Sullivan & Cromwell LLP
April 7, 2003
VIA E-MAIL: firstname.lastname@example.org
Mr. Jonathan G. Katz,
Re: Proposed Rules Relating to Implementation of Standards of Professional Conduct for Attorneys (File No. S7-45-02)
Dear Mr. Katz:
We are responding to Release No. 33-8186 (the "Second Proposing Release"), in which the Commission solicited comments on proposed rules, including rules initially proposed by the Commission in Release No. 33-8150 (the "First Proposing Release"), and rules adopted by the Commission in Release No. 33-8185 (the "Adopting Release"). The proposed and adopted rules relate to standards of professional conduct for attorneys, including rules implementing Section 307 of the Sarbanes-Oxley Act of 2002.
We appreciate the Commission's consideration of our comments and the comments of other practitioners in its revision of the initially proposed rules. We are particularly appreciative of the Commission's decision to defer final action with respect to its initial noisy withdrawal proposal. We are certain that the Commission's decision to approach with due care and deliberation fundamental professional regulation beyond the mandate of § 307 of the Sarbanes-Oxley Act is in the best interests of investors as well as regulated parties.
Principal Comment - Inadvisability of Noisy Withdrawal. We continue to be deeply concerned by the proposed attorney withdrawal and Commission notification rules. Adoption of either proposal would do great violence to the attorney-client relationship by weakening attorney-client confidentiality - the foundation of the relationship. Investors will not benefit from less rather than more attorney-client candor and communication, but such is the likely effect of a noisy withdrawal rule. We do not discern a substantive difference between the Commission's initial and alternative noisy withdrawal proposals, and the objections we raised in our initial letter to the Commission regarding the concept of a noisy withdrawal requirement remain.
Recommendations Regarding the Noisy Withdrawal Proposals. We also have several substantive recommendations with respect to particular aspects of the Commission's noisy withdrawal proposals. Should the Commission adopt a noisy withdrawal rule:
Other Comments. We also have the following comments concerning the rules as adopted:
1. The Commission should not adopt a mandatory attorney withdrawal and Commission notification rule.
We continue to have the grave concerns expressed in our letter to the Commission of December 18, 2002 regarding the Commission's possible adoption of a mandatory attorney withdrawal and Commission notification rule.1 Our principal objections to adoption of a withdrawal and notification rule are that such a rule would:
(i) adversely affect the relationships between issuers and their attorneys that have quietly and consistently served the investing public since the basic federal securities laws were originally enacted in the 1930s;
(ii) impair the ability of attorneys to be zealous advocates; and
(iii) exceed the Commission's authority.
Regarding the importance of the attorney-client privilege and the effect of a noisy withdrawal rule on the attorney-client relationship, we stated in our prior letter that:
Because the Commission has stated that it will consider all comment letters previously submitted, we will not go into further detail on our earlier comments.
The Commission's alternative proposal does not alleviate our principal concerns regarding the effects of a noisy withdrawal rule. We appreciate the Commission's sincere efforts to craft a rule that will enable it to reap the investor protection benefits that it no doubt believes would accrue from the enforcement assistance provided by a notification requirement, without preventing attorneys from meeting their ethical obligations, but we do not believe that it is possible to formulate such a rule. We continue to believe that the investing public is better served by a multitude of attorneys confidentially counseling issuers to do the right thing than by attorneys reporting evidence that the wrong thing was done, particularly when that reporting comes at the cost of the overall quality of issuer-attorney candor and communication. Whether or not the Commission ultimately accepts this view, it should not be under any illusion that its alternative proposal substantively addresses our concern regarding the damage such a rule would do to the attorney-client relationship - a concern that has been expressed to the Commission by nearly all members of the securities bar who have commented.
The alternative proposal nominally requires the issuer to notify the Commission of the attorney's withdrawal. But § 205.3(d) is a rule implementing an attorney professional conduct statute, not an issuer disclosure statute. The issuer has no independent obligation under the rule. Rather, it has a derivative obligation to disclose information protected by the privilege in response to the attorney's notice, which is itself mandatory. The rule would not decree ex ante exactly what the issuer must say, nor would it require the issuer simply to repeat the contents of the attorney's notice of withdrawal; however, the alternative rule's essence is the issuer's obligation to divulge privileged information in response to the attorney's notice. We note that the alternative proposal does more harm to the attorney-client privilege than the initial proposal because it would require public disclosure of more information (i.e., the "circumstances" of the withdrawal) than the initial proposal would require to be disclosed confidentially. The alternative proposal also requires that the issuer make its disclosure within two business days of the attorney's withdrawal, eliminating the discretion to take into account the relevant facts on the ground inherent in the initial proposal's directive that the attorney issue his or her disaffirmation "promptly."2
"The attorney-client privilege is the oldest of the privileges for confidential communications known to the common law."3 The "privilege is founded upon the necessity, in the interest and administration of justice, of the aid of persons having knowledge of the law and skilled in its practice, which assistance can only be safely and readily availed of when free from the consequences or the apprehension of disclosure."4 The privilege is of sufficient importance that it should safeguard against indirect as well as direct disclosures of protected information. We do not believe that an attorney should consider himself or herself to be acting in a manner consistent with his or her confidentiality obligations if he or she were to use a non-attorney (including the client) to make an otherwise prohibited disclosure. Should this method prove a permissible way to circumvent the attorney-client privilege, there will undoubtedly be no end to the list of authorities that will seek to impose similar requirements on attorneys representing regulated parties.
2. Should the Commission adopt a mandatory attorney withdrawal and Commission notification rule, the rule should be revised to limit the scope of the withdrawal provisions and to permit the issuer's board to not report the withdrawal to the Commission in appropriate circumstances.
Should the Commission adopt a mandatory attorney withdrawal and Commission notification rule, the rule should be revised from the form proposed so that the attorney withdrawal provisions do not require an attorney to withdraw from matters other than matters for which the attorney appears and practices before the Commission on behalf of the particular issuer. The rule should permit an issuer to not report the attorney's withdrawal in the event that an independent committee of the board of directors determines, based on the advice of counsel, (i) that the issuer has implemented an appropriate response, including by obtaining advice that a colorable defense could be raised with respect to the suspected material violation, or that an appropriate response was implemented previously, or (ii) that the attorney providing such notice acted unreasonably in withdrawing from representation. The rule should provide that an issuer's notice to the Commission regarding an attorney's withdrawal should be made on a confidential basis. Finally, the certainty threshold that should be met before an attorney is required or permitted to withdraw should exceed the threshold triggering the attorney's initial up-the-ladder report, and an attorney should be permitted to report outside the issuer only where the suspected material violation is ongoing or is about to occur.
The attorney withdrawal provisions in both of the Commission's proposals would require an attorney retained by the issuer "to withdraw from representing the issuer," however, the proposed rules do not make clear the extent of the required withdrawal.5 The Commission stated in the First Proposing Release that it expected that an attorney's withdrawal would be from "all matters."6 In the Second Proposing Release the Commission solicited comment regarding whether a required withdrawal should be "from all representation of the issuer, or only from representation on the matter concerning the material violation."7 We believe that the scope of the required withdrawal should not exceed matters with respect to which the attorney appears and practices before the Commission in the representation of the particular issuer. An "all or nothing rule" is undesirable because it would (i) incongruously impose the rules' most draconian requirement on engagements that are not otherwise covered by the rules' up-the-ladder reporting and other provisions; (ii) prejudice issuers with multinational operations and diverse representation requirements; and (iii) create a needless inconsistency between the rules applicable to in-house and outside counsel.
We believe that the range of representations subject to potential withdrawal under the attorney conduct rules should not exceed the range of representations encompassed by the definition of "appearing and practicing before the Commission." An "all matters" withdrawal requirement would be internally inconsistent because it would require the withdrawal of all attorneys affiliated with a single firm, including both attorneys who represent the issuer on matters before the Commission (and thus subject to the rules' reporting and other provisions), and attorneys who represent the issuer in matters unrelated to Commission practice (and thus otherwise without obligations under the rules). Such a rule would also extend far beyond any set of adopted conduct rules or accepted model canon governing both mandatory and permissive attorney withdrawals. ABA Model Rule 1.6(a) requires the withdrawal of counsel from representation where "the representation will result in violation of the rules of professional conduct or other law." (Emphasis added). ABA Model Rule 1.6(b) permits an attorney's withdrawal where, among other things, "the client persists in a course of action involving the lawyer's services that the lawyer reasonably believes is fraudulent" or "the client has used the lawyer's services to perpetrate a crime or fraud." (Emphasis added). The professional rules in the various states are in accord with the ABA's Model Rules on this point.8
A rule mandating withdrawal from all matters would not only exceed local requirements but would often be at odds with them. Attorneys are bound by an affirmative ethical obligation to continue representing a client at least until appropriate steps are taken to ensure that the withdrawal will not prejudice the client's interests. Under rules codifying this obligation, an attorney may be unable to withdraw from representation even in the circumstance in which it has come to the attorney's attention that the client has engaged in misconduct directly related to the representation. 9 An attorney has no inherent right to withdraw representation in a given matter simply because the attorney may for professional reasons withdraw from a separate matter. The Commission's proposed rule provides some cover by allowing that an attorney need not comply with the withdrawal requirement if the attorney would be prohibited from doing so by order or rule of any court or other applicable body, if the attorney seeks leave to withdraw.10 However, the exercise of seeking leave, for example from a state tribunal, to withdraw from a matter where the reason for the withdrawal does not meet so much as the threshold for a permissive withdrawal under applicable conduct rules would seem a futile exercise even ex ante. There seems little justification in burdening tribunals with pro forma requests for withdrawal, and there is a strong policy argument in favor of minimizing disruptions to tribunals with unnecessary counsel substitutions, even assuming tribunals could be prevailed upon to countenance requested substitutions.
The Commission can accomplish its purpose without adopting a rule that effectively collapses representations both implicating and unrelated to practice before the Commission into a deemed single representation for purposes of the withdrawal requirement. The issuer is indeed an organization, and an organization may require representation as to a host of unrelated and compartmentalized matters. An "all or nothing" withdrawal standard would undermine the ability of issuers with diverse or multinational operations and representation needs to retain effective continuous representation in its disparate active matters. Many companies have representation needs that are far afield from and do not affect securities disclosure. There is no investor protection rationale that would justify precluding an issuer from retaining desired counsel in matters unrelated to its dispute with counsel. To the contrary, an "all or nothing" rule would tend to create an incentive for issuers to disperse unrelated matters among various firms, or to avoid using outside counsel on disclosure matters. In either case, the effect could be to remove disclosure counsel from a position of proximity to counsel for other matters, which could adversely affect disclosure quality.
The requirement that an outside attorney's withdrawal be from "all matters" also creates an incongruity with the requirements applicable to in-house attorneys who need only cease "any participation or assistance in any matter concerning the violation."11 It is clear that the Commission believes that "[r]equiring an in-house attorney employed by the issuer to resign . . . appears to be unreasonably harsh."12 Nevertheless, if this standard is workable for inside attorneys it would seem to be all the more so for outside attorneys who may practice with firms with relatively compartmentalized practice groups that handle various unrelated matters for a single issuer.
B. An attorney should not be required to withdraw where he or she has discovered evidence of a material violation unrelated to the representation.
Proposed § 205.3(d) would require an attorney to withdraw if he or she does not receive an appropriate response within a reasonable period of time to the attorney's material violation report. The proposed rule does not distinguish the circumstance where an attorney becomes aware of evidence of a material violation that is related to the attorney's representation from the situation in which an attorney discovers evidence of a material violation unrelated to the engagement. There is a distinct lack of equity in a rule that requires an attorney to abandon an engagement as a result of the attorney's diligence in uncovering and responding to a potential issue. As we note in A. above, state ethics rules do not, without more, so much as permit a voluntary withdrawal under circumstances where the Commission's proposed rules would command withdrawal.
There is great value to the investor in a rule requiring an attorney to report up-the-ladder evidence of misconduct - however the attorney's awareness of the evidence may have originated. Any attorney attentive to his or her professional responsibilities would respond to such evidence, whether it was discovered in the course of the representation and germane to the engagement or overheard in a social setting. It serves no purpose, however, to "reward" the attorney for his or her discovery and reporting with the potential loss of the client. For example, an attorney representing an issuer before the Commission in connection with securities litigation could become aware of evidence that raises in the attorney's mind suspicions that material tax law violations unrelated to the subject matter of the litigation have taken place. The litigator should report this evidence up-the-ladder, and would be likely to do so irrespective of any regulatory obligation.
It is difficult to discern an investor protection rationale for requiring the litigator to undertake action beyond up-the-ladder reporting with respect to the evidence. The hypothetical litigator has not been retained to provide tax law advice and is unlikely to be comfortable or competent in rendering judgments on such matters.13 An attorney in such a situation should have every incentive to report the evidence, but the proposed rule creates an incentive to remain silent. A rule that creates an incentive for an attorney to not serve the client beyond the strict terms of the engagement is not in investors' interests.
C. Any noisy withdrawal rule should take into account that the matter of concern to investors is the suspected material violation, and not the lawyer's withdrawal.
The Commission has solicited comment regarding whether an issuer should be able to determine not to report an attorney's notice of withdrawal if an independent committee of the board of directors determines, based on the advice of counsel, (i) that subsequent to the attorney's notice, the issuer has implemented an appropriate response, or (ii) that the attorney providing such notice acted unreasonably.14 If the Commission ultimately adopts a noisy withdrawal rule, we believe that an issuer should be permitted not to disclose an attorney's written notice if it receives advice of counsel that the relevant circumstances meet the definition of "appropriate response." If an issuer believes that the definition has been met, and has received advice of counsel consistent with this view, the operative fact is not that of a material violation, which is in dispute and of which there is only "substantial evidence" in the view of a single attorney. Rather, the operative fact would be that there exists a disagreement between an issuer and an attorney for the issuer. The rules intend that an attorney's withdrawal serve as a proxy for the presence of a material violation. Where an issuer has obtained contrary advice from counsel, the mere fact of the first attorney's withdrawal is unlikely to serve as adequate proxy to justify an extraordinary disclosure on the part of the issuer. The rule should filter, prior to disclosure, evidence of attorney-client disagreements from evidence of material violations.
The Commission's suggestions are also consistent with the overriding purpose of many provisions of the Sarbanes-Oxley Act that are designed to empower boards of directors to meet their responsibilities as corporate stewards. The suggestions go part of the way to mitigating one of the problems the noisy withdrawal rules create, specifically the negative implications for corporate governance created by a requirement that the judgment of an issuer's lawyer effectively supersede the judgment of its board of directors. If ever there was a strong argument to support the substitution of the judgment of counsel for the judgment of the board, it would have to be predicated on the misfeasance of a tainted board or the nonfeasance of a supine board. The Commission's suggestions eliminate these dangers because they would allow reporting to be avoided only in the case where independent board members, informed by counsel, reach a reasoned conclusion that reporting is not necessary.
The language employed by the Commission in soliciting comment as to whether notice to the Commission should be required where advice of counsel is obtained to the effect that the issuer has "implemented" an appropriate response is ambiguous. The issuer should be permitted to not make a notification if it obtains counsel's advice that any element of the definition of "appropriate response" is met, and irrespective of the time at which the appropriate response occurred.15 If the issuer has been advised that its counsel can assert a colorable defense in a proceeding related to the reported evidence, and the issuer wishes to proceed on that basis, it should not be required to take further action to avoid a reporting obligation. Indeed, in such a circumstance the issuer's defense could be compromised by taking action inconsistent with the view of its counsel. The second counsel should also not be constrained to find that the appropriate response was undertaken "subsequent" to the withdrawal of the first attorney. The rule should take into account that attorneys may disagree as to whether appropriate remedial measures have been undertaken, and issuers should not be effectively penalized for retaining particularly conservative (or mistaken) counsel in the first instance.
D. An issuer's notice to the Commission regarding an attorney's withdrawal should be made on a confidential basis.
The Commission has solicited comment regarding whether an issuer's notification to the Commission under proposed alternative § 205.3(e) should be confidential or public.16 We believe that such reporting should be made on a confidential basis. Public reporting could lead to materially misleading, as well as unnecessary, disclosures.
The alternative proposal would require an attorney to withdraw in the event that the attorney "reasonably concludes that there is substantial evidence" of a material violation.17 This standard falls considerably below certainty. The Commission may believe that under such circumstances notification to it would be worthwhile in order to trigger potential Commission action. The Commission's action would likely take the form of an investigation to determine whether the attorney's concerns are adequately supported by the relevant facts. It may be determined in due course that the attorney's concerns are not adequately grounded in fact, that there is an underlying violation but that the violation does not meet the definition of "material violation," or that an appropriate response was implemented. A public disclosure of an attorney's withdrawal under the rules would likely trigger immediate massive price volatility in the issuer's publicly traded securities, as well as the filing of lawsuits. In the circumstance where the attorney is mistaken concerning the import of the identified substantial evidence, the issuer and its security holders will have paid a high price as a result of the inevitable public reaction to what would have proven to be a misleading disclosure. If disclosure to the Commission is made on a confidential basis, the issuer and the Commission can come to an understanding regarding the relevant facts free of an atmosphere of turmoil caused by disclosure to the public.
A requirement that an issuer make a separate disclosure regarding the attorney's withdrawal is also likely to be superfluous in most, if not all, instances. The definition of material violation includes the term "material," which the Commission intends to be understood under the term's well-established meaning under the federal securities laws.18 An issuer will be required to disclose the existence of material facts and circumstances, including imminent or ongoing material violations, under current disclosure requirements. As a result, the requirement that an issuer disclose publicly the attorney withdrawal would not fill a gap in the information the issuer would be required to disclose in the absence of the rule.
E. The certainty threshold that must be met before an attorney is required or permitted to withdraw should exceed the threshold triggering the attorney's initial up-the-ladder report, and an attorney should be permitted to report outside the issuer only where the suspected material violation is ongoing or is about to occur.
If the rules require an attorney to withdraw under specified circumstances, the circumstances should include a high level of certainty on the part of the attorney regarding the existence of an ongoing or impending material violation that will have a substantial impact on financial interests of the issuer or investors, before being required or permitted to report externally. The Commission's proposed "reasonably concludes" standard as set forth in its alternative noisy withdrawal proposal is an appropriate standard.19 The consequences of an attorney's withdrawal and disclosure, whether undertaken in response to a requirement or accomplished on his or her own initiative, can be momentous and all but irrevocable. The issuer and its investors should not be required to suffer the effects of such consequences absent a high degree of certainty on the part of the attorney that his or her action is warranted.
The rules should not permit reporting in the circumstance where the suspected material violation has occurred and is not ongoing. There is arguably a strong investor protection rationale served by permitting an attorney to disclose otherwise privileged information in order to prevent or cease a material violation. In such instances the attorney's disclosures can directly prevent or mitigate financial losses about to be suffered or being suffered by investors. Where the violation has occurred and is not ongoing, the investor protection rationale for an immediate disclosure on the part of the attorney is limited, if it exists at all, because the violation and consequences to investors are complete. The direct beneficiary of the attorney's immediate disclosure in such case is the enforcement authority. It is much more difficult to justify requiring disclosure of information protected by the attorney-client privilege in the circumstance where investors do not benefit directly and the enforcement authority assisted by the disclosure is the one against which the issuer will likely need to defend.
It is also less than clear that the circumstance in which a past material violation occurs but does not dovetail into an ongoing material violation will occur with much frequency in the federal securities law context. Given covered issuers' continuing obligations to disclose material information, the line between past and ongoing material violations is likely to be a close one. As a result, in the securities context it seems particularly appropriate to limit permissive withdrawals to circumstances in which a withdrawal is necessary to address a material violation that is believed to be ongoing or about to occur.
3. The definition of "appearing and practicing before the Commission" should be revised so that the rules do not capture practice incidental to advising as to the sufficiency of disclosure.
Investors and regulated parties alike would be best served by a clear rule establishing when an attorney's practice is covered by the conduct rules. A lawyer should intuitively understand that a direct engagement to advise an issuer with respect to the sufficiency of a disclosure document under the federal securities laws would subject the lawyer to applicable Commission regulation. A lawyer without such responsibilities is less likely to even be aware of regulations specifically related to appearing and practicing, and, if made aware, would not likely respond to such regulation in a way that would benefit investors. The interests of investors could be harmed by rules that encourage non-securities attorneys to steer clear of contact with practice that is incidental to appearing and practicing before the Commission. There is unavoidable complexity enough in the various standards for conduct and analysis embedded in the rules - there should not be ambiguity regarding the conduct covered by the rules in the first place.
Clause (iii) of the definition of "appearing and practicing before the Commission" contains a potential trap for the unwary in the form of an ambiguity as to whether attorneys will be covered by the rules in certain instances.20 The clause states that covered practice includes:
The clause is broad enough to capture transactional practice by an attorney who could legitimately believe that he or she has not engaged in covered activity. For example, an attorney engaged to represent a client in connection with the negotiation of an agreement may be called upon to offer advice as to whether the agreement should be filed with the Commission. If the attorney advises the client that the document need not be filed, and the document is nevertheless filed subsequently on the advice of a second attorney, the first attorney should not bear obligations under the rules other than for the advice that the document need not be filed.
The clause also seems so broad as to cover the great bulk of the ancillary review and advice that is an indispensable component of preparing disclosure documents, but which is generally accomplished by brief reviews of discrete information on the part of attorneys who never review a finished product. Section 307 of the Sarbanes-Oxley Act was "designed to assure that attorneys are responsible for fully informing their corporate client[s] of evidence of material violations of Federal securities law." 21 A non-securities attorney who engages in a piecemeal review of particular disclosure is unlikely to be able to "fully inform" the issuer of potential violations of securities law. Perhaps more importantly, such an attorney may be unwilling to incur the potential obligation to do so. Reviews of this nature may cease if providing the courtesy subjects the attorney to Commission regulation. Neither issuers nor investors would benefit from such a development.
The Commission has acknowledged that non-U.S. attorneys should not be covered by the rules in situations where their appearing and practicing before the Commission is incidental to their ordinary course practice in a field other than U.S. securities law. Such practitioners will not be responsible for making final judgments as to the sufficiency of disclosure. It is unnecessary for the rules to cover non-securities attorneys who are involved in disclosure production only incidentally. We therefore believe it appropriate to import into clause (iii) of the definition of "appearing and practicing before the Commission" an exception for incidental practice, similar to that included in the definition of "non-appearing foreign attorney."
Recommendation. For the foregoing reasons we recommend that the Commission revise clause (iii) of the definition of "appearing and practicing before the Commission" to read as follows:
4. The evidentiary threshold triggering an initial up-the-ladder report is set too low when considered in light of the requirement that an attorney report evidence "forthwith."
The adopted definition of "evidence of a material violation," the awareness of which triggers an attorney's obligation to report up-the-ladder, is met when it would be unreasonable for a prudent and competent attorney "not to conclude that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur."22 The Commission has adopted a relatively low evidentiary threshold for reporting (i.e., awareness on the part of the reporting attorney of credible evidence that a material violation is reasonably likely to have occurred, to be ongoing, or to be about to occur). The Commission stated in the Adopting Release that "[t]o be `reasonably likely' a material violation must be more than a mere possibility, but it need not be `more likely than not.'"23 As a result, § 205.3(b)(1), read together with the Adopting Release, requires an attorney to issue an initial up-the-ladder report even if the attorney does not believe that there is so much as a 50% chance that there is in fact a material violation. The rule thus effectively requires counsel to "cry wolf" to chief legal officers. The required cry is likely to be quite plaintive where the reporting attorney has little certainty regarding the attendant circumstances.
Investors will not be well served by a hair-trigger reporting requirement that forces a prudent and honest attorney to act in an imprudent and uninformed manner. If the Commission wishes to require attorneys to commence a formal reporting process "forthwith," it should permit them to build a greater degree of certainty than that meeting only a "reasonably likely" test. A higher standard, such as "more likely than not," would allow an attorney more certainty at the point of reporting, which should also enable the attorney to better evaluate whether an appropriate response has been received. A more likely than not standard also has the benefits of clarity and familiarity. The standard would provide a clear cutoff at 50%, whereas the Commission has not even attempted to quantify its adopted standard. The more likely than not standard is familiar to attorneys because it is the standard of the plaintiff's burden in civil litigation. The standard would thus be familiar to both regulated parties and to tribunals assessing compliance.
In the Adopting Release the Commission stated that it "intends the definition of the term "reasonably likely" to be consistent with the . . . final rule governing disclosure of off-balance sheet arrangements." This guidance may provide a further basis for interpreting the meaning of the term, but it seems inappropriate to apply a standard designed to elicit public disclosures of contingencies, identified as such, to trigger reporting within the highest levels of an issuer's governance structure regarding concerns of violations of law and fiduciary duty. Whether a law or duty has been violated may be a matter of dispute; however, the dispute would turn on whether it is more likely than not that the conduct occurred, not whether it is or is not reasonably likely that the violation occurred.
Recommendation. For the foregoing reasons we recommend that § 205.2(e) be revised to read as follows:
5. The Commission should revise the provisions related to "qualified legal compliance committees" ("QLCC") to encourage widespread adoption of the QLCC.
The Commission has encouraged issuers to adopt the QLCC as a means of effective corporate governance.24 We note, however, that the rules' provisions pertaining to QLCCs include unnecessary obstacles to widespread adoption. Issuers would be more likely to adopt the QLCC if the Commission were to revise provisions in the rules relating to QLCC membership and the required timing of establishment.
A. The Commission should revise the definition of "qualified legal compliance committee" to permit and encourage its creation by non-U.S. issuers and newly public issuers.
The Commission's conception of the QLCC as a mechanism to augment issuer reporting seems to be derived from its mandate in § 307 of the Sarbanes-Oxley Act to adopt rules requiring attorneys to report to, among other persons, "another committee" of non-employee directors other than the audit committee. Section 307 seems to provide the Commission with wide latitude to select criteria for such a committee. The adopted definition of "qualified legal compliance committee" may discourage widespread adoption of QLCCs. Specifically, the definition's lack of flexibility with respect to non-U.S. issuers and new reporting companies will discourage these entities' adoption of the QLCC, and the required overlap between the QLCC and the audit committee will unnecessarily burden audit committee members, discouraging adoption across the board.
The adopted definition of "qualified legal compliance committee" requires that the QLCC consist exclusively of non-employee directors. The Commission has indicated that it anticipates that QLCC membership qualifications will be amended to conform to the Commission's final audit committee independence rules under § 301 of the Sarbanes-Oxley Act.25 The Commission's newly adopted rules regarding audit committee membership qualification26 would permit a non-U.S. issuer to include on its audit committee employees who are not executive officers if the employees are elected or named under home country legal or listing requirements.27 The rules also permit a non-U.S. issuer to include on its audit committee representatives of governmental affiliates or majority shareholders under specified circumstances.28 In addition, the rules allow one member of a non-investment company issuer's audit committee to be exempt from independence requirements for a limited period from the effective date of the issuer's registration statement in connection with its initial public offering. 29 The attorney conduct rules are of universal applicability, as are the audit committee rules. The Commission has acknowledged in the context of its audit committee rules that it is simply impossible for certain non-U.S. issuers to establish any board committee comprised solely of non-employees or persons unaffiliated with a controlling governmental entity or shareholder. The Commission has also recognized that newly public issuers could benefit from flexibility to facilitate the transition from private to reporting company. The Commission should make equivalent dispensations for QLCC members of both foreign private issuers and both newly public issuers and issuers with an initial Securities Act registration statement on file with the Commission.
Recommendation. For the foregoing reasons we recommend that the Commission revise the definition of "qualified legal compliance committee" to provide to non-U.S. issuers, new reporting companies and issuers with a Securities Act registration statement on file with the Commission relief from the QLCC member independence requirements commensurate to the relief afforded such issuers in the Commission's final audit committee rules.
B. The Commission should revise the definition of "qualified legal compliance committee" to eliminate the required overlap between the QLCC and the audit committee.
The adopted QLCC definition also requires an overlap of no less than one member between the QLCC and the audit committee.30 We believe that this required overlap is unnecessary and threatens to add difficulty to the already daunting task that issuers may face in attempting to garner sufficient staffing for effective QLCCs. Anecdotal evidence and prominent press accounts have indicated that fears of greater liability have made it difficult to recruit audit committee members.31 The demands of QLCC membership would be, at a minimum, an incremental burden atop the burdens imposed by the Sarbanes-Oxley Act on audit committee members. The cumulative burdens placed on audit committee members may make it very difficult for the issuer community to find appropriate individuals willing to fulfill overlapping roles. We note also that nothing contained in § 307 of the Sarbanes-Oxley Act requires the "other committee" referenced to overlap in any way with the audit committee.
Recommendation. For the foregoing reasons we recommend that the Commission revise the definition of "qualified legal compliance committee" to permit a board of directors to designate members of the QLCC who meet the definition without regard to audit committee or other committee overlap.
C. An issuer should be permitted to establish a QLCC after a material violation report is made, and refer the report to the new QLCC.
The Commission's intent to encourage widespread adoption of the QLCC is also undermined by the requirement in § 205.3(c) that material violation reports may be referred only to a "previously formed" QLCC. If adoption of a QLCC creates an effective body to address material violation reports, such will be the case whether or not the committee existed prior to the origination of a particular report. Whether or not the QLCC was established ex ante, the committee will bring to bear a focused and informed group of independent directors to address any underlying issue.
The Commission notes in the First Proposing Release that "the QLCC institutionalizes the process of reviewing reported evidence of a material violation."32 The prior existence of a QLCC could encourage interested parties, other than attorneys, to report issues to the QLCC. However, even in the absence of a QLCC, such reports may be made to the audit committee under the Commission's new rules with respect to audit committees, and the up-the-ladder reporting rules will ensure that attorney reporting is undertaken in accordance with Commission-mandated procedures.33
6. The definition of "issuer" should be revised to eliminate ambiguity regarding when an attorney who represents a controlled person of an issuer will be deemed to represent the issuer.
The adopted definition of "issuer" effectively imputes an attorney-client relationship between an issuer and an attorney if the attorney performs services for an entity controlled by the issuer "on behalf of, or at the behest, or for the benefit of the issuer," whether or not the attorney is actually retained by the issuer.34 The Commission wisely jettisoned this imprecise "behalf, behest or benefit" language in its initially proposed definition of "in the representation of an issuer," and should delete it from the definition of issuer as well.35
The language attempts to address the circumstance in which an attorney "represents the parent company and its subsidiaries."36 The Commission is correct to take steps to ensure that the rules cannot be circumvented by pushing representation down levels in a holding company structure. Nevertheless, the "behalf, behest or benefit" language is overly broad and could lead to the imputation of an attorney-client relationship where patently inappropriate. For example, an attorney representing a subsidiary with substantial independent operations and legal issues may have confidentiality obligations to the subsidiary that would render it inappropriate for the attorney to disclose its confidential information to any of the subsidiary's constituents, including the parent company, even where an argument can be made that the attorney's representation of the subsidiary is "for the benefit" of the issuer. The attorney's duty of loyalty to the actual client will raise further issues where the client is less than 100% owned by the parent issuer. Also, many issuers have subsidiaries that are reporting companies in their own right and the attorneys for such subsidiaries will be covered by the attorney conduct rules in any event. The definition should be tailored to close a potential loophole that could allow issuers to avoid the rules by pushing down disclosure tasks to subsidiaries that are non-reporting companies. The definition need not cast a wide net that captures attorneys with legitimate professional obligations to subsidiaries or other controlled persons.
Recommendation. For the foregoing reasons we recommend that the Commission revise the last sentence of the definition of the term "issuer" to read as follows:
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We appreciate the opportunity to comment to the Commission on the proposed rules, and would be pleased to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to John T. Bostelman (212-558-3840), Richard R. Howe (212-558-3612) or Robert S. Risoleo (202-956-7510).
cc: Hon. William H. Donaldson, Chairman
Giovanni P. Prezioso
Alan L. Beller
Paul F. Roye
Annette L. Nazareth