SCHIFF HARDIN & WAITE
December 18, 2002
Jonathan G. Katz
Dear Mr. Katz:
Schiff Hardin & Waite appreciates the opportunity to comment on the Securities and Exchange Commission's ("Commission") proposed rules that would establish standards of professional conduct for attorneys who appear and practice before the Commission on behalf of issuers.1 We agree wholeheartedly with statements in the Proposing Release regarding the critical role that attorneys play in the Commission's processes. Moreover, after the sudden and spectacular failures of Enron and other large U.S. issuers, there is little doubt as to the need for reforms to enhance the protection of investors and increase their confidence in public companies; and attorneys rightly should play a significant role in this process. To this end, and subject to the incorporation of certain important modifications to the proposed rules recommended below and by others of which we are aware or have participated in formulating through the efforts of one or more of our partners, we commend the Commission with respect to that aspect of the proposals that would implement the so-called "up-the-ladder" reporting requirements mandated by Section 307 of the Sarbanes-Oxley Act of 2002 (the "Act").2
Nevertheless, we have significant concerns about certain aspects of the Commission's proposed rules, particularly those sections that would (i) mandate that attorneys withdraw from client representations, notify the Commission of such withdrawal and disaffirm documents on which they have worked under certain conditions (so-called "noisy withdrawal" requirement); and (ii) establish standards separate and apart from state bar ethics standards governing when attorneys are permitted to disclose confidential client information to the Commission. In both respects, the proposed rules diverge significantly from many state attorney ethics rules. While allowing attorneys the discretion to make disclosures to third parties of client confidential information that the attorney knows would result (as opposed to believes may result) in a material violation of the federal securities laws may have merit, the Commission may not be the proper authority to enact such rules. Indeed, we understand that many states currently are engaged in making the judgments required to determine the proper scope of permissible disclosures of client confidential information to third parties under their own attorney conduct rules. Further, where the Commission's proposed rules conflict with state bar ethics rules, it is not at all clear that the Commission's rules would in fact preempt those state ethics rules. In fact, we believe that in some instances attorneys appearing and practicing before the Commission may well be faced with the unfortunate dilemma of violating either a state bar rule or the Commission's new professional standards.
We believe that mandatory noisy withdrawal will seriously impede the flow of information between attorneys and their clients, discourage issuers from seeking advice from counsel on precisely those more difficult issues for which the advice of counsel is particularly important and may even discourage attorneys from delving too deeply into the affairs of their clients. As a consequence, these provisions will result in less compliance with the law, not more.
In light of the limited directive of Section 307 of the Act to impose an up-the-ladder reporting requirement, and the likely favorable impact that such a requirement will have on remedying potential material violations by issuers, we are at a loss as to why the Commission believes that the proposals mandated by the Act would be "incomplete" without the noisy withdrawal provisions. Given the longstanding role and extensive experience of state Supreme Courts in regulating the ethical conduct of attorneys generally, as well as current discussions underway by the American Bar Association ("ABA") and bar associations and groups throughout the country regarding the proper ethical obligations of attorneys representing clients involved in fraudulent or otherwise questionable activities, we question why the Commission would impose these obligations without the benefit of greater collaboration with and guidance from those who are charged with ensuring and, candidly, are more steeped in the proper balancing of the obligations of an attorney to his or her client and to the public at large.
In summary, we recommend that the Commission adopt rules relating to the up-the-ladder reporting requirements, with modifications and clarifications to the proposed rules and without the noisy withdrawal or permissive disclosure provisions. At a minimum, we suggest that the Commission defer adopting these latter provisions until it has gained experience with the impact that the up-the-ladder internal reporting requirements have on the conduct of issuers in addressing evidence of material violations of law and until the Commission consults more extensively with state Supreme Courts and state bar associations on the likely impact of the noisy withdrawal and permissive disclosure provisions on the attorney-client relationship.
These issues are discussed further below.
"Up-the-Ladder" Requirements of the Proposed Rules
Our comments with respect to the requirement that outside and in-house counsel report evidence of material violations of the securities laws, breaches of fiduciary duties or similar violations up-the-ladder within an issuer are focused on the scope of the proposed rules that would implement this requirement. In particular, several aspects of this portion of the proposed conduct rules are insufficiently specific or overbroad. For example:
These are just a few observations on the internal reporting aspects of the proposed rules. Rather than attempt to comment in detail on each aspect of the up-the-ladder reporting requirements, we commend to the Commission the comments of others that we understand are being submitted on various specific points of this aspect of the proposals, including the comments of the Corporation, Finance and Securities Law Section of the District of Columbia Bar and the comments of The Chicago Bar Association, which certain members of our firm assisted in formulating, and the comments of 77 Law Firms which we have joined, each of which sets forth many useful recommendations.5 We particularly encourage consideration of the comments, and modification of the proposed rules, with respect to adoption of a knowledge standard to trigger the reporting obligation, revision of the definition of "In the representation of an issuer," revision of the definition and responsibilities of supervisory attorneys, changes in the sanctions, adoption of a safe harbor, and reevaluation of QLCC organization and duties.
Noisy Withdrawal and Permissive Disclosure Requirements of the Proposed Rules
Noisy Withdrawal Generally. Under the so-called "noisy withdrawal" provisions of the proposed rules, outside counsel who have not received an appropriate and timely response to reports of evidence of material violations that are ongoing, or about to occur, and that are likely to result in substantial injury to the financial interest or property of the issuer or its investors are required to (i) withdraw from the representation of the issuer, indicating that the withdrawal is based on "professional considerations," (ii) give written notice to the Commission of such withdrawal within one business day of withdrawing (similarly indicating that the withdrawal was based on "professional considerations"), and (iii) promptly disaffirm to the Commission any opinion, document, affirmation, representation, characterization or the like in a document filed with or submitted to the Commission that the attorney prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading.6 In-house attorneys that do not receive appropriate and timely responses to reports made to their employing issuers under the rule similarly are required to promptly disaffirm to the Commission any opinion, document affirmation, representation, characterization or the like that the attorney prepared or was involved in preparing that may be materially false or misleading; but they are not required to resign from the issuer.7 These provisions raise several troubling issues, in our view, and ought to be seriously reconsidered by the Commission.
Noisy Withdrawal As Subverting Congressional Intent Underlying Section 307 of the Act. As an initial matter, and as acknowledged in the Proposing Release, the noisy withdrawal provisions go well beyond the express requirements of Section 307 of the Act. The Proposing Release suggests that the enactment of Section 307 was not meant to preclude the Commission from requiring attorneys to withdraw from engagements for professional considerations such as those that would be mandated by the proposed rules or to notify the Commission of such withdrawals.8 However, a review of the Senate floor discussion surrounding the enactment of Section 307 indicates, in fact, that sponsors of that section of the overall legislation that ultimately became the Act were well aware of the distinction between requiring an attorney to report up-the-ladder to the board of directors of a client and requiring an attorney to report violations to the Commission. Specifically, in discussing the scope of what ultimately was enacted as Section 307, Senator Enzi, a co-sponsor of the provision, stated:
The record of the Senate discussion of this provision suggests that one factor that dictated the limited scope of Section 307 was a concern about the impact that a rule requiring notice to the Commission might have on the attorney-client privilege and the obligation of attorneys to maintain client confidential information.10
The discussions surrounding Congress' enactment of Section 307 are important in several respects. First, they clearly indicate the concern among some members of Congress over assuring that the proposed legislation would not have an adverse impact on the relationship between an attorney and his or her client. In light of this, we believe the Commission's proposed noisy withdrawal rules not only are unauthorized by the legislation but actually are contrary to the legislative history indicating Congress' own determination not to require attorneys to report evidence of material violations11 to the Commission.12 Second, as discussed further below, the absence of any statutory requirement that the Commission impose a noisy withdrawal requirement calls into serious question assertions throughout the Proposing Release that the Commission's proposed rules will preempt any conflicting state attorney ethics rules.
Likely Adverse Impact of Noisy Withdrawal on the Attorney-Client Relationship. Our primary concern with the proposed rules is the negative impact the mandatory noisy withdrawal provisions (proposed Rules 205.3(d)(1) and 205.3(b)(3)) is likely to have on relationships between attorneys and their clients and upon the ability of attorneys to function effectively as counselors concerning their clients' adherence to law. The duty to maintain client confidential information defines an important aspect of the attorney-client relationship. Lawyers can best serve their clients when clients are free to discuss all aspects of a particular matter, including information that may be embarrassing or damaging to the client, without fear of reprisal. According to the Comment to Rule 1.6 of the ABA Model Rules of Professional Responsibility ("Model Rules"), confidentiality facilitates the fact-finding process that is critical to effective representation and also has the effect of encouraging early legal consultation.13
We believe that, instead of furthering the objective of better issuer disclosure, the proposed rules will have the opposite and unintended result - less compliance with law. For instance, clients regularly consult with counsel concerning their disclosure obligations and other regulatory and compliance issues. Those clients clearly expect their lawyers to point out to them instances in which there may be violations of law, whether disclosure violations, breaches of fiduciary duty, or otherwise. Clients both understand and expect that their communications with their counsel about these issues are confidential, so that they can share all of the details relating to a matter, information that is crucial to the lawyer's ability to help them work through relevant issues and to provide them with well-reasoned advice. The completeness of the information clients share enables the lawyer to fulfill his or her obligation to provide them with the best advice, upon which clients can make appropriate decisions. Under the proposed rules, lawyers would be required to act not only as counselors in providing advice to their clients but also as judges of whether the clients' responses to their lawyers' advice were "appropriate," essentially creating a potential conflict between attorney and client. We strongly believe that communications would be chilled if clients understood that their lawyers would be required to effectively blow the whistle on them if the lawyers concluded that their decisions were not an appropriate response. The risk is enhanced by the prospect that lawyers, in fulfilling their duty of communication with their clients (Illinois Rule of Professional Conduct 1.4; D.C. Rule of Professional Conduct 1.4) would have to advise their clients in advance of the obligation to make a noisy withdrawal under certain circumstances. The proposed rules also might provide a strong incentive for attorneys not to probe too deeply into situations involving their clients in order to avoid facing potential conflicts with clients.
Conflict Between Noisy Withdrawal Obligation and State Bar Ethics Obligations. Sensitive to the potential impact of the proposed rules on state attorney ethics rules, the Commission states that effecting a noisy withdrawal does not reveal any privileged communication between an attorney and his or her client, and that the use of the phrase "professional considerations" to explain the withdrawal keeps confidential the particular facts underlying the withdrawal while signaling that the withdrawal reflects substantially more than a disagreement about the best legal strategy or a dispute over the cost of the representation. In this regard, the Proposing Release also states that noisy withdrawals of the sort contemplated by the proposed rules have been recognized by the Model Rules and state bar rules as a compromise between silent withdrawal and disclosure of specific confidential information.14 The Proposing Release also purports to "make clear" that an attorney will not violate the attorney-client privilege in making the noisy withdrawal disclosures to the Commission and that such "disclosures `should' in most cases also be covered by the whistleblower protections of 18 U.S.C. 1514A."15
While Comments (notably not the rules themselves) to the Model Rules and to some state ethics rules do state that attorneys may effect noisy withdrawals from client representations, they do so under circumstances that, in our view, are more circumscribed than those set forth in proposed Rule 205.3(d). First, they are permissive, not mandatory as the Commission would order. And, there are some states, such as Illinois, that have not adopted the Comments to the Model Rules.16
Second, noisy withdrawal under the Model Rules and the ethics rules of various states does not point so ineluctably to the privileged information. For example, the Comments to District of Columbia Rules of Professional Conduct indicate that an attorney's statement to a court that he or she has withdrawn from a representation based upon "irreconcilable differences" does not constitute the disclosure of a client confidence, and that the withdrawing attorney may disaffirm or retract any opinion, document or statement that contains a material misrepresentation by the attorney that the attorney reasonably believes will be relied upon by others to their detriment.17 However, such a statement reveals significantly less information than would the Commission's proposed noisy withdrawal which, unlike a withdrawal for "irreconcilable differences," would clearly mean that an attorney believes that evidence of a material violation of the securities law or a breach of fiduciary duty has not been appropriately addressed by the issuer. In addition, and contrary to the discretionary disaffirmation permitted under state bar rules, proposed Rule 205.3(d) would mandate that an attorney disaffirm documents on which he or she has worked if they are tainted by the alleged material violation of law. The mandatory nature of the disaffirmation under the proposed rules alone significantly impedes the ability of attorneys to exercise professional discretion as to how to properly maintain client confidences. And depending on how specific the Commission requires such disaffirmations to be, there may be little difference between withdrawing, notifying the Commission, and disaffirming filed or submitted materials pursuant to the rule, and simply communicating the substance of the initial report of the material violation. Even where a notice to the Commission under the rules involves a broad disaffirmation of an entire filing (as opposed to a particular section of a filing) - such as a disaffirmation of work performed by an attorney on an issuer's Form 10-K, for example - the Commission may be able to glean the substance underlying a report of a material violation based solely on the nature of the practice of the attorney submitting the notice and disaffirmation.18
Third, Comment 19 to District of Columbia Rule 1.6 would allow disaffirmation of an opinion, document, affirmation or the like only if it contains a material misrepresentation by the attorney.19 The Commission's proposed rules require disaffirmation of a writing that the attorney prepared or assisted in preparing that the attorney reasonably believes is or may be materially false or misleading, calling upon the attorney to judge the statements of others about which he or she may have little expertise.
Attorneys making noisy withdrawals pursuant to the proposed rules may well be subject to significant disciplinary action and malpractice liability if, in hindsight, a state bar disciplinary panel or a judge or jury in a civil case determines that the noisy withdrawal and disaffirmation, in fact, resulted in the disclosure of protected client information.20 The threat of such consequences might be less of an impediment to the proposed rules if the attorneys subject to the rules could be confident that, as stated in the Proposing Release, the Commission's conduct rules preempt conflicting state ethics rules. However, in light of the fact that, as acknowledged in the Proposing Release, the noisy withdrawal provisions go well beyond what is required by the Act, as well as the legislative history discussed above regarding the concerns of some in Congress with requiring disclosures of material violations to third parties, we have serious reservations as to whether this aspect of the Commission's proposed rules would, in fact, receive the benefit of federal preemption.21 Similarly, in light of the magnitude of risk involved on this issue, a more definitive view by the Commission of the application of the federal whistleblower protections to disclosures made by attorneys to the Commission would seem appropriate.
Conflict With State Rules on Permissive Disclosure. We believe that those aspects of the proposed rules that would allow for the permissive disclosure of issuer confidential information - including the disclosure of contemporaneous records composed by an attorney submitting a report of evidence of a material violation - by an attorney without the consent of the client also may result in adverse consequences for the unwary attorney under state ethics rules, notwithstanding that such disclosures would be permitted rather than required under the proposed rules.22 For example, proposed Rule 205.3(e)(2) would permit the disclosure of protected client information by an attorney without the client's consent in order to, among other things, prevent an issuer from committing an illegal act that the attorney reasonably believes is likely to result in substantial injury to the financial interest or property of the issuer or investors. However, the District of Columbia Rules of Professional Conduct do not permit disclosure under these circumstances.23 While the Commission's rules do not mandate disclosure of confidential information under these circumstances, the Proposing Release purports to resolve any potential conflict between a state bar rule and the Commission's own conduct rules in favor of facilitating disclosure of the relevant confidences to the Commission stating that:
Similarly, proposed Rule 205.3(e)(3) provides that where an issuer, through its attorney, shares with the Commission, pursuant to a confidentiality agreement, information related to a material violation, such sharing does not constitute a waiver of any otherwise applicable privilege or protection as to other persons.
With all due respect, the extent to which the Commission's permissive disclosure provisions (and, as discussed above, noisy withdrawal requirements) will be deemed to preempt or supplant state ethics rules, and the Commission's authority to decree what is or is not a breach or waiver of the attorney-client privilege is, in our view, at best an open issue. For the reasons noted above related to the scope of Section 307 of the Act, it is not at all clear that state bar disciplinary bodies or judges, including in particular independent state Supreme Courts, will reach the same conclusion as does the Commission. In fact, it would not surprise us to find that one or more states takes a contrary view, leaving those attorneys that rely on the Commission's statements in the Proposing Release concerning the preemptive effect of its rules allowing noisy withdrawal and disclosure of confidential information to the Commission in serious difficulty in disciplinary and civil liability contexts. Similarly, the client that agrees to disclosure of privileged information pursuant to a confidentiality agreement between the client and the Commission in reliance upon the Commission's assurance that such sharing does not waive the privilege will quite possibly have been misled.25
The Need for More Deliberation on the Noisy Withdrawal and Permissive Disclosure Provisions. All of the comments expressed above suggest the need for a more rigorous inquiry into the likely impact of noisy withdrawal and permissive disclosure proposals on the relationship between attorneys appearing or practicing before the Commission and their clients, and the manner in which such a scheme comports with the existing regulation of attorney ethical conduct by the states. While the Act clearly mandates that the Commission have in place attorney conduct standards with respect to the up-the-ladder reporting requirements by January 26, 2003, there is no such urgency with respect to the proposed noisy withdrawal and permissive disclosure provisions. We also note that a task force of the ABA has issued a preliminary report recommending that the ABA amend the ABA Model Rules to require disclosure of client confidential information in order to prevent client conduct known to the lawyer to involve a crime, including violations of the federal securities laws and regulations, in furtherance of which the client has used or is using the lawyer's services and which is reasonably certain to result in substantial injury to the financial interests or property of another.26 Given the complexity of the various issues, the Commission should defer adopting this aspect of the proposal until it has more experience with the efficacy of the up-the-ladder reporting requirements, and has collaborated more closely with state Supreme Courts and bar association responsible for attorney ethics rules.27
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Again, we appreciate the opportunity to share our views with the Commission on these critically important issues. We would be pleased to discuss our comments further with the Commission or its staff.
cc: The Honorable Harvey L. Pitt, Chairman, SEC