On January 23, 2003, the Securities and Exchange Commission ("Commission") adopted final rules under Section 307 of the Sarbanes-Oxley Act of 2002, which establish standards of conduct for attorneys "appearing and practicing before the Commission" on behalf of an issuer. This is the first time the Commission has imposed rules which are directly aimed at regulating the conduct of attorneys. The new rules potentially redefine the relationship between public companies and their attorneys.
Generally, the new rules impose an "up-the-ladder" reporting obligation on attorneys if they become aware of evidence of a material violation of either federal or state law or a material breach of a fiduciary duty by an issuer or any of its directors, officers, employees or agents. The new rules will also require attorneys to make a "noisy withdrawal" from representing the issuer where after reporting evidence of a material violation up-the-ladder, reasonably believed that the issuer's directors did not make an appropriate response within a reasonable time. As of this writing, the Commission has not adopted final rules regarding the "noisy withdrawal" procedures.
ATTORNEYS SUBJECT TO THE RULES
The new rules adopted by the Commission apply to any attorneys "appearing and practicing before the Commission." The phrase "appearing and practicing before the Commission" is broadly defined to include:
- Transacting any business with the Commission, including communications in any form;
- Representing an issuer in a Commission administrative proceeding or in connection with any Commission investigation, inquiry, information request, or subpoena;
- Providing advice in respect of the United States securities laws or the Commission's rules or regulations thereunder regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission, including the provision of such advice in the context of preparing, or participating in the preparation of, any such document;
- Advising an issuer as to whether information or a statement, opinion, or other writing is required under the United States securities laws or the Commission's rules or regulations thereunder to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission.
The definition applies only to attorneys who perform legal services for the issuer under an attorney-client relationship. Thus, the definition excludes any attorneys employed by the issuer in non-legal positions. Also excluded from the definition is any foreign attorney who does not give guidance on U.S. securities laws and who, only incidentally, conducts activities that would constitute appearing and practicing before the Commission or does so only in consultation with an attorney licensed in a U.S. jurisdiction.
EVIDENCE OF A MATERIAL VIOLATION
The reporting obligations of an attorney under the new rules are triggered when the attorney, representing an issuer, becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer. As defined in the rules, "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." A "material violation" is a violation of an applicable federal or state securities law, a breach of fiduciary duty, or a similar violation of any United States federal or state law which is material. Materiality is not specifically defined in the attorney conduct rules, but in the adopting release the Commission noted that the term "material" had a well-established meaning under the federal securities laws.
Whether there is "evidence of a material violation," which triggers an attorney's reporting obligations under the rules, is based on an objective standard rather than the subjective belief of the attorney. The "circumstances" upon which the conduct of an attorney will be based are the circumstances existing at the time the attorney makes a decision as to whether or not there is evidence of a material violation which must be reported. Among other things, these circumstances may include the attorney's professional skills, background and experience, the time constraints under which the attorney is acting, the attorney's previous experience and familiarity with the client and the availability of other attorneys with whom the attorney may consult.
"UP-THE-LADDER" REPORTING OBLIGATIONS
As stated above, if an attorney becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney becomes subject to certain up-the-ladder reporting obligations under the new rules. The new rules set forth several alternatives for reporting the material violations up the ladder.
Reporting to the Chief Legal Officer
The first alternative mandates that the issuer's outside counsel report evidence of a material violation to the issuer's Chief Legal Officer, or the equivalent thereof (the "CLO"), or to both of the issuer's CLO and the CEO. The CLO is then required to investigate the material violation and to determine if a material violation has occurred, is ongoing or is about to occur. If the CLO concludes that no material violation has occurred, is ongoing or is about to occur, the CLO must communicate this information to the outside counsel who reported the violation and indicate his or her bases for the determination that no material violation is evident. If the CLO concludes that a material violation has occurred, is ongoing or is about to occur, the CLO must take reasonable steps to craft an "appropriate response" to the violation and communicate this solution to the outside counsel. An "appropriate response" is where the reporting attorney reasonably believes that the issuer's response shows that there is either:
- no material violation,
- that the issuer has undertaken appropriate remedial measures or
- that the issuer has retained or directed an attorney to review the matter and has implemented remedial measures or has been advised by that attorney that the issuer has a colorable defense to the violation.
If the outside counsel who reported the violation is satisfied with both the CLO's response and the timing of the response, the obligation to report the evidence further up-the-ladder is negated.
Reporting to the board of directors
If the reporting attorney reasonably concludes that the CLO's response to the evidence of a material violation is insufficient or the reporting attorney determines that reporting the violation to the CLO would be futile, he or she is obligated to report the violation further up-the-ladder to the issuer's board of directors. The reporting attorney must present evidence of the material violation to one of the following entities:
- The audit committee of the issuer's board of directors;
- Another committee of the issuer's board of directors consisting solely of directors who are not employed, directly or indirectly, by the issuer (if the issuer's board of directors has no audit committee); or
- The issuer's board of directors (if the issuer's board of directors has no committee consisting solely of directors who are not employed, directly or indirectly, by the issuer).
The body to which the report is made must then investigate the evidence and craft an "appropriate response" to the material violation. This response must be communicated to the reporting attorney. If the reporting attorney reasonably believes that the entity to whom the violation was reported has crafted an appropriate response, the reporting attorney is under no further reporting obligation with respect to that material violation.
Reporting to the issuer's qualified legal compliance committee
Under the new rules, issuers may establish a "qualified legal compliance committee." As an alternative to reporting to either the CLO or a committee or the issuer's board of directors, an attorney may report evidence of a material violation to the issuer's "qualifed legal compliance committee" if one exists. This "qualifed legal compliance committee" must:
- Consist of at least one member of the issuer's audit committee and two or more members of the issuer's board of directors;
- Have adopted written procedures for the confidential receipt, retention and consideration of any report of evidence of a material violation;
- Have the authority and obligation to inform the issuer's CLO and CEO of any evidence of a material violation;
- Have the authority and responsibility to determine if an investigation is necessary and if necessary to commence an investigation, notify the audit committee or board of directors of the investigation and retain such additional experts for the investigation as the committee deems necessary to complete its investigation; and
- At the conclusion of the investigation, have the authority and responsibility to recommend an appropriate response and inform the CLO or CEO and the board of directors of the appropriate remedial measures to be taken.
In contrast to reporting to the CLO or reporting to the board of directors, a report made to the issuer's "qualifed legal compliance committee" ends the reporting attorney's obligation to disclose evidence of a material violation.
"NOISY WITHDRAWAL"
The question remains: what is required when an attorney has reported the evidence of a material violation to a committee or the full board of directors but has not received an appropriate response? The Commission proposed two alternative answers to the above question. These two alternatives do not apply where the reporting attorney has disclosed the evidence of the material violation to the issuer's "qualifed legal compliance committee."
Alternative 1: Withdrawal and Reporting to the Commission.
Under one of the variants of the proposed rule, a reporting attorney who has not received an "appropriate response" from the issuer and who believes that the material violation is "likely to result in substantial injury to the financial interest or property of the issuer or of investors" is required to withdraw from representing the issuer and notify the Commission in writing. Within one day, the reporting attorney must notify the Commission in writing that he or she has withdrawn from representing the issuer and that the reporting attorney intends to disaffirm some opinion, document, affirmation or representation in a document to be filed with the Commission or incorporated into a document to be filed with the Commission. In addition, the reporting attorney must actually disaffirm in writing the information causing the material violation.
Alternative 2: Issuer Self-Reporting and Withdrawal.
Under the second proposed variant, a reporting attorney who did not receive an "appropriate response" from the issuer and who believes that the material violation is "likely to result in substantial injury to the financial interest or property of the issuer or of investors" is required to withdraw from representation of the issuer. Following the receipt of the written notice of withdrawal from the reporting attorney, the issuer is required to report the withdrawal and the circumstances surrounding it to the Commission on Form 8-K. The Form 8-K must be filed with the Commission within two (2) business days of receipt of the notice of withdrawal. If the issuer fails to file the required notice on Form 8-K, the reporting attorney may report the issuer's failure to file the Form 8-K and disclose the withdrawal to the Commission.
PREEMPTION OF STATE ETHICS RULES
Another concern about the new rules expressed by commentators is the potential effect of the new rules on state ethics rules governing attorneys. The Commission addressed this issue by making it clear that the new rules were intended to supplement applicable state ethics rules and were not intended to limit the ability of any state to impose additional obligations on an attorney, as long as those additional obligations are consistent with the attorney conduct rules adopted by the Commission. As a result, states can still impose more rigorous obligations on attorneys that those imposed by the Commission. However, if there is a conflict or inconsistency between state ethics rules and the Commission's attorney conduct rules, the attorney conduct rules will prevail over state ethics rules.
NO PRIVATE RIGHT OF ACTION
While any violations of the new rules will be actionable by the Commission, private plaintiffs will be prevented from bringing claims for the violations. The new rules expressly provide that there is no private right of action against any attorney, law firm, or issuer based upon compliance or noncompliance with the new rules requirements.
*article courtesy of Broady Hodder and Ryan York of Davis Wright Tremaine LLP