Los Angeles County Bar Association
December 18, 2002
Jonathan G. Katz, Secretary
Re: File No. S7-45-02
Dear Mr. Katz:
The Los Angeles County Bar Association ("LACBA") is the largest local voluntary bar association in the United States, with over 23,000 members, and LACBA's affiliate, the Beverly Hills Bar Association ("BHBA") is one of the largest voluntary metropolitan bar associations in the nation, with over 3,500 members. Our associations are dedicated to serving the legal profession, raising and maintaining professional and ethical standards of the bar, providing leadership on major issues affecting the profession and the community, facilitating access to legal services, and supporting the justice system.
We are writing on behalf of LACBA and BHBA to express our associations' comments on the proposed Part 205, to be added to Title 17, Chapter II, of the Code of Federal Regulations under the authority of the Sarbanes-Oxley Act of 2002. We greatly appreciate your willingness to consider our comments on this proposal.
LACBA and BHBA have studied the proposal and acknowledge the tremendous thought and time that went into this effort. Many of the ideas in the draft would bring about positive reforms and are worthy of support. We do, however, have concerns in relation to several specific recommendations, as set forth below.
1. "Blowing the Whistle" - §205.3(e)(2)
We are most concerned about the provision in §205.3(e)(2) that would authorize a lawyer to disclose to the SEC, without client authorization, confidential information related to the representation of a client to the extent the attorney "reasonably believes necessary...to prevent an issuer from committing an illegal act that is likely to result in substantial injury to the financial interest or property of the issuer."1 This rule is too broad, in our view, because it would apply to all kinds of property and financial interests of a publicly held corporation, whether or not such injury is material to the market value of its securities. If such a rule is necessary to the protection of capital markets, we think that it should be limited to harm that is material to the market in the issuer's securities.
We also oppose the authorization for an attorney to disclose such information to "rectify the consequences of the issuer's illegal act in the furtherance of which the attorney's services had been used." This provision has no restriction that ties it to activities that might impact the market in an issuer's securities. It would cover all kinds of actions that an attorney might consider to be illegal (whether criminal or not), and would give a roving commission, and perhaps obligation, to an attorney to police all of an issuer's activities. Such a provision was recently rejected by the American Bar Association's House of Delegates by a wide margin. If the capital markets need a rule authorizing disclosure of past illegal acts of an issuer, we think that the rule should be limited to those acts that are likely to have a material impact on the market for the issuer's securities.
These proposed changes appear to be based on misperceptions about the role of a lawyer in the legal system and the nature of the attorney-client relationship. Attorneys do not have duties to the public like those of accountants in certifying financial statements. Moreover, these proposed changes could undermine a lawyer's ability to develop an open and honest attorney-client relationship that enables the lawyer to learn of and counsel against potential misconduct. Lawyers have a special and unique role in our society: they are vested with the fiduciary duty of confidentiality to enable them to discourage and divert wrongful or illegal client conduct. Because lawyers are presently duty-bound to maintain the confidentiality of client information, we will never know when or how many attorneys successfully change the course of corporate conduct by counseling and advising their clients to perform responsibly.
Indeed, the proposed rule will likely make clients more reluctant to provide full disclosure to their lawyers, and will impede the ability of lawyers to steer their clients away from unlawful acts. Thus the proposed "whistle blowing" provision may in fact be counterproductive and increase the problems that the SEC is trying to solve.
The rules that protect confidential client information are based on a careful balance between the need to provide effective representation of the interests of clients and the need for public disclosure of such information. That balance has traditionally been struck in favor of prohibiting disclosure altogether, or at least absent a serious threat to life or limb.2 Under the traditional balance, an attorney may advise a client, "tell me everything that I should know about representing you - my lips are sealed, and no information will be made public except to represent your interests." Thus the client can have confidence when disclosing to a lawyer all relevant information without fear that the lawyer will disclose it to third parties. This information is invaluable as the lawyer seeks to counsel a client on legal options. We think that this balance is based on sound and enduring public policy, and is one of the core principles of the practice of law.
This proposed rule would dramatically change that balance. Under the recommended rule, a lawyer could no longer legitimately promise to guard a client's secrets and confidences in a wide variety of situations. In consequence, clients may well lose confidence in the lawyer's ability to maintain information in confidence. As a result, clients and the system of justice as a whole will suffer.
Application of the rule to past client conduct is particularly pernicious. It would prevent an attorney from providing any sort of adequate representation to a client with respect to past conduct that has caused substantial financial or property injury to an issuer. The protection of confidential client information in this context lies at the very heart of the role of a lawyer in providing legal representation to a client.
Furthermore, we believe that the "whistle blowing" provision of the proposed rule exceeds the mandate of the Sarbanes-Oxley Law. Section 3073 of that law requires that the SEC propose regulations requiring an attorney to "report up" evidence of violations up the chain of command in the organization. It does not mention regulations requiring an attorney to "report out" the violation to the SEC or the public. In Rule 205, the SEC proposes not only "reporting up," but also "reporting out." This goes beyond the congressional mandate and certainly, in our view, beyond sound public policy.
We also think it is important to note that the "whistle blowing" provision of §205.3(e) is at odds with California statutory law. California Business & Professions Code §6068(e) requires a lawyer, "To maintain inviolate the confidence, and at every peril to himself or herself to preserve the secrets, of his or her client." This statute embodies one of the core values of law practice. In consequence, it recognizes no exceptions and has governed attorney conduct in California for more than a century.
Furthermore, imposing a whistle blowing duty on lawyers may exceed the authority granted to the SEC under §307 of the Sarbanes-Oxley Law (even as combined with other existing SEC statutory authority).
We urge the SEC to tread cautiously in broadening exceptions to this core privilege underlying the sanctity of attorney-client relations. At the very least, the SEC should draft such an exception narrowly and limit it to those disclosures that are truly necessary to the preservation of the integrity of capital markets. As drafted, this rule is far too broad.
2. Section 205.2(f)
The obligations that §205.3, the main operative provision of proposed Rule 205, would impose on a lawyer are mostly predicated on the assumption that the lawyer represents a corporation that is the securities issuer. For example, §205.3(a) states that an attorney, acting in the representation of an issuer "represents the issuer as an organization." This is appropriate and consistent with ABA Model Rule 1.13, in those cases where the client is the issuer.
The definition in §205.2(f), however, renders the scope of Part 205 uncertain. For example, pursuant to §205.2(f), the rule would apply to the representation of a subsidiary, a director or an officer, whenever such representation is "at the behest or for the benefit" of the issuer. In such a situation, the attorney typically does not represent the organization at all, contrary to the requirements of §205.3(a). Indeed, the interests of the actual client (the subsidiary, the director, or the officer) may conflict dramatically with those of the organization.
A typical business corporation statute provides for the indemnification of a director or officer for expenses incurred in connection with litigation respecting the corporation. See, e.g., Delaware General Corporation Law §145. Where the officer or director receives such indemnification, that person's representation could be considered to be "at the behest" of the corporation, even if not for its benefit.
We believe that a subsidiary, officer or director is entitled to the undivided loyalty of his, her or its attorney. The interests of such a party may easily conflict with those of the organization. To impose on such an attorney the obligations of §205.3 would seriously undermine a core value of the practice of law.
Because of the problems in the definition articulated in §205.2(f), the ethical duties imposed in Part 205 may apply to attorneys not representing the issuer, thereby creating confusion, conflicting duties of loyalty and other problems. By way of example, consider the following troubling applications of this provision:
These problems (and others) arise from the formulation of the definition of "the representation of an issuer" in §205.2(f). The deletion of this definition could eliminate these issues.
3. Obligation to Act in Interests of Shareholders - §205.3(a)
We are troubled by the statement in §205.3(a) that an attorney who represents a corporation or other securities issuer must "act in the best interest of its . . . shareholders" (as well as the best interest of the issuer). Such an obligation to shareholders would make a dramatic change in present law. In our view, such a change is unwarranted.
We believe that the fiduciary duties of an attorney for an entity are owed to the entity itself, not separately to the shareholders. The principal fiduciary duties of a lawyer to a client are confidentiality, loyalty, independent judgment and care. The corporation gives directions to the lawyer through its duly authorized constituents, which are normally its directors and officers. In discharging the duties owing to a corporate client, an attorney should proceed "as is reasonably necessary in the best interest of the organization." See ABA Model Rule 1.13(b). In our view, Rule 1.13 (and California Rule 3-600, which is essentially similar) gives adequate guidance as to the nature of the entity to whom a lawyer owes his or her duties.
Furthermore, we seriously doubt that there is any "best interest of shareholders" that can be discerned for a publicly held corporation. The interests of shareholders are very diverse. Some may want dividends; some may want to control the corporation; some may want short-term appreciation on their investments; some may want long term appreciation. In addition, there may be bondholders and preferred stockholders, who may have quite different interests from either the corporation itself or the common shareholders. An attorney may not be able to represent these varying interests faithfully.
4. Definition of "breach of fiduciary duty" - §205.2(d)
The proposed rule in §205.2(d) broadly defines what constitutes a "breach of fiduciary duty." This definition, however, is internally inconsistent. On the one hand, it states that it such a breach is "any breach of fiduciary duty recognized at common law." What constitutes such a breach varies from state to state (and is much narrower in many foreign common law countries).
On the other hand, the definition states that it includes "misfeasance, nonfeasance, abdication of duty, abuse of trust, and approval of unlawful transactions." The law applicable to particular transactions at issue may or may not include all of these concepts. The rule should clarify that the applicable standard is drawn from the common law of the jurisdiction that governs the transaction at issue (usually state law), and should not be imported from other states having no connection with the underlying transaction.
In addition, the rule should clarify that "breach of duty," for the purpose of securities law practice before the SEC, means the violation of state corporation and securities laws that gives rise to material liabilities (including material contingent liabilities) that reasonable investors would consider important in making investment decisions.
5. "Noisy" Withdrawal - §205.3(d)
Section 205.3(d) mandates a "noisy" withdrawal (requiring or permitting an attorney to state that he or she is withdrawing "based on professional considerations") from the representation of a client in certain circumstances and permits it in others. California law, in contrast, generally prohibits a "noisy" withdrawal. The possibility that an attorney may be required or permitted to make a "noisy" withdrawal conflicts with an attorney's duty of loyalty. Therefore, it weakens the attorney-client relationship and lessens the chance that a client will fully and candidly disclose relevant information to the attorney so that the attorney can properly advise the client and counsel compliance with applicable law. For these reasons, we urge the SEC to delete the provision requiring or permitting a "noisy" withdrawal. Also, we urge the SEC to reconsider when and under what circumstances an attorney must or may withdraw.
6. Protection of In-House Lawyers - §205.3(d)
Finally, we are concerned that §205(d) does not give sufficient protection to an in-house lawyer who informs the SEC of the disaffirmation of an opinion, document, etc. Such an attorney would likely be in substantial danger of losing his or her job as a result of making such a disclosure to the SEC. While the SEC proposes to require that an attorney inform the SEC in appropriate circumstances, the SEC proposes no employment protection for such an in-house attorney.
We believe that, if the SEC requires an in-house attorney to report to the SEC the disaffirmation of an opinion, document, etc., it should also prohibit the employer from discharging the attorney for complying with this obligation.
Several states, including California, already provide this kind of protection for in-house counsel. Other states do not, and thus the duty that would be imposed on in-house counsel, and the concomitant protection that in fairness should be afforded them, would have the effect of overturning the law of several states.
In addition to the above comments on specific provisions of proposed Part 205, we think that the SEC should give attention to the overall impact of the adoption of this type of rule. In our view, the proposed change in a lawyer's duties has consequences far beyond the possible over-ruling of an individual state's legal ethics rules. It suggests changes in the scope of a lawyer's civil obligations, including possible liability for failing to act where action would be discretionary and a possible duty to investigate where no such duty exists at the present time and none is expressed in these proposed rules. Again, we think that the SEC should be extremely cautious in making new rules governing attorney conduct that may have such an impact.
Furthermore, we think that the SEC has underestimated to a substantial degree the administrative and financial impact that the proposed rule will have on securities issuers. The low threshold requiring an attorney to report "evidence of a material violation" could easily create a large flow of information to the chief legal officer or qualified legal compliance committee which could be expensive and unwieldy to process. This would conflict with the goal of the statute to "promote efficiency, competition and capital formation."
Thank you again for the opportunity to comment on the Preliminary Report. Please feel free to contact us if we can be of any further assistance.
Jon Rewinski 213-689-7553