SARBANES OXLEY ATTORNEY RESPONSIBILITY STANDARDS · PDF fileSARBANES OXLEY ATTORNEY...

SARBANES OXLEY ATTORNEY RESPONSIBILITY STANDARDS

DEBRA G. HATTER, Houston Haynes & Boone

State Bar Of Texas 2ND ANNUAL ADVANCED IN-HOUSE COUNSEL COURSE

August 14-15, 2003 San Antonio, Texas

CHAPTER 9

DEBRA G. HATTER Debra G. Hatter is an associate in the corporate securities practice group of Haynes and Boone, LLP’s Houston office. She has practiced for 9 years, focusing on corporate securities, mergers and acquisitions, corporate governance and general business matters. Prior to joining Haynes and Boone, LLP, Debra was an associate with Cleary, Gottlieb, Steen & Hamilton in the Washington, D.C. office. A native of West Haven, Connecticut, Debra received her law degree from the University of Pennsylvania Law School, and her undergraduate degree in mechanical engineering from the University of Pennsylvania School of Engineering and Applied Science. After law school, she was a law clerk to the Honorable Clifford Scott Green, Jr. of the United States District Court for the Eastern District of Pennsylvania. Debra has written several articles on corporate governance matters, including Rule 205 of the Sarbanes Oxley Act relating to the Attorney Conduct Rules.

Sarbanes Oxley Attorney Responsibility Standards Chapter 9

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TABLE OF CONTENTS

I. INTRODUCTION...................................................................................................................................... 1

II. SUMMARY OF THE FINAL RULE ON “UP THE LADDER” REPORTING......................................... 1 A. Appearing and practicing before the SEC............................................................................................... 1 B. Becomes Aware of Evidence of ............................................................................................................. 1 C. A Material Violation ............................................................................................................................. 2 D. Up the Ladder Reporting and an Appropriate Response........................................................................... 2 E. Alternative Reporting Procedure – Qualified Legal Compliance Committee ............................................. 2

III. SUPERVISING AND SUPERVISED ATTORNEYS................................................................................. 2

IV. PENALTIES; NO PRIVATE RIGHT OF ACTION .................................................................................. 3

V. PROPOSED ALTERNATIVE RULE........................................................................................................ 3

VI. CONCLUSION .......................................................................................................................................... 4

APPENDIX....................................................................................................................................................... 5


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SARBANES OXLEY ATTORNEY RESPONSIBILITY STANDARDS By Debra Hatter I. INTRODUCTION This article discusses the new attorney conduct rules of the SEC for all lawyers appearing and practicing before the SEC. The rule was the subject of much controversy as initially proposed with its “noisy withdrawal” requirement due to concerns about the attorney-client privilege. On January 23, 2003, pursuant to the requirements of Section 307 of the Sarbanes-Oxley Act of 2002, the SEC adopted a new Rule 205 entitled “Standards of Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an Issuer” (the “Standards”). The Standards set forth minimum ethical standards of conduct for attorneys practicing before the SEC and, to the extent inconsistent with state ethical laws, the Standards purport to pre-empt state law. Many lawyers feel that the Standards are likely to have the greatest effect on the day-to-day practice of law for in-house counsel of public companies since the provisions target lawyers. As initially proposed, the Standards would have required a lawyer who became aware of a material violation of certain federal or state laws to resign from representation of the issuer under certain circumstances for “professional considerations,” and advise the SEC of such resignation. The SEC deferred action on this proposed “noisy withdrawal” rule, and extended the period during which interested persons could comment on the proposed rule. The SEC also proposed an alternative to the noisy withdrawal rule under which an attorney who becomes aware of a material violation that is not properly addressed by the issuer would be required to resign for professional considerations. Under this alternative rule, however, the issuer would be required to notify the SEC of the resignation, unless the issuer satisfied certain requirements to avoid notification. II. SUMMARY OF THE FINAL RULE ON “UP

THE LADDER” REPORTING The Standards can be summarized as follows: If,

• in appearing and practicing before the SEC in the representation of an issuer,

• an attorney1 becomes aware of evidence of,

1 Attorney includes any person licensed or otherwise qualified to practice law in any jurisdiction but excluding non-appearing foreign lawyers.

• a material violation by the issuer,

the attorney must report the material violation “up the ladder” within the issuer, starting with the chief legal officer (or if there is no chief legal officer, the chief executive officer) and, if an appropriate response is not received, to the audit committee of the board of directors or another committee of the board composed solely of independent directors (or if no such committee exists, to the full board). A. Appearing and practicing before the SEC In response to comments, the SEC significantly reduced the number of attorneys who are “appearing and practicing” before the SEC and therefore subject to the rule. As revised, appearing and practicing before the SEC includes:

• transacting business with the SEC, including

communications; • representing an issuer in an administrative

proceeding, or in connection with an SEC investigation, inquiry, information request or subpoena;

• providing advice regarding securities laws or rules applicable to any document the attorney has notice will be filed with the SEC; and

• advising an issuer as to whether information is required to be filed with the SEC

• conducting an investigation on behalf of the issuer

As adopted, the Standards do not cover a person who, although an attorney, does not enter into an attorney-client relationship with the issuer. The SEC stated that the determination of whether an attorney-client relationship exists will be a federal question and will turn on the “expectations and understandings between the attorney and the issuer.” According to the final release applicability of the Standards is not linked to the applicability of the attorney-client privilege.

The Standards do not extend to a “non-appearing foreign attorney,” defined as an attorney admitted outside the U.S. who does not hold himself out as practicing U.S. law. Such a lawyer may conduct activities that would constitute practicing before the SEC, so long as either such activities are incidental to and in the ordinary course of his practice in a foreign jurisdiction or the foreign lawyer is appearing and practicing with a licensed U.S. lawyer.

B. Becomes Aware of Evidence of The SEC also changed the description of the level of knowledge that is necessary to trigger a lawyer’s duties under the Standards. “Evidence of a material violation” is now defined as “credible evidence, based


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upon which it would be unreasonable, under the circumstances, 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.” In the adopting release, the SEC describes this test as objective. The phrase “under the circumstances,” however, is intended to allow consideration of an individual attorney’s professional skills, background, experience, time constraints, familiarity with the issuer and the availability of other lawyers with whom the lawyer could consult. C. A Material Violation The definition of material violation did not change significantly. A material violation is defined as,

• a material violation of federal or state securities laws;

• a material breach of fiduciary duty arising under federal or state law; or

• a similar material violation of any federal or state law.

Significantly, in the final release the SEC did not define or provide guidance on the meaning of a “similar violation.” The proposing release noted that it likely extends beyond a violation of the securities laws and a breach of fiduciary duty. D. Up the Ladder Reporting and an Appropriate

Response The Standards provide that an attorney who becomes aware of a material violation by the issuer, must report the violation to the chief legal officer (“CLO”) of the issuer (or the CEO, if there is no CLO). The CLO is required to investigate the alleged material violation and, if the CLO determines a violation has occurred, is continuing to occur or is about to occur, take corrective action. The CLO is required to notify the reporting attorney of the action taken. If the reporting attorney reasonably believes that the CLO has not provided an appropriate response with respect to the material violation, the attorney is required to report the violation to an appropriate committee of the board or to the entire board.

An appropriate response is defined as any response pursuant to which the reporting attorney reasonably believes that:

• no material violation has occurred, is

ongoing, or is about to occur; • the issuer has adopted appropriate remedial

measures to stop the violation and remedy or otherwise address any violation that occurred and minimize the likelihood of recurrence; or

• the issuer has retained an attorney to review the violation and either (a) has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or (b) has been advised that the investigating attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer in any proceeding relating to the material violation.

The SEC emphasized that an appropriate response will be judged by objective standards to be applied with consideration of the circumstances involved, including the amount of evidence of a material violation available to the reporting attorney. The proposed rules indicated that an appropriate response included rectifying the violation, which implied an issuer must have made restitution. The final rules use the phrase “remedy or otherwise address” the material violation to indicate an issuer must only address the feasibility of restitution. E. Alternative Reporting Procedure – Qualified

Legal Compliance Committee The Standards also permit formation of a qualified legal compliance committee (“QLCC”) of the board of directors composed of at least one member of the audit committee and two or more independent directors. If a company elects to form a QLCC, the committee must have the authority and responsibility to handle reports of material violations, and to recommend remedial measures. If such a committee is formed and properly empowered, rather than report to the chief legal or executive officer, an attorney may report to this committee. Attorneys who report to the QLCC will fully satisfy their requirements under the Standards. In addition, a CLO who receives a report of a material violation may refer the report to the QLCC, in which case the QLCC becomes responsible for handling the report, including delivering an appropriate response to the reporting attorney. III. SUPERVISING AND SUPERVISED

ATTORNEYS The Standards provide that a supervising attorney is required to exercise reasonable efforts to ensure that his or her subordinate attorneys comply with the Standards. An attorney who supervises another lawyer when appearing and practicing before the SEC is a supervising attorney. The SEC considerably narrowed the defin ition of supervising attorney from that initially proposed. As initially proposed, the Standards would have made an attorney who routinely supervised another attorney a supervisor, even if the supervisor


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did not supervise the subordinate lawyer in activit ies that constituted appearing and practicing before the SEC. Commentators argued that every partner in a law firm could be deemed to be a supervising attorney over associates who practiced before the SEC. As adopted, the Standards require that the supervisor be responsible for supervision of activities of the subordinate attorney that constitute appearing and practicing before the SEC. In addition, the Standards provide that the CLO is the supervising attorney for all attorneys employed by an issuer. A subordinate attorney complies with the Standards if the subordinate attorney reports evidence of a material violation to his or her supervising attorney. If the subordinate attorney reasonably believes that the supervising attorney does not comply with the Standards, the subordinate attorney may, but is not required to, report up the ladder to the issuer. IV. PENALTIES; NO PRIVATE RIGHT OF

ACTION A violation of the mandatory provisions of the Standards will constitute a violation of the Securities Exchange Act of 1934, and subject the violating attorney to the civil penalties and other remedies for violation of federal securities laws. In addition, an attorney who violates the Standards may be subject to censure and denial of the privilege of practicing before the SEC. The SEC noted in the proposing release that a violation of the Standards will not, without additional acts, subject the violating attorney to criminal penalties. The Standards also provide that an attorney who complies with the Standards in good faith will not be subject to discipline or otherwise be liable under inconsistent standards imposed by any state or other U.S. jurisdiction. The Standards have a provision that specifically states that there is no private right of action for violation of the Standards. However, several commentators have raised the concern that this may change since historically shareholders have not been successful at suits against the corporation’s retained attorney but now with the shift in public policy towards the need to protect the investing public and imposing a duty on attorneys to reveal evidence of corporate misfeasance and fraud.

V. PROPOSED ALTERNATIVE RULE Probably the most controversial part of the Standards as initially proposed was the obligation to effect a noisy withdrawal. The SEC deferred action on the noisy withdrawal provision, by extending the public comment period and as of publication time the SEC had not adopted a final rule with respect to noisy withdrawal. It is widely believed by the bar that some form of noisy withdrawal will be adopted. The SEC

also proposed an alternative rule which would require the issuer (rather than the attorney) to advise the SEC of a withdrawal based on professional considerations. The Standards conflict with ethical rules for attorneys in many states. Current state rules generally permit (but do not require) an attorney to disclose confidential information under limited circumstances. Under the ABA Model Rules, for example, disclosure is permitted (but not required) to prevent “reasonably certain death or substantial bodily harm.” Many states, including Texas, have expanded a lawyer’s ability to disclose client confidences. (See chart in Appendix). In these states, a lawyer may disclose client confidences if the lawyer reasonably determines that the client is about to commit a criminal, fraudulent act that would result in substantial injury to the financial interest or property of another. A small minority of states require that an attorney disclose client confidences to prevent criminal, fraudulent acts. Under the original proposed rules, an attorney who did not receive an appropriate response to a reported material violation within a reasonable time and who believed that the violation was ongoing or about to occur, and was reasonably likely to result in substantial injury to the financial interest or property of the issuer or investors, would have been required to resign, notify the SEC and disaffirm tainted filings. An in-house attorney would have been required to notify the SEC and disaffirm tainted filings. The SEC published for comment an alternative proposal. This alternative provides that if an attorney (other than an in-house attorney) “reasonably concludes that there is substantial evidence of a material violation that is ongoing or about to occur and is likely to cause substantial injury to the financial interest of property of the issuer or investors” then the attorney must resign, citing professional reasons. An attorney is not required to resign if the resignation would violate an applicable court rule or judicial order. In such cases, the attorney must notify the issuer that it would have resigned for professional reasons, but for such rule or order. An in-house attorney must report the material violation up the ladder, but is not required to resign. Upon receipt of such resignation or notice, the issuer is required to file a Form 8-K disclosing the withdrawal or notice. Under the alternative proposed rule, a company which receives a notice of resignation for professional reasons may decide not to file a Form 8-K when, based on advice of counsel not involved in the material violation, the issuer determines,

• the attorney resigning or providing such

written notice acted unreasonably, or • the issuer has adopted an appropriate

response.


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VI. CONCLUSION The Standards are effective August 5, 2003.

Accordingly, issuers will need to • Educate directors, executive officers and in-

house attorneys on the new Standards; • Establish communication lines between law

department and executives and managers • Decide whether to form a QLCC; • Audit current compliance policies and

procedures • Develop procedures to deal with reports of

material violations; and • Consider requiring firms to comply with the

Standards in a certain way (for example, direct all material violations to the QLCC rather than the CLO).

Law firms will also have to develop procedures to comply with the Standards, including:

• Developing education programs for

supervised and supervising attorneys; • Establishing firm policies to deal with reports

of material violations including identifying a supervising attorney or committee within the firm to handle reports; and

• Modifying engagement letters to notify clients of the applicability of the Standards and their inconsistency with state law.


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APPENDIX

Comparison of SEC Standards and Texas Rules of Conduct

Analysis I: SEC “Up-the-Ladder” Reporting v. Texas Obligations to Report Within the Organization

SEC Standards of Professional Conduct (205.3) Texas Disciplinary Rules of Professional Conduct (1.12)

• If an attorney appearing and practicing

before the Commission in the representation of an issuer

• If an attorney representing a organization

• becomes aware of evidence of a material

violation by the issuer (205.3(b)(1)), specifically,

• a material violation of an applicable

United States federal or state securities law, a material breach of fiduciary duty arising under United States federal or state law, or a similar material violation of any United States federal or state law. (205.2(i)).

• learns or knows that:

• (1) an officer, employee, or other person associated with the organization has committed or intends to commit a violation of a legal obligation or a violation of the law which might reasonably be imputed to the organization;

• (2) the violation is likely to result in substantial injury

to the organization; and

• (3) the violation is related to a matter within the scope of the attorney’s representation of the organization (1.12(b))

• the attorney shall either2 • the attorney must take reasonable remedial actions

_____________________________________ _____________________________________ • Alternative 1 : report this evidence to the

issuer’s Chief Legal Officer (CLO) or to both the CLO and the Chief Executive Officer (CEO). (205.3(b))

• except when prior disclosure to persons outside the organization is required by law or other Rules, the lawyer shall first attempt to resolve a violation by taking measures within the organization (1.12(c))

• these measures may include:

• (1) if the attorney reasonably believes the CLO/CEO has failed to respond appropriately by adopting corrective measures, the attorney shall report the evidence to the issuer’s audit committee, another committee of independent directors or the full board of directors. (205.3(b)(3))

• (1) asking reconsideration of the matter (1.12(c)(1));

• (2) advising that a separate legal opinion on the matter

be sought for presentation to appropriate authority in the organization (1.12(c)(2)); and

• (3) referring the matter to higher authority in the

organization, including the highest authority that can act in behalf of the organization (1.12(c)(3))

• (2) if the attorney reasonably believes the

board of directors or committee has not appropriately responded within a reasonable time

• the attorney: (205.3(b)(9)) • (a) shall explain (to the

CLO/CEO/directors) the reasons the response was inappropriate

2 Referred to as “up-the-latter” reporting.


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response was inappropriate • (b) shall/may withdrawal [rules pending;

open for comment]

• shall/may withdrawal [1.15(a)/(b)]

_____________________________________ _____________________________________ • Alternative 2 : report this evidence to a

Qualified Legal Compliance Committee (“QLCC”) (if established by issuer). (205.3(c))3

• same Texas Rules apply as under Alternative 1.

• (1) the attorney’s obligation ends • (2) the QLCC must notify the issuer and

require the issuer to take corrective action

• if the issuer fails to act, the QLCC may:

• (a) recommend that the issuer implement an appropriate response

• (b) notify the SEC of the material violation

Analysis II: Divulging Confidences; SEC v. Texas (Past Conduct)

SEC Standards of Professional Conduct (205.3) Texas Disciplinary Rules of

Professional Conduct (1.05)

• A lawyer may: • A lawyer may:

• reveal confidential information to the SEC that the attorney reasonably believes necessary to rectify the consequences of a material violation by the issuer that 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. (205.3(d)(2))

• reveal confidential information to the extent revelation reasonably appears necessary to rectify the consequences of a clients criminal or fraudulent act in the commission of which the lawyers services had been used. (1.05(c)(8))

Analysis III: Divulging Confidences; SEC v. Texas (Ongoing Conduct)

SEC Standards of Professional Conduct (205.3) Texas Disciplinary Rules of

Professional Conduct (4.01)

• A lawyer may: • A lawyer shall not knowingly:

• reveal confidential information to the SEC that the attorney reasonably believes necessary: 1) to prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors. (205.3(d)(2))

• fail to disclose a material fact to a third person when disclosure is necessary to avoid making the lawyer a party to a criminal act or knowingly assisting a fraudulent act perpetrated by a client. (4.01(b))

3 Not required by the SEC, but suggested as an alternative.


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Analysis III: Divulging Confidences; SEC v. Texas (Future Conduct)

SEC Standards of Professional Conduct (205.3) Texas Disciplinary Rules of Professional Conduct (1.05)

• A lawyer may: • A lawyer may:

• reveal confidential information to the

SEC that the attorney reasonably believes necessary: 1) to prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors. (205.3(d)(2))

• reveal confidential information when the lawyer has reason to believe it is necessary to do so in order to prevent the client from committing a criminal or fraudulent act. (1.05(c)(7))

• A lawyer shall: • reveal confidential information to the extent revelation

reasonably appears necessary to prevent the client from committing a criminal or fraudulent act that is likely to result in death or substantial bodily harm to a person. (1.05(e))

Analysis IV: Divulging Confidences; Candor Before a Tribunal

SEC Standards of Professional Conduct (205.3(d))

Texas Disciplinary Rules of Professional Conduct (3.03)

• A lawyer may: • A lawyer shall not knowingly:

• reveal confidential information to the

SEC that the attorney reasonably believes necessary to prevent the issuer from perpetrating a fraud upon the Commission4. (205.3(d)(2)

• Make a false statement of material fact or law to a tribunal (3.03(a)(1))

• Fail to disclose a fact to a tribunal when disclosure is necessary to avoid assisting a criminal or fraudulent act (3.03(a)(2))

• Offer or use evidence that the lawyer knows to be false (3.03(a)(5))

• If a lawyer has offered material evidence and comes to know of its falsity, the lawyer shall make a good faith effort to persuade the client to authorize the lawyer to correct or withdraw the false evidence. If such efforts are unsuccessful, the lawyer shall take reasonable remedial measures, including disclosure of the true facts. (3.03(b))

4 Under the Texas Rules, the definition of “Tribunal” would not include SEC enforcement action.

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