12.16.2002
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Updates
The SEC has proposed a 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 practice and appear before the SEC representing issuers. In addition to the provisions explicitly required by Section 307, the proposed rule incorporates additional provisions that the SEC believes are important components of an effective "up-the-ladder" reporting system.
This is an informational Update on the proposed rule. The proposed rule has generated discussion and controversy. Therefore, its provisions may change before it is adopted as the final rule. The SEC is soliciting comments on or before December 18, 2002. The SEC will adopt the final rule by January 26, 2003.
Content of the Proposed Rule
Up-the-Ladder Reporting. The proposed rule imposes an "up-the-ladder" reporting obligation for an attorney who "reasonably believes" that a material violation of securities laws, breach of fiduciary duty or similar violation has occurred, is occurring or is about to occur. The proposed rule requires an attorney initially to report evidence of a material violation to the CEO, chief legal officer or other appropriate officer within the company.
If the CEO, chief legal officer or other officer does not timely provide an "appropriate response" to evidence of a material violation, the attorney must report the evidence to the audit committee, another committee of independent directors or the full board of directors.
An "appropriate response" must provide a basis for the attorney to reasonably believe that:
- no material violation is occurring, has occurred or is about to occur; or
- the company has adopted any necessary remedial measures.
"Noisy Withdrawal" Notification and Disaffirmation. 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 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.
A company must notify any attorney replacing a withdrawing attorney that such withdrawing attorney withdrew based on professional considerations. 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.
Chief Legal Officer Must Conduct Inquiry. When a company's chief legal officer is presented with a report of a possible material violation, he or she must conduct a reasonable inquiry to determine whether the reported violation has occurred, is occurring or is about to occur. If the chief legal officer concludes that no material violation is involved, the chief legal officer would have to notify the reporting attorney of this conclusion. If the chief legal officer determines that a violation has occurred, is occurring or is about to occur, he or she must take reasonable steps to ensure that the company adopts remedial measures and/or sanctions, including appropriate disclosures. The chief legal officer must report "up the ladder" within the company any measures adopted or sanctions imposed and must advise the reporting attorney of his or her conclusions.
Qualified Legal Compliance Committee. The proposed rule includes an alternative to handle reports of material violations. Under this alternative, a company would create a Qualified Legal Compliance Committee, comprised of one member of the company's audit committee and two or more other independent directors. An attorney with evidence of a material violation could report the evidence directly to the Qualified Legal Compliance Committee, rather than to the CEO or chief legal officer. Attorneys who report evidence of a material violation to a Qualified Legal Compliance Committee do not need to assess the company's response or be subject to the proposed "noisy withdrawal" requirement. Upon receipt of evidence of a material violation, the Qualified Legal Compliance Committee would be responsible for notifying the CEO and the chief legal officer, determining whether an investigation is warranted, directing any investigation and implementing remedial measures. If the company fails to appropriately implement remedial measures prescribed by the Qualified Legal Compliance Committee, each Qualified Legal Compliance Committee member, the CEO and the chief legal officer must notify the SEC and disaffirm documents "tainted" by the misconduct.
Attorneys Covered by the Proposed Rule
Section 307 of Sarbanes-Oxley and the proposed rule apply to all "attorneys appearing and practicing before the Commission in any way in the representation of issuers." The SEC defined the term "appearing and practicing before the SEC" expansively to include in-house and outside attorneys practicing abroad or within the United States who prepare or participate in the preparation of SEC-filed documents, transact any business with the SEC, represent any party in an SEC proceeding or investigation, or advise any party with respect to a document submitted to the SEC.
An attorney representing a company in a specific matter has a reporting obligation even if:
- the violation does not relate to the matter in which the attorney is involved; or
- the matter in which the attorney is involved is not one directly involving the SEC.
Attorneys specializing in areas other than securities law are covered by the proposed rule if their representation of a company involves contact with the SEC, they have reason to believe they are assisting in the preparation of a document that will be submitted to the SEC or they supervise an attorney who appears and practices before the SEC. In addition, the proposed definition of "appearing and practicing" is broad enough to include attorneys who do not serve in the legal department of a company or do not act in their capacities as attorneys but who transact business with the SEC or assist in the preparation of documents filed or submitted to the SEC.
Evidence Triggering the Reporting Obligations
The proposed rule obligates an attorney to report evidence of a "material violation" of securities laws or a breach of a fiduciary duty or similar violation by the company or any officer, director, employee or agent of the company. "Evidence of a material violation" means information that would lead a reasonable attorney to believe that a material violation has occurred, is occurring or is about to occur irrespective of whether the particular attorney subjectively believes that a violation exists. "Material violation" means a material violation of the securities laws, a material breach of a fiduciary duty or a similar material violation. The SEC has not proposed a definition of the term "similar violation," but it has stated that the term is intended to extend beyond a breach of a fiduciary duty or a violation of securities law.
The proposed 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.
Documentation Required
The proposed rule obligates an attorney to take "reasonable steps" under the circumstances to document any reports made to the chief legal officer, the CEO or the Qualified Legal Compliance Committee and the responses to those reports. Such documents must be retained for a "reasonable time." The attorney's contemporaneous record should include the date, time, location, manner and substance of the report and any response, and it should identify any witnesses to either. Exigent or extenuating circumstances may excuse the lack of a contemporaneous record, although the SEC expressed a belief that such cases will be rare.
Implications of the "Noisy Withdrawal" Notification and Disaffirmation Provision
The board's or board committee's failure to appropriately respond to evidence of misconduct in a reasonable time triggers an attorney's obligation to disaffirm tainted filings and, with respect to an outside attorney in the case of ongoing or future violations, to "noisily withdraw" and notify the SEC in writing of a withdrawal for "professional considerations." The proposed rule states that the SEC does not believe that any disclosures made by an attorney with respect to a noisy withdrawal violate the attorney-client privilege because the proposed rule does not require disclosure of the specifics of purported wrongdoing.
Attorneys with evidence of past, but not ongoing or future, material violations are permitted, but not required, to follow the "noisy withdrawal" notification and disaffirmation provisions.
Disclosure of Confidential Information
Under specific circumstances, the proposed 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 the documentation he or she has prepared under the rule to defend against charges of attorney misconduct. The proposed rule also allows an attorney to reveal confidential information to the extent necessary to prevent the commission of an illegal act that the attorney reasonably believes will result either in perpetration of a fraud upon the SEC or in substantial injury to the financial property interests of the issuer or investors. Similarly, the attorney may disclose confidential information to rectify a company's illegal actions when such actions have been advanced by the company's use of the attorney's services.
Supervisory and Subordinate Attorneys
The proposed 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 must comply with the reporting requirements and documentation obligations 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 only to report to their supervising attorney evidence of material violations of which they become aware.
Attorney's Obligations to Company
The proposed rule explicitly states that the client of an attorney representing a company is the company as an entity, not the company's individual officers or employees. Additionally, the attorney-client privilege for information relating to the company's affairs that the officers and employees communicate to the attorney belongs to the company as an entity.
Attorneys Retained or Directed to Investigate a Reported Material Violation
When an attorney is retained by a company to investigate a report of a material violation, the proposed rule states that such attorney is deemed to be appearing and practicing before the SEC and subject to the proposed 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.
Sanctions
Violations of the proposed rule would subject the violator to all the remedies and sanctions available under the Exchange Act, including injunctions and cease-and-desist orders, and could result in a censure, a suspension or a bar from practicing before the SEC.
An attorney is subject to discipline for:
- an intentional, reckless or knowing violation of the rule;
- a single instance of highly unreasonable, negligent conduct that results in a violation of the rule; or
- repeated instances of unreasonable, negligent conduct resulting in a violation of the rule.
The 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. The proposed rule does not establish a private right of action against an attorney or provide for criminal liability.
Practical Tips: Q&A for In-house and Outside Attorneys
Question: What measures should a company take based on the proposed rule?
Companies should consider establishing a Qualified Legal Compliance Committee, comprised of at least one member of the company's audit committee and two or more other independent directors. As a practical matter, a company could use its audit committee as the Qualified Legal Compliance Committee. If an attorney reports evidence of a material violation to the Qualified Legal Compliance Committee, this report satisfies his or her reporting obligation, and no "noisy withdrawal" is required. A chief legal officer who receives a report of a material violation can refer the report to the Qualified Legal Compliance Committee in lieu of conducting his or her own inquiry.
Question: Does Section 307 create a private right of action against an attorney?
No. The proposed rule does not create a new private right of action against an attorney or 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?
Yes. The attorney must report a past material violation up the ladder, but, no, the attorney is not required to make a noisy withdrawal. If the past material violation does not result in ongoing injury to investors, the "noisy withdrawal" notification and disaffirmation obligations are voluntary. However, an attorney should take great care in evaluating whether a past material violation continues to injure investors.
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 proposed rule?
Yes. The proposed rule covers attorneys specializing in areas other than securities law if their representation of a company involves contact with the SEC, if they have reason to believe they are assisting in the preparation of a document that will be submitted to the SEC or if they supervise an 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 proposed rule?
Yes. The proposed definition of "appearing and practicing" is broad enough to include attorneys who do not serve in the legal department of an issuer or do not act in their capacities as attorneys but who transact business with the SEC or assist in the preparation of documents filed or submitted to the SEC.
Text of the Proposed Rule
This Update is intended only as a summary of the SEC's proposed rule. You can review the full text of the proposed rule at http://www.sec.gov/rules/proposed/33-8150.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.
