Table of Contents
IDENTIFICATION AND EXPERIENCE OF ALAS
In Release No. 33-8186, the Commission solicits comments on (1) the mandatory "noisy withdrawal" provision first proposed as a part of Rule 205 in Release No. 33-8150, (2) an alternative mandatory withdrawal provision proposed in Release No. 33-8186 and (3) the Commission's final Rule 205 as adopted by Release No. 33-8185. ALAS comments on these subjects in that order. Some of the following comments refer to and incorporate ALAS' prior comments in response to Release 33-8150, which were filed with the Commission on December 18, 2002, and are on the Commission's web site at http://www.sec.gov/rules/proposed/s74502/alasi1.htm ("ALAS' 12/18/02 Comment").
IDENTIFICATION AND EXPERIENCE OF ALAS
The identification and experience of ALAS and its several Loss Prevention Counsel are described at the beginning of ALAS' 12/18/02 Comment.
I. RULE 205 SHOULD NOT INCLUDE MANDATORY WITHDRAWAL, REPORTING TO THE COMMISSION AND DISAFFIRMANCE OF PRIOR DOCUMENTS BY OUTSIDE COUNSEL FOR ISSUERS
A. The proposed Section 205.3(d)(1) and (2) Should Be Omitted from Rule 205 for the Reasons Stated in Section I of ALAS' 12/18/02 Comment
In Section I of its December 18, 2002 comment on Release 33-8150, ALAS listed several reasons mandatory attorney withdrawal, reporting to the Commission and disaffirmance of previously submitted documents should be eliminated from Rule 205. In summary, they are:
B. Even If Notice to the Commission of an Issuer's Failure to Respond "Appropriately" Is Adopted, Mandatory Attorney Withdrawal and Disaffirmance Are Not Necessary
The concept of mandatory notice to the Commission when an issuer fails to make an appropriate response to an attorney's report of evidence of a material violation should be decoupled from the concepts of mandatory attorney withdrawal from representing the issuer and mandatory disaffirmance of previously submitted documents. The first concept may serve a useful investor-protection goal. The latter two concepts do not advance that goal, and constitute unwarranted interference in the attorney-client relationship.
The investor protection goal can be advanced by requiring notice to the Commission by the issuer whenever an attorney notifies the issuer that the issuer has not made an appropriate response to the attorney's earlier report of evidence of a material violation. Under Section 205.3(b)(9), the attorney must notify the issuer's CLO, CEO and board of directors whenever this occurs, and must explain to them why the attorney considers the issuer's response inappropriate. When the attorney gives such notice and explanation to the issuer, Rule 205 can require the issuer to notify the Commission (as proposed in the Commission's alternative) without requiring the attorney to do so. This procedure largely avoids the conflict between the attorney's fiduciary duty of confidentiality to the client and the attorney's duties under Rule 205.
In cases where an attorney has informed an issuer that the issuer's response to a prior report of evidence of a material violation was not appropriate, either the attorney or the issuer, or both, often will decide to terminate the attorney's representation of the issuer, at least with respect to the matter that gave rise to the attorney's original report. But the decision to terminate that representation ultimately should be left to the attorney and the issuer, not imposed inflexibly by the Commission on all issuers in all such circumstances. Especially when the scope of mandated withdrawal is unclear, as it was in the Commission's original mandatory withdrawal proposal (see Section I.C below), mandatory withdrawal from all representation of the issuer may impose enormous and unnecessary costs and hardship on the issuer, and may be extraordinarily disruptive to the issuer's business. Once the Commission is assured that it will be notified of the attorney's conclusion that the issuer has not made an appropriate response, the additional cost, burden and disruption of mandatory withdrawal serve no useful purpose.
Mandating disaffirmance of documents in all cases of withdrawal is unnecessary to meet the purposes of investor protection. Very often, previously delivered documents will not be misleading or problematic and forcing their disaffirmance could have unintended negative consequences for the issuer. If disaffirmance makes sense in a particular situation, it should be evaluated and decided on a case by case basis.
C. If Mandatory Withdrawal Becomes Part of Rule 205, the Scope of Withdrawal Should Be Clearly Defined and Limited to Withdrawal from the Matter Giving Rise to the Attorney's Report
As noted in Section I.C of ALAS' 12/18/02 Comment, the Commission's original mandatory withdrawal proposal did not delineate from which issuer representations an attorney must withdraw. When read together with the commentary in Release No. 33-8150, the originally proposed Section 205.3(d)(1)(i) appears to require an attorney to withdrawal from all representations of the issuer, not just the representation that gave rise to the attorney's original report, and not just representations involving the Commission. Nowhere in Release 33-8150 does the Commission offer any explanation or justification for such a sweeping withdrawal requirement. No purpose is served by requiring withdrawal from completely unrelated representations involving, for example, defense of product liability, antitrust, or dozens of other litigation claims, or regulatory representations, or transactional matters wholly unrelated to the attorney's securities law work for the issuer. In fact, it is only in connection with the representation giving rise to the report that failure to withdraw could possibly continue to assist in the client's misconduct. In addition, requiring withdrawal from a broad range of matters would be costly and disruptive for the issuer, and could prejudice the issuer's legal or financial interests in the unrelated matters. These consequences are not in the interests of the issuer's shareholders.
II. THE COMMISSION'S ALTERNATIVE MANDATORY WITHDRAWAL PROPOSAL RETAINS VARIOUS PROBLEMS WITH THE ORIGINAL PROPOSAL AND STILL GOES BEYOND WHAT IS NECESSARY OR DESIRABLE FOR THE PROTECTION OF INVESTORS
The Commission's proposed alternative Section 205.3(d) includes many improvements over the related section of Rule 205 as originally proposed. These include: the higher level of evidence required before withdrawal would be required; a more definitive level of confidence regarding the evidence of a material violation; the addition of a requirement that the material violation is likely to cause substantial injury to the financial interest or property of the issuer or investors; elimination of the requirement to disaffirm documents; notice to the Commission by the issuer in lieu of notice by the attorney; notice alone in place of notice and withdrawal where the attorney is prohibited from withdrawing; and elimination of the requirement that an attorney withdraw "forthwith."
Nonetheless, the alternative provision still goes beyond what is necessary and desirable for the protection of investors.
A. Mandatory Withdrawal Is Unwarranted and Overly Broad
The Commission's proposed alternative mandatory withdrawal procedure still imposes on the issuer's attorney an unwarranted mandatory duty to withdraw. For the reasons stated in Sections I.A and I.B above, even under the alternative proposal, mandatory withdrawal should not be included in Rule 205. If the Commission decides to include the alternative mandatory withdrawal provision in Rule 205, it should clearly define and limit the scope of required withdrawal for the reasons stated in Section I.C above.
B. Immediate Public Notice Is Unnecessary and Potentially
Unfair to Issuers and Disruptive to the Public Markets
Even if the Commission adopts a mandatory withdrawal requirement, proposed Section 205.3(e), which requires that a current report be filed with the Commission within two business days of receipt of written notice of an attorney's withdrawal, is problematic for several reasons. Although we agree that disclosure can be beneficial in certain limited circumstances to protect the issuer and investors, and it is preferable for the issuer to give the notice instead of the attorney, giving notice directly to the public is fraught with unintended and potentially negative consequences.
For example, if an attorney and an issuer have a good faith disagreement about whether a material violation is ongoing or about to occur, or whether a particular suspected violation will cause substantial injury to the financial interest or property of the issuer or of investors, it may be premature to make public disclosure. The consequences of mandatory and rapid public disclosure could unnecessarily alarm the investing public of a non-existent or minor problem, resulting in devastating consequences to the issuer's reputation and stock price. Similar consequences could arise from the circumstances posited for comment in the proposing release, which included that the attorney providing the written notice acted unreasonably or that the issuer, subsequent to receiving the notice, has implemented an appropriate response.
As a result of the significant adverse consequences of immediate public notice of an attorney's withdrawal, attorneys representing issuers may be dissuaded from withdrawing and reporting. If this were to happen, the objective of notice to the Commission would not be met at all.
For these reasons, we recommend that if the Commission adopts a form of mandatory withdrawal, the notice be made by the issuer to the Commission and not directly to the public.
III. VARIOUS ASPECTS OF RULE 205 AS ADOPTED, AND OF THE COMMENTARY THEREON, REQUIRE CLARIFICATION
The final version of Rule 205 adopted by the Commission improves upon the version originally proposed. In particular, compliance with the rule and achievement of its goals are served by: deletion of mandatory attorney documentation requirements; the narrowed scope of applicability of the final rule, particularly with respect to foreign attorneys and attorneys who have no attorney-client relationship with, and render no securities law advice to, issuers; elimination of mandatory attorney disclosure in favor of permissive disclosure to prevent or rectify consequences of an issuer's material violation under Section 205.3(d)(2); inclusion of a form of attorney safe-harbor in Section 205.6(c); and inclusion of Section 205.7 stating expressly that Rule 205 creates no private right of action against attorneys for compliance or non-compliance with the rule.
A number of ambiguities and unanswered questions, however, are raised by the text of Rule 205 as adopted and, in at least one case, by the related commentary on that rule. In the interest of clarifying the Commission's intent and promoting better understanding among attorneys to whom the rule applies, the Commission should provide guidance to affected attorneys and issuers on the following questions.
A. Is Rule 205 Applicable to Attorneys Who Prepare Documents that They Have Notice Will Be Attached to or Incorporated in a Filing with the Commission, But Who Render No Securities Law Advice Concerning those Documents?
Section 205.2(a)(1)(iii) of the rule appears to provide that an attorney who prepares or participates in preparing a document that the attorney has notice will be filed with, submitted to, or incorporated in another document that will be filed with or submitted to the Commission is subject to Rule 205 only if the attorney provides "advice in respect of the United States securities laws or the Commission's rules or regulations there under" regarding that document. So, for example, an ERISA attorney who prepares an employee benefit plan for an issuer and has notice that the plan will be attached to a filing by the issuer with the Commission would not be subject to Rule 205 unless the attorney provided securities law advice to the issuer concerning that document or the necessity of its being filed. Despite the language of Section 205.2(a)(1)(iii), however, Commission staff members have stated publicly that an attorney like the one in the previous example would be subject to Rule 205 merely by virtue of having notice that the document the attorney prepares will be filed with the Commission. (For example, Sam Forstein expressed this view during an ABA videoconference entitled "What Lawyers Need to Know to Comply with the New SEC Professional Conduct Rules" on February 25, 2003.) Clarification of this issue will help avoid situations in which attorneys otherwise might be obligated to report on matters unrelated to their legal work for the issuer.
The Commission should revise the rule or issue additional commentary to clarify that the reporting obligation does not apply to attorneys who provide no securities law advice or services to the issuer.
B. "Reasonably Likely," as Used in Section 205.2(e), Should Not Be Interpreted to Mean Less Than "Probable"
Section 205.2(e) of Rule 205 defines "evidence of a material violation" as credible evidence, based upon which it would be unreasonable for the attorney not to conclude that it is "reasonably likely" that a material violation has occurred, is ongoing, or is about to occur. Although the word "reasonably" is defined in Section 205.2(l) when it relates to the actions of an attorney, the phrase "reasonably likely" is not further defined in Rule 205.
The ordinary, commonly understood meaning of the word "likely" is probable or having a high probability of occurring. Most attorneys will understand the phrase "reasonably likely" as used in Section 205.2(e) to mean probable or more likely than not. Nothing in Rule 205 itself seems inconsistent with this commonly accepted understanding of "reasonably likely."
In its commentary on Section 205.2(e), however, the Commission has included a sentence that contradicts the commonly understood meaning of the phrase "reasonably likely." That sentence states: "To be `reasonably likely' a material violation must be more than a mere possibility, but it need not be `more likely than not.'" Release No. 33-8185, 1/29/03, at 12. This commentary muddles the meaning of "reasonably likely" by attempting to assign to that phrase the meaning "possible," which is counter-intuitive for most attorneys, confusing and contrary to its commonly accepted meaning. In doing so, the Commission is creating a trap for attorneys who are subject to the rule.
The Commission's "less than probable" trigger for up the line reporting under Rule 205 is troublesome for more than merely semantic reasons. In some cases, such a low reporting trigger will require attorneys to report up the line when they have concluded, after due consideration and under all the circumstances, that a material violation probably was not and is not present and will not likely occur in the future. Such a reporting trigger will burden attorney-issuer relationships with unnecessary reporting, will cause issuers to expend unwarranted time and effort chasing after mere "possibilities" that outside attorneys have identified and concluded are improbable, and inevitably will cause issuers to treat up the line reports less seriously and carefully than if Rule 205 required reporting only when outside counsel had determined that a material violation was more likely than not to have occurred, be ongoing or be about to occur.
For these reasons, the Commission should withdraw the sentence quoted above from the commentary on Rule 205, and should make clear that the phrase "reasonably likely," as used in Section 205.2(e), has its ordinary common English meaning, more likely than not or having a high probability of occurring.
C. To Trigger Up the Line Reporting, Information an Attorney Learns Should Be Related to the Attorney's Representation of the Issuer
Once Rule 205 applies to an attorney representing an issuer, the rule's up the line reporting requirements can be triggered by information the attorney learns from any source, not just from the issuer, and by information that is totally unrelated to the scope of the attorney's representation of the issuer. Rule 205 should be changed so that information that triggers up the line reporting must be related to the attorney's representation of the issuer, as is the case under ABA Model Rule of Professional Conduct 1.13 and most state counterparts to Model Rule 1.13. Otherwise, the attorney may be required to make up the line reports on the basis of possibly second hand or incomplete information, on matters about which the attorney is not adequately informed, matters that the attorney cannot effectively monitor, matters concerning which the attorney has no basis to evaluate the appropriateness of the issuer's response, and (if the Commission adds a mandatory withdrawal requirement to Rule 205) matters from which the attorney cannot withdraw.
The requirement in Model Rule 1.13 that knowledge triggering an attorney's duty to act in the organizational client's best interest be related to the subject of the attorney's representation serves several important purposes. It assures that the attorney will have a reliable basis for whatever action he or she takes to protect the organization's interest. It also assures that the attorney will be able to evaluate the adequacy of responses by various levels of the organization's management. Finally, it increases the likelihood that the organizational client's management will treat seriously and respond effectively to the attorney's report in a way that will protect the organizational client's interests.
Without a "relatedness" requirement, attorneys may be forced to make up the line reports on situations about which they are not fully informed. This will create unnecessary burdens and costs for the issuer, will impair the attorney-issuer relationship, and ultimately will not advance the interests of investors.
D. Must an Attorney Making a Second Stage Up the Line Report Proceed in the Sequence Listed in Sections 205.3(b)(3)(i), (ii) and (iii), or Does the Attorney Have Discretion to Report to Any of the Audit Committee, an Independent Board Committee or the Board?
Section 205.3(b) provides that an attorney who concludes that an issuer has not made an appropriate response to the attorney's earlier report of evidence of a material violation must make a further report to either (i) the Audit Committee of the issuer's board, (ii) an independent board committee or (iii) the board itself. What is not clear from Section 205.3 is whether the attorney must make the second stage report to these entities in the order specified in the rule, or whether the attorney has discretion to choose among them, for example, may the attorney report to an independent board committee even if the board also has an audit committee, or report to the full board even if the board has both an audit committee and other independent committees? ALAS believes that it is most consistent with the purposes of Rule 205 to permit attorneys to choose which of these entities should receive this report. For example, there may be situations in which one or more members of the audit committee are implicated by the evidence of a material violation that was previously reported by the attorney. In that situation, it would obviously be better for the attorney to report to a committee other than the audit committee or to the full board. Whatever the Commission decides, it should clarify this question by amendment or appropriate commentary.
E. Must an Investigation or Proceeding Be Pending for Section 205.3(b)(6)(ii)'s Exemption from Required Reporting to Apply?
Section 205.3(b)(6)(ii) provides an exemption from making a report that would otherwise be required by Rule 205 if an attorney is retained by the issuer's CLO to assert, on behalf of the issuer or its agents, a "colorable defense" to an alleged material violation "in any investigation or judicial or administrative proceeding relating to such
evidence . . ." For an attorney to qualify for this exemption, does the investigation or proceeding actually have to be pending when the attorney is retained, or may it be an investigation or proceeding that the CLO or the issuer anticipates or has reason to believe may be initiated?
The Commission should clarify that in the context of Section 205.3(b)(6)(ii), it is sufficient for the colorable defense to be related to an investigation or proceeding that the CLO or the issuer reasonably anticipates may be initiated.
F. How Will an Attorney Know Whether a CLO Has Made "Reasonable and Timely" Reports to the Issuer's Board about a Proceeding so that Section 205.3(b)(6)(ii)'s Reporting Exclusion Will Apply?
The exemption from required reporting provided by Section 205.3(b)(6)(ii) is dependent on the issuer's CLO making "reasonable and timely" reports to the issuer's board on the progress of a proceeding in which an attorney is asserting a "colorable defense" on behalf of the issuer. But the rule imposes no duty on the issuer's CLO to inform the attorney involved in the proceeding what reports the CLO has made to the issuer's board, or what was contained in those reports. How can the attorney know whether the CLO has made "reasonable and timely" reports to the issuer's board, and thus make a judgment about whether the reporting exclusion is in effect, unless the CLO has an obligation under Rule 205 to inform the attorney about the timing and content of the CLO's reports to the board?
The Commission should clarify this question by an amendment to the rule imposing a requirement in connection with Section 205.3(b)(6)(ii) that the issuer's CLO inform the attorney involved of the timing and content of the CLO's reports to the issuer's board.
G. Will the Commission Treat Members of a Law Firm Committee that Assists a Firm Attorney to Understand and Interpret Rule 205 as " Supervisory Attorneys" for Purposes of Section 205.4(a)?
The Commission apparently intends that private law firms establish procedures to assist individual firm attorneys to comply with their obligations under Rule 205. The Commission's press release on Rule 205 noted that one reason for the delayed effective date of Rule 205 is "to provide . . . law firms sufficient time to put in place procedures to comply with [Rule 205's] requirements." SEC Press Release 2003-13, 1/23/03, at 2. Although reporting obligations under Rule 205 are clearly imposed only on individual attorneys, not on their firms, ALAS agrees that it will be beneficial to attorneys with Rule 205 reporting obligations to have access to the experience and disinterested judgment of other attorneys in their firms in interpreting and applying the rule's provisions. ALAS is inclined to recommend to its Member Firms that they establish new committees, or designate existing firm legal ethics or other appropriate firm committees, to assist individual attorneys in understanding and complying with their Rule 205 obligations.
One question that ALAS anticipates will be raised by its Member Firms is whether creating a new committee to advise and assist firm attorneys in complying with Rule 205, or whether assigning those functions to some existing firm committee such as the ethics or professional responsibility committee, will result in the Commission treating members of that committee as "supervisory attorneys" within the meaning of Section 205.4(a) of Rule 205.
ALAS believes that under the facts described above the Commission should not treat members of such a law firm committee as "supervising or directing" the individual attorney who is appearing and practicing before the Commission. First, the purpose of the committee is not to have its members supervise or direct the attorney's securities law work for the issuer. Rather, it is to have them advise the attorney on the attorney's own obligations under Rule 205. Second, under Rule 205 it is questionable whether any attorney in a law firm could properly direct or control the response of another firm attorney who is subject to Rule 205. The rule imposes reporting obligations on individual attorneys, and it is those individual attorneys who have the responsibility to comply with the rule. Third, if the rule treats members of such advisory committees as supervising attorneys, the securities attorney actually involved in the subject matter no longer will be the attorney with the reporting obligation. This outcome does not serve the purposes of the rule. Finally, treating committee members as "supervising or directing" attorneys who are subject to the rule and thereby subjecting them to Rule 205's requirements when they otherwise would not be covered by the rule, will create a disincentive for law firms to create such committees.
In ALAS' view, the existence of such law firm committees, which can bring together the experience of securities attorneys, ethics and professional responsibility attorneys and other attorneys with relevant training or experience, will advance the goal of Rule 205 compliance by all firm attorneys. For these reasons, ALAS believes that so long as a law firm's Rule 205 committee does not actually supervise or direct an individual attorney's substantive securities law work for, or advice to, an issuer, the members of that committee should not be treated as "supervising or directing" the attorney for purposes of Section 205.4(a).
ALAS, therefore, requests the Commission to clarify in the rule or commentary that if a law firm assigns to a new or existing law firm committee responsibility for advising and assisting individual firm attorneys in complying with their obligations under Rule 205, and specifically limits the committee's responsibilities to Rule 205 compliance, as opposed to directing or supervising the substantive securities law work of any individual attorney, the Commission will not treat the members of that committee as "supervising or directing another attorney who is appearing and practicing before the Commission," for purposes of Section 205.4(a) of the rule.