Danny M. Smolnik, Esq.
30 Rocklyn Drive
West Simsbury, Connecticut 06092
December 18, 2002
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549 - 0609
Re: File Number 33-8150.Wp
Proposed Rule: Implementation of Standards of Professional Conduct for Attorneys
Dear Secretary Katz:
I am an attorney admitted to practice in the State of Connecticut, before the United States District Court for the District of Connecticut and before the United States Tax Court. I have been in practice for 16 years and wish to share some of my observations regarding the Proposed Rule concerning Implementation of Standards of Professional Conduct of Attorneys, proposed under the auspices of Section 307 of the Sarbanes-Oxley Act. The comments made herein reflect my own views.
I appreciate the Commission's effort to clarify the ethical obligations of securities lawyers. However, the Proposed Rule contains certain provisions that will have a deleterious effect on lawyers, both outside and in-house lawyers and particularly on the industry participants who provide risk transfer products to those lawyers. I am concerned that the Rule will expand the potential liability of lawyers, thereby adversely impacting the availability and cost of professional liability insurance for lawyers. I am also concerned that the Rule imposes a fundamental change in the role of counsel that will ultimately discourage a trusting and productive relationship between attorneys and their issuer clients.
I believe that the Proposed Regulations, while clearly intended to provide aggressive and effective investigative and enforcement tools to the SEC, ought not be implemented in language or substance as written and that a revisitation of the enforcement environment is called for.
While consideration of the entire text of the Proposed Regulations is beyond the limited scope of this Comment Letter, I do wish to call to your attention my concerns regarding some significant issues.
The proposed use of the device of a regulation to effectively impress into service attorneys at all levels for the purpose of investigating, identifying and disclosing possible violations of the law is unprecedented in American law and contradicts a 200 year old tradition of federalism in regulating attorney behavior. That states would not have the sole authority to identify and respond to claims of misconduct by attorneys licensed by their jurisdictions is no small issue. That the Proposed Regulation places the role of the attorney as fiduciary and zealous advocate of his or her client into tension with a new role as inquisitor on behalf of the SEC is an astonishing act of sang froid by the Commission, in response to which the several states, which constitutionally regulate their licensed attorneys for the protection of their respective citizens, ought properly be incensed.
Of special note is the invidious imposition of the standard of the "reasonable" inquiry to be conducted by the attorney who wishes to avoid later potential liability under the Proposed Regulations. While "reasonableness" is, on its face, a politically palatable concept, in the context of a regulation the enforcement of which can end a lawyer's career the import of the word bears consideration.
Reasonableness is, in the final analysis, the outcome of a facts and circumstances test examining the outcome and the facts available to the actor at the time. It needs little explication to understand that what is reasonable to one person is often not so to another. Further, what is in cold retrospect reasonable for an attorney to have done in the past may not have appeared so in the context of political, emotional, personal and business agendas present at the time of the decision, but perhaps neither articulable nor admissible at the later trial of the matter.
Thus, counsel would be, under the Proposed Regulations, obliged to act defensively and engage an "up the ladder" reporting process in each and every situation where the attorney could perceive the risk that a later SEC inquiry might conclude differently than he or she did.
This mechanism is, not incidentally, so unworkable that a relatively accessible illustration should help make my point. Consider the scenario where a junior staff attorney has prepared documents associated with an publicly held Issuer's SEC filing. Consider further that this junior attorney finds himself or herself adequately confused or misapprehending later received information that he or she, in order to discharge his self-defensive obligations under the Proposed Regulations, reports his concerns up the ladder. Assume here that the issues at stake are of high level corporate sensitivity, to which only an executive committee of the Board of Directors is and should be fully aware. The junior attorney receives back a report that the issues are being satisfactorily handled and he ought attend to his regularly assigned duties. This report repeats itself, as it should, with each rung up the ladder the attorney proceeds. Finally, this junior attorney, believing himself or herself to have not received an "appropriate response" reports the situation to the SEC, which then opens or threatens to open an investigation. The attorney believes himself safe from response by his employer insofar as he has followed the regulatory mechanism. But it turns out that the Issuer was doing nothing wrong, its necessary secrecy was for the good of the company and the shareholders and the attorney's actions have thoroughly compromised both the transaction in question and the overall reputation of the Issuer, and the junior attorney had, in an overabundance of zeal and/or self preservation, simply misapprehended the situation.
This basic factual scenario circumscribes any number of events which can be wrongfully precipitated by the Proposed Regulations. In the example given, the attorney would likely be fired and possibly subjected to discipline by his state licensing authority. It will be of negligible defense that his intentions were to comply with the mandates of another jurisdiction, particularly when those intentions proved to be improperly executed under state law.
Indeed, had the attorney in our example not assiduously moved the issue up the ladder and the situation later proved to be a material violation, he would have suffered a similar fate at the hands of the SEC. This modern form of the prisoner's dilemma is inconsistent with American jurisprudence and the effective administration of justice.
It is an interesting irony that the very zeal which the Proposed Regulations anticipate to impart in attorneys subject to their scope is inversely concomitant to the ethically obliged zeal in advocacy and representation required of attorneys. In this case there can be little doubt that the necessary zeal in representation will be diminished, possibly in subtle ways, but diminished nonetheless, by the catastrophic sanctions of the Proposed Regulations imposed on attorneys for not directing that zeal instead to the SEC's enforcement agenda. The inevitable erosion of trust between the attorney and the client, and the simple economic redistribution of delicate SEC work to attorneys who are less likely to require substantial inquiry into certain issues yields a most paradoxical result. The SEC ends up with a less reliable reporting structure and the best, most stringent attorneys are less involved than ever in securities work. One or two cases brought under the regulations, if adopted as proposed, will put this paradox into permanent practice.
No where else in the landscape of the regulation of law practice does the bare "reasonableness" standard apply. The Proposed Regulations repeatedly call for an attorney (even an attorney who does not know of or has no intention of participating in an SEC filing) to "reasonably believe" that there is no violation, or to invoke the up-the-ladder reporting process. As mentioned supra, this leaves the burden of persuasion squarely on the attorney and calls for a factual investigation which will sustain a later retrospective inquiry into the "reasonableness" of the lawyer's actions. In effect, the up-the-ladder reporting leads to a terminus tantamount to withdrawal from representation or engagement. That is, the prescribed final rung of the ladder includes discountenancing of the lawyer's own client. This step is not insubstantial and is the subject of ethical rules in virtually every jurisdiction. Other jurisdictions do not allow such discountenancing based on a "reasonable" belief.
A review of an exemplar of some prominent jurisdictions: New York, Pennsylvania, Florida, California, Indiana, Massachusetts, and Texas, reveals that each of these jurisdictions, excepting California, has, as a legal prerequisite to the lawyer terminating representation based on the wrongful act of the client, that the lawyer both reasonably believe that the client is engaged or is about to engage in a criminal or fraudulent act involving the lawyer's services and that the client persist in such course of action. California allows such withdrawal if the client "seeks" to pursue an illegal course of conduct (implying objective, observable facts). Taken together, these elements make it apparent that this standard calls for what amounts to actual knowledge by the attorney that the client is using the lawyer to further an unlawful course of conduct.
The Proposed Regulations, however, conspicuously eliminate the standard of actual knowledge of the attorney. In fact, in using a bare reasonableness standard, the Proposed Regulations eliminate from the analysis whether or not the subject attorney actually believed any wrongdoing had taken place and replaces that judgment, for good or ill, with the later judgment of an SEC case officer. The chilling effect on counsel's loyalty does not escape my attention and is likely to precipitate suspicion and apprehension between lawyers and clients.
The language in the preambulatory discussion to the Proposed Regulations claiming that the rule is "not intended to impose upon an attorney . . . a duty to investigate evidence of a material violation or to determine whether in fact there is a material violation" is belied by the consistent invocation of the bare standard of reasonableness throughout the Proposed Regulations. The preamble so much as acknowledges this in the next line, noting that "[o]f course, nothing in the proposed rule is intended to discourage any such inquiry." In point of fact, it can be safely observed, the SEC seeks precisely such an inquiry by counsel through the imposition of the rule.
By imposing such a standard, therefore, the SEC proposes to create an entire new class of attorney liability arising retroactively out of a duty to someone other than the client. The attempts in the preamble either to deny such a result by rhetorical fiat or to moderate the result by arrogating to the Executive Branch the legislative authority to simply "immunize" attorneys who abide by the rule from liability to their clients are without effect.
Rather, insofar as there needs to be a rule, the attorneys within its ambit ought be able to know in advance both that they are within its ambit and that they will not be subject to second guessing later. Adoption of an "actual knowledge" standard is both necessary and functional in this setting, and will allow the new risks arising from the rule to be measured and meaningfully transferred.
Edward Greene's 1982 injunction that "[T]he Commission, as a matter of policy, generally refrains from using its administrative forum to conduct de novo determinations of the professional obligations of attorneys" might be well heeded today. The Commission, in attempting to craft a swift solution to a pervasive problem, is wielding a large, dull blade on a delicate organ of federalism and legal relationships which are the product of hundreds of years of evolution and well-considered juridical balance.
The new legal liabilities which the Proposed Regulations create will be precipitated not only by the direct costs of enforcement, but also by the indirect costs associated with the divided loyalties of counsel, the litigation costs associated with attorneys having to choose their plaintiff (the employer/client or the SEC), and the general costs of lost business opportunities resulting from decisions not made or wrongly made in deference to attorneys acting to protect themselves from SEC enforcement review of decisions made months or years before the review and in vastly different circumstances. It is the insurance industry which will be asked to redistribute these costs and, in many cases, will not be able to because of the tension created by the demand for division of loyalties incorporated in the Proposed Regulations. The economic effect of non-resdistributed risk on corporate shareholders and investors needs no further explanation to the SEC.
I appreciate this opportunity to comment on the Proposed Regulations. Please do not hesitate to contact me if I can offer more information.
Danny M. Smolnik