COMMENTS OF THE CORPORATION, FINANCE AND SECURITIES LAW SECTION
TABLE OF CONTENTS
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 Committees on Corporate Governance and Accounting, Broker-Dealer Regulation and SEC Enforcement. 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. 1 We appreciate the opportunity to submit our views on the Commission's proposed standards of professional conduct for attorneys, proposed 17 C.F.R. Part 205.
We are particularly concerned that the proposed "noisy withdrawal" provision goes far beyond the plain language of Section 307 of the Sarbanes-Oxley Act of 2002 and, in our opinion, conflicts with sound public policy. We recommend that, at a minimum, the SEC defer the promulgation of this provision, and two other provisions,2 that threaten to severely undermine the attorney-client privilege and the duty of confidentiality that attorneys have long owed their clients. Section 307 does not require the Commission to promulgate such far-reaching rules by January 26, 2003. Accordingly, we suggest that the Commission deliberate further before turning them into new law.
We also recommend that the Commission provide for a transition period before the proposed rules become effective. Even without the three provisions discussed above, Part 205 will impose substantial obligations on attorneys, many of whom do not view themselves as appearing and practicing before the Commission, and their supervisors. In addition, attorneys will need to develop, and provide to clients, appropriate disclosure regarding the limitations that Part 205 (as adopted) places on the ability of attorneys to represent clients zealously and to keep confidential the information that clients provide to the attorney. Accordingly, the Commission should allow time for the bar to understand the implications of Part 205 and to address Part 205's requirements.
We recognize that the Commission's work was driven by a directive from Congress as to the content of the proposed standards and the timing for their effectiveness. This comment letter is intended to focus attention on the broad implications and high social costs of the proposed standards of Part 205, but also to spell out a number of concerns with the clarity and workability of proposed Part 205.
In finalizing Part 205, the Commission should consider the burdens that the rule imposes on issuers, attorneys, and the investing public. First, and foremost, the noisy withdrawal provisions will impose extraordinary costs - both social and monetary - on legal practice before the Commission. Most of these costs will not be borne by counsel, but will be borne by issuers and ultimately by shareholders who are likely to have more expensive, but less comprehensive, disclosure as a result of these rules. First, we believe that the noisy withdrawal provisions would substantially chill communications between issuers and counsel, impairing compliance with not only the securities laws but potentially other laws. Second, because of the serious consequences of a noisy withdrawal that conflicts with other state ethical rules, attorneys are likely to need to retain other lawyers to counsel them regarding the attorneys' conflicting obligations of zealous representation and confidentiality under state ethics rules and withdrawal and notification under SEC Part 205. Third, to the extent that the rule requires an attorney to withdraw from representation of an issuer even though that representation is unrelated to the indicated material violation, the rule will substantially increase the cost of representation and undermine the quality of legal advice and other services.
Even without the noisy withdrawal provision, the burdens of proposed Part 205 are substantial. Among other things, the proposed rules sweep within the Commission's jurisdiction many attorneys who traditionally never thought of themselves as practicing or appearing before the SEC. The proposed rule is, at best, unclear as to what kinds of violations are within Part 205's ambit, and to what violations are "material violations." The proposed rule is likewise unclear as to when attorneys have obtained "evidence" of a material violation, and how covered attorneys should assess the appropriateness of the issuer's response to reports of possible material violations.
If enacted as proposed, Part 205 is likely to alter the attorney-client relationship in ways that do not serve the Commission's charter to protect investors. The rules threaten to chill communications between issuers and their attorneys, undermining the ability of attorneys to provide the guidance issuers need to comply with the law. The rules threaten to deter specialist attorneys (e.g., regulatory counsel) from reviewing select portions of SEC filings, adversely affecting the quality of disclosure in SEC filings and other disclosures. We intend these comments to identify and explain some of these unintended consequences and to suggest modifications that will help the Commission achieve a rule consistent with Section 307 of Sarbanes-Oxley and the public interest.
We divide our recommendations into ten sections:
The cornerstone of proposed Part 205 is the definition of "appearing and practicing before the Commission."3 It is from this definition that all other provisions of the proposed rules flow. Proposed Part 205.2(a) purports to provide a non-exhaustive definition of "appearing and practicing before the Commission," but offers no guidance on how an attorney should determine what additional conduct falls within the scope of the term. In light of the substantial obligations placed on issuers and attorneys by proposed Part 205, it is essential that the Commission establish a clear definition of "appearing and practicing before the Commission." Because the enumerated categories under Rule 205.2(c) are themselves broad, the catch-all "includes, but is not limited to" is unnecessary and injects uncertainty, and we recommend that the Commission delete this language. Attorneys and issuers are entitled to fair notice regarding the scope of Part 205.
We note that the proposed definition is substantially broader than the definition of "practicing before the Commission" set forth in SEC Rule of Practice 102(f). This is unnecessary and inappropriate. Section 307 of Sarbanes-Oxley compels the Commission to develop standards for attorneys "appearing and practicing" before the Commission. Congress's use of that conjunctive phrase, "appearing and practicing" before the Commission compels, or at least strongly suggests, that it intended a narrower scope than contained in the definition of "practicing" already adopted by the Commission in Rule 102(f). Unless the Commission is at least aware of the attorney's participation in a matter, through the attorney's entry of an appearance or communication with the Commission or its staff, the attorney generally should not be regarded as "appearing" before the Commission.
We are concerned with the proposed rule's extension to any attorney who "participates in the drafting process" and suggest that Part 205 be applied only to attorneys who "significantly participate" in the drafting and disclosure process. The inclusion of any participating attorney conflicts with the public interest by discouraging issuers from seeking input from attorneys. For example, if disclosure counsel contacts another attorney to confirm that certain information in the filing is accurate, and if the contacted attorney provides that information, then the contacted attorney arguably is "appearing and practicing before the Commission" within the meaning of the proposed rule. This appears too broad and contrary to the scheme envisioned in Sarbanes-Oxley. Including such attorneys within the scope of the Rule will adversely affect the quality of disclosure by deterring companies from seeking the input of a broad range of specialized counsel in drafting SEC filings and, more importantly, deterring counsel -- particularly non-securities counsel -- from commenting. As you are aware, some attorneys already decline to review or comment on SEC filings of their clients for fear of the potential civil liability that might otherwise result. But such consultations are valuable to issuers and to investors. Accordingly, the Commission should be concerned with any rule that may have the effect of discouraging these communications. The Commission should make it clear that the rule does not extend to attorneys who merely provide information for possible inclusion in an SEC filing or comment on the adequacy of specific disclosures in an SEC filing.
The proposed rule also extends to attorneys who participate in the process of drafting contracts and other documents that the attorney has reason to believe will be filed with or incorporated into any SEC filing (e.g., an employment lawyer who represents an issuer in negotiating an employment agreement with its CEO). Again, the statute does not require the Commission to include such attorneys. We also have concerns on how such attorneys (many of whom will have little or no familiarity with the federal securities laws or the extent of the issuer's business and disclosures) would go about assessing whether they have become aware of evidence of a material violation. Accordingly, we recommend that this component of the definition be deleted.
Under 205.2(a)(5)(i) of the proposed definition, an attorney appears and practices before the Commission if the attorney advises any party that any writing need not be filed with or submitted to the Commissioners, the Commission or its staff. This standard appears unworkable. Many attorneys (e.g., tax and regulatory attorneys) advise clients where various regulatory forms must be filed. We recommend that the Commission should limit its application to advising an issuer regarding whether to file a registration statement with the Commission, whether to file a current or periodic report, and what materials should be filed with the Commission as exhibits to registration statements, periodic report and current reports.
The inclusion of attorneys hired to conduct an investigation is also troubling. Part 205.3(b)(6) provides that an attorney retained or directed by an issuer to investigate evidence of a material violation reported under the part shall be deemed to be appearing and practicing before the Commission. We recommend that this provision be deleted. First, attorneys conducting an internal investigation, and not otherwise interacting with the Commission or even known to the Commission at that point, do not have a sufficient nexus with the Commission's processes to warrant coverage. Second, characterizing internal investigations as practicing or appearing before the Commission will only make issuers less willing to retain, and attorneys less willing to conduct, such investigations, an unintended consequence of the proposed rules but a likely one all the same. Finally, the inclusion of investigative counsel is simply unnecessary in light of the existing obligation that is placed by Part 205.3(b)(3) on the chief legal officer to assess the timeliness and appropriateness of the issuer's response. In light of the significant compliance benefits that flow from issuer's retention of investigative counsel, the Commission should explicitly exclude investigative counsel, who do not otherwise interact with the Commission, from the coverage of proposed Part 205.
We urge the Commission to clarify its definition of "attorney" to make it clear that it is limited to individual attorneys, and to state in the Adopting Release that it would pursue a "collective knowledge" theory against a law firm only in egregious situations. We are concerned that the Commission might seek to apply a "collective knowledge" standard and hold law firms liable even in situations where none of their individual attorneys had become aware of "evidence of a material violation." In circumstances in which several different attorneys within a law firm each holds a different piece of a puzzle which, when pieced together, constitute the requisite evidence, the Commission might seek to hold the firm liable. This standard would be unfair and unworkable, especially in large law firms that represent far-flung corporate clients in numerous individual matters. The burden of attempting to comply would be immense if, as a precautionary measure, firms were to require every attorney working on behalf of a given client to constantly be aware of the details of every matter in which the firm represents (or represented) that client, or to task a single attorney with constantly collecting and reviewing such information, so that the firm could be in a position to decide whether the totality of information generated a reporting obligation. Although we understand that the Commission might wish to proceed against a law firm itself where the law firm may have been complicit in the issuer's violation (see, In the Matter of Keating, Muething & Klekamp, 1979 WL 186379, SEC Release No. 34-15982 (1979)), such situations arise infrequently, and the Commission may proceed against such firms under existing theories. Law firms should not be forced to assume a compliance burden vastly disproportionate to the benefits the Commission expects to achieve.
In the proposing release, the Commission Staff states that it is proposing a broad definition of what constitutes "in the representation of an issuer" because a broad definition is essential to protect investors and that the term is "defined to cover attorneys providing any legal service at the request of, or for the benefit of, an issuer." When Congress limited Section 307 to attorneys "appearing and practicing before the Commission," however, Congress itself balanced the potential benefits of Section 307 against its reluctance to regulate all attorneys. Congress, as manifested in both the plain language of the statute and the speeches of the three senators who sponsored the amendment that became § 307, intended § 307 to reach only those attorneys who have entered into an attorney-client relationship with an issuer.4
Proposed Part 205.2(f) states that an attorney can be deemed to represent an issuer even though the issuer is not the attorney's client. We recommend that the Commission modify this provision and define "in the representation of an issuer" to mean "acting as attorney in an attorney-client relationship with the issuer." The sponsors of the amendment that became Section 307 stressed that it would merely codify the long-standing principle that counsel to an entity represents the entity, not the entity's management. To the extent that the proposed rules extend beyond the attorney-client relationship, they conflict with the plain language of Section 307, the legislative history behind Section 307, and sound public policy.
The proposing release appears to suggest, for example, that an attorney who has entered into an attorney-client relationship with an investment adviser acts "in the representation of" the investment companies to which the investment adviser owes a fiduciary duty, even though the attorney has not entered into an attorney-client relationship with the issuer. We believe that this conclusion is incorrect in many cases. Contrary to the proposing release, we believe that requiring an attorney for an investment adviser to report confidential information to an investment company, in the absence of a joint representation of that investment company, is a clear breach of the attorney-client privilege.
We are also concerned that the neither the proposed rules nor the proposing release sets forth any limiting principle on when a lawyer's duty runs both to the client and to an issuer, in the absence of a joint representation. Consider an attorney personally retained by a CFO to advise in connection with signing a required certification of an issuer's periodic reports. The CFO owes a fiduciary duty to the issuer, and has a common interest with that issuer in complying with the federal securities laws. The CFO, however, has the right to expect that his attorney will keep confidential information that the CFO confided in the attorney and will not relay that information to others, including the issuer, without his consent. It is not clear whether the proposed rules preserve the right of the CFO to seek his own counsel.5
In this respect, it is important for the Commission to bear in mind that the attorney-client privilege serves an important function in promoting voluntary compliance with the law. As courts have long recognized, "[v]oluntary compliance with the law often depends on sound legal advice; sound legal advice in turn often depends on the attorney-client and work product privileges." EEOC v. Lutheran Social Services, 186 F.3d 959 (D.C. Cir. 1999) (citing In re Sealed case, 330 U.S. App. D.C. 368, 146 F.3d 881, 884 (D.C. Cir. 1998)). The D.C. Rules of Professional Conduct explain this reality in more detail:
Rule 1.6, comments 1- 4, D.C. Rules of Professional Conduct. By undermining the attorney-client privilege between the fiduciary to the issuer and the fiduciary's counsel, the proposed rule would undermine voluntary compliance with the law.
The proposed rule provides insufficient guidance on when an attorney shall be deemed to have become aware of information in appearing and practicing before the Commission in the representation of an issuer. We recommend that the rule be limited to information obtained in connection with the attorney's appearing and practicing before the Commission, and at a time of an active attorney-client relationship.
The Commission should also modify Part 205.2(a)(5) to specify that the attorney need not act based upon information that is publicly available or has already been reported to the Commission. At this point, investors are already in possession of the relevant information, and the Commission is on the same footing as counsel.
Part 205.2(e) provides, "Evidence of a material violation means information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur." We have several concerns regarding this provision.
First, the Proposing Release invites comments on the appropriate measure of evidence. We begin from the assumption that the confidentiality of the attorney-client relationship serves important societal policies and exceptions to that confidentiality should not be triggered by uncertain beliefs about whether violations have occurred. The "reasonably believes" standard is a relatively low, negligence-oriented standard which would lead to frequent invocation of Part 205 by lawyers fearful of being second-guessed about the reasonableness of their judgment. The "reasonably believes" language may be found in the Comment to Model Rule of Professional Conduct 1.6, where the disclosure is permissive rather than mandatory and restricted to violent crimes. We believe the more appropriate standard, used in jurisdictions which allow lawyers to more broadly reveal the intent of clients to commit crimes, is the "reasonably certain" standard. E.g., N.Y. State Op. 562 (1984) (interpreting DR4-101(C)(3)). After canvassing 33 states with broader versions of Rule 1.6 or its equivalent not limited to violent crime, the A.B.A. Commission on Evaluation of the Rules of Professional Conduct used the "reasonably certain" standard in its proposed broadening of Rule 1.6 beyond violent crime. Report of the Commission on Evaluation of the Rules of Professional Conduct (Nov. 2000). We believe the same more rigorous standard is appropriate in Part 205.
The legislative history indicates that Congress contemplated a similarly rigorous standard. Senator Michael Enzi, one of the key sponsors of Section 307, made the following statement regarding the reporting obligation required by Section 307:
(S6555 of the July 10, 2002 Congressional Record - Senate)(emphasis supplied). In contrast, the legislative history provides no support for adoption of the negligence standard set forth in the proposing release.
The reasonably certain threshold for reporting possible violations up the chain would serve a valuable winnowing effect on what otherwise may be an unmanageable volume of information. Lawyers advise clients routinely about legal risk - including the possibility that the conduct may later be found to be a material violation -- in a proposed course of action, while leaving it for the client to decide whether to incur that risk. Many issuers are large organizations with numerous divisions and subsidiaries. If the presence of such legal risk meant that the matter had to be decided by the issuer's chief legal officer, chief executive officer, or audit committee, the nature of the attorney's relationship with management would be transformed and senior management and audit committees of large issuers would be overwhelmed.
Second, if the Commission decides to use a negligence standard, then the Commission should delete 205.2(e) and revise 205.3(b)(l) to read as follows:
This change is consistent with the approach taken in the proposing release:
Proposing Release at 27 (footnote omitted).
We note that the proposed rule refers to "evidence" of a material violation, which suggests that the attorney is entitled to make certain informed professional judgments about the sources of information, the credibility of the information, and to weigh them against the possibility of other mitigating information that the attorney may know. The Commission should confirm whether this interpretation is correct.
The Proposing Release suggests that an attorney should conclude that information is "evidence of a material violation" only if it is clearly illegal. Proposing Release at 27. ("The duty to report `up the ladder' does not . . . arise where an officer actually pursues a course of action despite being advised by the attorney that the course of action had been held illegal by courts in three states, in none of which the issuer does business, even if the attorney thinks there is a reasonable argument that other courts would also be likely to find it illegal.") We support this position. However, we note that this important concept is not reflected in the Commission's proposed definition of "evidence of material violation." If the Commission retains a negligence standard, the proposed rule should be modified to incorporate the concept that the information does not constitute "evidence of a material violation" unless the indicated conduct is clearly illegal in the relevant jurisdiction(s).
Finally, proposed Part 205 defines "material" to refer "to conduct or information about which a reasonable investor would want to be informed before making an investment decision." This proposed definition is different from the well-established definition set forth by the Supreme Court. Namely, information is material if "there is a substantial likelihood that a reasonable shareholder would consider it important" in making an investment decision, and that it must be substantially likely that a fact "would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224 (1988). When Congress uses a term that has been defined by the Supreme Court, the presumption should be that Congress intended to adopt that definition. Moreover, the use of a different definition is confusing, and would negate the experience of the Commission, the courts, and the securities bar in working with the Supreme Court definition. We recommend that the Commission replace the proposed definition with the Supreme Court definition.
We recommend that the Commission modify its definition of "violation." The reference in Section 307 to securities laws is fairly clear. Section 2(a)(15) of Sarbanes-Oxley incorporates the definition now set forth in Section 3(a)(47) of the Exchange Act, the federal securities statutes administered by the SEC, as well as rules, regulations and orders issued by the Commission thereunder.
We recognize that Section 307 directs the Commission to address breaches of fiduciary duty in the rule. The proposed definition, however, makes virtually any breach of fiduciary duty reportable if an attorney, acting reasonably, would believe that a reasonable investor would want to be informed about the breach prior to making an investment decision. We also have concerns that items that could not reasonably be expected to have a material effect on the issuer's financial statements could nonetheless be deemed material because they reflect on the integrity or competence of management. We believe that this test would be unworkable in practice, as counsel would have no precedent to look to in determining whether a breach of fiduciary duty needed to be disclosed. For these reasons, we recommend that breaches of fiduciary duty be subject to a separate materiality standard which requires a reasonable likelihood that the breach of fiduciary duty will have a material effect on the issuer's financial statements.
We also believe that, given the elaborate reporting scheme contemplated by the rule, the Commission should define the types of violations that will be regarded as "similar violations." Attorneys should not be exposed to liability for failing to report other, unspecified types of violations, and the courts are more likely to defer to the Commission's judgment if it defines the term after notice-and-comment rulemaking.
3. Proposed Part 205.3(a)'s Requirement that "[A]n Attorney Appearing and Practicing Before the Commission in the Representation of an Issuer . . . Shall Act in the Best Interest of the Issuer and its Shareholders
Proposed Part 205.3 sets out what the proposing release terms "the core" of the proposed rules.6 205.3(a) states that an attorney who represents an issuer represents the issuer "as an organization" and must "act in the best interest of the issuer and its shareholders." The first proposition is consistent with an attorney's recognized ethical obligations under United States notions of professional responsibility;7 the second is inconsistent with the first and misstates what attorneys do.
Attorneys for an organization represent only the organization and not the individual owners or managers. Boards of directors, managers and other employees, and shareholders are each "constituents" of the corporate organization who, to differing degrees and in differing situations, may act on behalf of the corporation and give instructions to the corporation's attorneys.8 Attorneys owe their professional duties to the corporate entities that retain them, not to any of the corporation's constituents.9 Indeed, attorneys are required to inform constituents of this basic fact when it is apparent that the corporation's interests may be adverse to those of the corporate constituents with whom the attorney is dealing.10
In addition, contrary to the Commission's assertion, attorneys do not have an obligation to act in the best interests of their clients. Instead, attorneys are obligated to zealously represent (that is, act on behalf of) clients. Applicable rules make clear that it is the client that chooses the objectives the attorney must pursue, no matter how unwise, unwarranted, or unsound those objectives may be.11 These are choices for the client, not the attorney, because it is the client, not the attorney, who bears the consequences of actions taken in the client's name.12 Indeed, if instructed by the client to take any lawful action, an attorney generally is obligated so to act, even if contrary (in the attorney's judgment) to the client's best interest. Where the attorney's client is an organization, an attorney takes ultimate instruction from the board of directors, not because the board is more likely than management to do what is best for the corporation, but because the board, as to all but a few issues, has the ultimate legal authority to bind the corporation and instruct the attorney as to what to do.
Proposed Part 205.3(b)(1) provides that, under certain circumstances, the attorney "shall report any evidence of a material violation to the issuer's chief legal officer and its chief executive officer . . . ." (Emphasis added.) Proposed Part 205.4 provides that, under certain circumstances, the attorney "shall report the evidence of a material violation to . . . [t]he audit committee of the issuer's board of directors . . . ." (Emphasis added.) The distinction, if any, between "any evidence" in Part 205.3(b)(a) and "the evidence" in Part 205.4 is unclear. We believe that the Commission should adopt a different standard. As noted in the proposing release, ABA Model Rule 1.4 requires an attorney to "keep a client reasonably informed about the status of a matter" as "reasonably necessary to permit the client to make informed decisions regarding the representation." (Footnotes omitted.) Proposing Release at 28. Accordingly, we propose the Commission modify the proposed rule to require that the reporting attorney report information possessed by the reporting attorney that is reasonably necessary for the issuer to make informed decisions in response to the report. This proposal advances the public interest, by requiring that the reporting attorney report only salient information to the issuer.
The proposed rule does not specify how quickly an attorney must report. We recommend that the Commission require the attorney to make the report within a reasonable time in light of all the relevant factors (including other time commitments, the burden of assessing the information and preparing the report, the strength of the evidence, the materiality of the indicated violations, and the threat of ongoing or imminent violations).
Our concern with these provisions is three-fold. First, it is unnecessary, as most attorneys would maintain some documentation of their decision-making process regardless of a specific requirement. Second, because the Commission would be mandating the preparation and retention of such documents, attorneys would tend to be overinclusive, in order to obviate their being second-guessed. The time and resources that attorneys would devote would be disproportionate to the benefit gained by the creation of this obligation (especially because such costs ultimately would be borne by Issuers). Third, rather than being overinclusive, attorneys might be underinclusive in order to avoid creating an audit trail. Such sketchy documentation would provide no benefit and - in fact - would be counterproductive in any subsequent inquiry.
The rule should make clear that the reporting attorney is entitled to rely on the representations of other professionals as to the adequacy of remedial measures. We are concerned by the suggestion in the proposing release that if the issuer retains a reputable law firm to conduct an internal investigation in response to the an attorney's report, the reporting attorney is obligated to study the resulting findings:
Proposing Release at 14.
The Commission should reconsider this position. Our disagreement is based on a number of factors:
The Commission should bear in mind that proposed Part 205.3(b)(3) requires that the issuer's chief legal officer ("CLO") take detailed meaningful steps in response to an attorney's report of a possible material violation, including to:
We recommend that the proposed rules be modified to provide that if the attorney obtains representations that the CLO has fulfilled the obligations set forth in Part 205(b)(3), then the reporting attorney has received an appropriate response for the purpose of Part 205.3(d), unless the reporting attorney is reasonably certain that the representations are untrue.
The proposed rule implies that the appropriateness of a response need not include compensation of injured parties. We support this standard. Requiring an attorney to assess whether a response appropriately compensated injured parties would be deeply impractical. Identifying and compensating injured parties is a difficult task, but one to which the private plaintiff's bar devotes considerable attention. A reporting attorney is likely to have little expertise or resources in this area, and requiring the reporting attorney to make such an assessment would impose additional cost and potential liability to attorneys, with no appreciable benefit to the issuer or to investors. Accordingly, we recommend that Part 205(b) be modified to read as follows:
The noisy withdrawal provisions, if enacted as written, are especially troubling with respect to counsel defending an issuer in connection with an SEC investigation or litigation. Accordingly, even if the Commission adopts some version of the noisy withdrawal provision, we recommend that the provision not to these contexts. This recommendation is based on the following factors:
The proposed noisy withdrawal requirement provides inadequate time for an attorney to reach the complex and difficult conclusion that a noisy withdrawal is required. This conclusion requires a number of difficult judgments, including: (1) the likelihood, based on the information then available to the reporting attorney, that there has been a violation of the securities laws, a breach of fiduciary duty, or similar violation and (2) an assessment of whether the issuer's response is appropriate and timely.13 The reporting attorney will be making this assessment with the knowledge that if the attorney inappropriately notifies the Commission in compliance with Proposed Part 205.3(d), the attorney shall have breached the attorney's obligation to maintain the confidences and secrets of the client, prejudicing the client and exposing the attorney to disciplinary proceedings and, potentially, substantial personal liability.
To judge whether information constitutes "evidence of a material violation" is often difficult, even after the evidence has been gathered and weighed. To make such determinations requires detailed review of the evidence, delicate assessments of credibility, and painstaking scrutiny of applicable law or accounting principles.
The rule should clarify that the timeliness of a reporting attorney's actions will be viewed in light of specific circumstances of the issuer, and in light of the legitimate, good-faith demands of the reporting lawyer's professional obligations. Issues like this may well arise when the attorney is addressing other demands for other clients that the attorney is ethically obligated to attend to. In addition, the attorney should be provided time to discuss the attorney's remaining concerns with the issuer and attempt to reach resolution of these concerns. It should be clear that proposed rule (which requires that the attorney resign "forthwith") allows for that process.
The proposed rule arguably requires the attorney to withdraw from all representation of the issuer if an appropriate response is not received. The proposing release offers no explanation for why this sweeping requirement is necessary or beneficial to the issuer or to investors. It is easy to envision instances in which an issuer's shareholders will be harmed as a result of counsel's required withdrawal.
Consider a regulatory attorney who assists an issuer in complying with federal or state regulations (e.g., a banking lawyer). The attorney reviews a periodic report of the issuer and concludes that he is aware of "evidence of a material violation." The issuer retains counsel who conducts an extensive investigation and issues a report comparable in detail and scope to the Enron report and takes a number of remedial measures. The regulatory attorney decides, however, that the response might not be appropriate. Why should the Commission require the regulatory attorney to cease providing regulatory advice? Requiring the attorney to withdraw increases the risk that the issuer will inadvertently commit violations that might have been adverted with the advice and assistance of the regulatory attorney.
We believe that the withdrawal provision should be limited to requiring counsel to withdraw from an engagement to the extent that the engagement would result in the attorney knowingly providing assistance to an issuer in violating any provision of the federal securities laws.
Proposed Part 205.3(d)(i)(C) provides that, under certain circumstances, the reporting attorney must "disaffirm to the Commission any opinion, document, affirmation, representation, characterization, or the like in a document filed with or submitted to the Commission, or incorporated into such a document, that the attorney has prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading."
We recommend that the Commission eliminate the requirement that an attorney submit disaffirmations to the Commission. If, however, the Commission decides to retain this requirement, we recommend that the following modifications to make the requirement more clearer and more reasonable.
Part 205.3(d)(i)(c) and Part 205.3(d)(ii) requires, under certain circumstances, that an attorney disaffirm anything that the "attorney reasonably believes is or may be false or misleading." The "may be" component of this provision requires clarification. It will be relatively rare that an attorney will have sufficient information to preclude the possibility that a document contains representations that are materially false and misleading. If an attorney is required to disaffirm each document that contains a representation that the attorney prepared or assisted in preparing and that a reasonable attorney would conclude "may be" materially false and misleading, the attorney would likely disaffirm every document filed with or submitted to the Commission that the attorney has prepared or assisted in preparing and that contains representations. This step would not be in the public interest.
We are concerned that the provision requiring supervisory attorneys to "make reasonable efforts to ensure that a subordinate attorney . . . that he or she supervises, directs or has supervisory authority over . . . conforms to this part and complies with the statutes and other rules administered by the Commission," proposed Part 205.4(b), is taking the Commission into the substantive regulation of lawyers and the business and operations of law firms. In light of the potential for confusion this may engender, and the lack of any Congressional mandate to do so, the Commission should defer this aspect of Part 205 pending further review.
The Commission does not directly regulate the practice of law or the structure of law firms, as it does for broker-dealers and other regulated entities. It is surprising, therefore, that 205.4(b) imposes an affirmative supervisory duty on lawyers that the SEC does not place on broker-dealers, where the duty to supervise is an affirmative defense rather than an affirmative obligation. It is also worth noting that registered entities' supervisory obligations extend to supervising with a view toward preventing violations of the federal securities laws, rather than the arguably more stringent duty to ensure "compl[iance] with the statutes and other rules administered by the Commission" of 205.4(b). We are concerned that this requirement will evolve into a requirement that law firms and legal departments develop and maintain the costly supervision and compliance structures that the SEC currently requires of broker-dealers.14
We believe that the definition of "supervisory attorney" needs to be refined. At many law firms, attorneys are supervised by a number of other attorneys. For example, an associate in the Washington, D.C. office of a national law firm might, in a sense, be supervised by the managing partner of the firm, the managing partner of the Washington, D.C. office, the partners in charge of the associate's department(s) and/or practice group(s), and the attorneys supervising the attorney on the particular engagement and/or task at issue. We do not believe that it is appropriate or meaningful to provide that the managing partner of the firm, the managing partner of the Washington, D.C. office, the partner in charge of the associate's department(s) and/or practice group(s) appear and practice before the Commission "[t]o the extent that a subordinate attorney appears and practices before the Commission on behalf of an issuer." We suggest that it would be more appropriate to limit the definition of "supervisory attorney" to the attorney(s) supervising the subordinate attorney on the particular engagement(s) or task(s) in the course of which the attorney became aware of the "evidence of a material violation."
It is in the public interest for an attorney appearing and practicing before the Commission in the representation of an issuer to feel free to consult within the firm regarding the attorney's responsibilities under Part 205. The proposed rules recognize this public interest with respect to an attorney consulting with a supervisory attorney. We believe that the proposed rules should be modified to encourage such consultations with attorneys who are not supervisory attorneys within the meaning of Part 205.4. For example, the proposed rule should encourage a law firm attorney to consult with a securities expert or the firm's general counsel. Similarly, the proposed rule should encourage a legal department attorney to consult with a colleague or with outside counsel with special expertise. As currently drafted, however, the proposed rules discourage such consultations by creating a substantial risk that the reporting obligations of Part 205 would then be imposed on the consulted attorney. This risk serves no public interest and chills consultations that are in the public interest. Accordingly, we recommend that the Commission adopt a provision to the following effect:
Our comments on this alternative to the "noisy withdrawal" proposals are subject to all of our comments on various definitional and substantive issues elsewhere in our letter.
As we have stated elsewhere in this submission, we believe that attorney noisy withdrawal proposals neither are required by Section 307 of Sarbanes-Oxley nor are they in the public interest or for the protection of investors. Thus, our comments on the proposed alternative to that proposal should not be taken to mean that we, in any way, support that proposal. Unfortunately, the alternatives to noisy withdrawal are so onerous that we think they will be very seldom used.
The Commission has proposed that an attorney, including a "chief legal officer" (CLO), who reports what the attorney responsibly believes is evidence of a material violation of "the securities laws," breach of fiduciary duty or "similar material violation" (which term is undefined), would not be required to withdraw from representing the issuer and, except as provided in proposed Part 205.3(b)(3), applicable only to CLOs, would not be subject to the proposed "noisy withdrawal."15
While proposed Part 205.3(c) may be a viable alternative for an outside attorney, it is not a meaningful alternative for the attorney's client, the issuer, the members of the QLCC or CLOs. The proposed alternative merely shifts burdens to the Commission from the attorney to the issuer, the individual members of the QLCC and the CLO. If they fail to report to the Commission as required by the proposed rules, they are subject to enforcement proceedings, based on no element of scienter, for failure to report, even if, in fact, there has been no violation of law.
We believe that the substantive thrust of the "noisy withdrawal" proposals, including the proposed QLCC alternative, which would require self-reporting of possible, but unadjudicated violations of law and state law fiduciary duties, is unprecedented and is not an appropriate exercise of the authority under Section 307 of Sarbanes-Oxley or any provision of the federal securities laws.
Moreover, we believe that an issuer may be reluctant to confer on the QLCC, the authority required under proposed Part 205.2(j). Proposed Part 205.2(j) requires that the QLCC be authorized, not only to conduct any "necessary" inquiry into the reported evidence, but also to require the issuer to take "appropriate" remedial measures to prevent ongoing or to alleviate past material violations (albeit unadjudicated) and to notify the Commission of the material violation and disaffirm in writing any tainted document submitted to the Commission, if the issuer, in any material respect, fails to take any remedial measure directed by the QLCC. Further, we question whether the Commission has the statutory authority to require self-reporting by issuers or individual directors of unadjudicated violations of law or breaches of state law fiduciary duties.
The proposed requirement that each member of the QLCC, individually, have the responsibility to so notify the Commission and to disaffirm documents submitted to it would place an extremely heavy burden on the directors who serve on the QLCC. We believe that an issuer would have great difficulty in attracting directors to serve on a QLCC under these circumstances.
We also question the Commission's basis for prescriptive qualification requirements for eligibility to serve on a QLCC. We would have no objection to a requirement that all members of the QLCC not be employed, directly or "indirectly" (if the Commission provides appropriate guidance on the term "indirectly"), by the issuer or that they all must be "independent," as defined in Section 301(a) of Sarbanes-Oxley and Section 10A(m)(3) of the Exchange Act or any applicable national securities exchange or NASD listing standard. However, in light of the substantial obligations that the Sarbanes-Oxley Act, existing and proposed SEC rules, and SRO listing standards and proposed listing standards place on members of audit committees, we see no reason to require, as the Commission proposes, that at least one member of the QLCC also be a member of the issuer's audit committee. We believe this would only be yet another barrier to an issuer attracting qualified individuals to serve on a QLCC. We, however, would have no objection to a proposal for the QLCC advising or reporting to the audit committee with respect to the QLCC's actions.
In addition, the Commission's proposal in Part 205.3(c) permits an attorney to report evidence of a material violation or breach of fiduciary duty to the QLCC, as an alternative to reporting to the Commission, only if the issuer has "duly formed" (an undefined term) the QLCC. This requirement would appear to nullify the attorney's alternative if the QLCC was not "duly formed." It is not clear whether this puts a burden on an attorney to determine whether the QLCC was duly formed. Such a burden would be inappropriate, since, for example, the outside attorney may not know whether the member of the audit committee serving on the QLCC is qualified to be a member of the audit committee; may not know whether the QLCC has the authority and responsibility required by the proposed part; and may not know whether the members of the QLCC are "indirectly" employed by the issuer. Even if the attorney inquires and receives satisfactory answers, the QLCC still may not in fact be "duly formed" and, as drafted, the alternative would not be available. We suggest, instead, that an attorney be permitted to satisfy the proposed alternative, if the attorney reports to a QLCC designated by the issuer and the attorney does not know, without any inquiry requirement, that the QLCC was not "duly formed."
We also believe that the Commission should provide guidance in the final rules as to whether the attorney must report to the QLCC in writing and whether the attorney is subject to the proposed documentation and record retention proposals in this regard.
The proposed rules provide, in part, that "with respect to attorneys appearing and practicing before the Commission on behalf of an issuer, `improper professional conduct' includes . . . [r]epeated instances of unreasonable conduct, each resulting in a violation of a provision of this part." Proposed Part 205.6(b)(2)((ii).
First, the term "on behalf of an issuer" is undefined. If this term is intended to be narrower than the definition of "in the representation of an issuer," then the rules should define the term to clarify the distinction. If this term is intended to mean "in the representation of the issuer" then the term should be replaced by "in the representation of the issuer."16
Second, the appropriate culpability standard turns on the standard chosen as triggering the various reporting requirements in the rule. If, the Commission chooses a relatively low standard as triggering the reporting requirements, then an attorney practicing before the Commission will routinely encounter numerous instances that trigger the reporting requirement, and the standard of culpability should be relatively high (conduct that is intentional or extremely reckless). If, as we recommend, the Commission chooses a relatively high standard (reasonably certain) as triggering the reporting requirements, then a lower standard of culpability might be appropriate. In addition, if, contrary to our recommendation, the Commission retains the noisy withdrawal provisions, the Commission should limit sanctions for failure to make a noisy withdrawal to conduct that is intentional or extremely reckless.
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In conclusion, we deeply respect the important work of the Commission in these challenging times, and recognize the enormous staff efforts that have gone into the Commission's compliance with Sarbanes-Oxley. We hope that this letter is constructive, and that you understand the depth of concern about proposed Part 205 among securities lawyers and among other attorneys who represent issuers in various capacities. While much of the proposed rule is well-conceived, we have attempted to address those parts that need additional work. Finally, we hope the Commission will reconsider those parts of the proposed rule that threaten to undermine the attorney-client privilege that is fundamental to the American system of justice and has served our capital markets well, though not perfectly, for so many years.
cc: The Honorable Harvey L. Pitt