Charles Schwab & Co., Inc.
December 20, 2002
Jonathan G. Katz
Re: Standards of Professional Conduct for Attorneys, File No. S7-45-02
Dear Mr. Katz:
I submit this comment letter in response to the Commission's Proposing Release to implement Section 307 of the Sarbanes-Oxley Act. I am General Counsel of Charles Schwab & Co., Inc., the primary operating subsidiary of The Charles Schwab Corporation, which is a publicly traded company subject to Section 307. My comments focus primarily on the obligations of in-house counsel under the proposed rules.
In general, the efforts of Congress, the Commission and the SROs to raise the standards of corporate governance for publicly-traded companies in the United States are to be applauded. Congress' determination is correct that both in-house and outside counsel have important roles to play in improving corporate governance. It is helpful to clarify that lawyers for a corporation owe their duties to the corporation, rather than to any single individual at that corporation. In principle, the proposition that significant potential violations of law should be escalated appropriately within a corporation is unarguably correct. However, I have several concerns about the implementation of Section 307 in the Commission's proposed rules.
1. Ability of the CLO to Remedy Violations. The proposed rules require that both in-house and outside counsel report evidence of material violations to an issuer's Chief Legal Officer (CLO). If the CLO determines that a material violation has occurred, then the rules require the CLO to "ensure that the issuer adopts appropriate remedial measures" such as disclosure, sanctions or imposition of new procedures, and then shall "promptly report" those measures to the CEO. The difficulty with this proposal is that in almost no public company of which I am aware does the CLO have the authority, on his or her own, to take these steps. A CLO may investigate, inform and advise, but a CLO typically does not have authority to sanction employees outside of his or her chain of command, to require the business units to adopt new procedures, or even to make disclosure on behalf of the company without the concurrence of other executives. The Commission's rule should reflect this reality, and it should reflect the possibility that the CLO's advice may, in whole or in part, be rejected by the relevant business people.1
2. Ability to Judge Materiality. The proposal, as currently formulated, requires outside counsel to make judgments about what items are material to a public company. The Commission should recognize that these are among the most difficult legal judgments to make even for inside counsel who are intimately familiar with a company's business. For outside counsel, who may be handling only a single litigation or regulatory matter for the company, the judgment is almost impossible. Outside counsel will often be unfamiliar with a company's internal procedures, its anticipated business strategies, its other pending litigation, its reserves and its insurance coverages. Given the Commission's facts-and-circumstances guidance about "qualitative" materiality, in few large cases will outside counsel be able to conclude that a matter is certainly immaterial and therefore need not be reported to the CLO. The proposed rules create strong incentives for outside counsel to report a matter to the CLO, and no disincentives. The result will necessarily be extensive over-reporting: outside counsel in an abundance of caution will report all sorts of matters which the CLO will determine not to be material. The Commission should explicitly recognize that outside counsel (and subordinate in-house counsel) are in a comparatively poor position to second-guess a CLO's judgments about materiality. 2 Except in the rare case that outside counsel is able to conclude, based on the facts available to them, that the CLO's judgment about materiality is clearly erroneous, the Commission should recognize that it is appropriate for outside counsel (and subordinate in-house counsel) to defer to the CLO's judgment about lack of materiality.
For similar reasons, the Commission should not penalize outside or in-house counsel who make good faith judgments about materiality that the Commission or its staff subsequently determine with the benefit of hindsight to be erroneous. As the Commission stated in the context of Regulation FD, "issuers [should] not be second-guessed on close materiality judgments. Neither will we, nor could we, bring enforcement actions . . . for mistaken materiality determinations that were not reckless." Securities Act Rel. No. 7881 (Aug. 15, 2000).3 The Commission cannot logically hold individual lawyers to a higher standard in judging materiality than that to which it holds entire corporations.
3. "Up-the-Ladder" Reporting. The Commission's release repeatedly describes the proposal as "up-the-ladder" reporting. In fact, "the top of the ladder" might be a more appropriate description. As drafted, the proposal effectively requires every outside law firm, and every in-house counsel, to report matters directly to the CLO. Such an approach may potentially be appropriate for small public companies with small in-house legal staffs and limited litigation dockets. However, for sophisticated companies with large in-house legal staffs and many outside counsel, the rule as drafted is likely to be unadministrable. Because of the incentives to over-report discussed above, CLOs at sophisticated companies are likely to receive many reports of matters that they subsequently determine to be immaterial. Rather than requiring all reports to go directly to the CLO in the first instance, the Commission should allow large corporations to establish true "up-the-ladder" reporting systems, in which subordinate lawyers report matters to intermediate supervisory lawyers. Similarly, the Commission should allow corporations to instruct outside counsel to report to the counsel who retained them or to a chief litigation counsel, with subsequent escalation within the company's legal staff as appropriate. Such a winnowing-out process will allow CLOs to focus their energy and attention on the truly significant matters.
4. Who Is an Attorney? The release proposes that anyone within a public company who has a law degree (or who holds themselves out as a legal expert, even without a law degree) is subject to the rule - no matter whether they are serving as a lawyer for the company or not. I believe this position is much too broad. Schwab, like many companies, frequently hires employees with legal background to serve in non-legal positions. These non-legal positions include oversight functions such as Compliance, as well as business functions, such as trust administrators. Lawyers often have skills and background which are valuable even in these non-legal positions. If, solely by virtue of having a legal background, a person has additional regulatory duties and liabilities, there will be a great disincentive for companies to hire such persons in these non-legal positions. Moreover, there will be a similarly substantial disincentive for individuals with law degrees to accept such non-legal positions at public companies. The SEC should not want to restrict the talent pool from which public companies draw employees. Particularly in the case of Compliance, imposing these rules on lawyers serving in non-legal positions will have the perverse effect of decreasing the effectiveness of the function by diminishing the number of qualified people willing to serve. The Commission should limit these rules to lawyers who in fact are serving as such.
5. Cost-Benefit Information. The Commission's estimate of the cost of the proposed rules is, to put it mildly, a substantial underestimate. The Commission, in its Paperwork Reduction, Cost-Benefit and Regulatory Flexibility discussions, guesses that ten times a year that a company will have to "report out" potential violations. However, the Commission does not estimate the cost of reporting "up-the-ladder" and documenting responses to the vastly larger number of matters that ultimately turn out not to be material violations. The Commission's rule imposes substantial investigation and documentation requirements not only for matters that turn out to be material violations, but also for matters that are not material violations. I believe there will be hundreds of immaterial matters for each material one, and that the cost of investigating and documenting will be closer to 100 lawyer hours each, rather than ten hours each. In other words, the Commission is underestimating the cost of these rules by a factor of over 1,000. Whatever the benefits of the proposed rules, the Commission has an obligation to estimate and assess more accurately the true economic impact of its rule proposals.
6. I join the many comment letters from bar associations, law firms and others urging the Commission to defer action on the "noisy withdrawal" and "reporting out" portions of the proposed rules at this time. The Commission should adopt the statutorily-mandated "up-the-ladder" provisions and solicit further input, with more opportunity for comment, about the more contentious non-mandated portions of the proposed rules.4 Such a course will result in better-informed and more effective rules governing these important topics.
I appreciate the opportunity to provide input on this important proposal and would be happy to discuss these comments with you further.
cc: Chairman Pitt