC has adopted a final rule implementing Section 307 of the Sarbanes-Oxley Act of 2002. Section 307 directs the SEC to issue a rule addressing minimum ethical standards for attorneys who appear and practice before the SEC representing issuers. The final rule will become effective August 5, 2003. In addition, the SEC issued a companion release extending the comment period for the proposed rule requiring an outside attorney to make a "noisy withdrawal" in certain situations, and seeking comment on an alternative proposal. The SEC is soliciting comments on the "noisy withdrawal" provisions and alternative until April 7, 2003.
Content of the Final Rule
The final rule imposes an "up-the-ladder" reporting obligation for an attorney who becomes aware of evidence that a material violation of securities law, material breach of fiduciary duty or similar material violation has occurred, is occurring or is about to occur. The final rule requires an attorney initially to report evidence of a material violation to the issuer's chief legal officer ("CLO") or to both its CLO and its CEO.
Unless an attorney who has reported "up-the-ladder" reasonably believes the CLO or CEO has provided an "appropriate response" to evidence of a material violation within a reasonable time, the attorney must report the evidence to the audit committee, another committee of independent directors or the full board of directors.
An "appropriate response" means a response that leads the attorney to reasonably believe that:
no material violation is occurring, has occurred or is about to occur;
- the company has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or
- the company, with the consent of the board of directors, the audit committee, another committee of independent directors or a Qualified Legal Compliance Committee ("QLCC"), has retained or directed an attorney to review the reported evidence of a material violation and either:
- has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or
- has been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the company (or the company's officer, director, employee or agent) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation.
Chief Legal Officer Must Conduct Inquiry
When a company's CLO is presented with a report of a possible material violation, he or she must conduct an inquiry as he or she reasonably believes is appropriate to determine whether the reported violation has occurred, is occurring or is about to occur. If the CLO determines that no material violation is involved, the CLO must notify the reporting attorney of this conclusion, and the basis for the determination. Unless the CLO reasonably believes that no violation has occurred, is occurring or is about to occur, he or she must take all reasonable steps to cause the company to adopt an appropriate response, and advise the reporting attorney of such.
Qualified Legal Compliance Committee
The final rule includes an alternative to handle reports of material violations. Under this alternative, a company would create a Qualified Legal Compliance Committee (or provide that its audit or another committee would serve the same function), comprised of one member of the company's audit committee (or an equivalent committee of independent directors) and two or more additional independent directors. An attorney with evidence of a material violation could report the evidence directly to the QLCC, rather than to the CLO or CLO and CEO. Attorneys who report evidence of a material violation to a QLCC do not need to assess the company's response. Upon receipt of evidence of a material violation, the QLCC would be responsible for notifying the CEO and the CLO, determining whether an investigation is warranted, initiating any investigation and recommending an appropriate response. The QLCC has the authority and responsibility, acting by majority vote, to take all other appropriate action, including the authority to notify the SEC if the company fails in any material respect to implement an appropriate response to a QLCC recommendation.
The CLO may also refer a report of evidence of a material violation to the QLCC in lieu of conducting his or her own inquiry as discussed in the prior section.
Attorneys Covered by the Final Rule
The final rule applies to all "attorneys appearing and practicing before the Commission in the representation of an issuer," and covers both in-house and outside counsel. The SEC defines "appearing and practicing" to include:
transacting any business with the SEC, including communications in any form;
- representing a company in an SEC administrative proceeding or in connection with any SEC investigation, inquiry, information request or subpoena;
- providing advice regarding United States securities law or the SEC's rules or regulations regarding any document that the attorney has notice will be filed with or submitted to the SEC, or incorporated into any such document (including providing such advice in the context of preparing, or participating in preparing, any such document); or
- advising a company regarding whether information or a statement, opinion or other writing is required under United States securities law or the SEC's rules or regulations to be filed with or submitted to the SEC, or incorporated into any such document.
The definition specifically excludes an attorney who conducts these activities outside the context of providing legal services to a company with whom the attorney has an attorney-client relationship, as well as certain foreign attorneys.
Attorneys specializing in areas other than securities law are nonetheless covered by the final rule if their representation of a company involves communications in any form with the SEC, or if they have notice that they are assisting in the preparation of a document that will be submitted to the SEC, or if they actually direct or supervise a subordinate attorney who appears and practices before the SEC. In addition, the definition of "appearing and practicing" is broad enough to include attorneys who do not serve in the legal department of a company, but do provide legal services to the company within the context of an attorney-client relationship.
Evidence Triggering the Reporting Obligations
The final rule obligates an attorney to report "evidence of a material violation" by the company or any officer, director, employee or agent of the company. The final rule's definition of "evidence of a material violation" is intended to clarify aspects of the objective standard the SEC sought to achieve in its proposed definition. "Evidence of a material violation" means credible evidence, based upon which it would be unreasonable, under the circumstances, 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. "Material violation" means a material violation of an applicable United States federal or state securities law, a material breach of a fiduciary duty arising under United States federal or state law, or a similar material violation of any United States federal or state law. To be "reasonably likely," a material violation must be more than a mere possibility, but it need not be "more likely than not" to occur. The SEC has not proposed a definition of the term "similar violation," but it stated in the proposing release that the term is intended to extend beyond a breach of a fiduciary duty or a violation of securities law.
The final rule does not require an attorney to conduct his or her own investigation into potential violations, nor does it require the attorney to "know" that a violation has been committed before reporting it.
Final Rule Supplements Current Standards of Professional Conduct
The final rule states that it supplements applicable standards of professional conduct of any jurisdiction where an attorney is admitted or practices and is not intended to limit the ability of any jurisdiction to impose additional obligations on an attorney not inconsistent with the final rule. Further, the final rule states that where the standards of professional conduct of a state or other United States jurisdiction where an attorney is admitted or practices conflict with the final rule, the final rule governs.
Documentation Not Required
The final rule eliminated the proposed requirement obligating an attorney to take reasonable steps under the circumstances to document any reports made to the CLO, the CEO or the QLCC and the responses to those reports. However, the SEC notes that in lieu of any affirmative requirement, attorneys will likely still consider whether to advise a client in writing that it may be violating the law.
Attorney's Obligations to Company
The final rule explicitly states that the client of an attorney representing a company is the company as an entity, not the company's individual officers, directors or employees. In order not to suggest it is creating a fiduciary duty to shareholders, the SEC deleted the proposed rule reference to the attorney being obligated to act in the best interest of shareholders. Additionally, the proposing release noted that the attorney-client privilege covering information relating to the company's affairs that its officers and employees communicate to the attorney belongs to the company as an entity.
Disclosure of Confidential Information
Under specific circumstances, the final rule authorizes an attorney to disclose confidential information related to his or her appearance and practice before the SEC in the representation of a company. An attorney may use documentation he or she has prepared to defend against charges of attorney misconduct. The final rule also permits, but does not require, an attorney to reveal confidential information to the extent the attorney believes reasonably necessary to prevent the commission of a material violation likely to cause substantial injury to the financial property interests of the company or investors, or the perpetration of a fraud upon the SEC. Similarly, the attorney may disclose confidential information to rectify a company's material violations that caused or may cause substantial injury to the financial property interests of the company or investors, but only when such actions have been advanced by the company's use of the attorney's services. The adopting release states that a mandatory disclosure requirement imposed by a state would be an additional requirement consistent with the SEC's permissive disclosure rule.
Supervisory and Subordinate Attorneys
The final rule details the respective responsibilities of supervisory and subordinate attorneys, both those employed in-house by the company and those serving as outside counsel retained by the company. A supervising attorney who actually directs or supervises the actions of a subordinate attorney appearing and practicing before the SEC must comply with the reporting requirements after a subordinate informs him or her of evidence of a material violation. Subordinate attorneys are not exempt from the rule, but they are required to report evidence of material violations of which they become aware only to their supervising attorney. An attorney under the direct supervision or direction of a company's CLO, however, is not a subordinate attorney, and must comply with the full reporting obligations of the final rule.
Attorneys Retained or Directed to Investigate a Reported Material Violation
When an attorney is retained or directed by a company to investigate a report of a material violation, the final rule states that such attorney is deemed to be appearing and practicing before the SEC and subject to the final rule. Additionally, such attorney's appointment does not relieve the officers or directors of the company of their duty to respond to the attorney who reported the material violation.
However, an attorney retained or directed by the company's CLO to investigate such evidence does not have a reporting obligation if the attorney:
reports the results of such investigation to the CLO, and either (i) both the attorney and the CLO reasonably believe that no material violation is involved or (ii) the CLO reports the results of the investigation to the company's board of directors, the audit committee, another committee of independent directors or the QLCC; or
- was retained or directed by the CLO to assert, consistent with his or her professional obligations, a colorable defense on behalf of the company (or an officer, director, employee or agent of the company) in any investigation or judicial or administrative proceeding relating to such evidence of a material violation, and the CLO provides reasonable and timely reports on the progress and outcome of such proceeding to the company's board of directors, the audit committee, another committee of independent directors or the QLCC.
Similarly, an attorney retained or directed by a QLCC to investigate evidence of a material violation or to assert a colorable defense on behalf of the company does not have a reporting obligation to the CLO or CLO and CEO.
Sanctions and Discipline
Violations of the final rule would subject the violator to the civil penalties and remedies available to the SEC, including injunctions and cease-and-desist orders, and could result in a censure, a suspension or a bar from practicing before the SEC.
The final rule provides that the SEC may impose discipline on and sanction an attorney who violates the rule, even when the attorney is also subject to discipline in the state where he or she practices or is admitted. However, the final rule clarifies that an attorney who complies in good faith with the rule will not be subject to discipline for a violation of inconsistent standards imposed by a state or other United States jurisdiction. Further, foreign attorneys subject to the rule are not required to comply with the rule to the extent that compliance is prohibited by applicable foreign law. The final rule expressly provides that it does not establish a private right of action against an attorney. Further, the final rule does not provide for criminal liability.
Content of the Companion Release: Extended Comment Period Regarding "Noisy Withdrawal" and an Alternative Proposal
In connection with the adoption of the final rule, the SEC issued a companion release extending the comment period for the proposed rule requiring an outside attorney to make a "noisy withdrawal" in certain situations. In addition, the SEC seeks comment on an alternative proposal to "noisy withdrawal" that would require a company, rather than an attorney, to publicly disclose a withdrawal. The SEC is soliciting comments on the "noisy withdrawal" provisions and the alternative until April 7, 2003.
Proposed "Noisy Withdrawal" Notification and Disaffirmation
As discussed in more detail in our December 16, 2002 Update, the proposed rule would require an outside attorney to make a "noisy withdrawal" if he or she believes that the board or board committee has not appropriately responded, within a reasonable period of time, to evidence of a material violation that is ongoing or about to occur and is likely to result in substantial injury to the company or investors. Under these circumstances, the outside attorney must:
withdraw from representing the company, indicating that withdrawal is based on "professional considerations";
- within one business day of withdrawing, notify the SEC in writing of this withdrawal for "professional considerations"; and
- promptly disaffirm any false or materially misleading submission to the SEC in which he or she has participated in preparing.
An in-house attorney who believes that the board or the appropriate committee has not appropriately responded to evidence of an ongoing or potential material violation need not resign but must disaffirm any "tainted" documents filed with the SEC and notify the SEC.
The SEC is also soliciting comments on an alternative that limits attorney withdrawal to narrower circumstances and requires a company, rather than the attorney, to report to the SEC the attorney's withdrawal or notice of failure to receive an appropriate response to a report of a material violation. The alternative proposal only requires an attorney to withdraw where the attorney reasonably concludes there is substantial evidence that a material violation is ongoing or about to occur and is likely to cause substantial injury to the company or investors. The alternative proposal does not contain "noisy withdrawal" and disaffirmation requirements. Instead, a company must report to the SEC an attorney's written notice of withdrawal or failure to receive an appropriate response. A company must also disclose publicly in a Form 8-K, 20-F or 40-F an attorney's notice of withdrawal "and the circumstances related thereto" within two business days of its receipt of the attorney's written notice. If a company fails to give proper public notice, an attorney may inform the SEC that he or she has withdrawn for "professional considerations."
Practical Tips: Q&A for In-house and Outside Attorneys
Question: What measures should a company take based on the final rule?
Companies should consider establishing a QLCC comprised of at least one member of the company's audit committee and two or more additional independent directors. Alternatively, a company may provide for its audit committee to serve the same function as the QLCC. If an attorney reports evidence of a material violation to the QLCC, this report satisfies his or her reporting obligation. A CLO who receives a report of a material violation can refer the report to the QLCC in lieu of conducting his or her own inquiry.
Question: Does Section 307 create a private right of action against an attorney?
No. The final rule expressly provides that it does not create a new private right of action against an attorney. Further, the final rule does not provide for criminal liability.
Question: If an attorney is aware of a past material violation by an issuer, is the attorney obligated to report such violation "up the ladder," make a "noisy withdrawal" and disaffirm any tainted filings?
Under the final rule, the attorney must report a past material violation up the ladder, but no, the attorney is not required to make a noisy withdrawal. Although the SEC is still considering "noisy withdrawal," the companion release does not contain any proposal where an attorney aware of a past material violation must make a "noisy withdrawal." Under the original proposal, if the past material violation does not result in ongoing injury to investors, the "noisy withdrawal" notification and disaffirmation obligations would have been voluntary.
Question: If an attorney's primary area of practice is not securities law but the attorney supervises subordinate attorneys who "appear or practice before the SEC," is the supervisory attorney subject to the final rule?
Yes. The final rule covers attorneys specializing in areas other than securities law if their representation of a company constitutes "appearing and practicing" before the SEC or if they actually direct or supervise a subordinate attorney who appears and practices before the SEC.
Question: Is a licensed attorney working for an issuer in another capacity, such as CFO, subject to the final rule?
Yes. The definition of "appearing and practicing" is broad enough to include attorneys who do not serve in the legal department of an issuer but do provide legal services to the company within the context of an attorney-client relationship.
Text of the Final Rule and Companion Release
You can find the full text of the SEC's final rule on "up-the-ladder" reporting for attorneys at http://www.sec.gov/rules/final/33-8185.htm and the full text of the companion release at http://www.sec.gov/rules/proposed/33-8186.htm. You can find further discussion of the Sarbanes-Oxley Act and of other recent laws, regulations, and rule proposals of interest to public companies on our website.