U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the Meeting of the Business Law Section of the American Bar Association, Committee on Federal Regulation of Securities


Paul F. Roye

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
November 22, 2002

The Securities and Exchange Commission disclaims responsibility for any private publication or statement by any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

I. Introduction

Thank you and good afternoon. It is a pleasure to be here today. First, let me say that the Committee on Federal Regulation of Securities of the Business Law Section of the ABA has played, and continues to play, an important role in our work at the Commission. We rely on your thoughtful comments and analysis of the Commission's proposals to assist us in our efforts to develop a balanced, sensible and effective regulatory framework for application of the federal securities laws. We may not always agree, but your knowledge, practical experience and objectivity is vitally necessary if the comment process on the Commission's proposed regulations is to accomplish its intended objectives. As a result of statutory mandates and the increasing need to respond quickly to developments in the securities markets, comment periods on rule proposals out of necessity have been shortened. We appreciate your ability to respond to Commission proposals in not only a comprehensive and thoughtful way, but with speed and timeliness. We trust that you will continue to assist us in this manner and view this as an important component of your professional obligations.

I greatly appreciate the invitation to discuss with you today some of the Commission's recent initiatives, particularly those in the investment management area. However, before I begin, I must, as always, indicate that my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

II. Recent Developments

These days, if one were to read only the headlines of the newspapers, it is easy to get the impression that the Commission has been distracted from its mission. While, in fact, under Chairman Pitt's leadership, the Commission has experienced a remarkably productive year, launching the most aggressive reform agenda in the history of the Commission. The Commission has undertaken numerous initiatives in the areas of enforcement, corporate governance and disclosure, regulation of market participants and accounting reform. The Commission brought a record number of enforcements cases, 24% more than in FY 2001, including a record number of actions for financial reporting and issuer disclosure violations. The Commission has called for accelerated filings of periodic reports, timely disclosure of insider transactions and required CEO/CFO certifications of companies' quarterly and annual reports. The Commission has also launched investigations into the performance of rating agencies, the implications of hedge fund growth and held hearings on market structure issues.

To stem declining investor confidence in our markets which resulted from the spate of recent corporate scandals, the Commission has made more useful, reliable and understandable disclosures a priority, and we undertook a number of initiatives to further this goal in the investment management area. These include proposed rules regarding mutual fund and investment adviser proxy voting disclosure, proposed amendments to modernize the mutual fund advertising rules, the launch of the Investment Adviser Public Disclosure Website, whereby disciplinary and other information regarding advisers is readily accessible over the Internet, and the adoption of a new registration form for variable life insurance policies.

Chairman Pitt has also stressed the need to update and modernize our rules. To further this objective, the Commission proposed amendments to the custody rules for investment companies and investment advisers, expanded the scope of the fund merger rule, proposed amendments to allow certain affiliated transactions consistent with investor protection and proposed a rule permitting Internet investment advisers to register with the Commission. As part of its continuing efforts to further innovation within the fund industry, the Commission also issued a concept release on actively-managed exchange traded funds, approved the first exchange-traded funds based on fixed-income indices and declared effective the registration of an all-electronic variable annuity product. Next week the Commission will consider a proposed rule to exempt research and development companies from the provisions of the Investment Company Act, in response to a rulemaking petition from the biotech industry.

III. Statutory Mandates

Driving many of the Commission's recent reforms are two pieces of sweeping legislation which were enacted by a virtually unanimous Congress in response to the events of September 11, and the rash of corporate frauds and failures occurring earlier this year. These statutes, the USA PATRIOT Act of 2001 and the Sarbanes-Oxley Act of 2002, each mandate far-reaching reforms in the regulation of our financial markets. The Commission has been devoting substantial time and attention to fulfilling these mandates under tight implementing deadlines imposed by each Act.


The Patriot Act is aimed at preventing, detecting and prosecuting international money laundering and terrorist financing activity. The Act's requirements generally apply to all financial institutions, including investment companies. The Treasury Department, with the assistance of the Commission and other federal financial regulators, has adopted, and proposed for adoption, rules designed to adapt the anti-money laundering program requirements of the Bank Secrecy Act to particular financial institutions. Mutual funds have been one major focus of these rules, in part, because mutual fund assets represent such a large percentage of assets held by all financial institutions.

In April of this year, Treasury, through its Financial Crimes Enforcement Network, issued an interim final rule requiring mutual funds to develop and implement anti-money laundering programs reasonably designed to prevent funds from being used to launder money or finance terrorist activities. We also worked closely with Treasury on their rule proposal issued on September 26, 2002, that would require certain unregistered investment companies, commodity pools and REITS to develop and implement anti-money laundering programs.

The Commission also proposed in a joint rule-making with the Treasury Department to require mutual funds to adopt procedures to verify the identities of their customers and to keep records related to their customer verification programs, along with a parallel proposal that would cover broker-dealers, to curb money laundering activity. Earlier this week, the Commission approved a joint report to Congress with the Treasury and the Federal Reserve Board recommending effective regulations to apply the anti-money laundering requirements of the Bank Secrecy Act to various types of investment companies.

We expect that more rulemaking implementing the Patriot Act will be forthcoming in the weeks ahead.

B. The Sarbanes-Oxley Act

The Sarbanes-Oxley Act was enacted in the aftermath of Enron, WorldCom and other corporate scandals to increase investor confidence in our securities markets through increased financial disclosure and corporate governance reforms. Among other things, the Act creates a new oversight board for the accounting profession, mandates new measures intended to promote auditor independence, adds new disclosure requirements for public companies, and strengthens the criminal penalties for securities fraud.

In August, the Commission adopted rules to implement new certification requirements in the Act that enhance the direct responsibility of senior corporate management for financial reporting and for the quality of financial disclosures by public companies.

Other rules proposed under Sarbanes-Oxley would require issuers, including registered management investment companies, to disclose whether the companies (and in the case of investment companies their advisers and principal underwriters) have adopted codes of ethics for their senior and executive officers (but does not require companies to adopt ethics codes) and whether the company's audit committee includes a "financial expert" and certain other information about the financial experts. The proposal defines financial expert to include individuals with certain attributes specified in Sarbanes-Oxley and includes a number of factors the board must consider when determining whether an individual has all of the required attributes. The Commission specifically asked for comment on whether this definition should be modified in any way in the case of investment companies.

Another proposed rule under Sarbanes-Oxley would prohibit officers and directors of an issuer, and anyone acting under their direction, from taking action to fraudulently influence the auditor of an issuer's financial statements.

Earlier this week, the Commission approved rule proposals that would require auditors to maintain work papers and certain other documents relevant to their audits and review of financial statements, require certain disclosures and reporting by auditors, and establish conditions under which auditing firms would not be considered independent for purposes of performing audits of public company financial statements.

To enhance the independence of accountants that audit and review financial statements, the Commission proposed rules to:

  • Revise its regulations related to the non-audit services that, if provided to an audit client, would impair an accounting firm's independence (based on the nine prohibited services listed in Sarbanes-Oxley);
  • Require that an issuer's audit committee pre-approve all audit and non-audit services provided to the issuer by the auditor of an issuer's financial statements;
  • Prohibit partners on the audit engagement team from providing audit services to the issuer for more than five consecutive years and from returning to audit services with the same issuer within five years;
  • Prohibit an accounting firm from auditing an audit client's financial statements if certain members of management of that client had been members of the accounting firm's audit engagement team within the one-year period preceding the commencement of audit procedures;
  • Require that the auditor of an issuer's financial statements report certain matters to the issuer's audit committee, including "critical" accounting policies used by the issuer; and
  • Require disclosure to investors of information related to the audit and non-audit services provided by, and fees paid by the issuer to, the auditor of the issuer's financial statements.

In addition, under the proposed rules, an accountant would not be independent from an audit client, if any partner, principal or shareholder of the accounting firm who is a member of the engagement team, received compensation based directly on any service provided or sold to that client, other than audit, review and attest services.

In each of the Sarbanes-Oxley rule proposals, the Commission endeavored to apply the statutory requirements in a manner that carries forth the intent of Congress in enacting these provisions, which were generally drafted in the context of public operating companies and are not tailored to the particular characteristics of investment companies. The Commission faced similar challenges in working with Treasury in applying the mandates in the Patriot Act in the investment management area. For this reason, we value your comments concerning the impact of the Commission's proposals on your clients, and we urge you and your clients to submit them.

C. The Attorney Conduct Rule

As you are no doubt aware, on November 6th, the Commission approved rule proposals under Sarbanes-Oxley that set forth minimum standards of conduct for attorneys appearing and practicing before the Commission in their representation of issuers. The proposed rule was posted on the Commission's website yesterday — fulfilling a promise to Stan Keller that they would be out in time for this Section meeting. I expect that this proposal will be of widespread interest, particularly within the legal community, and I will use the remainder of my time to discuss this important initiative.

In the proposing release, the Commission noted that attorneys play a varied and crucial role in the Commission's processes. The materials that attorneys prepare that are filed with the Commission on behalf of issuers are relied upon by the public in making investment decisions and therefore "the Commission and the investing public must be able to rely on the integrity of in-house and retained lawyers who represent issuers." The Commission also noted that attorneys play an important role in the internal operations and governance of issuers. This concept was recognized several years ago by the Commission in the investment management area, as the Commission embarked upon an effort to enhance the independence and effectiveness of independent directors of investment companies, so that they could fulfill their most important role - the protection of the investors. One component of this effort was a requirement that if the independent directors of an investment company retained their own counsel, that such counsel be independent of affiliated external service providers to the fund. The Commission's goal was to promote the concept that independent directors should receive unbiased, independent legal advice in protecting the interest of fund shareholders; from negotiating advisory contracts and overseeing fund fees, to policing conflicts of interest between the fund and affiliated parties. Even though the final rule proposal left to the discretion of the independent directors the determination as to whether their counsel was independent, a small number of you accused the Commission of regulating the legal profession. Well, I guess I should simply say that our modest effort to advance the notion of independent legal counsel in the investment company area, was so successful, that Congress thought the strengthening of the role of independent directors and independent counsel should be more broadly applied, hence the requirements and authority given the Commission set forth by the Sarbanes-Oxley Act. So you can thank the investment company lawyers among you for blazing this trail.

But seriously, the actions of some attorneys in the recent corporate debacles have brought increased scrutiny on the legal profession. Indeed, the preliminary report of the ABA's Task Force on Corporate Accountability (the "Cheek Report") this past July concluded that "the system of corporate governance at many public companies has failed dramatically." This very helpful and thoughtful report also acknowledged that attorneys representing and advising corporate clients "bear some share of the blame for this failure." Apparently concluding that these issues were sufficiently serious that they should not be left to the legal profession alone to resolve, Congress enacted Section 307 of the Sarbanes-Oxley Act.

Section 307 of Sarbanes-Oxley requires the Commission to prescribe minimum standards of professional conduct for attorneys appearing and practicing before the Commission and provides that these standards of conduct must include a rule requiring an attorney to report "evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by the company or any agent thereof" to the chief legal counsel or the chief executive officer of the company (or the equivalent); and, if they do not respond appropriately to the evidence, then the attorney must report the evidence to the audit committee, another committee of independent directors, or the full board of directors. The proposed rules respond to Congress' mandate that the Commission adopt an "up the ladder" reporting system, recognizing that attorneys interact with the Commission on behalf of issuer clients in a number of ways, and that such a mechanism protects investors by reaching attorney conduct that may threaten the Commission's processes and harm investors.

Since many of you have undoubtedly not had a chance to read the proposal, I thought it would be useful if I briefly reviewed some of its key provisions.

1. At the core of the rule is the concept that an attorney representing an issuer, represents the issuer as an entity, rather than the officers or executives who may have hired the attorney, or with whom the attorney may interact in the course of his or her representation. Accordingly, the attorney is obligated to act in the best interests of the issuer and its shareholders. Just as the independent counsel provision in the fund governance rules caused fund lawyers to focus on and discuss with fund directors just who it is that they are representing, the proposed lawyer conduct rules would bring into clear focus just who the client is in the public company context.

2. The rule would require an attorney who represents an issuer before the Commission to report evidence of a "material violation" when he becomes aware of information that would lead a reasonable attorney to believe that such a violation has occurred, is occurring or is about to occur. In this way, the reporting duty would arise only when it is appropriate for the protection of investors. The attorney would be initially directed to make this report to the issuer's chief legal officer and chief executive officer, and also would be obligated to take reasonable steps to document the report, and the response to it. This requirement is intended to protect the attorney if his or her compliance with the proposed rule is put at issue in the future.

3. When presented with a report of a possible material violation, the chief legal officer must determine whether to conduct an inquiry to determine whether a violation has actually occurred. If the officer concludes that there has been no material violation, the officer must then notify the reporting attorney of this conclusion, and take reasonable steps to preserve documentary evidence. If the officer concludes that a material violation has occurred, the officer must take reasonable steps to ensure that the issuer adopts appropriate remedial measures and/or sanctions - including appropriate disclosures, report "up the ladder" within the issuer the remedial measures that have been adopted, and advise the reporting attorney of his or her conclusions.

4. The provisions of the rule would be satisfied if a reporting attorney receives an appropriate response within a reasonable time and has documented the report and response. If an attorney does not receive an appropriate response within a reasonable time, the attorney would be required to report the evidence of a material violation to the issuer's audit committee, another committee of independent directors, or to the full board. If a reasonable attorney would conclude that it would be futile to report the evidence to the chief legal officer and chief executive officer, the attorney may report directly to the issuer's audit committee, another committee of independent directors, or to the full board. If a reporting attorney reports a matter all the way "up the ladder" and a reasonable attorney would conclude that the issuer has not responded appropriately, the attorney must then document the response.

In this case, the rule would require or would permit a so called "noisy withdrawal," that is, notification of withdrawal for professional considerations communicated to the Commission. The provision distinguishes between outside attorneys retained by the issuer and attorneys employed by the issuer because attorneys employed by an issuer face greater potential obstacles to compliance, and because the personal cost of compliance to an attorney employed by the issuer is greater. The provision would require attorneys to disaffirm a document or filing with the Commission if they believe there has been, or will be a violation. When an attorney files a notification with the Commission as part of a "noisy withdrawal," the proposed rule provides that no violation of the attorney/client privilege occurs.

5. The proposal also sets forth the specific circumstances under which an attorney is authorized to disclose confidential information related to his or her practice before the Commission when representing an issuer. Under this provision, an attorney would be allowed to use the contemporaneous records he or she creates to defend against charges of attorney misconduct. This right is similar to the "self-defense" exception contained in the ABA Model Rules and state ethical rules. The rule also would allow an attorney to reveal confidential information to the Commission to the extent necessary to prevent an illegal act resulting in the perpetration of fraud upon the Commission or in substantial injury to the issuer's financial or property interests. Similarly, the attorney would be allowed to disclose confidential information to rectify an issuer's illegal actions when the actions have been advanced by the issuer's use of the attorney's services. The rule also specifies that an issuer does not waive any privileges by sharing confidential information regarding misconduct by the issuer's employees or officers with the SEC pursuant to a confidentiality agreement.

6. The rule proposal also details the responsibilities of supervisory and subordinate attorneys, both those serving as in-house counsel and those serving as outside counsel retained by the issuer.

7. The rule also describes how the Commission may prosecute violations of the rule. Pursuant to a provision in Sarbanes-Oxley, a violation of the rule would constitute a violation of the Securities Exchange Act of 1934. Thus, a violator would be subject to all the remedies and sanctions available under the Exchange Act, including injunctions, cease and desist orders, and officer and director bars.

We expect these rules to generate extensive comment. We understand the ABA has already formed a task force specifically for the purpose of relaying its concerns regarding the proposal to the Commission during the comment period. However, the rule proposal may address some of your initial fears. For example, the proposed rule does not attempt to articulate a comprehensive set of standards regulating all aspects of the conduct of attorneys who appear and practice before the Commission. The Commission indicated in the release that it does not intend to supplant state ethics laws unnecessarily, particularly in areas where the Commission lacks expertise.

In addition to the concerns of the securities bar in general, we will be particularly interested in your views on how the proposal will apply to lawyers representing clients in the investment management area.

The proposed rule includes a broad definition of what constitutes "in the representation of an issuer". The Commission explained that a broad definition is essential to protect investors, and is defined to cover any attorney providing legal services at the request of, or for the benefit of, an issuer. In the investment management area, the Commission states that an attorney employed by a privately-held investment adviser who prepares, or assists in preparing, materials that the attorney believes will be filed with the Commission on behalf of a registered investment company is appearing and practicing before the Commission. Under the proposal, the attorney, although employed by a privately-held investment adviser, is representing the investment company before the Commission. If the attorney were to discover evidence of a material violation by an officer of the investment adviser that may materially injure the investment company, the attorney is obliged under the proposal to report that evidence to the chief legal officer of the investment company. Because the investment adviser is an agent of the investment company and owes the investment company a fiduciary duty under common law and the Investment Company Act, the proposed rule would require the attorney to report evidence of a material violation by any agent of an issuer to the issuer's chief legal officer or chief executive officer.

In the proposal, the Commission points out that this reporting obligation does not violate the attorney-client privilege. Rather, the attorney is reporting evidence of a material violation to its client -- the investment company. The Commission considers the attorney employed by the investment adviser and representing the investment company before the Commission to have joint clients, between which there is no expectation of confidentiality. The Commission's approach reflects the view that frankness and candor between co-clients regarding matters of common interest normally precludes any expectations of confidentiality regarding communication with their attorney.

As I have outlined, the proposed rules not only impose a rigorous "up-the-ladder" reporting requirement, but the rule proposal incorporates several corollary concepts which the Commission viewed as essential to implementation of an effective "up-the-ladder" reporting system. These provisions embody ethical principles which the ABA has been considering for years and is similar to ethical rules which have already been enacted in a number of jurisdictions. The Commission has attempted to strike the appropriate balance between deterring instances of attorney and issuer misconduct and not chilling zealous advocacy by attorneys in the representation of their clients and discouraging issuers from seeking and obtaining effective and creative legal advice.

We will look to you to provide guidance on how these rules may be adapted to the special concerns of counsel to investment companies and advisers, and other circumstances. In this regard, you should note that, to comply with Congress' mandate in Sarbanes-Oxley that the Commission finalize the rule by January 26, 2003, the comment period is truncated - only 30 days.

As you consider weighing in with your comments on these proposals, I would again note that the issues raised in this rule proposal have been debated for years in the bar. The Commission itself adopted Rule 102(e) under its Rules of Practice to protect its processes and ensure the competence of professionals who appear and practice before it. And its authority to promulgate such a rule has been controversial and periodically challenged. However, Sarbanes-Oxley gives the Commission express statutory authority to promulgate rules establishing ethical standards for attorneys representing issuers and expects the Commission to carry forth its mandate. Congress and the American public have demanded action on this issue. However, government mandated rules cannot address the problem alone. The problem must be solved by professionals who are faithful to their professional obligations. So, let us all work together to promote a culture in the legal profession that encourages the highest ethical standards.

IV. Conclusion

Again, we look forward to learning your views on the attorney conduct rules, as well as on other pending rule proposals. With such far-reaching reform in the regulation of our financial markets under consideration, it is truly a momentous period at the Commission, with potentially significant implications for our securities markets, market participants and investors. We readily acknowledge that we have no monopoly on wisdom and we welcome your input.

Again, I appreciate the opportunity to discuss some of the Commission's initiatives with you today and I thank you very much for listening.



Modified: 11/27/2002