December 18, 2002
By e-mail to: "email@example.com"
Jonathan G. Katz
Re: Sarbanes-Oxley Act § 307 - Implementation of Standards of Professional Conduct for Attorneys;
Comment to File No. 33-8150.wp
Dear Mr. Katz:
We write on behalf of the Federal Bar Council in response to the Securities and Exchange Commission's (the "Commission") solicitation of comments to the proposed rules in Release Nos. 33-8150/34-46868 (the "Proposal"), issued pursuant to Section 307 ("§ 307") of the Sarbanes-Oxley Act of 2002 ("SO Act"), on the establishment of minimum standards of professional conduct for attorneys appearing and practicing before the Commission.
The Federal Bar Council, founded in 1932, is an organization of lawyers who practice in federal courts within the Second Circuit. It is dedicated to promoting excellence in federal practice and fellowship among federal practitioners. Our organization sponsors a variety of standing committees, educational programs, workshops and internships focusing on the practice of law in the courts of the Second Circuit. A large number of former trustees of the Federal Bar Council have gone on to serve in the federal judiciary, including the Hon. Ruth Bader Ginsburg, Associate Justice of the United States Supreme Court. A significant number of our members practice in the area of federal securities laws. We write to express our concerns about portions of the Proposal.
This letter proceeds in three sections. First, we offer a summary statement of our position in respect of the rule-making required by § 307. Second, we set out a number of policy concerns raised by the Proposal. Finally, we illustrate these concerns with comments on certain specific issues raised by the Proposal.
First and foremost, we urge the SEC to limit the rules it adopts on January 26, 2003. The short time between the issuance of the Proposal on November 21, 2002, and the close of the comment period on December 18, 2002, has given the Federal Bar Council as well as the legal community at large precious little time to reflect, deliberate and propose alternatives that would achieve the goals of the legislation, while at the same time accommodate the substantial concerns we and others may identify.
As a consequence, we believe that the rule issued on January 26th should essentially track the statutory language1 and expressly provide, as the drafters of § 307 contemplated, that the rules trigger no private right of action.2 Nothing else is required by the enabling legislation.3 Any further additions or amendments can be implemented in due course, after the Commission has had ample opportunity to receive and consider the wide-ranging domestic and foreign views that this seminal Proposal is likely to trigger.4
Our Broader Concerns
We are troubled that such unobjectionable a statutory enactment as § 307 - which on its face "acts in a very simple way"5 to require what virtually all responsible practitioners would regard as their professional obligation in representing a corporate client - could have generated such complex Proposal, which may in our view have precisely the opposite effect the congressional sponsors of § 307 intended.
Leaving aside the monumental shift in the law of attorney-client privilege which the Proposal embodies, as concerns the business operations of issuers, the proposed rules may, at the very least -
The Proposal imperils, in our view, a cornerstone of the regulatory practice carefully developed in over sixty years of the Commission's effort - i.e., the extraordinary flexibility and informality with which issuers, practitioners and regulators typically exchange views and share in the design of solutions to common issues. The actual (and uncodified) operation of this interactive and cooperative system, rightfully admired the world over, is a delicate fabric that the Proposal may well tear. Cooperation will be a virtue of the past and counsel may have to put a premium on remaining uninformed.
Indeed, we are concerned that conflicts between issuers and their lawyers that will or may arise as a result of the Proposal have not been fully explored. For example, the Proposal may create an unbridgeable conflict between lawyer and client, with the lawyer forced even to keep records to defend his conduct from the inevitable challenges that would follow whenever, with the wisdom of hindsight, the Commission and any third party elected to challenge the decisions made.
There are also many special issues that arise in connection with the operation of the Proposal as against lawyers representing issuers in adversary proceedings with the Commission. The extent to which the Proposal will be used during on-going proceedings against advocates before or against the Commission is unclear. This ambiguity raises the specter of a regulatory environment in which counsel will have to rely on the restraint or discretion of the regulator not to interfere with the effectiveness of counsel's representation.
The Proposal will impose substantial additional expense on issuers by geometrically increasing the number and cost to shareholders of lawyers who will be retained. While we, as an association of lawyers, might selfishly profit from this Proposal, which might appropriately be titled a "Full Employment of Lawyers" rule, we believe that we must speak out against an imposition on shareholders of burdensome additional legal costs.
The Proposal specifically makes each level of corporate hierarchy a possible target of Commission sanctions for acts, advice and disclosure -- a serious enough threat that each would reasonably seek legal advice to ensure compliance with obligations and protection from sanctions. Because the Proposal makes the corporation's lawyers, either directly or indirectly, reporters to the Commission of possible wrongdoing by the corporation's officers and employees (including lawyers), they understandably will seek legal advice, not from the corporation's-in-house or retained attorneys but from individually-retained attorneys with whom the individual officer or employee would have a fully-protected attorney-client privilege. That individually-retained lawyer would not be within the reach of the Proposal as that lawyer would not be acting for the issuer before the Commission. But, although not representing the issuer, that lawyer's fees will undoubtedly be paid by the Corporation -- i.e., by the shareholders -- as part of the officer/employee's "package", thus substantially increasing the legal fees paid by the shareholders.
Currently, an attorney for the issuer must abide by the attorney-client privilege unless the issuer affirmatively waives it. Similarly, as the issuer can act only through officers/employees, the attorney-client privilege covers the officer/employee as well, unless the issuer, which "owns" the privilege, waives it. As a practical matter, this has been sufficient protection for the officer/employee who wishes to hear the advice of an attorney, unless the interests of the issuer was clearly adverse to the position of the officer/employee, e.g., defalcation of corporate assets. However, if the Proposal is adopted, automatically depriving the officer/employee of the protection of the attorney-client privilege without regard to the interests of the corporation, the officer/employee will be less likely to seek advice from the issuer-corporation's attorneys. The Commission recognizes this danger, in noting, in its comment to proposed § 205.3(b)(1), the likely "reduced consultations with an issuer's attorneys."
The number of additional attorneys who may be retained under the Proposal may well be substantial. Each officer/employee whom corporate counsel seeks to interview, without attorney-client protection from disclosure, will likely first seek advice from individually-retained outside counsel to obtain an evaluation and advice on what that officer would say to corporate counsel. Then, as to the up-the-ladder disclosure required by the Proposal, each recipient of the disclosure having rule-imposed obligations -- the CLO, CEO, audit committee members, QLCC members, Board of Directors members -- would likely separately seek legal advice from separate counsel to insure full protection of the attorney-client privilege. We do not believe that the Proposal, intended and publicized as protection of shareholders, does so to the extent it imposes substantial additional legal expenses on them.
The approach of the Proposal in its provisions favoring absolute prompt disclosure may well ignore the real interests of the shareholders whom the Proposal seeks to protect. Proposed § 205.3(b) would require an attorney representing an issuer to report to the issuer "evidence of 'a material violation,'" thereby triggering all the consequent up-the-ladder disclosures. The ABA's Model Rule imposes a less stringent reporting requirement, limiting it to where "a lawyer...knows" of such violation, and then further limits the action the lawyer should take to what "is reasonably necessary in the best interest of the organization." Those differences are substantial.
First, all lawyers know that "evidence" may be found that is probative of a material violation but which, after examining other relevant evidence, is found on balance not to establish that such material violation has in fact taken place. However, the Proposal appears to require disclosure even where all other evidence points to the contrary. Indeed, the comments specifically state that the reporting obligation does not involve "imposing an initial investigation upon the attorney," even where "the evidence...appear[s] unlikely to result in substantial injury to the issuer."
Second, the best interests of the issuer and its stockholders are not always furthered by unfettered disclosure. Counsel and the issuer's executives may reasonable conclude that internal corrections, rather than outside spotlight, might avoid debilitating litigation and loss of value to the company's shareholders.6 Although corporate executives and most litigators recognize litigation is not always in the client's best interests, the Proposal appears to suggest that it is. The result of the Proposal's mandatory disclosure requirements -- whether by up-the-ladder disclosures, noisy withdrawals, or reports to the Commission, but allowing for no exceptions that would give any protection without public disclosure - may well adversely affect the issuer's stock and make the issuer a target of litigation the costs of which are ultimately borne by the shareholders.
We appreciate that the Commission faces a statutorily-mandated deadline of January 26th. But there is nothing in § 307 that authorizes, let alone requires, the adoption of the far-reaching Proposals made public only a few weeks ago. Indeed, there is nothing in the legislative history of the SO Act empirically to link § 307 with any widespread misconduct by the securities bar. We respectfully submit that reticence in the rule-making objectives should be the guidepost given such absence of concrete empirical evidence that § 307 is indeed a solution to a widespread problem, not a solution in search of a problem.
Finally, as we noted above, the timing of the Proposal is unfortunate. It was issued on November 21st, barely a few days before the Thanksgiving holidays, and requires comments by December 18th, a season which would find most interested persons and practitioners elsewhere occupied. The timing problem is further compounded for the foreign bar and foreign issuers. Under these circumstances, we are confident that nowhere nearly as many commentators as would wish to have their views considered, given the gravity of the matters to be addressed, will be able to make them known to the Commission on a timely or fully thought-out basis.
We specifically urge the Commissions to refrain from taking the proposed action with respect to "noisy withdrawal," and substantially to narrow the scope of the terms: (a) "Appearing and Practicing before the Commission", (b) "In the Representation of an Issuer", and (c) the standard of knowledge to trigger "up the ladder" reporting.
Nothing in § 307 forces - or, in our view, authorizes - the Commission to address, let alone resolve, this issue by January 26th, or indeed at any time. Indeed, our review of the legislative history of the SO Act indicates that this subject was not within the intention of the legislature. At a minimum, the Commission should not act on January 26th on a matter such as "noisy withdrawal", which for practitioners before the Commission eviscerates the attorney-client privilege as it is in force in virtually all jurisdictions, preempts state ethical rules, and threatens to overturn all germane federal and state rules of evidence.8
Instead of seeking to incorporate the ethical rules which traditional state regulatory bodies have adopted (or may in the future adopt) on ethical matters and the attorney-client privilege in particular, the Proposal preempts much of this ground precisely when these very issues - i.e., the ethical restraints and obligations of a lawyer whose client is in the process of committing a financial wrong - are being energetically debated, most immediately by the ABA House of Delegates at a meeting scheduled for next February.
For example, a majority of states already allow, and some require, withdrawal in circumstances contemplated by the Proposal. But the ethical rules currently in place do not mandate disclosure of client confidences or even force counsel's hand in the context of past misconduct.9 These rules now in place reflect a careful balance about how best to encourage candid disclosures from clients to insure effective representation while not turning lawyers into instruments of fraud or crime.10 They deserve much more deference than the Proposal accords them.11
In other words, the current rules on these matters are not simply idiosyncratic norms to further clients' or lawyers' interests or the product of mere accident. They are the result of several generations of intense (and obviously ongoing) debate about the proper balance between the right to counsel, protection from future harm, and the public's "right to know." If adopted, the Proposal will likely cause clients to be less candid with counsel12, a situation well known in foreign legal environments with little tradition of counsel confidentiality. We do not believe that the public will benefit or the rule of law will be well-served by a Proposal that uproots generations of carefully-crafted ethical rules.
Appearing and Practicing Before the Commission.13
This definition should be significantly narrowed by, for example, limiting the reach to attorneys who have prepared a material portion or have had substantial involvement in the preparation of disclosure statements known by the attorney as being used for filing with the Commission or to be incorporated in such filings. Whatever the scope of the final rule, however, it is clear beyond doubt that the current formulation is too broad.
As it stands, the Proposal reaches those attorneys who advise that no filings are required, who do not serve as counsel but act in a business capacity14, and attorneys advising clients in connection with the Commission's own investigations, subpoenas, and administrative proceedings, including even those filing Wells Submissions, which are an advocate's partisan plea on behalf of a client, not a submission of public disclosure material. This latter category places the Commission in the position of being a party to a litigated proceeding while simultaneously having the capacity to investigate counsel appearing in that proceeding concerning counsel's decision whether to disclose confidential matters that may bear on the matters in dispute. This will not engender confidence in the rule of law in proceedings before the Commission.
In the Representation of an Issuer.15
This definition likewise raises significant issues of scope. It extends the reach of the Proposal from lawyers employed by the issuer to anyone acting "for the benefit" of the issuer. The examples used in the Proposals to justify this expansive reach refer to nonpublic subsidiaries of an issuer, an investment advisor and the related investment company, or the case of co-clients. None of these justifies a definition that is so broad as to cover any lawyer acting for the benefit of the issuer.
The definition is particularly troubling as it covers lawyers hired by third parties whose work may benefit the issuer but with whom the issuer has no relationship at all, let alone an attorney-client relation. A company is thus exposed to the discretion and judgment of attorneys it has not hired and who will be saddled with a reporting obligation about an entity with which they have no contact. The problem for the third party lawyer is even more acute. How precisely is a third party lawyer in a position to evaluate the response of an entity with which he has no relation? The final rules should make clear that only counsel retained by the company should be burdened with the obligation to report up-the-ladder and only within the entity that established an attorney-client relationship with that lawyer.
Standard of Knowledge To Trigger "Up the Ladder" Reporting.16
The Proposal triggers reporting obligations when a lawyer "becomes aware" of "evidence of a material violation", defined as evidence of a "material violation of the securities laws, a material breach of fiduciary duty, or similar violation" of which a "reasonable investor would want to be informed."17
This proposed standard is highly problematic. Compliance will be measured in hindsight. Knowing this, attorneys may report on the barest of evidence - even where, subjectively, the lawyer does not believe that a violation has taken place - for fear of the dire personal consequences that could follow from later being judged wrong.18 Indeed, the more imaginative the lawyer, the more "misconduct" he can infer from any given set of facts. We believe that up-the-ladder reporting would, under these criteria, become the order of the day. Accordingly, the Proposal should be clarified so that reporting is required under an objective standard that will more closely resemble current rules governing when up-the-ladder reporting is required.19
In contrast to the current rules, the Proposal mandates reporting "evidence of a material violation." But, as noted above, "evidence" suggestive of misconduct is always available, but may not support a reasonable conclusion that a violation has taken place when evaluated in the context of contrary or inconsistent proof. Yet the Proposal appears to require disclosure even if all inconsistent evidence points in the contrary direction. Indeed, this is the most likely course since the Proposal observes that the reporting obligation does not impose an obligation of investigation on the attorney. Without further investigation fully to inform one's judgment, it is almost inevitable that any indicia of wrongdoing will be regarded as triggering the reporting obligation, particularly where the Proposal contains significant other incentives for lawyers to act cautiously.
Moreover, the triggering knowledge standard in the Proposal - "became aware of evidence" - is a significant departure from the actual knowledge standard in most professional responsibility rules governing the obligation of attorneys to take action to address illegal conduct likely to result in injury. Even if it were appropriate to reduce the triggering standard from "actual" knowledge to "reasonably believes", a position which we do not endorse, there should be no lesser standard than the latter lest the reporting obligation become simply a routine exercise in lawyer self-protection.
As noted, time pressures prevent us from commenting further. But the issues raised here, as well as the concerns likely to be raised by many other commentators, could best be addressed if the Commission chose to adopt on January 26th rules more limited to the explicit statutory mandate and the objectives articulated by the proponents of § 307. We respectfully urge the Commission to do only that now and proceed in a deliberate and orderly manner by, for example, holding public hearings and allowing additional time for comment, if it believes more than that is required.
1 This is precisely the type of rule suggested by the drafters of the statute on the authority of which the Commission now acts, namely "a simple rule with two parts":
"'No. 1, [A] lawyer [engaged by the company] with evidence of a material violation has to report that evidence either to the chief legal counsel or the chief executive officer of the company.' 'No. 2: If the person to whom that lawyer reports doesn't respond appropriately by remedying the violation...the lawyer has an obligation to [report] to the [company's] audit committee or to the board'."
See Proposal n.38 (quoting statements of Senator Edwards at 148 Cong. Rec. S6552 (July 10, 2002)(emphasis added).
2 The clear intent of the Congressional drafters was that (a) only the Commission enforce § 307 and the rules adopted thereunder, and (b) § 307 and these rules create no private right of action for damages or injunctive relief. See Proposal n.81 (quoting statements by Senators Edwards and Enzi at 148 Cong. Rec. S6552 ("Nothing in this bill gives anybody the right to file a private lawsuit against anybody. The only people who can enforce this amendment are the people at the SEC.") and S6555).
3 The Commission's most successful prophylactic rule - Rule 10b-5 - certainly offers a precedent of relative simplicity and adherence to the statutory language pursuant to which it was enacted.
4 See Proposal n.4 (observing that the rule may be supplemented after the congressional deadline of January 26, 2003).
5 See Remarks by Senator Edwards, 148 Cong. Rec. S6552 (July 10, 2002).
6 The Proposal's public disclosure provisions are premised on what we believe to be the unsound premise that a lawyer for an organization represents both the organization and its constituents - i.e. the issuer and its shareholders. This is as wrong as contending, for example, that the lawyer for a trust is also the lawyer for each of the trust's beneficiaries. Model Rule 1.13 in fact expressly distinguishes between a lawyer's representation of an entity and the representation of the entity's beneficiaries or constituencies.
7 Section 205.3(d)(1) of the Proposal.
8 It is debatable whether Congress would have the authority to preempt this area traditionally committed to state regulation, or if it had such power whether Congress would have (or could have) delegated its implementation to a regulatory agency like the Commission whose central mandate lies outside of ethical, evidentiary, forensic or similar spheres. In any event, as we have noted, the SO Act has not spoken at all about "noisy withdrawal".
9 For example, Rule 1.6 of the Model Rules allows disclosure of confidences only in a case of criminal acts likely to result in death or physical harm. Under the Code of Professional Responsibility in New York, DR 4-101(C) does not permit disclosure except to prevent a future crime or an ongoing fraud (in reliance on counsel's express and false representation). In New York, even withdrawal under circumstances where a lawyer believes that fraud or crime is ongoing, requires great care not to imperil the (former) client's predicament by such withdrawal. EC 2-32.
10 We do not understand these ethical constraints to contemplate that lawyers become, in effect, mandatory "informers" against their clients, or to require counsel to keep careful records available to the state as a roadmap for prosecution. See § 205.3(b)(2). Lawyers, unlike accountants, are not the conduit through which to extract confidential information about clients for public consumption, much less for the use by the prosecuting state.
11 The Proposal's declaration that disclosure of confidential information to the Commission will not compromise the attorney-client privilege is a dubious proposition and one that needs far greater airing before lawyers are asked to act in reliance on it.
12 Indeed, it is at least arguable that the enactment of the Proposal would require counsel, in furtherance of those ethical constraints not covered by the Proposal, to advise the client not to be candid with the lawyer.
13 Section 205.2(a) of the Proposal.
14 It is unclear how a non-practicing graduate of a law school may divest himself of the appellation "lawyer" sufficiently to be outside the reach of these rules.
15 Section 205.2(f) of the Proposal.
16 Section 205(b)(1) of the Proposal.
17 Violations include "any breach of fiduciary duty recognized at common law, including but not limited to, misfeasance, nonfeasance, abdication of duty, abuse of trust, and approval of unlawful transactions."
18 This problem is compounded by the "noisy withdrawal" provisions and the related record-keeping requirements. These records may become the repository, for full public review, of even suspicions of wrongdoing or misconduct.
19 See Model Rule 1.13(b); New York DR 5-109(B)(which contains its own "up the ladder" reporting option in subsection B(3)).