April 7, 2003
Securities and Exchange Commission
Re: File No. S7-45-02
Ladies and Gentlemen:
This letter is submitted in response to the request of the Securities and Exchange Commission in its Release Nos. 33-8185; 34-47276; IC-25929; File No. S7-45-02, entitled "Final Rule: Implementation of Standards of Professional Conduct for Attorneys" (the "Adopting Release").
We commend the Commission for improving certain aspects of Rule 205 from the original proposal, particularly if the Commission does not adopt the currently pending attorney withdrawal provisions (concerning which we have filed a separate comment letter).
However, we urge the Commission to reconsider certain other provisions of Rule 205 as adopted. In particular, we continue to be troubled by the impact that the evidentiary objective standard imposed by the rule would have on the independence of the bar and attorneys' ability to zealously advocate on behalf of their clients. While advocating on behalf of a client, an attorney must be able to advance positions in unsettled areas of the law and with which the Commission disagrees. These unsettled issues may not be resolved until appropriate judicial review has been completed and a court has determined whether the conduct in question constitutes legal and proper conduct or not.
Under the Rule, an attorney could be subject to severe penalties if the Commission disagrees with, for example, a disclosure decision (a matter of judgment) or with a course of conduct taken in an unsettled area of the law. This threat significantly impairs the attorney's role as an independent advisor and the ability of attorneys' to zealously advocate a client's position. It is hard to imagine a situation in which taking a position contrary to that of the Commission would not be viewed by a practicing attorney as incurring some risk that it would be judged, after the fact, "unreasonable." Thus, the Commission has strongly discouraged, if not essentially eliminated, an attorney's ability to take a position contrary to the Commission's stated position.
An attorney who counsels a client in good faith should not thereby be subject to the discipline of the government agency that administers the very law on which the attorney is advising. Such a system negates the essential requirement of a bar independent from government.
We urge the Commission to stop and carefully consider the impact this rule will have on the independence of the bar and on attorneys' ability to zealously advocate on behalf of their clients. This is not something that should be changed lightly or even, we submit, in the face of public outcry over corporate scandals the rule would not have prevented. There is more at stake here than the current political and public pressure to take a hard stand. By imposing a reasonableness, "20/20 hindsight" standard and by effectively limiting the defenses an attorney can raise on behalf of a client, this rule lessens the independence of the bar and gives an enforcement agency a hammer to force acquiescence with its position even where reasonable minds could in good faith differ. This result is contrary to the fundamentals on which our system of laws was formed.
Reasonable Belief Standard
Under the Rule, "evidence of a material violation" is defined as "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." We urge the Commission to reconsider this objective standard and to adopt instead an actual knowledge standard similar to that contained in the ABA Rules of Professional Conduct (the "ABA Rules").
The ABA Rules provide that an attorney's knowledge "may be inferred from the circumstances."1 Thus, this standard of knowledge is not wholly subjective. We further believe that a knowledge standard is wholly consistent with Section 307 of the Sarbanes-Oxley Act and adequately protects investors. In our experience most attorneys counsel their clients to do the right thing, and the vast majority of clients, when so counseled, ultimately do the right thing. By imposing an objective "reasonable attorney" (or "unreasonable attorney") standard, an attorney is likely to be more sensitive to protecting his or her own interests for fear of being second guessed after additional facts are revealed that the attorney did not then know or could not, at the time, fully appreciate. Indeed, it is hard to imagine a situation, after a violation has been exposed or merely alleged and investors have suffered a loss, in which it could not, indeed will not, be asserted that the attorney was "aware" of some piece of information that, in hindsight judged by a hypothetical "reasonable" attorney standard, the attorney should have believed (although in fact did not believe) was "evidence of a material violation."
Further, imposing an objective standard changes the dynamic of the attorney-client relationship and, indeed, changes the character of advice an attorney can safely give his or her client. We urge the Commission to respect the fact that, while accountants must be "independent" of the corporation, attorneys need not and, in fact, must not be independent from their clients in the same sense. In a corporate setting, under the ABA Rules their client is the corporation. Attorneys are advocates. The touchstone of the attorney's professional and ethical obligation is the attorney's duty to the client, not some undefined duty to "the market" or "public investors," and especially not to the government agency that, among other roles, can bring an enforcement proceeding against the client. Attorneys must be free to advise their clients on matters of law that are unsettled, must be free to argue positions with respect to which the Commission disagrees and must be free to represent their clients in adversarial proceedings against the Commission without concern for self-exposure and self-protection. By adopting an objective "not unreasonable" standard, Rule 205 interferes (and permits an interested regulatory authority to interfere) with attorneys' ability to zealously represent their clients.
A bar independent from governmental interference is fundamental to our system of laws, and we urge the Commission not to diminish that independence. With a reasonableness standard, in the face of a close call with respect to a disclosure issue or an unsettled or unclear area of the law, an attorney will have an incentive to counsel the client to take the most conservative route (which might not be in the best interest of the client and its stakeholders) rather than educate the client with respect to the risks and other ramifications of taking various positions. In addition, a reasonableness standard would, in effect, require an attorney to advise a client to follow informal guidance from, or "best practices" suggested by, the Commission whether or not the attorney (and the client) agree with the Commission's position and whether or not the attorney believes the Commission's position is in fact legally correct. If the client chooses any action other than the most conservative (or that preferred by the Commission), attorneys will have to seriously consider whether in hindsight that action will be viewed by the Commission as "unreasonable" and subject the attorney to sanctions under Rule 205. Anytime the Commission disagrees with the position taken (even if the law is unsettled by the courts), the attorney could be subject to sanctions, including a bar from appearing and practicing before the Commission. This empowers a regulatory agency to coerce an attorney, with threat of sanctions and loss of livelihood, from taking (and, in effect, makes it highly unlikely that most attorneys would ever again take) a position contrary to that of the agency on behalf of a client even when the matter is unsettled by the courts.
It is not enough for the Commission to say, in essence, "trust us - despite the power given to us under the Rule, we will enforce it appropriately." Not only does that provide little comfort that the Commission will not later change its mind (under political pressure or for other reasons), it does not change the fact that it will have set a precedent and standard of conduct that likely will be used in actions against attorneys, not for enforcement of this rule, but by others, in the search for a deep pocket, for the alleged breach of the law by the attorney's client.
We strongly urge the Commission not to interfere with one of the most fundamental tenets of our system of laws (a bar free from the government) and to leave intact attorneys' ability to represent their clients (even, perhaps especially, when the Commission disagrees with the position) by adopting a subjective rather than an objective standard in the Rule.
Colorable Defense Standard
The definition of appropriate response includes a "response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes...that the issuer, with the consent of the issuer's board of directors...has retained or directed an attorney to review the reported evidence of a material violation and...has been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer..." (Italics added). In addition, Section 3(b)(6)(ii) of the Rule states that "[a]n attorney shall not have any obligation to report evidence of a material violation under this paragraph (b) if the attorney was retained or directed by the chief legal officer (or equivalent thereof) to assert, consistent with his or her professional obligations, a colorable defense on behalf of the issuer..." and Section 3(b)(7)(ii) states that "[a]n attorney shall not have any obligation to report evidence of a material violation under this paragraph (b) if the attorney was retained or directed by a qualified legal compliance committee to assert, consistent with his or her professional obligations, a colorable defense on behalf of the issuer..." (Italics added).
In the commentary to the Rule the Commission states "[t]he term `colorable defense' does not encompass all defenses, but rather is intended to incorporate standards governing the positions that an attorney appropriately may take before the tribunal before whom he or she is practicing."2 We believe an attorney's assertion of any defense he or she could assert within existing ethics rules is a "position an attorney may appropriately take." By using the term "colorable defense," the Rule creates an ambiguity with respect to the array of defenses an attorney could assert on behalf of the issuer and still fall within the provisions of the Rule referred to above. Specifically, it is unclear which defenses an attorney could assert on behalf of an issuer consistent with existing ethics rules that do not constitute a "colorable defense." By including that limitation in the Rule, the Commission creates an inference that there is such a category of defenses without identifying what they are. It is inappropriate for a regulatory agency charged with regulating an issuer to limit the scope of defenses an attorney could otherwise assert on behalf of the issuer consistent with his or her ethical obligations. Accordingly, we urge the Commission to delete the word "colorable" from each of the sections referenced above.
Definition of "Material Violation"
By adding the phrase "of any United States federal or state law" after "or a similar material violation" in the definition of "material violation," the Rule apparently makes securities attorneys responsible for identifying and reporting violations of nonsecurities laws, such as environmental or employment laws. If the intent of the Commission is to include violations of any laws within the reach of the Rule, the Commission is simply ignoring the word "similar" in Section 307 of the Sarbanes-Oxley Act. We believe that such laws should not be included within the purview of Rule 205. Just as nonsecurities lawyers are not equipped to practice securities law, securities lawyers are not necessarily equipped to identify violations of employment, environmental or other nonsecurities and noncorporate laws. What securities lawyers are equipped to do, and where the Rule's focus should be, is to assist the issuer in assessing the consequences under the securities laws of violations of non-securities laws, and in determining what disclosure, if any, is required with respect to such violations under the securities laws. Securities lawyers are not equipped, nor will their clients engage them, to police the business entity's compliance with every federal and state law.
Further, as proposed, the definition of "material violation" would appear to encompass a past violation that is not ongoing. We believe that there are numerous instances in which such violations, even if material at the time the violation occurred, will have ceased to be material and will have already been responded to, or will not require any response, by the issuer. Subjecting violations of this type to the requirements of Rule 205 would not further the purposes of the legislation. Indeed, it would appear that the only instance in which a past violation that is not ongoing would appropriately be subject to Rule 205 is where the fact that the violation occurred continues to constitute a material fact that is required under the existing requirements of the federal securities laws to be disclosed by the issuer. If, in this instance, appropriate disclosure is made, no further action should be required. Conversely, the issuer's failure to make appropriate disclosure in this circumstance would constitute a material violation subject to the requirements of Rule 205. Although there may be other means of achieving a comparable result (e.g., by clarifying that the materiality of a past violation is to be assessed at or after the time at which the attorney becomes aware of evidence thereof, irrespective of any greater significance that may have attached to the violation at some earlier point in time), we believe that the most appropriate and effective means of addressing this issue would be to revise section 2(i) of Rule 205 to read as follows:
Lack of Definition of Material
By leaving the definition of "material" undefined, Rule 205 creates an ambiguity with respect to its meaning, despite the Commission's commentary in the Adopting Release that it intends for the "well-established meaning under the federal securities laws to apply."3 Absent a definition of the term in the Rule, it could later be construed to have a meaning other than that established by the United States Supreme Court: "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote"4 or that there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available."5 For example, a court could later find that the failure by an issuer to qualify to do business in a particular jurisdiction is "material" (a total failure to comply with a statute requiring qualification in a particular jurisdiction is certainly a "material violation" of that particular statute) even though there is no economic consequence to the company and, therefore, a reasonable investor would not consider the information important in making an investment or voting decision. Consequently, we urge the Commission to adopt the following definition of "materiality" in Rule 205:
Definition of Appearing and Practicing before the Commission
Notwithstanding the changes in the final Rule, it remains unclear to what extent the definition of "appearing and practicing before the Commission" would include attorneys who do not, in a strict sense, provide "advice in respect of the United States securities laws or the Commission's rules or regulations thereunder," but who do prepare or participate in preparing a document that the attorney has notice will be filed with the Commission. For example, is an employment attorney who drafts an employment agreement that he or she knows will be filed as an exhibit to a registration statement or an Exchange Act report "appearing and practicing before the Commission?" Is a litigator who prepares or reviews a description of material litigation that is included in a prospectus or an Exchange Act Report "appearing and practicing before the Commission?" We believe that such persons should not be, and that Section 2(a) of Rule 205 should be interpreted so that such persons are not, included within the definition of "appearing and practicing before the Commission, because such persons are not providing advice in respect of the securities laws or the Commission's rules and regulations. They are simply performing their non-securities laws legal expertise functions. However, there is some language in the commentary to the Adopting Release that makes the distinction unclear.6
Attorneys specializing in other areas of law and who have little or no experience with, or knowledge of, the securities laws should not be required to determine whether they have evidence that a violation of the securities laws has occurred, initiate the up the ladder reporting process and evaluate whether the corporation's response is "appropriate." This is particularly troubling with respect to disclosure issues, which are primarily matters of judgment. Members of the securities bar spend years developing the appropriate expertise to make judgments about such matters, and it is not appropriate for someone not so trained to make those judgments. It is also unclear, if such a person is deemed to be "appearing and practicing before the Commission," how long their status as such lasts and whether it would apply to other issuers for whom the attorney works.
Moreover, deeming such attorneys to be appearing and practicing before the Commission exacerbates the "material" definition problem addressed in the immediately preceding section of this letter. An environmental lawyer, for example, who reviews environmental disclosure in a prospectus for accuracy may have "evidence" of a violation of the terms of a water discharge permit which, in a securities lawyer's judgment, does not meet the requirements for disclosure in Regulation S-K. It may, however, be a "material" violation of that particular permit. But that attorney does not have the skill set to make a determination of whether it is "material" under Rule 205 and whether he has a reporting obligation or not.
We request that the Commission clarify in a further release that an attorney who simply reviews or prepares portions of a disclosure document or drafts a contract he or she knows will be filed with a disclosure document and who is not providing advice in respect of United States securities laws is not appearing and practicing before the Commission.
Definition of Supervisory Attorney
Under a strict reading of the provisions of Section 4 of Rule 205, a partner specializing in, for example, private company mergers and acquisitions could be deemed to be "appearing and practicing" before the Commission if that partner supervises an associate with respect to the private divestiture of a subsidiary of Client A, a non-public company, and that associate advises Client B, a client with which the M&A partner has no relationship, with respect to the filing of a registration statement or an Exchange Act report. For the reasons discussed above, it is inappropriate for attorneys without the requisite training to make judgments about violations of the securities laws and, in particular, about disclosure matters. Based on the statement in the Adopting Release that a "senior attorney who supervises or directs a subordinate on other matters unrelated to the subordinate's appearing and practicing before the Commission would not be a supervisory attorney under the final rule," we do not believe this is the Commission's intention.7
A strict reading of the provisions could also include an attorney who has general supervisory authority over another attorney (for example, the managing partner of a law firm or the head of a regional office of a law firm). The language in the commentary to section 4 makes this interpretation even more likely.8 For the same reasons the M&A partner in the example above should not be deemed to be "appearing and practicing before the Commission," an attorney with only general supervisory authority over an attorney appearing and practicing before the Commission should also be deemed not to be appearing and practicing before the Commission.
We propose that the definition of a supervisory attorney be modified so that it is absolutely clear that it applies only to supervision of the specific matter with respect to which the subordinate attorney is appearing and practicing before the Commission. Section 4(a) of Rule 205 could be modified to read as follows:
If the Commission means something different, it should make that explicit in the Rule, rather than creating ambiguities by release commentary.
Requirement that QLCC Be Established Before Report
The commentary to Section 3(c) of Rule 205 states that "[o]ne commenter suggested that the Commission's final rules should make clear that, for a matter to be referred to a QLCC, the issuer must have a QLCC in place and is not permitted simply to establish a QLCC to respond to a specific incident."9 As adopted, the Rule takes that position. We do not see any reason to require a QLCC to have been established before the report of evidence of a material violation. An issuer cannot avoid the provisions of Rule 205 simply by forming a QLCC. In order to be a QLCC, the committee, whenever formed, must fit within the definition of a Qualified Legal Compliance Committee in Section 2(k) of Rule 205, including having the "authority and responsibility" to:
The fact the a QLCC is formed in response to a particular report does not in any way diminish its authority or responsibility under the Rule or diminish the efficacy of the Rule. It simply makes no difference whether a QLCC is formed before or after the report. Accordingly, we urge the Commission to amend the rule to remove this requirement.
Requirement that QLCC Have Authority to Notify the Commission of a Failure to Implement an Appropriate Response
Section 205.2(k)(4) provides that a QLCC must have the
We submit that the authority to notify the Commission, surely an event of great significance to an issuer, should not be delegated by an issuer's board of directors to a committee of the board. That decision should be made by the full board, the governing body charged by statute with the responsibility for governance of the issuer.
At the point at which this provision becomes meaningful, under Rule 205 the QLCC will have completed an investigation, informed the board of directors of the results of the investigation, recommended to the board an appropriate response to the evidence and informed the board of the appropriate remedial measures the QLCC thinks should be adopted. In short, the goal of the "up the ladder" reporting system under Rule 205 will have been achieved -- all of the information, after a full investigation, and the recommended remedial measures will have been presented to the issuer's board of directors.
The full board should then be responsible for the decision whether some, all or any of the recommended actions should be taken and should be responsible for the decision as to whether the Commission should be notified. The board should not be "second-guessed" in those decisions by a committee of the board. Under the Rule, the QLCC is charged with conducting an independent investigation. It should not be able to trump the full board's fully informed decision as to the appropriate course of action the issuer will take after that investigation.
For these reasons, we recommend the Commission amend Rule 205 by eliminating subsection 2(k)(4) altogether or, alternatively, changing the language italicized above to read "including the authority to recommend to the board of directors that the board notify the Commission . . .."
We would be happy to discuss any questions the Commission or its staff may have with respect to this letter. Any such questions may be directed to Robert L. Estep at (214) 969-3719.