Proposed SEC Standards — Round 2 for SEC Bar | New York Legal Ethics Reporter

Proposed SEC Standards — Round 2 for SEC Bar

By Roy Simon

[Originally published in NYPRR March 2003]

On Nov. 21, 2002, to comply with the Congressional mandate in §307 of the Sarbanes-Oxley Act of 2002, the SEC issued proposed Standards of Professional Conduct for Attorneys. Among other things, the November proposals would have required an attorney to make a so-called “noisy withdrawal” if an issuer did not respond appropriately after an attorney reported evidence of a material violation of the securities laws.

On Jan. 30, 2003, after reviewing numerous comments on its November proposals, the SEC released “final rules.” These final rules will take effect around July 30, 2003, which will be 180 days after their publication in the Federal Register. In the same release, however, in response to the “vast majority” of those who commented on the November proposals (including the American Bar Association and the Association of the Bar of the City of New York), the SEC extended the comment period on the noisy withdrawal proposals, and offered an “alternative” to the noisy withdrawal proposals.

The SEC will be receiving comments on the noisy withdrawal proposals and the alternative proposals until April 7, 2003. Moreover, the SEC has stated that its actions on the alternative proposals may lead it to change the final rules that were issued on Jan. 30, 2003. Thus, three options are actively on the SEC table: (1) the original noisy withdrawal rules proposed in November 2002; (2) the alternative to noisy withdrawal proposed in January of 2003; and (3) the final rules as adopted, which are scheduled to take effect in late July. This article reports on these three options with the aim of encouraging readers to file comments with the SEC by the April 7th deadline

SEC’s Final Rules as Adopted

If the SEC does nothing further, the final rules that the SEC has already adopted will take effect in late July 2003. Thus, the final rules are the official status quo against which the other options should be measured.

Basically, the final rules apply to any attorney who appears and practices before the SEC in the representation of issuers in any manner. If such an attorney discovers “evidence” that a material violation” of the securities laws has occurred, is occurring, or is about to occur, then the attorney must report the evidence directly to the issuer’s chief legal officer (CLO). The attorney has the option of reporting the evidence to the CEO as well, but reporting to the CEO does not excuse reporting to the CLO. The mandatory reporting rules do not depend on whether the reporting attorney “knows” or has “knowledge” of a past, present, or future material violation — the trigger for a report is merely that the attorney has “evidence” of a material violation.

Once an attorney reports evidence of a material violation to the CLO, the CLO must do two things: (a) inquire into the evidence of the material violation, and (b) take reasonable steps to cause the issuer to adopt an “appropriate response,” unless the CLO reasonably believes based on this inquiry that no material violation has occurred, is occurring, or is about to occur.

If the CLO and/or CEO do not provide an appropriate response within a reasonable time, the attorney must (a) report the evidence “up the ladder” to an appropriate committee of the issuer’s board of directors or to the full Board, and (b) explain to the CLO, CEO, or Board why the response (or lack of any response) to her original report is inappropriate.

If the issuer still fails to adopt an appropriate response at this juncture, the final rules permit (but do not require) the attorney to report confidential information to the SEC to the extent the attorney reasonably believes necessary for any of three purposes:

(i) to prevent the issuer from committing a material violation likely to cause substantial injury to the financial interest or property of the issuer or investors, or

(ii) to prevent the issuer, in a Commission investigation or administrative proceeding from committing perjury, suborning perjury, or perpetrating a fraud upon the Commission, or

(iii) to rectify the consequences of a material violation by the issuer that has caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney’s services were used.

(For the sake of space and simplicity, I am not going to discuss the provisions of the final rules creating a new creature called a “Qualified Legal Compliance Committee,” or QLCC, an optional committee composed of at least one member of the issuer’s audit committee or equivalent committee and two independent directors. A QLCC would have special responsibilities for responding to an attorney’s report of evidence of a material violation. If an issuer creates a QLCC before receiving the attorney’s report, then the attorney’s follow-up responsibilities are significantly reduced.)

Noisy Withdrawal Comments Period Extended

The final rules as adopted do not include the SEC’s November 2002 proposal for mandatory “noisy withdrawal,” but the comment period on the noisy withdrawal proposal has now been extended until April 7, 2003. The proposed noisy withdrawal provisions would apply whenever an attorney has reported evidence of a material violation but (1) has received a response that falls short of what is “appropriate” (i.e., the issuer admits a material violation but takes measures that are too weak, or the issuer unjustifiably denies any material violation), or (2) the attorney has not received any response at all within a reasonable time. Once this trigger is in place — either an inadequate response or no response at all — the proposed noisy withdrawal provisions would apply, but they would distinguish (a) past violations from ongoing violations and imminent future violations, and (b) “retained” (i.e., outside) counsel from “employed” (i.e., in-house) counsel.

The most controversial noisy withdrawal provisions relate to violations that are (1) either ongoing or about to occur, and are (2) likely to result in substantial injury to the financial interests or property of the issuer or its investors. In these situations, outside counsel would be required to take three steps:

1. Withdraw forthwith based on “professional considerations,” and

2. Notify the SEC of the withdrawal by the next business day, and

3. Promptly disaffirm to the SEC any opinion, document, representation, etc., that the attorney prepared and filed with the SEC that the attorney reasonably believes may be materially false or misleading.

An in-house attorney, in contrast, would not have to withdraw (because that would mean quitting her job, which is too heavy a burden), but the in-house attorney would have to notify the SEC by the next business day that a disaffirmance of opinions or documents will be forthcoming, and then promptly follow up with the actual disaffirmance.

If the violation has already occurred and has likely resulted in substantial injury to the financial interest or property of the issuer or its investors, but the violation is not ongoing, the identical steps would apply but would be discretionary (“may”) instead of mandatory (“must”). Thus, past violations would give the reporting attorney the option of reporting to the SEC, whereas ongoing or imminent violations would require the attorney to report to the SEC.

In addition, once an attorney withdrew, the issuer’s chief legal officer (CLO) would be required to inform any successor attorney that the previous attorney withdrew based on “professional considerations.”

Finally, §205.3 (d)(3) of the alternative rules states that the mandatory or discretionary notifications to the SEC would not breach the attorney-client privilege.

As I have noted, the SEC’s January release announcing the final rules omitted the noisy withdrawal provisions but extended the comment period on them until April 7th. Also, recognizing that many segments of the bar oppose the noisy withdrawal proposal, the SEC has proposed an alternative to noisy withdrawal, to which I now turn.

Alternative to Noisy Withdrawal

Like the final rules already approved, and like the noisy withdrawal proposal, the alternative rules proposed in January distinguish between attorneys “retained by the issuer” (outside counsel), and attorneys “employed by the issuer” (in-house counsel). When outside counsel has reported evidence of a material violation and has failed to receive an appropriate response within a reasonable time, the alternative proposal begins with two commands:

(d)(1)(A) An attorney retained by the issuer shall withdraw from representing the issuer, and shall notify the issuer, in writing, that the withdrawal is based on professional considerations.

I do not think the attorney must withdraw from every matter in which the attorney represents the issuer. Rather, I think the attorney must withdraw only from matters related to the possible material violation. Of course, the issuer will completely understand the meaning of the phrase “professional considerations.”

The alternative rules would be more lenient to in-house counsel because in-house lawyers are usually unable to withdraw from a matter without quitting or jeopardizing their jobs. Nevertheless, when in house lawyers have reported evidence of a material violation and have failed to receive an appropriate response within a reasonable time, they are subject to two commands that closely parallel the obligations of outside counsel:

(d)(1)(B) An attorney employed by the issuer [1] shall cease forthwith any participation or assistance in any matter concerning the violation and [2] shall notify the issuer, in writing, that he or she believes that the issuer has not provided an appropriate response in a reasonable time to his or her report of evidence of a material violation …

What if a reporting attorney (inside or outside) who is representing the issuer before a court or administrative body moves to withdraw but the tribunal denies the motion? The alternative rules anticipate that situation and address it with a dispensation and a directive, as follows:

(d)(2) An attorney shall not be required to take any action pursuant to paragraph (d)(1) of this section if the attorney would be prohibited from doing so by order or rule of any court, administrative body or other authority with jurisdiction over the attorney, after having sought leave to withdraw from representation or to cease participation or assistance in a matter. An attorney shall give notice to the issuer that, but for such prohibition, he or she would have taken such action pursuant to paragraph (d)(1) or (d)(2), and such notice shall be deemed the equivalent of such action for purposes of this part.

In other words, if an attorney moves to withdraw or to cease participating and the court or administrative body requires the attorney to continue, then the attorney may continue without violating the SEC rules — but the attorney must notify the issuer that she would have withdrawn or ceased participating if the court or administrative body had permitted her to do so. At that point, the alternative rules impose no further obligations on the attorney.

What if the issuer fires an in-house or outside attorney for reporting evidence of a material violation? The alternative rules also anticipate this situation by providing as follows:

(3) An attorney employed or retained by an issuer who has reported evidence of a material violation under this part and reasonably believes that he or she has been discharged for so doing shall notify the issuer’s chief legal officer (or the equivalent thereof) forthwith.

In other words, if an inside or outside attorney is discharged in retaliation for filing a report, the attorney must “forthwith” write or call the CLO (the proposal does not require written notification), saying something like, “I believe I have been discharged for complying with 17 C.F.R. §205.3(a) by reporting evidence of a material violation.” But notice to the CLO by itself will not warn successor attorneys that the issuer may be engaged in illegal activities. Further, the ethics rules of most jurisdictions may not allow the withdrawing attorney to warn the successor attorney. How do the alternative rules overcome the problem faced by a successor lawyer? The alternative rules would provide as follows:

(d)(4) The issuer’s chief legal officer (or the equivalent thereof) shall notify any attorney retained or employed to replace an attorney who has given notice to an issuer pursuant to paragraph (d)(1), (d)(2) or (d)(3) of this section that the previous attorney has withdrawn, ceased to participate or assist or has been discharged, as the case may be, pursuant to the provisions of this paragraph.

Thus, if the issuer replaces the reporting attorney with a new attorney, the issuer must in effect notify the replacement attorney that the former attorney believes she was required to resign pursuant to the SEC rules after failing to receive a timely or appropriate response to the report of evidence of a material violation, or that the attorney believes she was discharged for making a mandatory report.

An even more powerful companion provision, §205.3(e), shifts the burden of compliance from the attorney to the issuer by requiring the issuer to report the attorney’s withdrawal or alleged retaliatory discharge to the SEC. That provision, entitled “Duties of an issuer where an attorney has given notice pursuant to paragraph (d),” says:

(e) Where an attorney has provided an issuer with a written notice pursuant to paragraph (d)(1), (d)(2) or (d)(3) of this section, the issuer shall, within two business days of receipt of such written notice, report such notice and the circumstances related thereto on Form 8-K, 20-F, or 40-F (§§249.308, 220f or 240f of this chapter), as applicable.

Thus, the alternative rules would transfer the burden of compliance at this point from the attorney to the issuer, which must now in effect inform the SEC that one of its attorneys has withdrawn “for professional considerations” or has claimed that she was fired for making a mandatory report. From the attorney’s perspective, this proposal relieves the attorney of the painful and unprofitable experience of informing on her own client — but from the issuer’s perspective, the result is the same: the SEC finds out that one of the issuer’s attorneys has resigned for professional considerations or alleges that she has been fired for reporting evidence of illegal conduct.

But what if the issuer fails or refuses to tell the SEC that the attorney has withdrawn for professional considerations or is claiming retaliatory discharge? The SEC has anticipated that problem as well. In §205.3(f), entitled “Additional actions by an attorney,” the alternative rules say:

(f) An attorney retained or employed by the issuer may, if an issuer does not comply with paragraph (e) of this section, inform the Commission that the attorney has provided the issuer with notice pursuant to paragraph (d)(1), (d)(2), or (d)(3) of this section, indicating that such action was based on professional considerations.

Section (f) thus amounts to a discretionary noisy withdrawal rule. If the issuer itself does not inform the SEC that the attorney has withdrawn for “professional considerations,” then the attorney is permitted to do so. But it is important to emphasize that the attorney retains discretion whether to report to the SEC or not, because the proposed rule says that the attorney “may” do so, not that she “must.”

Comparing SEC Proposals to New York’s Ethics Rules

One useful way to evaluate the SEC’s final rules and the alternative rules is to compare them to the New York Code of Professional Responsibility. Suppose that a New York attorney serving a New York corporate client came across evidence of that the client had materially violated, was in the process of violating, or was about to violate the securities laws. What rights and duties would that attorney have under the New York Code of Professional Responsibility?

The most closely parallel provision is New York’s DR 5-109(B). This provision of the Code is triggered when a lawyer for an organization “knows” that an officer, employee, or other person associated with the organization is engaged in “a violation of law that reasonably might be imputed to the organization, and is likely to result in substantial injury to the organization.” In that situation, the lawyer “shall proceed as is reasonably necessary in the best interests of the organization.” To give some substance to this vague guideline, the rule lists various appropriate measures, including: (1) asking the client to reconsider the course of conduct; (2) advising the client to get a separate legal opinion to present to “appropriate authority within the organization;” and (3) “[r]eferring the matter to higher authority in the organization, including, if warranted by the seriousness of the matter, referral to the “highest authority” in the organization (typically the Board of Directors).

If the lawyer has taken appropriate measures under DR 5-109(B) but the Board still “insists on action, or a refusal to act, that is clearly a violation of law and is likely to result in substantial injury to the organization” — essentially the same situation envisioned in the SEC rules — then DR 5-109(C) provides that the lawyer “may resign in accordance with DR 2-110(B)” (which governs withdrawal). Thus, DR 5-109 essentially mandates up-the-ladder reporting within the organization, but neither requires nor allows a lawyer to report to anyone outside the organization. The most a lawyer can do by invoking the authority of DR 5-109 is to report a violation of law to the Board and then resign if the Board does not take steps to prevent or cure the violation.

However, DR 5-109 is not the only relevant rule in the New York Code. Under DR 4-101(C)(3), a lawyer may report the “intention of a client to commit a crime and the information necessary to prevent the crime.” Thus, if the issuer’s action or refusal to act is a crime (as opposed to merely a civil wrong), then DR 4-101(C)(3) permits (but does not require) the lawyer to reveal the issuer’s intention to commit the crime and tell the authorities how to prevent it.

Also relevant is DR 7-102(B), which provides:

B. A lawyer who receives information clearly establishing that:

1. The client has, in the course of the representation, perpetrated a fraud upon a person or tribunal shall promptly call upon the client to rectify the same, and if the client refuses or is unable to do so, the lawyer shall reveal the fraud to the affected person or tribunal, except when the information is protected as a confidence or secret.

2. A person other than the client has perpetrated a fraud upon a tribunal[,] shall reveal the fraud to the tribunal.

Thus, if a lawyer receives evidence “clearly establishing” that an issuer has completed a past (i.e., no longer ongoing) fraud against a person or a tribunal (which would not include the SEC but would include an administrative body with adjudicatory powers), the lawyer must “call upon the client to rectify” the fraud. However, if the client will not rectify the past fraud, the lawyer is relatively powerless because — despite the tough sounding “shall reveal” language — the exception for confidences and secrets swallows the rule whole.

Moreover, if the person who engaged in wrongdoing is anyone other than the client (e.g., wrongdoing by an individual within the corporation who is not acting on behalf of the corporation), and the wrong is a fraud on anyone other than a tribunal, then the lawyer is likewise powerless. Under DR 7-102(B)(2), the only thing a lawyer must reveal is a fraud on a tribunal (i.e., not a fraud on the SEC, on the corporation, or on investors) by someone other than the client. That situation would seem unlikely to arise in a securities law practice.

However, in various circumstances, DR 4-101(C)(5), may permit an attorney to make New York’s version of a “noisy withdrawal.” That rule provides that a lawyer “may” (not must) reveal:

Confidences or secrets to the extent implicit in withdrawing a written or oral opinion or representation previously given by the lawyer and believed by the lawyer still to be relied upon by a third person where the lawyer has discovered that the opinion or representation was based on materially inaccurate information or is being used to further a crime or fraud.

Thus, under the New York Code, if a lawyer has filed a document with the SEC on behalf of an issuer and later learns either that (a) the document was based on “materially inaccurate information,” or (b) the issuer is using a document based on accurate information to “further a crime or fraud,” and if the lawyer also believes that third parties (e.g., investors, lenders, or the SEC) are still relying on the document, then the lawyer may notify the SEC (or any other affected party) that he is withdrawing the document. The lawyer may not say why he is withdrawing a document, because DR 4-101(C)(5) permits a lawyer to reveal confidences or secrets only to the extent “implicit” in withdrawing the document. But the withdrawal will send up a bright yellow flag cautioning those who relied on the document to look into the situation again, with a skeptical eye.

In addition, under DR 2-110, a lawyer must withdraw if the lawyer believes that continued representation will result in violation of a Disciplinary Rule — for example, if the lawyer will be assisting the issuer in conduct that the lawyer knows to be “illegal or fraudulent” — and a lawyer may withdraw if the client insists that the lawyer pursue an “illegal” course of conduct in the future or has “used the lawyer’s services to perpetrate a crime or fraud” in the past.

Comparing the New York Code of Professional Responsibility to the SEC proposals and the SEC’s final rules as adopted, we find many differences. Some of the most significant differences are these:

• The final SEC rules as adopted mandate up-the-ladder measures when a lawyer who practices before the SEC has “evidence” of a material violation of the securities laws. New York’s DR 5-109(B) mandates up-the-ladder measures only when a lawyer “knows” of illegal conduct within the corporation. However, this difference is not a legitimate subject for comment because Congress mandated in §307 of the Sarbanes-Oxley Act that the SEC adopt a rule requiring a report based on mere “evidence.”

• The final SEC rules as adopted mandate a report to the CLO directly, whereas New York’s DR 5-109(B) allows a lawyer to start much lower on the corporate ladder. This also is mandated by §307 of the Sarbanes-Oxley Act and is not subject to comment.

• If a lawyer’s up-the-ladder efforts under the SEC final rules as adopted fail to generate a timely and appropriate response, then the final rules permit the attorney to report confidential information to the SEC to the extent the attorney reasonably believes necessary not only to prevent the issuer from committing various future wrongs (e.g., injuring investors, suborning perjury, or committing fraud on a tribunal), but also to rectify the consequences of harmful past material violations in which the issuer used the attorney’s services. The New York Code does not allow an attorney to reveal an issuer’s confidences or secrets to the SEC to rectify the consequences of past wrongs.

The SEC’s pending noisy withdrawal proposal diverges even more dramatically from the New York Code:

• If an attorney reached the top of the issuer’s corporate ladder without obtaining a timely and appropriate response, the SEC’s alternative noisy withdrawal proposal would require an attorney to (1) withdraw forthwith based on “professional considerations;” (2) notify the SEC of the withdrawal by the next business day; and (3) promptly disaffirm to the SEC any opinion, document, or representation, that the attorney prepared and filed with the SEC that the attorney “reasonably believes may be materially false or misleading.”

New York, in contrast, makes all of these steps discretionary in this situation—and even then the attorney’s discretion to withdraw or reveal is qualified by additional conditions (e.g., the client’s intention to commit a crime).

The alternative to noisy withdrawal released by the SEC in January also goes considerably further than the New York Code. For example:

• The alternative proposal would mandate withdrawal when the attorney has not received a timely or appropriate response to a mandatory report of a material violation. Under DR 2-110, in contrast, withdrawal is permissive rather than mandatory unless continued representation will result in violation of a Disciplinary Rule.

• The alternative proposal requires an attorney who believes he has been discharged in retaliation for reporting evidence of a material violation to report that belief to his former client or employer. Under the New York Code of Professional Responsibility (or any other New York law), the attorney has the right to report such a belief but not a duty.

Evaluating Three Options

The essential question is which set of rules will be best for the long term health of issuers, investors, and the legal profession — the final SEC rules as adopted, the November 2002 noisy withdrawal proposal, or the January 2003 alternative proposal? In its late January releases, the SEC candidly admitted that opponents of the November 2002 noisy withdrawal proposal outnumbered its supporters. Some opponents raised relatively technical objections (e.g., the SEC lacked power to promulgate a noisy withdrawal rule, or the proposals would infringe on the jurisdiction of state ethics setting bodies, or they would conflict with the ethics rules of foreign countries), but many other opponents argued that the rule would backfire or be ineffective because it would cause clients to keep attorneys out of the loop, making it less likely that attorneys would ever learn evidence of wrongdoing. If attorneys do not come across evidence of ongoing or intended wrongdoing, then they cannot take steps to talk clients out of wrongdoing or report the client’s intention to commit a crime if the client persists in wrongdoing.

Thus, the mandatory noisy withdrawal proposal is not a desirable option unless the discretionary notification provisions in January 2003 final rules as adopted prove to be ineffective. The alternative proposals that merely empower attorneys to shift mandatory disclosure responsibilities to clients do little or nothing to remedy the potentially adverse unintended consequences of a mandatory disclosure regime. However, the discretionary notification provisions in the final rules, like New York’s DR 4-101(C)(3), provide attorneys with the right but not the duty to report a client’s intention to begin or continue criminal behavior. Coupled with the mandatory internal up-the-ladder reporting rules directly mandated by the Sarbanes-Oxley Act, this discretion to report future crimes is a powerful deterrent to client misconduct. Given that we already have parallel provisions in New York, which is the financial capital of America, it is hard to argue that these discretionary notification provisions disrupt an attorney’s representation of issuers.

On the other hand, if an issuer has already abused the attorney-client relationship by duping an attorney into providing services to further damaging illegal or fraudulent conduct, the interests in maintaining confidentiality and keeping the attorney in the loop significantly diminish. We don’t want issuers to keep attorneys in the loop so that the attorneys can serve as ignorant pawns in the issuer’s illegal conduct. In this situation a crime or fraud which an issuer misused the lawyer’s services simultaneously penalizes the client for abusing the attorney-client relationship and protects investors and issuers against substantial financial harm. This discretion goes beyond what New York’s DR 7-102(B)(1) currently allows, but Enron, WorldCom, and other catastrophic failures in which lawyers’ services were used justify expanding an attorney’s discretion in the securities field to repair damage that the attorney has unwittingly assisted.

Conclusion

Last September in this publication (see “New Rules for Lawyers Practicing Before the SEC,” NYPRR , Sept. 2002), I expressed the following view:

The SEC should see how its new reporting rule works out in practice — together with the tough new regulations in the Sarbanes-Oxley Act governing accounting — before taking the next step and requiring lawyers to report mere “evidence” of corporate wrongdoing to people outside a corporation. If mandatory internal reporting might chill attorney-client communications in the corporate setting, mandatory external reporting might cryogenically freeze them. And when lawyers are cut out of the communications loop, they won’t easily learn any evidence to report…

I still adhere to that view. The SEC’s final rules as adopted boldly implement the fairly radical changes wrought by the Sarbanes-Oxley Act. They allow reporting to the SEC when an issuer intends to commit a securities law violation or defraud a tribunal in the future, or when the issuer has committed a securities law violation in the past using the lawyer’s services, and they protect lawyers against retaliatory discharge for making the internal up-the-ladder reports required by the new rules. The SEC and the legal profession should work hard to make these rules operate effectively before taking the additional step of mandating noisy withdrawals or shifting to issuers the burden of reporting that an attorney has withdrawn on ethical grounds. The SEC has done a careful and competent job of drafting the congressionally mandated rules and taking public comments into account. Now, it is time for the SEC to stop writing rules and start enforcing them.

Roy Simon is a Professor of Law at Hofstra University School of Law and the author of Simon’s New York Code of Professional Responsibility Annotated, which is published annually by West.

DISCLAIMER: This article provides general coverage of its subject area and is presented to the reader for informational purposes only with the understanding that the laws governing legal ethics and professional responsibility are always changing. The information in this article is not a substitute for legal advice and may not be suitable in a particular situation. Consult your attorney for legal advice. New York Legal Ethics Reporter provides this article with the understanding that neither New York Legal Ethics Reporter LLC, nor Frankfurt Kurnit Klein & Selz, nor Hofstra University, nor their representatives, nor any of the authors are engaged herein in rendering legal advice. New York Legal Ethics Reporter LLC, Frankfurt Kurnit Klein & Selz, Hofstra University, their representatives, and the authors shall not be liable for any damages resulting from any error, inaccuracy, or omission.

Roy Simon