TROUTMAN SANDERS LLP
ATTORNEYS AT LAW
A LIMITED LIABILITY PARTNERSHIP
600 PEACHTREE STREET, N.E. - SUITE 5200
ATLANTA, GEORGIA 30308-2216
April 7, 2003
VIA ELECTRONIC MAIL
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. S7-45-02
Dear Mr. Katz:
As outside counsel to many publicly-traded companies, we are submitting comments concerning the Securities and Exchange Commission's proposal to adopt new rules under Parts 205, 240 and 249 of 17 C.F.R., as set forth in Commission Release Nos. 33-8186/34-47282/IC-25920, Implementation of Standards of Professional Conduct for Attorneys (the "Proposing Release").1
The Commission's proposed alternative to "noisy withdrawal" suffers from the same infirmity as the original proposal, as it presents a conflict that frustrates the Commission's purposes by pitting a series of attorney judgments about which management and its counsel may honestly disagree against the risk to investors and the markets that the attorney's judgment is ultimately found to be wrong. The cause of the conflict is the erroneous presumption that the attorney can predict with certainty the correct resolution to many qualitative issues. The effect of both Commission proposals would be that issuers will hesitate to discuss legal questions with their counsel for fear that the attorney's judgments will result either (a) in the issuer's having to take unnecessary actions and expense to prevent any form of "reporting out" or (b) in the issuer's having to shoulder the effects on its stock price of a Form 8-K or other Commission filing that would generate an inference that the issuer has been violating securities laws or breaching fiduciary duties to its investors. The proposed rules would reduce the kind of attorney discussions with management about possible or existing material violations that the Commission intends to foster while adding no assurance that the most serious violations will see the light of day.
We suggest that the Commission eliminate all mandatory external reporting of disagreements between issuer's counsel and the issuer. We also suggest that the proposed "noisy withdrawal" and alternative concepts be replaced by a permissive and confidential consultation with Commission staff when the issuer desires regulatory guidance concerning such disagreements.
The Purpose of the "Noisy Withdrawal" Rule
In the Proposing Release, the Commission stated that the proposals regarding noisy withdrawal and its alternative "are intended to further the purposes of the up-the-ladder requirement and enhance investor confidence in the financial reporting process."2 The new proposal is no more likely to achieve those goals than the initial proposal.
The Original Proposal Presented a Series of Choices that Frustrate the Goals of the Rule
As now adopted in Part 205, an attorney begins up-the-ladder reporting within the issuer when the attorney becomes aware of evidence of a material violation, which is defined as "credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur."3 The adopted rule includes a half dozen qualitative variables leading to the attorney's obligation to report: "credible evidence," "unreasonable, under the circumstances," "prudent and competent attorney," "material violation," "reasonably likely . . . to occur."4 If an attorney should reach a judgment that all of these variables are satisfied, he must then report his judgment to the CLO.5 Under the originally proposed noisy withdrawal rule, the attorney is then faced with a second series of qualitative judgments: whether he has received an "appropriate response" to his report or a response in a "reasonable time" and whether he "reasonably believes" that the material violation is ongoing or is about to occur or is "likely to result in substantial injury to the financial interest or property of the issuer or its investors."6
Under the noisy withdrawal proposal, if the attorney has reached all of the foregoing qualitative judgments, including the ultimate judgment that he has not received an "appropriate response" from management or the board of directors, he must then take steps to disclose his views to the Commission and the public. In doing so, he must terminate the client relationship and include yet another qualitative judgment: After withdrawing from representing the issuer, he must state that he is doing so for "professional considerations," and he must give written notice to the Commission within one day of his withdrawal and promptly disaffirm any opinion, document or representation to the Commission if he "reasonably believes [it] is or may be materially false or misleading."7
If a reporting attorney's judgments are not immediately and unequivocally deemed by regulators and investors to be correct, by making a noisy withdrawal, he has gravely and publicly attacked the issuer's management and directors on a matter of his sole judgment. If he is not right, trading investors would be hurt by having received an erroneous suggestion about the issuer. The issuer also would needlessly lose its attorney's or its outside law firm's services, possibly at a time when continued counsel would be beneficial.8 Faced with these possibilities, management would hesitate to provide attorneys the information that is necessary to enable an attorney to conclude that there is evidence of a material violation or to seek counsel on close questions. Also recognizing the conflict, skillful securities counsel -- the lawyers the Commission would want to encourage to give full candor in their advice to issuers -- in most cases could readily develop arguments that would negate one or more of the judgmental components leading to a noisy withdrawal. Such arguments would be developed at the threshold, in which event the issuer's management would never receive the attorney's advice that it should look into a possibly problematic situation. Because these arguments would not be resolved until years later, the timely need for the attention to a potential problem would be totally lost. As a consequence, the needed dialogue between attorney and client would be shortened on both sides.
In not including noisy withdrawal among the provisions adopted in January, the Commission acknowledged in a remarkable understatement that noisy withdrawal carried implications for the relationship between issuers and their counsel.9 Those implications are both severe and, we submit, necessarily contrary to the Commission's intent to improve corporate governance and public disclosure. The Commission's proposal is so focused on ensuring public disclosure of possible securities violations by the issuers that refuse to listen to counsel10 as to jeopardize the means by which issuers that want to prevent or correct violations can attempt to do so, which is by having frank discussions with and receiving guidance from securities counsel.
The New Proposal Suffers From the Same Infirmity
The proposed alternative to noisy withdrawal suffers from the same infirmity as the original proposal. As with the original proposal, the attorney's withdrawal would be preceded by the same collection of qualitative variables, and some new ones: "reasonably concludes," "substantial evidence of a material violation" and "likely to cause substantial injury."11 The attorney, as in the original proposal, would have to inform the issuer that he was withdrawing for "professional considerations."12 Instead of a requirement that the attorney communicate directly with the Commission, the new proposal requires the issuer to give notice of the attorney's withdrawal for professional considerations to the Commission and the public in two days.13 While this makes disclosure of the withdrawal more circuitous, the natural consequence is the same: At the threshold, (1) the issuer would avoid sharing with the attorney information that might raise questions management considers immaterial, or (2) upon receiving such information, the attorney either would make all the qualitative judgments to find a material violation in order to protect his privilege to practice before the Commission or would develop reasonable arguments for concluding that all the qualitative variables are not satisfied. In any event, the risk of public misunderstanding of the attorney's judgment and the risk to the attorney's professional career would overwhelm the focused early exchange on material issues that the Commission intends to foster.
Nor is there improvement in the new proposal that would allow the attorney to report to the Commission if the issuer does not. There are two possible situations: The attorney chooses to say nothing or the attorney reports that the issuer has failed to report his withdrawal for professional considerations.
If the issuer does not give notice of the attorney's withdrawal for professional considerations, the attorney is safe, since the issuer's clear violation of proposed section 205.3(d) would be strong evidence that the attorney's judgment about a material violation was correct. In that event, the attorney could decide to say nothing, as he would not be required to report to the Commission the issuer's violation in not disclosing his withdrawal.14 The ultimate consequence would be that an evidently clear material violation would go entirely undisclosed.
More likely, the issuer would disclose the attorney's withdrawal for professional considerations and then set forth a detailed explanation why he was wrong. In that event, if the issuer were ultimately found to be correct, those who depend on its share price would have been unnecessarily injured, and the issuer would have suffered the burden of immediate attack by many who would take advantage of the mere public pendency of an issue adverse to its management.
For so severe a consequence to investors and the markets, public disclosure of attorney withdrawal due to the attorney's judgment that the issuer is not appropriately responding to a material violation should be grounded in established and certain standards or be permissive so to match the judgment of disclosure with the qualitative judgments concerning the materiality of a violation and the appropriateness of management's response.
There Is an Alternative
The reporting out concept proceeds on a presumption that a mandatory public disclosure rule is necessary to assure protection of the interests of the issuer and its investors. As we have shown, that presumption is invalid. The concept would function effectively to generate the disclosure it requires only where there is indisputable certainty of a material violation harmful to those interests (which certainty is virtually impossible due to the judgments that have to be made along the ladder) and assuming issuers allow counsel access to enough information to even conclude there is evidence of a material violation. At the same time it would introduce an unnecessary tension and reduction of candor into the relationship between the issuer and its outside counsel. And that assumes that the attorney and issuer's management are acting in good faith. For those with other intentions, they would not pause to violate the reporting out provisions as they engage in serious violations of substantive securities laws.
We submit that, given the adopted provisions for up-the-ladder reporting, and the Sarbanes-Oxley provisions and Commission rules increasing the authority, responsibility and duties of the management and directors of public companies, there is more than ample incentive for their lawyers and them to address potential problems with focused care for the financial interests of the company and its shareholders. To serve the Commission's desire to integrate its statutory implementation and regulatory policy into such considerations, and to provide the option for an important third judgment, we suggest that the noisy withdrawal and alternative proposals be replaced by an option for the issuer to consult with the staff of the Commission in confidence about any disagreements that arise following an up-the-ladder report. The issuer would know that, if the staff regards the matter as sufficiently serious, it will urge remedial action, which the issuer would ignore at its peril. If the Commission considers the issuer's position appropriate, the issuer's management will have the additional protection of the regulator's agreement. If the attorney believes that state ethics or other professional rules would require his withdrawal, then he would be free to do so without fear that his choice creates unnecessary adverse consequences to investors.
We appreciate the opportunity to comment on the proposals. If you have any questions regarding our comments, please contact either Jim Smith (404-885-3111), Stuart Pierson (202-274-2897) or Cheryl Grant (404-885-3431).
TROUTMAN SANDERS LLP
cc: Hon. William H. Donaldson
Hon. Paul S. Atkins
Hon. Roel C. Campos
Hon. Cynthia A. Glassman
Hon. Harvey J. Goldschmid
Giovanni P. Prezioso
Alan L. Beller
Director, Division of Corporation Finance
|1|| 68 Fed. Reg. 6324 (Feb. 6, 2003).
|2|| Proposing Release at 6326.
|3|| 17 C.F.R. §§ 205.3(b), 205.2(e).
|4|| See 17 C.F.R. § 205.2(e), (i), (l). The extent of variation in the attorney's duty to report is increased since the term "reasonably likely" is unclear and not defined in the adopted rules.
|5|| 17 C.F.R. § 205.3(b).
|6|| See Proposing Release at 6326.
|8|| It is still unclear whether the Commission intends withdrawal to apply to only the matter connected to the material violation, all of the individual reporting attorney's matters with the issuer, or, in the case of a law firm, the entire law firm's matters with the issuer, ranging from litigation to intellectual property and so on.
|9|| See Commission Press Release 2003-13. In explaining the noisy withdrawal from its initial proposal, the Commission also acknowledged that it went beyond the statutory dictates of the Sarbanes-Oxley Act. See Proposing Release at 6324. There is, therefore, no statutory mandate for any noisy withdrawal provision.
|10|| The Commission's comments in the Proposing Release suggest that it believes there will be a limited number of issuers that refuse to listen to counsel. See Proposing Release at 6326 ("As explained in the [initial] Proposing Release, proposed § 205.3(d) addresses what we hope is the rare situation in which an attorney reasonably believes an issuer has either made no response . . or has not made an appropriate response. . . ."); Commission Release No. 33-8150, 67 Fed. Reg. 71670, 71689 (Dec. 2, 2002) ("Although such extreme situations should be rare . . . ."). We believe that most issuers do not ignore their attorneys' alerts regarding material securities law violations.
|11|| See Proposing Release at 6328.
|12|| Proposing Release at 6328.
|13|| Proposing Release at 6329.
|14|| See Proposing Release at 6330.