Cleary, Gottlieb, Steen & Hamilton
December 18, 2002
Jonathan G. Katz, Esquire
Re: File No. S7-45-02; Proposed Rules Implementing Section 307 of the Sarbanes-Oxley Act
Dear Mr. Katz:
We are former general counsels of the Commission. We submit this comment letter on the Commission's rule proposal implementing Section 307 in light of our experience at the Commission, our involvement with these issues during our tenures, and our hope that we can contribute to a constructive discussion of the Commission's proposals. We write for ourselves as well as for our colleagues at Cleary, Gottlieb, Steen & Hamilton, who share our views.
We strongly support the up-the-ladder reporting requirement set forth in Section 307 of the Sarbanes-Oxley Act. We have reservations, though, about the way in which the Commission proposes to implement the requirement, which we set forth below. We also believe the "noisy withdrawal" requirement and the Qualified Legal Compliance Committee alternative are not yet well enough thought through to warrant adoption as this time, and we suggest the Commission withdraw those portions of the proposal for later consideration. We suggest this not as a means of burying the ideas; they may have much to commend them. But it appears to us that the Commission has not had the time to come to grips with their nuances and their potential impact, nor has it yet carefully weighed the strongly competing considerations that must be balanced before making a sensible proposal.
The Commission's statutory mission is to protect investors and to promote fair and orderly markets. Regulation of lawyers falls within the Commission's purview to the extent it furthers the Commission's fundamental mission, but not more. The Commission has no general authority over the ethical obligations of lawyers. At the same time, lawyers, just like everyone else, are subject to and must comply with the federal securities laws. Their obligation to obey the securities laws - and the duties that the Commission appropriately should impose upon them - in areas in which they are not acting as professionals should be the same as those imposed upon the public generally, neither more nor less. The Commission has no regulatory interest in lawyers in areas in which their conduct is unrelated to their professional responsibilities. In those areas, lawyers stand before the Commission on the same footing as physicians, laborers, philosophers, educators, and employees of the federal government.
The Commission has no special claim to institutional expertise in the regulation of the legal profession. While lawyers, both inside and out of the Commission, are integral to its operations, they are neither more nor less so than are lawyers to the operation of the Federal Communications Commission, the Federal Energy Regulatory Commission, or most other regulatory bodies in the federal and state governments. As a body, the Commission is not especially expert in matters of lawyer professional responsibility. While the Commission has had brushes with these issues from time to time (about once a decade), they have never been, and rightfully so, an abiding Commission preoccupation. Traditionally, responsibility for regulating lawyers has resided in the courts, and the American Bar Association and the American Law Institute codes generally have been considered the most authoritative compendia of the law governing lawyers.
The implication of these principles, in our view, is as follows:
If the Commission shares these principles, then we recommend it make the following modifications to the proposal:
We explain each of our recommendations below.
To the extent any of the choices reflected in the Commission's proposal were animated by the Commission's basic understanding of the core professional obligations of lawyers - and they must have been - the Commission should consider reviewing its conclusion based on a corrected understanding. Proposed Rule 205.3 sets out what the proposing release terms "the core" of the proposed "Standards of Professional Conduct for Attorneys."1 Rule 205.3(a) states that an attorney representing an issuer represents it "as an organization" and must "act in the best interest of the issuer and its shareholders." The first proposition is consistent with a lawyer's recognized ethical obligations under accepted notions of professional responsibility;2 the second prong is inconsistent with the first and misstates what lawyers do. While it is possible that the Commission intended to impose a new standard of conduct upon lawyers, there is no indication of that in the proposing release.
Attorneys for an organization represent only the organization and not the individual owners or managers. Boards of directors, managers and other employees, and shareholders, are each "constituents" of the corporate organization who, to differing degrees and in differing situations, may act on behalf of the corporation and give instructions to the corporation's attorneys.3 Attorneys owe their professional duties to the corporate entities that retain them, not to any of the corporation's constituents.4 Indeed, lawyers are required to inform constituents of this basic fact when it is apparent that the corporation's interests may be adverse to those of the corporate constituents with whom the attorney is dealing.5 Because it suggests that lawyers owe duties directly to shareholders, the Commission's formulation, in addition to being a radical departure from current law, creates the risk that shareholders could seek to sue attorneys for breach of duties.
Contrary to the Commission's assertion, lawyers do not have an obligation to act in the best interests of their clients. Instead, lawyers are obligated to zealously represent (that is, act on behalf of) clients. Applicable rules make clear that it is the client that chooses the objectives the lawyer must pursue, no matter how unwise, unwarranted, or unsound those objectives may be.6 These are choices for the client, not the lawyer, because it is the client, not the lawyer, who bears the consequences of actions taken in the client's name.7 Indeed, if instructed by the client to take any lawful action, a lawyer generally is obligated so to act, even if contrary (in the attorney's judgment) to the client's best interest. Where the lawyer's client is an organization, a lawyer takes ultimate instruction from the board of directors, not because the board is more likely than management to do what is best for the corporation, but because the board, as to all but a few issues, has the ultimate legal authority to bind the corporation and instruct the lawyer as to what she must do.
The Commission's proposals would reach lawyers who do not practice law. It is hard to see why they should. The Commission did not explain why, when not engaged in the practice of law, lawyers should be subject to rules different than those imposed on everyone else. We know of no other circumstance in which lawyers are subject to particular obligations because of what professional license they hold rather than what they are doing. To the extent the Commission's rules would impose sanctions based on status rather than conduct, they might well be found to be arbitrary and capricious.
Similarly, the Commission's proposals would impose a regulatory regime on those whose contact with the Commission or the federal securities laws is highly tangential. By defining "appearing and practicing before the Commission" to include "participating in the process of preparing" any communication to or filed with the Commission, the proposed rules sweep within their scope lawyers whose brush with the Commission and its processes is tangential. Application of the rules to these lawyers can create a trap for the unwary without significantly advancing the Commission's mission. This problem is exacerbated for foreign lawyers, who will generally not be knowledgeable about federal securities laws and who typically will be taking instructions from U.S. lawyers. Accordingly, we suggest the Commission revise this definition to include "substantial" participation in the process of preparing a communication to or filing with the Commission. We also suggest that "appearing and practicing before the Commission" include an exception for foreign lawyers who consult with United States securities lawyers who are retained by the issuer with respect to the matter before the Commission. This, in our view, will limit the potential unfairness for foreign lawyers while encouraging consultation on U.S. securities law issues.
As currently formulated, the Commission's definition of "evidence" would include information that would cause "a" reasonable lawyer to conclude that a material violation has occurred, is occurring, or is about to occur. While this may not have been the Commission's intention, the formulation is susceptible to the interpretation that the reporting obligations are triggered whenever there would be a single reasonable attorney who would believe that a material violation has occurred, is occurring, or is about to occur.
There has been much debate over whether the Commission's proposed standard as to what constitutes "evidence" should be changed from an objective one, which focuses on what the hypothetical "reasonable" attorney would believe, to a subjective one, which would focus on what the attorney in question actually believes. We think this debate misses the point.
Rather, what is important is that the triggering standard be clear to promote uniform application and be unequivocal enough to avoid chilling attorneys from providing advice as to which reasonable persons can differ. Lawyers who are differently situated often have different views about the existence of a violation. In our experience, the world in which the Commission operates certainly looks different from different sides of the table. From the Commission's side, particularly when one looks in retrospect after all pieces of the puzzle have been put in place, the world looks less ambiguous than it does as events are unfolding. Given those risks, and given the possibility of chilling advocacy if the standard admits of too much ambiguity, we believe a standard that defines evidence as "information that would lead any reasonable attorney to conclude that a material violation clearly has occurred, is occurring, or is about to occur" provides the appropriate level of objectivity and clarity. We suggest changing "believe" to "conclude" for similar reasons. Whatever the precise formulation, the Commission should make clear that this is similar to a directed verdict standard- that is, the evidence to be reported must be such that any reasonable fact finder would conclude there has been a violation, and no reasonable fact finder could conclude otherwise.
The Commission has a basic policy choice to make: whether it does, or does not, intend to enforce Part 205 by inquiring into the substance of a lawyer's conversations with directors or employees of its corporate client. We are not talking of the technical niceties of attorney-client privilege law, which are always fertile ground for litigation and highly dependent on the particulars of a given situation. If the Commission intends to authorize the Enforcement Division, in order to enforce Part 205, to inquire into attorney-client conversations whenever it can make a colorable claim that the conversations are not privileged, there inevitably will be many circumstances in which it will be able to get to the substance of those communications. The documentation provisions of proposed Part 205 strongly suggest that this result is what the Commission intends. To us, it appears that the only plausible reason for these provisions may be to provide an audit trail for subsequent enforcement actions.
In our view, the Commission should not over-emphasize ease of enforcement for these rules. The significance of mandatory reporting requirements is not principally that the threat of sanctions will force lawyers to take steps they ordinarily refuse to take. Rather, making reporting mandatory empowers lawyers to report because they can make clear to their manager/clients that they have no discretion to do otherwise and because the requirement creates an expectation in boards of directors that, where required, lawyers will indeed report. In this circumstance, creation of an audit trail need not be a high priority.
Moreover, even from an enforcement perspective, we doubt the documentation requirements would be very useful. The requirements would be largely unnecessary where lawyers advise their clients that their conduct is unlawful. In that circumstance, lawyers have ample incentive to memorialize their advice and their clients' response. Where the lawyer has not complied with the reporting requirements, there is not much enforcement leverage to be gained by the documentation requirement. By definition, there would be no documentation. And the absence of documentation would hardly give rise to an inference that the lawyer in fact concluded, or should have concluded, that the issuer was violating the law, but failed to report.
On the other side of the equation, practicing lawyers will take the documentation provisions to mean that, when they advise their clients about the most sensitive matters, someone else is in the room. We are concerned that requiring lawyers to create a written record that, they know, may someday be read by staff of the Commission will significantly influence, perhaps even distort, the advice the lawyer would give if no one were looking over his shoulder.
The Commission also should understand that it is proposing far more than the usual "noisy withdrawal." Noisy withdrawal is generally understood to refer to situations in which a lawyer withdraws from an engagement while making clear to third parties that they can no longer rely on certain statements or opinions previously made by the lawyer. Noisy withdrawal is appropriate where a lawyer wishes to make sure that his services are not used to perpetrate or perpetuate a fraud.
The noisy withdrawal the Commission has proposed is much more. It is withdrawal accompanied by the lawyer's statement, albeit nominally coded, that his client is violating or is about to violate a law, that the lawyer has sought to get the client to stop but to no avail, and that the client's conduct, if left unstopped, will result in substantial financial injury to an issuer or its shareholders. The meaning of the message would be unmistakable; that it would be conveyed by the shorthand of withdrawal for "professional considerations" does nothing to diminish the clarity of the message. In that sense, the message that a lawyer is withdrawing for professional considerations stands on the same footing as coded "guidance" to securities analysts, or the infamous "Your bunny has a good nose."8
As others have noted, the Commission is not required to promulgate noisy withdrawal provisions now. And, also as others have noted, the Commission's proposal on noisy withdrawal could use more thought and more public comment. Indeed, the Commission's roundtable yesterday on the international aspects of these proposals has highlighted how these provisions as applied to foreign lawyers are inconsistent with and in some instances prohibited by foreign ethical rules, which the Commission has no authority to override. This is a highly controversial issue that has captured the attention of the bench and the bar and engendered protracted and spirited debate. There is no reason to think that the Commission is likely to produce a better solution than have others with more experience and expertise in grappling with the issue. There is certainly no reason to think the Commission can do so quickly. There is every reason to think that the Commission should wait to take such far-reaching action until its new Chairman is on the job and should afford a much longer comment period to assure informed decision-making.
We do not think the Commission should drop the matter entirely. We are troubled by the notion that lawyers are permitted, indeed in many instances required, to hold closely information that, if revealed, could forestall major financial hardship for thousands, in some cases millions, of investors. But that kind of information does not just drop down on lawyers from the sky; it comes from clients who have developed relationships of trust with their lawyers, which in turn enables their lawyers to exert considerable influence in leading their clients to comply with the federal securities laws. The threat of having to report to the Commission may make clients more prone to follow their lawyers' advice; it might also make them less likely to seek advice in the first place. It may be that the better rule - one in force in 40 states - is to permit lawyers to report wrongdoing, but not to require it. We do not know the answers to these questions; but we are certain that the Commission could benefit from more time for a searching and thorough examination of these issues.
The QLCC provisions in the proposed rules would relieve some of the pressure on lawyers. Whether the provisions make sense from a corporate governance perspective, and whether the Commission has the power to enforce them, are other matters completely.
The Commission does not now require issuers to report to it when the issuer is violating the law. Perhaps the Commission could promulgate such a rule, but presumably it understands that such a rule would be ineffective and just result in cumulating an issuer's violations. For the same reasons, the Commission does not have a rule requiring all employees of an issuer to report to the Commission certain types of securities violations. It is hard to discern the rationale for imposing a similar personal obligation on members of a committee of an issuer's board of directors simply because the report of a violation comes from a lawyer rather than from any other employee or agent of the issuer. And it is equally hard to see why anyone would take on such an obligation.
The rationale for requiring reporting up the ladder or to the Commission is that it is a natural outgrowth of an attorney's duties to his client and to the public. But lay members of a QLCC have no such duty. To the extent the Commission wants to create such a duty, it makes little sense to have it arise solely when a report comes from a lawyer.
The Commission may be searching for an alternative to noisy withdrawal when the issuer refuses to act in response to a lawyer's reports. We think this is a wise search, and we believe the proper solution lies neither in creating unprecedented rules of professional responsibility nor in conditioning the lawyer's discharge from liability under these new rules on an issuer's adoption of a new governance mechanism to create a disclosure obligation personal to certain of the issuer's outside directors. A better course, we believe, was suggested at yesterday's roundtable. The Commission should consider requiring "quiet" withdrawal under circumstances that are consistent with those that give rise to mandatory withdrawal under existing rules of professional responsibility. The Commission could also consider requiring the issuer to disclose such a withdrawal (but not the lawyer's communication to its client) on Form 8-K. There also may be substantial merit, from a corporate governance standpoint, to encouraging issuers to have legal and compliance committees. We believe the Commission should consider this matter at greater length and in greater depth, and not under the constraints of the schedule imposed by Section 307 for the mandatory elements of the proposed rules.
Imposing an up-the-ladder reporting requirement on lawyers whose clients are being investigated by the Commission or being sued in administrative proceedings is a bad idea. It would impose a serious constraint on the ability of lawyers to advocate their clients' causes, at precisely those occasions when clients most need their lawyers' unstinting support. Moreover, it will make it harder - not easier - for lawyers to advise their clients forthrightly about the realities of their situations.
There would be an unavoidable chilling effect on the advocacy of lawyers who represent clients before the Commission in investigations and administrative proceedings if Rule 205 applies to them. To begin with, advocates are not supposed to be "objective." They are supposed to commit themselves without reservation to their clients' cause. The Commission's proposal pre-supposes a detachment that lawyers cannot - and under our adversary system should not - have. Once a legal proceeding gets under way, the lawyer is the client's partisan, biased in his client's behalf, and not its impartial judge.
Our legal system rests on the premise that justice is most likely to emerge from proceedings structured around the clash of adversaries. Lawyers representing clients before the Commission must be free to make all non-frivolous arguments to the staff.
The Commission should realize that, in the context of an investigation or administrative proceeding, it is the adversary. We understand it does not violate minimum standards of due process for the Commission to supervise its investigators and authorize a proceeding, while remaining the agency's court of last resort some time after a record has been created in an adversary proceeding involving the Division of Enforcement. But it is quite another thing to empower the staff to investigate - on any grounds - lawyers whose bedrock professional responsibility may require them to take positions that drive the staff to distraction.
In the heat of battle lawyers often question the bona fides of their opponents' arguments. We have seen it happen often while at the Commission and while in private practice. Many times we have been in post-mortems following testimony, a meeting, or a hearing and wondered out loud how our adversary could possibly have taken such preposterous positions. Empowering the Commission staff to investigate whether lawyers' assessments of a case as explained to their clients are identical to their arguments before the Commission places lawyers at greater risk for the content of their advocacy and the content of their advice to their clients. It serves neither the interests of investors nor the interests of justice to encourage defensive lawyering.
Further, outside of the gaze of the Commission, defense lawyers serve the public interest by educating their clients to the realities of the potential consequences of their behavior. Defense lawyers can do this effectively only after they have gained their clients' trust and demonstrated that they are acting to further the clients' interests. Both of us have had experiences in which we believe we have been influential in guiding clients to change future behavior. Our influence often has been in direct proportion to our ability to demonstrate to clients that we are on their side, watching out for their interests, and prepared to make an uncompromising defense. The proposed rules would discourage developing this type of trust by requiring the lawyer -- the client's champion -- to the tell the client early in the representation that he thinks the client is going to lose. The client's likely conclusion is that it erred in choosing such a feckless defender, not that it erred in violating the law.
An up the ladder reporting requirement for defense lawyers is especially problematic when it goes to evaluating whether a client's response is "appropriate." The proposing release seems to indicate that a response that the lawyer should make any colorable argument is appropriate but that a response telling the lawyer to argue that no violation occurred is not. We do not understand the difference, but we do understand the mischief of prescribing by rule the defenses to an ongoing defense engagement that the government finds "appropriate."
Finally, we believe that, whatever the Commission's disposition of its "noisy withdrawal" proposal, it should not apply to lawyers engaged in defending clients in investigations or administrative proceedings. The requirement should not apply even if the lawyer is defending the client in proceedings concerning ongoing misconduct, and even if the misconduct is causing substantial financial injury to the issuer or investors. Requiring lawyers in that situation to withdraw is tantamount to a rule that clients go without a defense. Requiring lawyers to notify the Commission under those circumstances would be tantamount to requiring lawyers to testify against their clients.
Edward F. Greene David M. Becker