CONFERENCE OF CHIEF JUSTICES
December 13, 2002
Jonathan G. Katz, Secretary
RE: File No. 33-8150.wp
Dear Mr. Katz:
The Conference of Chief Justices respectfully submits for consideration of the Securities and Exchange Commission these comments on the proposed rules implementing Section 307 of the Sarbanes-Oxley Act. The Conference is transmitting these comments electronically. The positions taken by the Conference are solely those of the Conference and are independent of those of any other person or entity.
Principles of Federalism
The positions of the Conference begin with the premise that state supreme courts are traditionally the ultimate authority for the promulgation and enforcement of the regulation of lawyers on a day-to-day basis.(1) The Conference recognizes, of course, that federal courts and other tribunals may impose further requirements on lawyers in their practice before those tribunals. The Rules for Appearance and Practice before the Commission are long-standing examples.(2) The Conference also recognizes that an Act of Congress expressly preempting state law is presumptively valid under the Supremacy Clause(3) within the valid confines of the preempting legislation.
In keeping with the principles that balance supremacy and federalism, we assume for present purposes the validity and the underlying public interest of Section 307 of the Sarbanes-Oxley Act.(4) That Act requires the Commission to adopt rules "setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers, including a rule...requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof" within the corporation "up the ladder," as specified in the Act.(5)
An "Up the Ladder" Rule is Required by the Act
The "up the ladder" rule contemplated by the Act would be a mandatory rule that is similar, but not identical, to Model Rule 1.13 of the Model Rules of Professional Conduct, versions of which have been adopted by many state supreme courts to apply to lawyers licensed to practice by the respective states. Model Rule1.13 requires, as a matter of state ethics rules, that a lawyer for the corporation report serious law violations "up the ladder" within the corporation. Whether or not a mandatory federal version of Model Rule 1.13 as prescribed by the Act is necessary or consistent with principles of federalism is not the issue. Congress has deemed such a rule to be in the public interest in this limited area, and the Conference does not contend for purposes of these comments that such a Congressional policy determination is beyond the power of the Congress.
We submit, however, that the Act should be read to be consistent with principles of federalism insofar as it extends into the area of traditional state ethics rules and enforcement. It appears from the floor debate in the Senate that the drafters were targeting the need for clear and mandatory internal reporting "up the ladder" within the corporation. In the floor debate in the Senate, Senator Sarbanes inquired of Senator Edwards, the sponsor of the bill known as the "Edwards Amendment," whether the provision was limited to reporting within the corporation, and not outside. Senator Edwards confirmed that his amendment, which ultimately became Section 307, applies only to internal reporting within the corporation and does not require outside reporting.(6) Therefore, the Conference has concluded that the Commission rules to be promulgated under Section 307 should relate solely to internal reporting within the corporation, notwithstanding some arguably broader language in the Act.
Breadth of the Proposed Rules
We have examined the proposed rules and comment that were posted on the Commission's website on November 21, 2002. Focusing on proposed Rule 205.3, Issuer as Client, we have significant federalism concerns with the breadth of the proposed rules. These concerns are reinforced by the proposed application to attorneys "appearing and practicing before the Commission" as defined in Rule 205.2(a). As we read that definition, the reach of the proposed rules would go well beyond actual appearance and practice before the Commission and would include lawyers "participating in the process of preparing" any writing that the lawyer has reason to believe will be "incorporated into any ... document filed with or submitted to the ... Commission, or its staff...."(7) The rule, therefore, would seem to cover many transactional lawyers who are also subject to state ethics rules.
Because of the breadth of the proposed rules, there are federalism concerns and concerns that lawyers may be subject to inconsistent regulations at the state and federal levels. Moreover, the traditional role of the states as regulators of lawyer ethics is based largely on the enforcement capabilities of state supreme courts and their permanent, professional disciplinary counsel. Historically, each state has its time-tested enforcement apparatus to bring down wrongdoing in thousands of cases every year. Effective regulation of lawyer ethics requires the resources and special expertise of state supreme courts and state disciplinary counsel, which is vastly different from the securities market expertise and resources of the Commission. It will be impracticable, in our view, to replicate this lawyer regulatory regime of the states at the federal level.
Proposed Rules 205.3 (d) and (e)
With respect to proposed Rule 205.3(b), we recognize that this rule is designed to implement the "up the ladder" requirement of Section 307 of the Act. We also recognize that proposed Rule 205.3(c), providing the alternative internal reporting procedure through a qualified legal compliance committee, is a logical extension of the mandate of Section 307 of the Act to deal with internal reporting.
Our concerns center primarily on proposed Rules 205.3(d) (the so-called mandatory "noisy withdrawal" provision) and 205.3(e) (the so-called permissive "reporting out" provision). The Conference does not object to carefully circumscribed rules permitting "noisy withdrawal" or disclosure of client information outside the corporation if implemented by state supreme court ethics rules. In this comment letter we will address first the "reporting out" provision and second the "noisy withdrawal" provision.
The Conference has endorsed a proposed Model Rule that had been recommended by the ABA Ethics 2000 Commission to the ABA House of Delegates, which recommendation the ABA House had rejected in August 2001. The Ethics 2000 Commission proposed Model Rules 1.6(b)(2) and (3) that would permit--but not require--a lawyer to disclose client information outside the company if disclosure is reasonably necessary to prevent, mitigate or rectify the perpetration of a fraud or crime that is reasonably certain to cause substantial financial injury and in furtherance of which the perpetrator is using the lawyer's services. As set forth in the following Resolution, unanimously adopted by the Conference at its regular business meeting on August 1, 2002, the Conference is squarely on record as adopting a more aggressive approach than the ABA House of Delegates. Thus, the Conference has endorsed a policy that would permit the lawyer--as a matter of state ethics rules--to disclose a client's confidence under the circumstances stated in the Ethics 2000 proposal:
The Ethics 2000 proposal, endorsed by the Conference, is consistent with the ethics rules currently in force in 41 states. State supreme courts are now considering new state ethics rules in light of the Ethics 2000 proposals and the new Model Rules adopted by the ABA House. The endorsement by the Conference of the Ethics 2000 proposed permissive disclosure, while not inconsistent with the Commission's proposed rules, relates only to state ethics policy.
The Commission's proposed Rule 205.3(e) would permit outside disclosure as a matter of federal regulation of lawyer ethics. We believe that the outside reporting provision in the proposed rules goes beyond the intended scope of Section 307, which targets only "up the ladder" internal reporting. Accordingly, the proposed rule permitting outside reporting raises serious federalism issues that concern the Conference.
The Conference respectfully urges that the Commission defer promulgating rules that would permit outside reporting of the corporate client's confidences as a matter of federal regulation, and await further developments by state supreme courts as well as future corporate governance experiences to determine if such federal rules are necessary or desirable.
The same is true with respect to the "noisy withdrawal" requirements in the Commission's proposed Rule 205.3(d). The ABA Model Rules and the ethics rules adopted by various state supreme courts permit a noisy withdrawal.(8) The rule currently proposed by the Commission would go well beyond these state ethics rules and not only would require a noisy withdrawal but also would impose such a rule by federal regulation.
Like the permissive "reporting out" requirement of proposed Rule 205.3(e), we respectfully submit that a mandatory, federal "noisy withdrawal" rule, as proposed in Rule 205.3(d), is beyond the intended scope of the Act and is inconsistent with principles of federalism. Accordingly, we urge the Commission to defer taking any such steps on the proposed "noisy withdrawal" rule as well as the proposed reporting out rule.(9)
Historic Commission Policy
In our view, the expansive approach now proposed by the Commission for the regulation of the ethics of lawyers, as set forth in these proposed rules, is radically inconsistent not only with principles of federalism but also with historic Commission policy.(10) This traditional policy of the Commission has not been overturned by the Act, which was intended to require only a mandatory "up the ladder" rule. Accordingly, it would be consistent with the traditional approach of the Commission to defer further consideration of these proposed rules.
Comments on State Disciplinary Enforcement
Finally, the Conference is concerned about suggestions that have appeared in the debate on the Senate floor on the Edwards Amendment and in Chairman Pitt's August 12, 2002 speech to the ABA Section of Business Law to the effect that in some instances state disciplinary enforcement of SEC ethics referrals has been lacking. The Conference respectfully requests that the Commission advise it of any specific instances of such a lack of enforcement. If there are specific instances, the Conference will immediately urge the chief justice of any such state to take whatever steps may be reasonably required in that state promptly to investigate and, if necessary, to correct any such instances. The Conference would also request all chief justices to ensure that prompt action is taken on any future Commission referrals.
The Conference appreciates the opportunity to comment on the proposed rules and we stand ready to follow up or to answer any questions.