April 7, 2003
Jonathan G. Katz,
Re: Proposed Rule: Implementation of Standards of Professional Conduct for Attorneys
File No. S7-45-02
Dear Mr. Katz,
This letter is submitted in response to the Release Nos. 33-8186; 34-47282; IC-25920, (the "Proposing Release"), wherein the Securities and Exchange Commission (the "SEC") solicited comments on its proposed rules under Section 307 of the Sarbanes-Oxley Act1 (the "Act").
In light of the recent Enron-like scandals, Congress enacted Section 307 of the Act, which requires the SEC to issue national rules establishing minimum professional standards for lawyers appearing and practicing before the SEC on behalf of issuers. To fulfill its mandate under Section 307, the SEC first issued the Proposed Rules2 on November 21, 2002. After taking into account the comments3 of those concerned, on January 29, 2003, it issued the Final Rules4, as well as the Proposing Release with the "noisy withdrawal" proposal5. Since this proposal was highly controversial, the SEC provided an extended comment period till April 7, 2003 on the proposal itself, as well as a proposed alternative to it.
The SEC has stated that the intended purpose of entire proposed Part 205, which incorporates the SEC rules under Section 307 of the Act, is "to protect investors and increase their confidence in public companies by ensuring that attorneys who work for those companies respond appropriately to evidence of material misconduct." I fully support these laudable objectives, and commend the SEC on its efforts to adopt rules that fulfill this purpose but at the same time take into account the concerns of all affected by such rules. I believe that the SEC should adopt the "noisy withdrawal" proposal, subject to changes on some points, but without any modification on others. I discuss these issues below.
1) The current "Triggering" Standard for "noisy withdrawal" should be changed
The "noisy withdrawal" provisions in Section 205.3 (d) of the "noisy withdrawal" proposal are triggered when the `reporting' attorney:
If a "noisy withdrawal" rule is adopted, it becomes crucial to determine the appropriate triggering standard for this rule, and whether the proposed standard is appropriate or not.
(a) The current definition of "reasonably believes" incorporates a largely subjective standard that needs to be replaced by an essentially objective standard
Initially, the Proposed Rule defined "reasonably believes" to mean, "that an attorney, acting reasonably, would believe the matter in question"6 (the "first definition"). This was a modification of the Model Rules' definition of "reasonably believes", i.e., `the lawyer believes the matter in question and the circumstances are such that the belief is reasonable'7. The SEC stated that it intended this phrase to denote a purely `objective' standard-devoid of any subjective element, in contradistinction to its usage in the Model Rules, but it was open to a different definition of this phrase.8 In their comments to the SEC, few people supported this objective standard9, most opposing it as being too onerous and problematic. Several asked the SEC to use the Model Rules' definition of "reasonably believes"10 that incorporates a subjective element, while others urged it to adopt a higher triggering standard that requires the lawyer's "actual knowledge"11 of the fact in question. It was, and continues to be argued in support of this "actual knowledge" standard (also defined in the Model Rules12), that it would solve the problem of imposing a "reasonable" securities law expert standard on all lawyers (even those who were not expert in securities laws).13 After taking into consideration these comments, the SEC in the Final Rule abandoned its first definition in favor of the Model Rule definition of "reasonably believes" that is modified only to the extent of emphasizing that the range of possible reasonable beliefs regarding a matter may be broad, limited only by beliefs that are unreasonable. The changed definition of "reasonably believes" now seen in the Final Rule is "that an attorney believes the matter in question and that the circumstances are such that the belief is not unreasonable."14
The SEC has emphasized that this definition is no longer used in conjunction with the phrase, "evidence of a material violation,"- that is used in the SEC rules to denote a completely objective standard-thus dispensing with the earlier proposal that intended to completely exclude the subjective element from "reasonable belief". It is necessary to see the two elements of this new definition in conjunction-the first part- "attorney believes the matter" seems to connote a largely subjective standard, qualified only by the second part-"circumstances are such that the belief is not unreasonable", which seems to bring in the objective element. To me, it looks like this definition could possibly be interpreted as saying that, for the attorney to "noisily withdraw", he needs to subjectively believe the matter in question, and only the propriety of the attorney's "noisily withdrawal" is going to be judged against some sort of objective standard. This is different from just introducing a subjective element into a largely objective standard-in fact quite the converse-the triggering test here looks quite similar to the "actual knowledge" test, albeit with a lower threshold of subjective element (`belief' as opposed to `knowledge'), and differing also insofar as it incorporates the "objective" element, but seemingly only as a defense. This is one way of interpreting this definition, but it also quite likely that this was not the reading SEC intended to give "reasonably believes". It might instead have meant to impose essentially an objective standard, but one that takes into consideration the lawyer's context. Such interpretation would ascertain the reasonableness of the lawyer's belief in light of his expertise and experience. I would call this a sensible approach, but if it is indeed the intended one, then it would be better for the SEC to say it in a less convoluted and unambiguous manner, as explained below in (b).
I favor an objective triggering standard, as embodied in the first definition of "reasonably believes" by the SEC, because I think a subjective standard would be largely self-defeating as it gives the lawyers a clear escape route-they can easily say that they did not "believe" the matter in question, thus their "noisy withdrawal" duties were never triggered. Furthermore, an "actual knowledge" standard, or any other that incorporates a subjective element, would tend to pose cumbersome evidentiary hurdles.
(b) Add rider to objective triggering standard to clarify that lawyer's context will be taken into consideration; no need for rider emphasizing that wide range of reasonable beliefs possible
If the purpose of altering the first definition originally adopted by the SEC in the Proposed Rule was only to overcome the problem of imposing a standard "securities law expert" standard on all lawyers, then the SEC could, and still can achieve the same result by qualifying the "reasonable person" standard in its first definition, as being that of a reasonable person of the qualifications, training, expertise, position, seniority and experience (in relation to both securities law and the issuer in question), of the lawyer in question. When supplemented with this rider, the original SEC triggering standard seems more appropriate.
Moreover, it has been seen that the SEC altered the Model Rules definition of "reasonably believes" to emphasize that the range of possible reasonable beliefs regarding a matter may be broad, limited only by beliefs that are unreasonable. To similarly emphasize that a range of conduct may be reasonable, the SEC adopted a modified version of the Model Rule15 definition of "reasonable" or "reasonably", which denotes conduct that would not be unreasonable for a prudent and competent attorney modified only.16 Thus, given the above rider which takes into consideration the varying responses of lawyers depending upon their varied background, it remains no longer necessary for the SEC to separately emphasize that a wide spectrum of reasonable beliefs and conduct is conceivable under these rules. Even if these differences stem from things other than differences in backgrounds, there should not be a problem. It is quite easy to contemplate business situations where there exist a wide array of entirely plausible responses or behavior that meet the criteria of being reasonable. The possibility of having such a myriad of diverse, yet reasonable conduct and beliefs in the context of corporate management is well encoded in the judicially evolved concept of "business judgment rule". Under this rule, the courts refuse to second-guess the decisions of the Board of directors, treating them with deference as long as they were disinterested, exercised due care and were acting in good faith. While the business judgment rule in itself is not applicable to lawyers and their decisions of "noisy withdrawal", I use it simply to illustrate that it is well recognized by all (including, surely a body as specialized as the SEC) that business decisions cannot be easily straight jacketed into legal or illegal, instead often involve close calls and grey areas where more than one option could reasonably be taken. There is thus no need in my opinion, for the SEC to adopt additional language to stress this undisputed point of "reasonable" incorporating a multitude of options, both in terms of conduct and belief-besides being a mere surplusage, it tends to confuse matters. If the SEC wants however, it can state this in the explanatory notes, or articulate it as a clarification, but not do so by using "unreasonable" as a reference point like it does now, because as discussed above, that seems to bring in a reverse kind of "reasonable person" standard, which seems to function more as a defense than a triggering standard.
(c) Employ the "reasonably should know" phraseology as defined in Model Rules but qualified by rider explained above
I have argued above that the SEC triggering standard incorporated in its first definition of "reasonably believes", is the appropriate threshold to employ when qualified by the stated rider. That standard, though couched in the "reasonably believes" phraseology, resembles more closely the "reasonably should know" definition of the Model Rules17, that refers to an objective standard, namely one where `a lawyer of reasonable prudence and competence would ascertain the matter in question'. It might therefore be more appropriate to define the standard in the SEC rules in terms of a "reasonably should know" definition, qualified by the rider which we discussed that takes into account the lawyers' context. I believe such a triggering standard would be more effective and pragmatic in terms of administration and enforcement of the Rules-it tackles the problem of attorneys attaching different significance to the same evidence due to differences in their backgrounds, and also takes into account the fact that a number of reasonable beliefs are possible in business matters.
A last point to be factored in, if we adopt an objective triggering standard18, is what consequences follow for a lawyer who mistakenly, albeit in good faith, "noisily withdraws". Even though the SEC rules do not explicitly deal with this question, I would say none, in keeping with the scheme of the Final Rules that creates a `safe harbor' provision for attorneys acting in good faith in the event that they violate inconsistent standards imposed by a state or other United States jurisdiction.19 That apart, in reality it is highly unlikely for the SEC in hindsight to determine that a lawyer's "noisy withdrawal" was unwarranted, though the reverse might be true. However, it might be useful for the SEC to clarify that when a reporting lawyer, acting under the "reasonable man" standard and in good faith, "noisily withdraws", he is entitled to a safe harbor.
2) The rule should be limited to circumstances narrower than "material violations"
Another major point of contention is that the SEC Rule is not limited to a "crime/fraud", which is the favored phraseology in most state ethical rules, but instead uses the term "material violation", which term encompasses securities law violation, breach of fiduciary duty, or similar violation20, and arguably goes well beyond the scope of "crime/fraud". In other words, the state ethics rules typically do not permit noisy withdrawal under these broader set of circumstances, but require at least some underlying crime or fraud, and most even require that this crime/ fraud have implicated the lawyer's services.21 Thus follows a two pronged attack against this proposal-one, that the rule should only be triggered when a lawyer's services have been implicated, and two, it should be confined to a material violation that rises to the level of "crime/fraud". To elaborate, it is argued that because a securities violation, breach of fiduciary duty, or similar violation could be the result of acts or omissions that may not amount to a crime/fraud, SEC would impose requirements potentially at odds with these state bar rules.22 However, the SEC can find refuge in the recent amendment to Model Rule 1.6 that expressly allows confidential information to be disclosed in order `to comply with other law'-a phrase that is unquestionably even broader than `material violation'. In my opinion, notwithstanding the SEC's authority(or lack thereof) to do so, one might question the wisdom of applying "noisy withdrawal" duties to the entire gamut of things currently covered by `material violation'. Thus, the SEC should consider possibly limiting its definition in the context of "noisy withdrawal" to material violations that amount to "crime/fraud", and implicate the lawyer's services, irrespective of whether it retains the broader definition for the purposes of "up-the-ladder" reporting. The definition of "fraud" for the purposes of these Rules should track the Model Rules' definition of "fraud" which "denotes conduct that is fraudulent under the substantive or procedural law of the applicable jurisdiction and has a purpose to deceive"23. In this case, it would include securities fraud under the federal securities laws24, and fraudulent conduct under other federal laws.
3) The rule should not distinguish between retained attorneys and employed attorneys
It is argued that "noisy withdrawal" for employed attorneys should only be permissive, and not mandatory even for ongoing material violations. I would however argue that if different standards were made applicable to retained and employed attorneys for purposes of this rule, it would render the rule meaningless. To illustrate, if less stringent rules were applied for one compared to the other, issuers would simply use that as a loophole and "employ" attorneys, who have the less onerous "noisy withdrawal" and related responsibilities. Moreover, an in-house attorney, because of his employment with the client, will often be in a far better position than a retained attorney, to detect material violations and to take suitable action. The only difference that exists now, is that the employed attorney is not required to resign in cases where the retained attorney is,25 but that seems a sensible difference, given the fact that the employed attorney is working solely for the issuer, and not multiple clients like a retained attorney, and mandating him to resign would probably run afoul of his constitutional rights. However, I recognize that this very reason-that employed attorney serves only the issuer-would make his position extremely precarious. The attorney is ostensibly protected by the whistleblower protections, but his "noisy withdrawal" would make it practically impossible for him to continue with the client thereafter, resulting probably in a de facto resignation.
Thus, while effective enforcement of these rules dictates that we give no additional concessions to the employed attorney, the severe fallout of the rules on an employed attorney necessitate a serious reconsideration of the matter. It is a tough balancing act to perform between the interests of the employed attorney and the investing public. However, I would argue that the somewhat harsh consequences for the employed attorney can be mitigated to a large extent by effectively using the QLCC, which provides an alternative reporting procedure to an attorney retained or employed by an issuer. An attorney who reports evidence of a material violation to such a QLCC would have satisfied his reporting obligation and not be required to assess the issuer's response to the reported evidence of a material violation.26 Though open to both retained and employed attorneys, I would argue that the latter are better positioned in the organization to take advantage of this alternative route. This is because the in house attorney, compared to his retained counterpart has a more substantial and direct involvement in the issuer's overall internal corporate governance structure. Even though the QLCC is to be established by the issuer's Board of Directors, the in house counsel would play a major role in the design and working of an internal legal compliance systems like the QLCC. Thus, the employed attorney can, and should try to use his position to ensure that the employer organization establishes a QLCC27, and he could then fulfill his obligations under the SEC Rules by reporting to the QLCC, and reporting-out, if any, would then be the responsibility of the QLCC. Retained attorneys in contrast, while having the same option, will not generally have the same degree of involvement or say in, if and how the client should set up the QLCC, though once set up, it can be used to the same extent by them. Thus, while the practical effects of these rules could be seen as being more onerous for employed attorneys, I would argue that there is also an offsetting, inbuilt leverage point (in the provision of QLCCs) that can be used more favorably by them.
A problem specific to retained attorneys arises when such attorney works for a large or multinational law firm. The conflict of interest rules would usually require the withdrawing attorney's knowledge to be imputed to the entire firm, but it is recommended that such imputation be limited to only the representation that concerns the lawyer's "noisy withdrawal", or related representations that involve the lawyer's disaffirmed opinion, or documents. To also impute such conflict to other unrelated matters where that law firm represents the issuer, would be highly disruptive.
On a balance of arguments, I would not favor introducing a distinction between retained and employed attorney in the "noisy withdrawal" provisions.
4. A "noisy withdrawal" requirement would not be self-defeating in purpose
It is important to remember that the mandate of Section 307 of the Act and of the proposed SEC rules under that section, is to act "in the public interest and for the protection of investors." Hence, the utility of the "noisy withdrawal" rule needs to be analyzed against the backdrop of such policy interests.
The core principles of attorney-client privilege and a lawyer's obligation to preserve client confidentiality, subject to exceptions, have developed as a bedrock policy of our adversarial legal system. The underlying rationale of these concepts is to facilitate full and frank communications between attorney-client so that clients can have access to effective legal representation and obtain the best legal advice, which incidentally but importantly enhances the ability of lawyers to counsel legal compliance. It is being argued that the "noisy withdrawal" proposal would chill the norm of zealous advocacy and be counterproductive. Those opposing this rule feel that it would thwart complete disclosure by issuers to lawyers, impair relationship of trust and confidence between them, and thereby undermine the ability of lawyers to advise and persuade their clients to comply with legal requirements, resulting in more (and not less) harm to the investing public. The SEC however explicitly states in the Proposing Release that it does not want the rule to discourage issuers from seeking and obtaining effective and creative legal advice.
At the outset, it is difficult to imagine how issuers can conduct their business and accomplish their goals, without the counsel of a lawyer, especially in an area as specialized as securities laws, hence I do not think that the fear of lawyer's "noisy withdrawal" will result in issuers not seeking legal counsel. At the same time, I would not say that these concerns are entirely misplaced. However, I believe that they can be allayed by lawyers adopting a sensible and pragmatic approach in adhering to these rules. Lawyers need to be conscious of the long tradition of judicial deference given to decisions of organizations under the "business judgment rule", and not second-guess the issuer. They should not give in to "knee-jerk" reactions and resort to "noisy withdrawal" every time they have a difference of opinion with the issuer's officers. "Noisy withdrawal" should be looked upon as the last resort, and be limited to such parties, and such extent, as is necessary to accomplish its purpose.28 The lawyers should effectively use the alternative reporting procedure provided by reporting to QLCCs, wherever established, and if not, work towards their establishment.
It is necessary for the SEC while adopting its final rules, to strike a balance between the interests of the investing public, the issuers and the attorneys. For the reasons stated above, I believe that SEC should adopt "noisy withdrawal" provisions, subject to certain modifications. It would be most unfortunate if under pressure, the SEC were to backtrack entirely on its proposal, or adopt a highly watered down (permissive only) version of the proposal discussed.
I appreciate the opportunity to comment on the proposed rules. For a more complete discussion on this as well as other issues concerning the SEC proposal on "noisy withdrawal", kindly visit http://www.jeanmonnetprogram.org/papers/puja.doc. Should you have any questions regarding this, please feel free to contact me (212-443-5271).