December 18, 2002
Mr. Jonathan G. Katz
Re: Section 307 of the Sarbanes-Oxley Act of 2002: Implementation of Standards of Professional Conduct for Attorneys, Release Nos. 33-8150, 34-46868; IC-25829, File No. S7-45-02
Dear Mr. Katz:
On November 21, 2002, the Securities and Exchange Commission gave notice of its proposal to add a new Part 205 to the Code of Federal Regulations which would establish standards of professional conduct for attorneys who appear and practice before the Commission in the representation of issuers1. Comments are due by December 18, 2002.
Given the short comment period, we urge the Commission to reconsider adopting that part of the proposed regulations that would require lawyers to notify the SEC of their withdrawal as counsel to an issuer and to disaffirm filed documents.
This proposal directly contradicts the clear intention of Congress. In drafting Section 307 of the Sarbanes-Oxley Act of 2002, Senators Sarbanes, Edwards and Enzi unequivocally rejected notification to the SEC2 and they made that clear in their discussion of the Section reported in the Congressional Record.
We believe that Congress got it right. There is no consensus that reporting to the SEC is either appropriate or wise. Some think it corrosive: it presumes that corporate issuers are entirely corrupt at the highest levels and that the Congressional remedy of reporting up the corporate ladder will fail. We believe the Commission should give the American Bar Association time to consider the preliminary report of its Task Force on Corporate Responsibility3 and time to develop an approach that has the endorsement of the private bar.
Dechert is submitting this comment letter because, as a firm, we consider the rulemaking proposal to be of far reaching impact to the role of lawyers and their relationship to corporations. Dechert is an international law firm with offices in 13 locations. Some 25 of our 750 lawyers previously have been members of the Staff of the SEC. We have great respect for the role the agency and its Staff has played over the years in formulating and enforcing the nation's securities laws.
Our comments are divided between those relating to that portion of the proposed regulations which, pursuant to Section 307 of the Sarbanes-Oxley Act of 2002, must be addressed by January 26, 2003 and that portion of the proposed regulations which have not been mandated by Congress, and, indeed, was considered and rejected by Congress.
Reporting Up the Corporate Ladder
Congress has specifically required the Commission to issue rules by January 26, 2003, including a rule that would require:
Congress, no doubt, thought this formulation was straightforward. However, the sweep of the proposed regulations, including the broad scope of the proposed definitions, introduce significant uncertainty as to just who will be subject to reporting up the ladder and go beyond what the Congressional sponsors intended.4
The entire thrust of paragraph (b) of proposed Section 205.3 turns upon the interplay of a number of interlocking definitions, including definitions of the following words and phrases: "attorney," "appearing and practicing before the Commission," "evidence of a material violation," "in the representation of an issuer," "breach of fiduciary duty," "material violation," "reasonably believes," and "reasonable or reasonably."
The definition of "appearing and practicing before the Commission" matters because the proposed sanctions for violation of the proposed regulations, as is required by Section 307 of the Sarbanes-Oxley Act, can extend only to attorneys who are said to be those who appear and practice before the Commission. Congress did not seek to require all lawyers hired or retained by an issuer to report misconduct up the ladder (although they clearly could have done so had they so wished). In the proposing release, the SEC makes clear that these sanctions include bringing civil actions seeking injunctive and other appropriate equitable relief, as well as civil money damages under Section 21(d) of the Securities Exchange Act of 1934 or, in the alternative a cease-and-desist proceeding pursuant to Section 21(c) of the Exchange Act5.
For that reason, we urge the Commission to reexamine the Congressional intent behind Section 307. We believe it is clear that Congress wanted the SEC to require persons who are lawyers and who know that they appear and practice before the Commission to undertake to report material violations of securities law, material breaches of fiduciary duty and material similar acts up the corporate ladder.
While U.S. securities lawyers clearly know and understand that they appear and practice before the Commission, foreign lawyers, as well as those caught up on the broad sweep of the interlocking definitions of "attorney" and "appearing and practicing" may easily fail to appreciate that Section 307 of the Sarbanes-Oxley Act may be interpreted by the SEC to subject them to Exchange Act sanctions. For example, if such lawyers are found to have had a hand in the drafting of some portion of a document ultimately filed with the Commission, they may fail to understand that this tangential involvement makes them generally subject to the mandated reporting of any material violations, including those which are not related to the filed document
Moreover, the very expansive reading that the proposed rule would give to the definition of "attorney" and the definition of "appearing and practicing before the Commission" would apply to many lawyers (and non-lawyers) who give commonly used words and phrases their common meanings and will not appreciate that they have been made subject to the regulations by SEC interpretation. The circular nature of Paragraph (b) of Section 205.4, which would confer the status of an attorney appearing and practicing before the Commission on every subordinate of a supervisory attorney who is, in fact, appearing and practicing before the Commission and, conversely, would confer the status of an attorney appearing and practicing before the Commission on every supervisory attorney who supervises an attorney who is, in fact, appearing and practicing before the Commission, will mean that, as a practical matter, virtually any attorney employed by an issuer is susceptible of being subject to the substantive reporting provisions of the proposed regulations6. Given the risk of being sanctioned for a failure to supervise, supervisory attorneys, will be likely to treat all internal attorneys7 as subject to the requirements of the proposed regulations. Moreover, proposing release commentary on Section 205.5 would make those within the ambit of the regulations even broader, expressly stating that the status of a subordinate attorney can be conferred on an attorney supervised by a non-lawyer8.
Paragraph (b) of Section 205.4 is also unclear as to whether a supervisory attorney, which is said to automatically include the issuer's chief legal officer, can be said to be supervising outside counsel. We believe the Commission should make it clear that this cannot be the case, given the duties imposed upon supervisory attorneys. Clarifying this point makes sense, but even more sense needs to be made: Assume an outside law firm with patent expertise is engaged by Issuer X to provide advice with respect to a patent application. The supervisory attorney at the law firm does not, even as most broadly read, appear and practice before the Commission on behalf of the issuer, nor does any subordinate attorney in the firm so appear and practice. As we read the proposed language, no one at the law firm would be subject to the reporting material violations of securities law, etc. The answer appears to be different if the outside law firm were also engaged to provide general corporate and securities advice to the issuer9. The answer also appears to be different if the patent firm's partner consults a fellow partner about the securities law implications of a failure to obtain the patent, as opposed to directing a securities associate to do research on this issue10.
In raising these issues, we are seeking to illustrate that the very broadly drafted definitional language is replete with serious ambiguities, that, by the nature of the Sarbanes-Oxley legislation, will be interpreted only in an administrative or civil proceeding brought by the SEC. We believe that the SEC will more than adequately fulfill the desire of Congress to cause lawyers to report misconduct up the corporate ladder if it focuses on that group of lawyers who meet the common sense meaning of lawyers who practice before the Commission without extending the reporting obligation to more tangential individuals.
Finally, attorneys appearing and practicing before the Commission, however broadly defined need to have a clear understanding of what is meant by "evidence of a material violation." The proposed definition of "material" should explicitly track the language of Basic, Inc. v. Levinson11. Lawyers would then have a firm basis, informed by voluminous case law, upon which to determine whether they are confronted with a violation that is material. The phraseology, "conduct or information about which a reasonable investor would want to be informed" materially departs from the Basic, Inc. v. Levinson formulation, substituting a lower, vaguer standard.12
We also believe the phrases, "reasonable or reasonably," and "reasonably believes" should follow the approach that has been taken by some members of The ABA Task Force on Corporate Responsibility: i.e., evidence of the material violation should mean evidence such that the violation would be obvious to a lawyer of reasonable prudence and competence given the facts actually known to the lawyer13. If the Basic, Inc. v. Levinson standard of materiality is made explicit and the definitions of reasonability we have suggested are adopted, then there is some reason to believe that attorneys who are not skilled securities lawyers (but who are subject to the proposed rule), as well as skilled securities lawyers, can fairly understand and pursue their obligation to report misconduct up the corporate ladder.
Tightening this definition would go a long way to establishing reasonable parameters as to what constitutes a material violation of securities laws, a material breach of fiduciary duty or a similar material violation because in every instance the violation would have to be such that "there must be a substantial likelihood"14 that the disclosure of the material violation "would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available" if not disclosed.15
Enhancing the Effectiveness of Reporting up the Corporate Ladder; Qualified Legal Compliance Committee.
Reporting up the corporate ladder will, we believe, work powerfully if internal structures are instituted by issuers that make the process widely understood and accepted within a corporation's culture. The ABA Task Force on Corporate Responsibility has focused very usefully on suggesting ways of making the reporting mechanism workable by proposing the adoption of internal reporting protocols that are promulgated at the highest corporate levels. One of the problems with informal reporting up the ladder recognized by the ABA Task Force is the expectation that may be held by senior management that the lawyers they work most closely with and trust the very most - the general counsel or outside corporate counsel - owe a duty of loyalty to them personally. Clearly delineated lines of communication recognizing that the duty of loyalty is owed the corporation would dispel that very human assumption in a neutral and healthy way, empowering a lawyer to report over the head of senior management.
Section 307 in effect, mandates the adoption of healthy reporting protocols. In order to maximize a sense of corporate buy-in, and not just rote compliance, regulations adopted under Sarbanes-Oxley might require that the Boards of Directors adopt Codes of Conduct that clearly delineate the lines of communication within the corporation that are established to aid in compliance with Section 307, as well as delineating the purposes of the reporting protocol. We strongly urge the Commission to work creatively to bolster the effectiveness of the Sarbanes-Oxley Act internal reporting mandate before considering regulations that would mandate that lawyers must report to the Commission.
Finally, the idea of the establishment of a Qualified Legal Compliance Committee is a good alternative, whether or not the Commission insists that without such a committee, outside counsel may be required to make a noisy withdrawal to the SEC.
Reporting to the SEC
We urge the Commission to exercise its regulatory powers carefully, wisely and within the scope of the mandate Congress gave the agency16. The SEC's thoughtful approach to the role of the securities lawyer as enforcer of the securities laws set forth in the opinion it delivered in the Carter, Johnson17 case struck a fine balance that should not be repudiated.
We believe it would be a profound mistake for the Commission unilaterally to impose an obligation on attorneys to notify the SEC of their withdrawal and then to disaffirm any document filed with the Commission believed to be materially false or misleading. Due process is required, consensus among those who will be subject to the rule is essential. The difficult and conflicting policy considerations that underlie requiring or permitting lawyers to make noisy withdrawals to an appropriate third party to remedy or prevent financial injury require more than a 30-day written debate between one government agency and the securities law bar.
If the Commission determines to go ahead with mandating noisy withdrawal, then at minimum it must address the following issues:
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We appreciate the opportunity to comment on the rules proposed to be adopted by the Commission pursuant to Section 307. If we can be of any further assistance in this regard, please do not hesitate to contact Margaret A. Bancroft (212) 698-3590, Herbert F. Goodrich, Jr. (215) 994-2905, John V. O'Hanlon (617) 728-7111, Arthur Newbold (215) 994-2624, Jack W. Murphy (202) 261-3303 or Bruce B. Wood (212)698-3531.
cc: Hon. Harvey L. Pitt, Chairman