Investment Company Institute
December 18, 2002
Jonathan G. Katz
Re: Implementation of Standards of Professional Conduct for
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission's proposal to implement the requirements in Section 307 of the Sarbanes-Oxley Act of 2002 (the "Act").2 The Commission's proposal would prescribe minimum standards of professional conduct for attorneys appearing and practicing before the Commission in the representation of issuers.
The Institute strongly supports the intent of the proposal -- to "protect investors and increase their confidence in public companies by ensuring that attorneys who work for those companies do not ignore evidence of material misconduct." However, the Institute has serious concerns with the potential impact of certain provisions of the proposed rule on investment companies. We believe that these provisions will substantially alter the nature of investment company governance and attorney-client relationships in the investment company industry in ways that will impair the ability of attorneys to effectively assist investment companies in complying with the securities laws. We are also concerned that the short time period provided for public comment on the proposed rule is inadequate to consider properly the ramifications of these aspects of the proposed rule for investment companies.
The two aspects of the proposal that we believe are most problematic are (1) the Commission's treatment of attorneys representing an investment adviser to an investment company as jointly representing the investment company (the "Joint Representation Position")3 and (2) the "reporting out" provisions. Both of these go far beyond what is required under Section 307.
Thus, while we acknowledge that the Commission must consider the provisions of the proposed rule relating to the "up-the-ladder" reporting provisions on a schedule that complies with the statutory mandate, we recommend that, at a minimum, the Commission not adopt, at this time, the more controversial Joint Representation Position and "reporting out" provisions. Instead, the Commission should solicit further, and more directed, comment on them. This would allow for a more thorough examination of the ramifications of these provisions. We note that the concerns that led to the enactment of the Act, including Section 307, were found in operating companies, not investment companies. Indeed, investment companies are already subject to a pervasive scheme under which fund advisers must regularly report detailed information to the fund's board. By all accounts, this has worked effectively. Thus, there is no policy reason for the Commission to apply the Joint Representation Position or the "reporting out" provisions to investment companies, much less to apply them on the extremely rapid schedule set by the Act for the "up-the-ladder" reporting provisions.4
In addition to our comments on these matters, which are set forth below, we also have comments on other issues, including in particular the treatment under the proposed rule of attorneys who are performing non-legal services for an investment company.
I. Attorneys for Investment Company Advisers
As mandated by Section 307 of the Act, the proposed rule would impose a reporting obligation on any attorney who appears or practices before the Commission "in the representation of" an issuer. The proposed rule defines the phrase "in the representation of" to include any attorney who acts "on behalf of, at the behest of, or for the benefit of" any issuer. The Joint Representation Position makes clear the Commission's intention that this broad definition would operate to include any attorney employed by an investment adviser to an investment company who "appears or practices before the Commission" with respect to the investment company. The phrase "appearing or practicing before the Commission" is itself broadly defined to include not only communications with any member of the Commission or its staff but any involvement in preparing any document to be filed or submitted to the Commission.
The Proposing Release bases the Joint Representation Position on the fact that fund advisers have fiduciary duties to the funds they advise. While true, it is also the case that funds and advisers are separate entities, each entitled to their own counsel (which is frequently the arrangement). In no area of the law do the fiduciary duties of care and loyalty cause the fiduciary's attorney to owe separately the professional responsibilities of legal representation to the person to whom the fiduciary duties are owed.5
Section 307 does not require the Commission to adopt rules that will have this unique impact on investment companies, and there is nothing in the legislative or administrative record to support adoption of the Joint Representation Position. In fact, the types of scandals that led to the enactment of the Act have been absent from the investment company industry. SEC Commissioner Paul Atkins stated in a recent speech discussing the application of the Act to the fund industry that the fund industry "has largely operated for over sixty years without major scandal" and that "it is apparent from the nature of [the Act's] requirements, and the text of Sarbanes-Oxley itself, that the drafters of the legislation clearly had conventional, operating companies in mind."6
In proposing the Joint Representation Position, the Commission also has failed to take into account that the Investment Company Act and the rules thereunder already impose an array of requirements for fund advisers to report information to fund boards. For example, Section 15(c) of the Investment Company Act requires advisers, at least annually, to furnish sufficient information to fund boards to enable them to evaluate the investment advisory contract. Moreover, numerous rules under the Investment Company Act require directors to be provided with various types of information.7 No other issuer is subject to comparable requirements. In addition, the SEC only recently adopted a rule that all but mandates that a fund's independent directors be represented by "independent counsel." This rule is designed to ensure that fund directors have the benefit of legal counsel on a range of issues, including their evaluation of the information provided to them under the laws and regulations referred to above.
Section 307 is intended to ensure that the appropriate persons within a company - including, in many cases, the company's directors - are apprised of potential violations of law. This has not been a concern in the investment company industry, largely because of the requirements noted above. There is thus no reason for the SEC to go beyond the requirements of Section 307 and impose additional reporting obligations on attorneys to fund advisers.
Moreover, the Joint Representation Position is not only unnecessary; it could have serious and far-reaching consequences. Subjecting investment adviser attorneys to the reporting requirements of the rule would undermine the attorney-client privilege between such attorneys and the investment adviser and would severely damage the ability of such attorneys to conduct internal investigations or other internal compliance inquiries. In response, investment advisers may limit or even eliminate the participation of their internal and outside lawyers in the preparation of fund filings and materials, and in providing day-to-day advice to advisory personnel responsible for managing funds, in order to ensure that such lawyers are not "involved in the representation of an issuer" or "practicing before the Commission" within the meaning of the proposed rule. This, in turn, would threaten the quality of the legal advice provided to funds, which is especially important in the case of highly regulated entities like investment companies. In addition, legal expenses for investment companies could increase, perhaps substantially, as investment companies are forced to retain their own counsel to perform the roles previously held by internal and/or outside lawyers of investment advisers.
These problems will be magnified by the fact that the potential scope of the Joint Representation Position is extremely broad. For example, a growing number of funds utilize multiple subadvisers. Would each attorney for a subadviser similarly be deemed to be representing the fund?8 What if an attorney for an adviser worked on a matter of general applicability to an adviser's clients (e.g., brokerage allocation policies)? Would this constitute "joint representation" under the Commission's proposal? These and other ambiguities under the Commission's proposal are themselves reason enough for the Commission to, at a minimum, defer adoption of the Joint Representation Position.
The Institute therefore recommends that the proposed rule be amended so that attorneys would be deemed to act "in the representation of" an investment company only insofar as they are employed or retained by the investment company itself, and not by the investment adviser. In particular, an attorney employed or retained by an investment adviser to a fund should not be deemed to be jointly representing the fund.9 This should be the case even where, as is common, the adviser is responsible for a wide range of services (including, for example, preparing registration statements and other regulatory filings) pursuant to its advisory agreement with the fund. Investment advisory agreements are contracts between the fund and the investment advisory firm, not between the fund and the investment adviser's attorneys.
At a minimum, the Commission should defer consideration of the applicability of Section 307 to attorneys for investment advisers to funds until it has had sufficient opportunity to thoroughly review this matter. Given the extremely short period of time before rules under Section 307 must be adopted, and the fact that the proposed rules raise numerous other difficult issues, many of which have much broader applicability (including the "reporting out" provisions discussed below), we are concerned that this issue will not receive sufficient consideration. The Commission therefore should seek additional comment on the ramifications of this proposal before proceeding further.
II. "Reporting Out" Requirements
The proposed rule would require each attorney appearing and practicing before the Commission in the representation of an issuer to give notice to the Commission of each attorney's belief of any inappropriate response by the issuer to reported evidence of a material violation that is ongoing or has yet to occur. The rule would permit, but not require, each attorney to the issuer to do so where the material violation has already occurred but is not ongoing.
Several commenters have already raised concerns with the "reporting out" proposal,10 including its effect on attorney-client privilege11 and possible conflicts with state law. We would like to point out some particular problems this proposal raises for investment companies.
The proposed rule's definition of "material violation," in the context of investment companies, would capture much more than just criminal or fraudulent conduct; it also would encompass a host of substantive regulatory violations that are not the result of bad faith acts. For example, it would include violations of the broad affiliated transactions prohibitions or the daily pricing provisions of the Investment Company Act, as well as any act that can be construed as a violation of the fiduciary duty of care. The investment company industry has a successful record in resolving these types of violations through internal procedures and investigations that depend on the confidentiality of the attorneys conducting them. Unfortunately, however, the proposed rule may make employees more reluctant to come forward and assist in an internal investigation or other internal compliance inquiries if they believe that their communications with investment company lawyers are much more likely to result in a Commission investigation or enforcement action. The "reporting out" provisions therefore may seriously damage the self-regulatory mechanisms that today effectively redress the overwhelming majority of violations of the Investment Company Act.
In light of the fact that the "reporting out" provisions would conflict with time-tested investment company practice, and, as other commenters also have pointed out, that these provisions are not mandated under Section 307, the Institute recommends that the Commission amend the proposed rule so that these provisions would not apply to attorneys representing investment companies. At a minimum, the Commission should defer adopting these requirements until it has had time to consider the issue more thoroughly.
III. Attorneys in Non-Legal Capacities
Investment companies and their advisers employ a large number of persons who, though admitted to practice law, are not members of their firm's legal department and do not act in their capacities as attorneys. Many such persons may, for example, serve as investment company directors or be employed in a fund's administration, accounting or operations departments.
The Institute believes that such persons should not be subject to the proposed rule's reporting requirements. To impose on such persons the reporting obligations of the proposed rule simply because they are qualified to serve as an attorney would be an unjustified expansion of the proposed rule's reporting obligations. These individuals are not "appearing or practicing" before the Commission or "involved in the representation of" an issuer as attorneys, as contemplated by Section 307. Subjecting these individuals to the proposed rule's reporting requirements also would create adverse consequences. For example, in the case of investment company directors, an individual director's obligation to report potential violations would undermine the trust and collegiality that holds together a well-functioning board of directors. In the case of employees, most company structures provide that they report "up the ladder" within their own departments. The proposed rule would require an employee to subordinate the usual reporting structure and "report up" through a legal communication ladder devised for members of the legal department. Such a requirement could impair the trust and confidence between the employee and his or her reporting supervisor and diminish the supervisor's willingness to hire and promote qualified employees who would have the reporting responsibilities of members of a firm's legal department.
For these reasons, the Institute recommends that the Commission revise the proposed rule to make clear that persons admitted to practice law but who do not serve in the legal department of an issuer or do not act in their capacities as attorneys are not subject to the proposed rule's reporting requirements.
IV. Additional Comments
A. Non-U.S. Attorneys
The proposed rule would apply to non-U.S. attorneys "appearing and practicing" before the Commission in the representation of an issuer. This assertion of jurisdiction presents numerous delicate and complex issues regarding the regulation of attorneys in a large number of widely differing legal systems. The Institute therefore recommends that the Commission, as a matter of comity, take greater time to allow consideration of these issues.
B. Maintaining Contemporaneous Documentation
Various provisions of the proposed rule would require each attorney subject to the rule to maintain written documentation of actions taken to implement the reporting obligations imposed by the rule. The Institute opposes these provisions of the proposed rule as they do not promote or enhance the rule's underlying policy objective -- to ensure that attorneys do not ignore evidence of material misconduct. Instead, they would convert what may be a best practice into an independent basis for ethical violations subject to the same enforcement and/or disciplinary sanctions as a substantive violation.
The rationale provided by the Commission to justify these potentially harsh provisions is that written documentation may protect an attorney in any proceeding in which his or her compliance with the proposed rule becomes an issue. The Institute believes that competent attorneys generally will take reasonable steps to protect themselves without the threat of disciplinary sanctions. Accordingly, the Institute recommends that the Commission amend the proposed rule so that the written documentation requirements would not be independent grounds for enforcement and/or disciplinary action.
C. No Private Right of Action
The Proposing Release states that nothing in Section 307 creates a private right of action against an attorney based on his or her compliance or non-compliance with its provisions, and that there never was an intention to create such a private right of action. The Commission, however, requests comment on whether the proposed rule should include a "safe harbor" provision prohibiting private rights of action based on an attorney's actions under the proposal.
The Institute believes that the Commission's enforcement authority, both existing and that set forth in the proposed rule, will be sufficient to address violations of the rule. Permitting private rights of action will generate an atmosphere of second-guessing and lead to unnecessary and costly litigation. The Institute therefore recommends that the Commission expressly provide a "safe harbor" provision prohibiting private suits challenging an attorney's decision to take, or not to take, action under the proposed rule.
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The Institute appreciates your consideration of our views on these important matters. If you have any questions regarding our comments or would like additional information, please contact the undersigned at (202) 326-5815.
cc: The Honorable Harvey L. Pitt, Chairman
Giovanni P. Prezioso, General Counsel
Paul F. Roye, Director