Transmitted by e-mail to firstname.lastname@example.org
December 12, 2002
Jonathan G. Katz, Secretary
Re: File No. 33-8150.wp
I am a professor at Brooklyn Law School and a former Commissioner of the Securities and Exchange Commission ("SEC"). I have served on both a public company board and non-public company boards and in the past I have been engaged in private practice in a wide variety of securities matters. Although I joined with other securities practitioners in endorsing a comment letter previously sent in by former Commissioner Edward Fleischman, and nothing I will say here is intended to derogate from the substance of that letter, I am submitting this letter on my own behalf to further amplify my personal views.
Proposed Rule 205 of the Securities and Exchange Commission ("SEC" or the "Commission") goes so far beyond the mandate of Section 307 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), Pub. L. No. 107-204, 116 Stat. 745 (2002), as to call into question the SEC's good faith in publishing this rule.
After targeting accountants and audit committees as gatekeepers who should compel public corporations to be more honest in their financial reporting, the SEC has now decided to enlist lawyers as key law enforcement officials, changing their allegiance from their clients to the SEC. This is opposite to the intent of Section 307 which was supposed to reinforce an attorney's allegiance to the corporate client. The SEC has become shamefully politicized; its credibility has been questioned and its independence has been undermined. Rule 205 will not restore investor confidence in either the SEC, Wall Street or public companies. Indeed, it is likely to soseriously impair frank and open communications between public companies and their counsel as to result in less disclosure and greater disregard for SEC regulations.
Section 307 of the Sarbanes-Oxley requires the SEC to issue rules setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers, including (1) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the CEO of the company; and (2) if the counsel or officer does not appropriately respond to the evidence, adopting, as necessary, appropriate remedial measures or sanctions, requiring the attorney to report the evidence to the audit committee or another committee comprised of independent directors. This provision was introduced as a rider to Sarbanes-Oxley by Senator John Edwards, based on the suggestion of several law professors, to ensure that when a lawyer represents a public company the client is the corporation and not the CEO nor the CFO. The Commission is a government regulatory agency, not a surrogate for public corporations. There was little discussion or examination of the Edwards amendment, and an unrealistic deadline of 180 days after passage of Sarbanes-Oxley was inserted for SEC rulemaking. It is hard to believe that in such a fashion, without debate or thoughtful consideration Congress intended either to federalize the law of fiduciary duty and attorney-client privilege or to make attorneys quasi-government agents for the enforcement of securities laws by the SEC. Yet, this is precisely what the SEC has suggested it intends to do by proposing Rule 205 to implement Section 307 of Sarbanes-Oxley.
Section 307 of Sarbanes-Oxley gives statutory authority to the SEC's Rule 102(e), which was long questioned by me and others. Although this solves the authority question for the SEC's promulgation of Rule 102(e), it does not solve the public policy questions involved nor give the SEC unlimited authority to regulate lawyers generally. Section 307 also adopts the holding of In the Matter of Carter and Johnson, 22 S.E.C. Docket 292 (1981), that attorneys learning of substantial and continuing disclosure violations by their clients must take prompt steps to end the client's noncompliance. The Carter & Johnson approach was not enforced by the SEC administratively. Instead the SEC announced through its then General Counsel that it would bring cases against attorneys in federal district courts. Although Carter & Johnson goes further than existing rules of legal ethics which do require an attorney to report violations of law up the ladder and if necessary resign, Section 307 as written is not much more onerous than existing ethics rules in most jurisdictions. The SEC's rule proposal, however, is contrary to rules of ethics everywhere.
The basic problem with proposed Rule 205 is that it goes far beyond the mandate of Section 307 of Sarbanes-Oxley and attempts to make corporate attorneys responsible for documenting their clients' violations of law and then reporting those violations to a government prosecutor. This is a return to the much discredited and ultimately abandoned whistle blower theory of SEC v. National Student Marketing Corp., 457 F. Supp. 682 (D.D.C. 1978), which was never accepted by any court. Rule 205, as proposed, would impair zealous advocacy, eliminate the attorney-client privilege for corporate and securities attorneys and discourage, if not end,open and effective communications between issuers and lawyers concerning compliance with the federal securities laws. The SEC proposes to determine any questions of attorney-client privilege involved in whistle blowing and pre-empt any state law rules preventing such conduct. This determination evidences incredible hubris on the part of an agency which constantly claims it is too underfunded to do the tasks already assigned by Congress. Why should the SEC take on work not authorized which will, in addition, involve confrontations with state court judges and possible court challenges as an impairment of the Constitutional right to counsel?
The SEC needs lawyers to interpret to issuers the myriad arcane regulations applicable to public companies. Rule 205 will seriously undermine the work of securities lawyers and probably decrease compliance with SEC disclosure requirements, since issuers will be disinclined to consult with their lawyers about difficult disclosure problems. In addition, the proposed rule is riddled with numerous faulty judgements and standards.
Proposed Rule 205 would apply to attorneys acting as attorneys, but in addition it would apply to other corporate employees who happen to be attorneys. Many public corporations employ persons who have attended law school and passed the bar in non-legal positions, including regulatory experts in food and drug law, patent law, environmental law and similar areas, investment bankers, human resources personnel and financial officers. Many of these employees have no expertise in securities law. The SEC's intention to apply its rules of professional responsibility to persons with a legal education working in a non-professional capacity is not justified as an interpretation of Sarbanes-Oxley or as a matter of policy. Furthermore, it will lead to absurd results. If a CEO happens to be an attorney is he supposed to report to the CLO if he discovers evidence of a material violation of the securities laws? Does the CLO then report back to the CEO? If a director happens to be an attorney, perhaps even a member of the qualified legal compliance committee ("QLCC"), is he supposed to report a material violation to himself? The SEC has long asserted that an attorney who violates the securities laws should not be excused from liability simply because he happens to be an attorney. By the same token there is no reason to apply Rule 205 to employees who are not working as attorneys simply because they have a legal education.
The SEC has further proposed to apply Rule 205 to foreign lawyers. It is bad enough that the SEC has proposed to interpret attorney-client privilege questions under American law, and then pre-empt state law, but the SEC has also proposed to override whatever legal ethics systems apply to foreign lawyers that may prevent them from policing their clients' securities law obligations and then blowing the whistle if their clients fail to comply with SEC regulations. It will be surprising if foreign authorities will permit such jurisdictional overreaching into the area of legal ethics and professional practice. Furthermore, the SEC has little expertise in these matters.
The SEC proposes to extend Rule 205 to the representation of witnesses in an SEC investigation or proceeding and to documents submitted in enforcement investigations. For example, the proposing release specifically mentions Wells submissions as a type of documentan attorney might have to disavow. This is an extremely dangerous effort by a prosecutor to prevent a person who is a target of an SEC investigation from having effective legal representation. If a United States Attorney proposed disciplining attorneys who were representing persons in a grand jury investigation or criminal prosecution, the same law professors who lobbied for Section 307 of Sarbanes-Oxley would probably protest. Why should corporations and corporate employees be deprived of the services of a zealous advocate? How can the object of an SEC investigation consult freely with an attorney if evidence of a violation of the securities laws then becomes a matter the attorney must report to his corporate superiors, document in writing (presumably for the SEC to subpoena and discover) and the attorney must blow the whistle on the client? It seems quite unlikely that in passing Sarbanes-Oxley the Congress intended to deprive persons of their Constitutional right to counsel.
Proposed Rule 205 would apply to any breach of fiduciary duty recognized at common law. Section 307 admittedly contains the phrase "breach of fiduciary duty or similar violation" in describing the types of problems that must be reported "up the ladder." But it is inconceivable that Congress meant by these hastily drafted words to overturn Supreme Court case law drawing a distinction between the federal securities laws and state corporation laws concerning fiduciary duty. (See Schreiber v. Burlington Norther, Inc., 472 U.S. 1 (1985); Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977)). Further, since the substantive provisions of Sarbanes-Oxley changes this line between federal and state law only with respect to a few particularized matters, such as the composition of audit committees and loans to executive officers and directors, it would be anomalous if Congress expanded the SEC's jurisdiction to regulate attorneys to matters beyond the SEC's jurisdiction to regulate public corporations. The only sensible interpretation of Section 307 is that only those breaches of fiduciary duty that must be reported under the federal securities laws by public companies should be the subject of an attorney's obligations to report up the ladder under Sarbanes-Oxley. The SEC seems to have thrown common sense to the winds, however, in its Rule 205 proposal.
The SEC's proposal that public companies form a QLCC is a bureaucratic reaction to a problem created by the SEC-abolition of the attorney-client privilege. Although some corporations have compliance committees for one reason or another, a decision to report a violation of law to a government agency is a decision that should be made by the entire board of directors. Most audit committees, which now have to have independent directors would generally review such a problem in the first instance and that is entirely appropriate.
The knowledge standards used throughout the SEC's proposed rule are much too low. An attorney who "becomes aware of evidence of a material violation" is obligated to report this evidence up the ladder. If a CLO "reasonably believes" a violation has occurred, is occuring or is about to occur, he must take appropriate action. Under existing ethical standards, an attorney's obligation to report up the ladder or withdraw from a representation occurs only when a lawyer "knows" of conduct involving a violation of law. The low knowledge thresholds that the SEC has substituted for this ethical standard could easily result in undue attention being paid by lower level attorneys to reporting "evidence" of possible securities law violations and documentingthese reports. This is not likely to benefit investors, but rather to lead to time consuming, expensive and unnecessary conversations between corporate lawyers and corporate officers about trivial matters. The sections of the SEC's proposed release dealing with the paperwork reduction act and costs are laughable. Public companies have already spent more time and money just trying to understand Rule 205 and how to react to it.
The SEC was put in an untenable position by having a mid-January deadline for promulgation of a rule to implement Section 307 of Sarbanes-Oxley. But this is no excuse for the issuance of such a far-reaching, controversial and essentially misguided rule at the end of the year, which will not give concerned bar associations and lawyers who are not Rule 102(e) experts the time to consider and make thoughtful comment on this rule. Trying to rush though this rule under a lame duck chairman is simply part of the political spectacle in which the SEC has unhappily participated over the past few months. As a former Commissioner, I am saddened by the SEC's loss of independence and credibility and I believe that the adoption of Rule 205 as proposed will do nothing to restore confidence in the Commission's competence or effectiveness.
Please go back to the drawing boards. If this means missing a mid-January deadline for adopting the rule, put into effect a less encompassing rule that requires attorneys working on SEC disclosure documents for public companies to go "up the ladder" if they know that the corporation has engaged in a material violation of the securities laws or a breach of fiduciary duty requiring disclosure under the federal securities laws. This was the intent of Section 307 in any event.
Very truly yours,
Roberta S. Karmel