PART 205


File No. S7-45-02


Task Force

Kenneth B. Winer, Co-Chair
Gregory S. Bruch, Co-Chair
Bruce A. Baird
David M. Becker
James E. Day
Gary L. Goldsholle
Abbey G. Hairston
Paul Huey-Burns
Howard Kramer
David B.H. Martin
Phillip Parker
Richard H. Rowe
Paul Schott Stevens

These comments are submitted on behalf of the Corporation, Finance and Securities Law Section of the District of Columbia Bar (the "Section") and were prepared by a task force formed by the Section's Committee on Corporate Governance and Accounting, and Committee on Broker-Dealer Regulation and SEC Enforcement.1 The views expressed herein represent only those of the Section and not those of the D.C. Bar or its Board of Governors. The Section has many attorneys who routinely counsel issuers, and we respect and support the Commission's ongoing efforts to promote the integrity of the capital markets.

We have studied the final rule released January 29, 2003 and applaud the efforts of the Commission and the Staff to develop a workable and effective approach to the challenges posed by Section 307 and the need to improve investor confidence in the securities markets. The Commission and the Staff clearly gave careful thought, within remarkably tight time constraints, to our comments and the numerous other comments submitted to the Commission.

The primary purpose of this submission is to comment on the alternative proposal to noisy withdrawal. We also suggest some minor modifications to the rule released on January 29, 2003. We appreciate the opportunity to submit our views on these matters.

A. Comments on Noisy Withdrawal

We divide our comments regarding the alternative to the noisy withdrawal provision into two parts. First, we express our general opposition to the alternative. Second, we identify comments regarding the proposed alternative.

1. General Comments

We recommend that the Commission not modify Part 205 to require that the Commission be notified of certain attorney reports made pursuant to Part 205. We believe such an amendment to be unnecessary because we agree with the view, implicit in Section 307, that the appropriate goal is to ensure that senior management and, if necessary, the independent directors are apprised of "evidence of a material violation." Investors rely on management to manage issuers and the Board of Directors to oversee that management. Indeed, we believe such an amendment to be counterproductive because a requirement that the Commission be notified of such reports will undermine the relationship of trust and confidence between client and attorney. This relationship serves the public interest by promoting voluntary compliance with the law and enhancing the ability of attorneys to represent clients effectively.

We also recommend that the Commission not amend Part 205 to require an attorney to withdraw from representing an issuer. We believe that withdrawal should only be required if the attorney knows or should know that he or she is causing the violation or knowingly provides substantial assistance to the violation. Existing provisions of the Exchange Act already authorize the imposition of sanctions against any person (including attorneys) who engages in such conduct.

2. Specific Comments

If the Commission nevertheless wants to adopt either a Commission notice requirement or an attorney withdrawal requirement, we recommend that the Commission adopt a number of modifications. We recommend these modifications because we believe that they would promote the public interest by making the part more workable.

a. Limit Withdrawal Requirement

The attorney should be required to withdraw only if, and to the extent that, the client is, or is about to, use the attorney's services in committing the material violation. Requiring an attorney to withdraw from matters that do not involve the attorney in the material violation inappropriately prejudices the issuer and its shareholders and raises serious constitutional issues. Attorney withdrawal should not be used as an instrument for punishing issuers that disagree with an assessment by an attorney. Using attorney withdrawal as a punishment is especially inappropriate because the attorney might lack the expertise and resources to reach an informed judgment. Moreover, attorneys will be extremely reluctant to withdraw from representing clients in circumstances where the withdrawal could severely prejudice the issuer. In light of the delicate judgments involved, imposing a broad withdrawal requirement could therefore chill the attorney's willingness to make the appropriate assessments.

b. Limit Commission Notification Requirement

We believe that notice to the Commission is especially inappropriate if the attorney's client did not use the attorney's services in committing the material violation. The states that require attorneys to breach attorney-client confidentiality limit the requirement to instances in which the client used the attorney's services to commit the violation. If, however, the Commission believes that this limitation unduly narrows the Commission notice requirement, then we suggest that the Commission decouple the notice requirement from the requirement that the attorney withdraw from representing the issuer.

We suggest that the Commission replace the "substantial evidence" standard incorporated into the proposed alternative. The "substantial evidence" test is vague and susceptible to interpretations that would set the threshold too low. The threshold for the Commission notice requirement should be higher than the threshold for internal reporting. The "substantial evidence" test could, however, be read as a lower threshold than the test that triggers the internal reporting requirements.

If the Commission adopts a variant of either the noisy withdrawal provision or the proposed alternative, the Commission should not require notice if it would be unreasonable under the circumstances for a prudent and competent attorney not to conclude that:

  • it is more likely than not that a material violation of the antifraud provisions of the federal securities laws is ongoing or about to occur,

  • the issuer's response is appropriate and timely; and

  • it is more likely than not that the ongoing or future violation will substantially injure investors.

As discussed below, this proposed standard basically adopts the standard incorporated into the definition of "evidence of a material violation" with two additional significant modifications.

This proposed standard would not require Commission notification if it were more likely than not that

  • there is no ongoing or future material violation; or

  • that the ongoing or future violation would cause substantial injury to investors.

The requirement of "substantial injury" is consistent with the law of those states that permit an attorney to breach the duty of confidence owed to a client only if there is a threat of "substantial injury." In most instances, if it is more likely than not that there is an ongoing or a future material violation, it will also be more likely than not that the ongoing or future violation would cause injury. The exception is when it is unlikely that there will be significant trading in the securities of the issuer. In such a circumstance, it does not make sense to require reporting out to the Commission. Accordingly, the Commission should not require notice to the Commission if the attorney reasonably believes that no investor will trade adverse to the omitted information except investors with knowledge of the information.

This proposed standard is limited to material violations of the antifraud provisions of the federal securities laws. There are several reasons why this limitation is appropriate.

  • No one knows what the term "similar material violation of United States federal or state law" means. The Commission should not require an attorney to breach attorney-client confidentiality based on speculation regarding the scope of the term.

  • Breaches of fiduciary duty are peripheral to the Commission's mission. The Commission is unlikely to launch an investigation of a breach of fiduciary duty that does not violate the federal securities laws.

  • The federal securities laws reserve special treatment for violations of the antifraud provision of the federal securities laws. See Exchange Act § 21(d)(3) (civil penalties), § 21(d) (officer and director bar), and § 21E (exclusion from safe-harbor for forward looking statements).

  • The adverse impact of the notification requirement on the relationship of trust and confidence between attorney and client may be reduced if the requirement is limited to material violations of the antifraud provisions. Issuers may inadvertently violate other provisions of the federal securities laws, whereas scienter is an essential element of a violation of the antifraud provisions.

If the Commission adopts a reporting-out requirement, the notice to the Commission should be private, as it is for reports that auditors file under § 10A of the Exchange Act. Public notice is not necessary to protect investors. Private notice will suffice to trigger an enforcement inquiry and companies therefore will have a heightened incentive, once notice is given to the Commission, to ensure that the company's disclosures fairly present the financial condition and performance of the company. Public notice would be harmful, further impairing the willingness of company personnel and directors to confide in company counsel.

c. Independent Director Override

We agree with the Commission's suggestion that if the Commission adopts a reporting-out requirement, it should provide that, if certain conditions are met, the independent directors can decide that notice to the Commission is not warranted. Specifically, if the Commission adopts a reporting-out requirement, it should also provide that notice to the Commission is not required if it would not be unreasonable for a competent and prudent director to conclude that:

  • it was not more likely than not that a material violation was ongoing or about to occur;

  • it was not more likely than not that there would be substantial injury to investors; or

  • the issuer was adopting appropriate remedial measures.

Giving the independent directors this opportunity advances the interests of investors not only by increasing the likelihood of an attorney providing notice in appropriate circumstances, but also by reducing the risk that the issuer will provide notice to the Commission where there was no material violation or the issuer is taking appropriate remedial measures.

B. Proposed Modifications

In this part of our comment letter, we suggest minor modifications to the rules that the Commission adopted in January 2003. We propose the modifications because we believe that they will improve the operation of the rules and serve the public interest.

3. Hearsay

In discussing the definition of "evidence of a material violation" in the promulgating release, the Commission states that "an attorney is not required (or expected) to report `gossip, hearsay, [or] innuendo.'" Most out-of-court statements are technically hearsay. Federal Rule of Evidence 801 (Definition of Hearsay). We question whether the Commission intended this statement to be taken literally and suggest that the Commission clarify its position regarding credible hearsay.

4. Protection from Liability

Section 205.6(c) provides protection for attorneys against liability that might otherwise arise from an attorney attempting to comply with the part. We agree that there is a need for such protection. Many provisions of the part are vague or require the exercise of judgment with which others might disagree. At a minimum, the protection afforded by the section should be amended to protect attorneys from discipline and other liability if they are acting reasonably and in good faith; an attorney who reasonably and in good faith took action in response to the requirements of the part should be protected from liability. Otherwise, attorneys will be (1) deterred from taking action in response to the part's requirements and (2) unfairly exposed to liability.

This expanded protection will be especially important if the Commission amends the rules to adopt a variant of either the original or alternative "noisy withdrawal" provision. An attorney could impose substantial losses on his or her client by withdrawing from representing the issuer or giving notice to the Commission in an effort to comply with the amended rules. In some instances, however, it will turn out that the issuer was neither engaged in nor about to engage in a material violation. In attempting to comply with the part, the attorney will risk substantial personal liability, if the issuer or client then sues the attorney for the losses. Absent expanded protection, this risk will chill the willingness of the attorney to comply with the rules.

In promulgating Section 205.6(c), the Commission relied on the supremacy clause and the principle that federal law trumps state law. We are members of the Bar of the District of Columbia, which is not a state. Has the Commission considered whether it can trump the laws of the District of Columbia? If not, then to the extent that Part 205 imposes duties that conflict with D.C. law (including the D.C. Rules of Professional Conduct) then the part unfairly subject members of the D.C. Bar to exposure under the laws of the District of Columbia. The Commission should consider this issue in drafting the rules, especially noisy withdrawal provisions that clearly are not mandated by Congress and pose an especially high risk of creating personal liability for the attorney.

C. Conclusion

We thank you again for this opportunity to comment on the proposed alternative and to propose minor modification to the rules that the Commission adopted in January.

1 These comments were drafted by a task force consisting of Kenneth B. Winer, Co-Chair, Gregory S. Bruch, Co-Chair, Bruce A. Baird, David M. Becker, James E. Day, Gary L. Goldsholle, Abbey G. Hairston, Paul Huey-Burns, Howard Kramer, David B.H. Martin, Phillip Parker, Richard H. Rowe and Paul Schott Stevens. The comments reflect the consensus of the task force and not necessarily the views of any individual member.