December 18, 2002
Jonathan G. Katz, Secretary
Re: Proposed Rule- Implementation of Standards of Professional Conduct for Attorneys
Dear Mr. Katz:
I am writing to forward comments on selected portions of the Commission's proposed rules to implement Section 307 of the Sarbanes-Oxley Act. I am a Professor of Law at the University of Pittsburgh and have taught legal ethics for the past eight years. These comments were authored by upper class law students at the University of Pittsburgh School of Law. The students participated this semester in my course, "White Collar Civil Liability," a course that focused on the lawyer's role in the representation of large, publicly held companies and that covered many of the issues addressed in the Commission's proposed rules.
The students listed below asked me to assist them in submitting these comments. Although we discussed the issues as a group, each comment was authored by the student named in the heading and should be considered as the views of that student and not attributed to the group. Also, although I served as an advisor and editor for each of the students, the views expressed in the comments are those of its student author and not necessarily my own views. (My views on the proposed rules are best captured by the comments that have been submitted to the Commission today by Susan Koniak, Roger Cramton, and George Cohen.)
The student authors are Jennifer Andrade, Michael Butler, Ana Cottone, Shawn Davis, Konrad Jarzyna, Robert Kacey, Thomas Kavanaugh, Meghan Schardt, and Brian Thompson. These authors are law students and not yet members of the bar. Nonetheless, I decided to assist them in putting their views before the Commission. Although they cannot speak from experience as practicing lawyers, they do speak as students who care about these matters and who stand at the threshold our profession. I respectfully request, on their behalf, the Commission's consideration of their thoughts and views.
Comments on Section 205.3(b)(1) (Shawn Davis)
The Commission has invited comments on "whether the `reasonably believes' standard is an appropriate standard to trigger the requirement that an attorney make a report; or whether the requirement should be triggered only in circumstances where the attorney `knows' or `reasonably should know' of a material violation."
The Commission has proposed use of a "reasonable belief" standard as opposed to an actual knowledge standard, which had been set forth by the ABA's Model Rule 1.13(b), which states:
If a lawyer for an organization knows that an officer, employee, or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law which reasonably might be imputed to the organization, and is likely to result in substantial injury to the organization, the lawyer shall proceed as is reasonably necessary in the best interest of the organization.
The Commission is right to reject the "actual knowledge" standard. Actual knowledge of a "material violation" would allow far too much risk that a substantial injury to the issuer might actually occur. Use of the "actual knowledge" standard would do little to stop the type of fraud that prompted Congressional action. Encouraging lawyers to defer reporting "up the ladder" until they actually know a material violation has law has occurred would not be in the client's interests. Delay in reporting within the entity would diminish the chance to intercept fraud and to mitigate the entity's exposure to liability.
When enforcing this rule, the Commission should take into account the circumstances of less experienced attorneys. An attorney with little or no experience may not have the knowledge and foresight that is necessary to spot everything that may or may not constitute fraud. Section 205.5 defines the responsibilities of a subordinate attorney. Section 205.5(c) states that "a subordinate attorney complies with Section 205.3 if the attorney reports to his or her supervising attorney under Section 205.3(b) evidence of a `material violation' that the subordinate attorney becomes aware of in the course of appearing and practicing before the Commission." An inexperienced attorney may not have enough knowledge to properly "reasonably believe" that there is fraudulent activity taking place, and therefore will not report such instances.
Section 205.4 defines the responsibilities of a supervising attorney. Section 205.4(b) states that, "a subordinate attorney shall make reasonable efforts to ensure that a subordinate attorney...conforms to this part and complies with the statutes and other rules administered by the Commission." A supervising attorney should make efforts to ensure that a subordinate, less experienced attorney will be properly trained so that they can spot the warning signals of fraud.
Comments on Section 205.3(b)(3) (Robert Kacey)
Section 205.3(b)(3) requires the CLO, upon receiving the report of evidence of a material violation, to undertake such inquiry as the CLO "reasonably believes is necessary." If the CLO concludes that a material violation of law is involved, the CLO must "ensure that the issuer adopts appropriate remedial measures." In that event, Section 205.3(b)(3) provides: "The chief legal officer shall promptly report the remedial measures adopted and/or sanctions imposed to the chief executive officer, to the audit committee of the issuer's board of directors, or to the issuer's board of directors, and to the reporting attorney." This language leaves room for interpretation, and it also seems to suggest that the CLO would only have to report either to the CEO, the audit committee, or the board. The CLO should have to report the remedial measures to each of the enumerated persons or entities. Assuring that the CEO, audit committee, and full board know that the company was involved in a material violation and has responded with remedial measures makes an effective remedial response more likely. To make this change, the Commission need only substitute the word "and" for "or" in the quoted passage above.
Comments on Sections 205.3(b)(4) and (b)(5) (Thomas Kavanaugh)
Section 307 of the Sarbanes-Oxley Act of 2002 (the "Act") requires the Securities and Exchange Commission (the "Commission") to prescribe minimum standard of professional conduct for attorneys appearing and practicing before the Commission in the representation of corporations that are subject to the federal securities laws. Section 307 of the Act had previously generated controversy because of its breadth and vagueness prior to the Commission's release of its Proposed Rules. The release of the Proposed Rules has generated many questions. For example, it is not entirely clear what kind or amount of evidence will trigger an attorney's disclosure obligation. Nor is it entirely clear how an attorney will determine whether or not the chief legal counsel ("CLO") or the chief executive officer (`CEO") have responded appropriately to the evidence. Most importantly, Section 307 and the Proposed Rules have also generated concern because of their obvious potential to create conflicting obligations for attorneys under federal law and under state ethics law. Nevertheless, in responding to the recent corporate crises, the end result must be that attorneys can no longer sit idly by if they believe that corporate wrongdoing has taken place and this legislation dictates the attorney's role in the prevention of corporate misconduct.
Although attorneys of issuers should neither be required to second-guess reasonable business decisions nor should an attorney be required in ordinary circumstances to report corporate decisions outside the company, reporting important matters up the corporate ladder, wholly within the company, is fully consistent with the attorney's essential ethical duty of loyalty to the client. In the event that the reporting attorney does not receive an appropriate response within a reasonable time from the CLO or CEO, Section 205.3(b)(4)'s command that the attorney would have the duty to report the material violation to the audit committee, another committee of independent directors, or to the full board is a rule wholly consistent with the attorney's ethical duty of loyalty to client.
Section 205.3(b)(4) sets forth the "up the ladder" reporting process. If an attorney who has made a report reasonably believes that the CLO or the CEO of the issuer has not provided an appropriate response, or has not responded within a reasonable time, the attorney shall report the evidence of a material violation to: (i) the audit committee of the issuer's board of directors; or (ii) if the issuer's board of directors has no audit committee then to another committee of the issuer's board of directors consisting solely of directors who are not employed, directly or indirectly, by the issuer and are not, in the case of a registered investment company, "interested persons" as defined in the Investment Company Act of 1940; or (iii) if the issuer's board of directors does not have a committee consisting solely of directors who are not employed, directly or indirectly, by the issuer and are not, in the case of a registered investment company, "interested person" as defined in the Investment Company Act of 1940, then to the issuer's board of directors.
This "up the ladder" reporting requirement is appropriate. The audit committee is a sensible place to begin. The Act requires that this committee be composed entirely of independent directors. The committee's basic function assures the group's familiarity with the financial affairs of the company. The next option of reporting to a committee of the issuer's board of directors consisting solely of directors who are not employed by the issuer makes sense when the issuer's board of directors has no audit committee. Lastly, if there is no committee consisting solely of independent directors, then the reporting attorney may go rightly to the full board.
The Commission may wish to consider whether to extend the attorney's reporting duties beyond merely requiring the attorney to report the evidence of a material violation to only the CLO or CEO. For example, this reporting requirement could and possibly should extend further up the corporate ladder by requiring the reporting attorney to report evidence of a material violation to the issuer's directors as mandated in paragraph 205.3(b)(4), even if the attorney believes the CEO or CLO's response is appropriate. Understandably, this might create some awkwardness in the relations between the attorney and the CEO or CLO and would burden the board. However, this extended reporting duty, by making sure that the board is aware of these matters, would further promote the essential legislative objective behind the Sarbanes-Oxley Act. Informed, active, and reasonably independent boards would provide a major bulwark against the repeat of the scandals of recent years.
Comments on Section 205.3(b)(7) (Brian Thompson)
Section 205.3(b)(7) provides that when an attorney receives an appropriate and timely response to evidence the attorney reported in accordance with subsections (b)(1), (b)(4) or (b)(5), and takes reasonable steps to document their report and the response to such report, the attorney "need do nothing more under this section regarding the evidence of a material violation." This is what the Commission calls the "safe harbor" provision.
Section (b)(7)'s "safe harbor" is appropriate. Although the practice of law has changed with the ever-increasing intricacies involved, an attorney's duty has remained consistent. Acting as an advisor, the attorney's role is to communicate, in a competent manner, the law and its consequences to the client. Attorneys are not responsible to investigate and ensure that their own clients have implemented that advice.
The Proposed Rules require an attorney not only to advise a client of evidence of a material violation of law, the rules also require an attorney to remain watchful for such evidence. Information or evidence that will lead an attorney to reasonably believe there is a material violation may come from many sources. The attorney will have to be vigilant and perceptive. When such evidence appears to the attorney, the Proposed Rules require the attorney to report the evidence of a material violation. This reporting, whether directed to the Chief Legal Officer (CLO), Chief Executive Officer (CEO), or other appropriate individuals representing the entity, is the very essence of an attorney's duty. Once an attorney has reported and thereafter received and documented an appropriate response, the attorney has fulfilled his duty to the client.
Moreover, the "safe harbor" provision will likely promote reporting as required in sections (b)(1), (b)(4) or (b)(5). Without a "safe harbor" provision, attorneys would understand that reporting evidence of a possible violation would mean taking on the additional burden of overseeing any remedial response. This burden may discourage attorneys, at least in close cases, from initiating the reporting process.
The "safe harbor" approach reflects the proper role of the attorney and also recognizes the essential autonomy of the client. Using the attorney's advice and counsel, the client must choose how it will respond to the evidence of a material violation. An attorney's role has never been a policing type role in which an attorney forced a client to follow the attorney's advice and monitored the client's response. Requiring an attorney to take on this role would transform an attorney into a quasi-SEC officer.
Therefore, a safe-harbor with broad scope is harmonious with an attorney's role and will promote reporting of material violations without expanding an attorney's role in an uneconomical and impractical fashion.
Comments to Section 205.3(b)(8) (Brian Thompson)
Section 205.3(b)(8) pertains to circumstances where an attorney does not receive an appropriate response to evidence he has reported, or does not receive any response from the issuer. Under subsection (b)(8), an attorney who does not receive an appropriate response to their report under sections (b)(1), (b)(4) or (b)(5) must explain his or her reasons for believing the response was inappropriate to the individual to whom the attorney initially reported. The attorney must also take reasonable steps to document the response and retain such documentation for a reasonable time.
It would be an extraordinary occurrence for an issuer to give an inappropriate response, or no response at all, to an attorney's report of a material violation. When it does happen, subsection (b)(8) appropriately requires the attorney to communicate the reasons for the judgment that the client's response is not appropriate. This communication will enable the client to reconsider its response. For instance, in the situation where an inappropriate response is given, it may be because the client-issuer did not truly understand all of the issues involved with the reported material violation. It may also be the case that a client-issuer understood why there is a material violation, but the issuer's proposed remedial response is inadequate. The communication demanded by Section 205.3(b)(8) allows one last chance for a satisfactory resolution of the matter.
Comments on Section 205.3(c) (Meghan Schardt)
Section 307 of the Sarbanes-Oxley Act requires attorneys to report evidence of securities law violations or breaches of fiduciary duties first to the CEO or CLO. If the matter is not remedied, §307 requires the attorney then proceed to the board of directors with his knowledge of corporate misdeeds. Reporting to a qualified legal compliance committee ("QLCC") has been proposed by the SEC in 205.3(c) as an alternative reporting procedure. Additionally, the CLO or CEO can refer any report to the QLCC. While the QLCC is a potentially viable concept, the Commission should consider making changes to its definition and operation.
The QLCC must be comprised of two or more "independent" members of the board of directors and one member of the issuer's audit committee. Rule 205.2(j). Because the Proposed Rules contemplate shifting the responsibility for compliance to the QLCC, the committee needs both independence and expertise. Thus, the Commission should consider amending Section 205.3(c) to require that one member of the QLCC be an experienced securities lawyer not associated with the outside firm and not otherwise associated with the company. This would assure that the QLCC had at least one member with the legal expertise to consider the report and with the independence to critically consider, if necessary, the positions taken by the company's lawyers.
The Commission is correct that the QLCC alternative reporting requirement better reflects congressional intent, and is more efficient than other reporting methods under Rules 205.3(b) and (d). In order to gain full value of this alternative, the Commission should consider requiring companies to create and use QLCC's. An exception might be made for smaller companies.
Ultimately, the QLCC requirement will not serve to chill continued corporate growth in the United States. Any costs associated with the implementation of QLCC's are outweighed by the regulatory value such committees bring to the issuer. Issuers and investors would be better protected from fraud if internal preventative mechanisms such as the QLCC exist.
Comments on Section 205.3(d) (Jennifer Andrade and Ana Cottone)
Section 205.3(d) of the Proposed Rules requires "noisy withdrawal" when an attorney who has reported "evidence of a material violation" does not receive an "appropriate response" and the attorney concludes that the violation is likely to result in "substantial injury" to the client or the investors. Such withdrawal includes notification to the Commission that the attorney's withdrawal from the representation of the issuer was based on "professional considerations."
Requiring notice to the Commission that the attorney has withdrawn for "professional considerations" fails to protect client confidentiality because "professional considerations" will essentially become a code word that everyone can translate. More specifically, when the attorney gives the notice, the Commission and everyone who has access to this notice will know that 1) the attorney reasonably believed a `material violation' was at issue and 2) after reporting `up the ladder' internally 3) the issue could not be resolved and 4) no `appropriate response' was offered, and 5) such `material violation' is occurring or is about to occur that will 6) result in substantial injury to the financial interests of investors.
Section 205.3(d) thus collides with ABA Model Rule 1.6, which sets forth the ethical duty of confidentiality to the client. Section 205.3(d) creates a legal fiction of "limited disclosure" that actually requires full disclosure of information that, under ABA rules, would be protected. Although the comments to ABA Model Rule 1.6 state that "noisy withdrawal" may be appropriate, the use of the noisy withdrawal option is left to the discretion of the attorney, not required by law. Also, protection of the attorney's interests, i.e., self-defense, seems to be the purpose of the noisy withdrawal option under the ABA Rules. Section 205.3(d), in contrast, requires "noisy withdrawal" in situations that would arguably be protected under the Model Rules.
In summary, the combination of the noisy withdrawal and the disaffirmation of specific work product under Section 205.3(d) results in an obvious breach of client confidentiality with irreparable damage to a corporation's ability to receive effective assistance of counsel.
Comments on Section 205.3 (e)(2) (Michael Butler)
The fiduciary relationship existing between lawyer and client and the proper functioning of the legal system require the lawyer to preserve confidences and secrets of one who has employed or sought to employ the lawyer. A client should feel free to discuss whatever the client wishes with the lawyer. A lawyer should be fully informed of all the facts of the matter the lawyer is handling in order for the client to obtain the full advantage of our legal system. The lawyer must use independent professional judgment in determining how best to serve and advance the client's interests.
This traditional view of the lawyer's ethical obligation to hold the client's confidences and secrets is what has facilitated the full development of facts essential to proper representation of the client. The duty of confidential is an integral cornerstone of the legal profession.
However, the duty of confidentiality has never allowed a client to utilize the lawyer's services to commit a criminal or fraudulent act. Today's corporate climate has seen an excess of greed and corruption distort the market, manipulate accounting practices, and deceive the public. Lawyers in some of these corporate scandals were either complicit in the fraudulent dealings or in other scandals were willfully blind to what was occurring.
Section 205.3(e)(2) of the Proposed Rules outlines three instances where the lawyer would be permitted to disclose client confidences. The rule should contain all three of these provisions for lawyer disclosure. Disclosures in these circumstances are appropriate for two reasons. First, disclosure is consistent with state laws that impose liability upon a lawyer for aiding and abetting a client's crime or fraud. Second, disclosure, or the lawyer's threat of disclosure, will help deter the fraud that in recent cases has weakened the public's faith in the integrity of the market.
Although clients expect to discuss with the lawyer all matters with the assurance that the private discourse would not be revealed, this expectation does not extend to such an extent that a client is assured that the attorney will be an accomplice or silent soldier to criminal activity. The lawyer is only permitted to disclose when there is enough evidence that the lawyer reasonably believes illegality is likely to occur, or has already occurred with the use of the lawyer's services, which is a standard that is high enough for clients to still trust their lawyer to hold most confidences.
The reasonable belief standard is not so low that the traditional fiduciary relationship existing between lawyer and client and the proper functioning of the legal system is compromised. What is compromised is the corporation's ability to shield illegal acts with their counsel's assistance. It is important to note that the entity is the client. When the lawyer discloses confidences of a perpetuated fraud by the officers of a corporation, the disclosed information to the proper regulatory body will actually be to the benefit of the corporation which is the true, actual client.
The Commission should not delay action on this section until the ABA has had an opportunity to determine its position on Model Rule 1.6 in connection with its current reconsideration of the Ethics 2000 proposal. The Commission's promulgation of these Proposed Rules on lawyer disclosure will become a resource for the ABA to consider on how it may reconstruct the lawyer's duty of confidentiality.
While the basic effect of this section of the Proposed Rules is to preempt any state ethics law that might forbid disclosure in these listed circumstances, when state law requires disclosure, then the lawyer should be required to disclose, to the Commission or to whomever the duty is owed. The basic purpose of Section 307 is to mandate lawyer action to prevent fraud. To use the Rules to weaken state law requiring lawyers to act to prevent client fraud would be inconsistent with the basic intent of Section 307.
Comments on Section 205.4 and 205.5 (Konrad Jarzyna)
Section 205.4 and 205.5 allocate responsibilities between supervisory and subordinate attorneys who practice before the Commission. Both sections appear to have one underlying purpose, which is centralizing responsibility within a law firm or a legal department of a corporation. There are two visible benefits of having these two sections implemented. First of all, it will allow the attorneys to know exactly what their role and responsibilities are under the rules. Secondly, in case of a breach or violation it will not be as difficult to determine who is liable and, moreover, other employees of a firm or department will not find themselves responsible for acts or omissions of which they were not aware. Knowing the responsible party will save time and money that would otherwise be spent on investigation, discovery etc. Needless to say, these sections will not prevent us from corporate fraud. They will, however, provide assistance in more efficient and effective enforcement of the Commission's rules and regulations.
In order to be assured that the abovementioned goals are met, the definition of supervisory and subordinate attorney needs to be constructed more narrowly. Looking at the applicability of the sections to a large firm or a large legal department with many employees and many layers of authority, one major problem arises. Simply saying, one attorney's supervisor is another attorney's subordinate. Under the current definitions it appears that a supervising attorney who finds out about a material violation will be able to report it up the ladder to his supervisor and thereby will be in full compliance with Section 205.5 and, most likely, will not be deemed in violation of Section 205.4, reasonably believing that his supervisor is responsible for the reporting requirement. This "passing the buck" strategy should not be permitted. Thus, the comments to these sections should make it clear that the immediate supervisor of a subordinate attorney is the one fully responsible for the reporting and is not subordinate to another attorney for the purposes of these sections. Moreover, for the attorneys trying to comply with Section 205.5(d), it will be much easier to determine whether the violation they discovered is being properly reported, as they will know who exactly is responsible for the reporting.
Section 205.5(d) provides that when a subordinate attorney reasonably believes that the supervisory attorney has failed to comply with the reporting requirement, the subordinate attorney may report the matter to the client and may implement the "noisy withdrawal" provided in Section 205.3(d). Although putting the initial responsibility for reporting on the supervisory attorney makes sense, allowing an attorney to stand by and take no action when the attorney possesses a reasonable belief that the securities law are being violated and the representation of the client is continuing is not appropriate. Attorneys, whether supervisory or subordinate, owe a duty of loyalty to the client. This duty compels them to act in the best interest of their client even if such action involves significant personal cost.
Thus, Section 205.5(d) should be changed to read:
(d) A subordinate attorney must take the steps permitted or required by §205.3(b), and (d) if the subordinate attorney reasonably believes that a supervisory attorney to whom he or she has reported evidence of a material violation under §205.3(b) has failed to comply with §205.3.
Although this change places a burden on the subordinate attorney, that burden is consistent with the attorney's duty of loyalty to the client.