By Norman B. Arnoff and Martin Mushkin
This article was originally published in the New York Law Journal on June 10, 2003. The rule examined in the article became effective on August 5, 2003.
I. Scope and Purpose of 17CFR Part 205
Section 307 of the Sarbanes-Oxley Act of 2002 requires that the SEC prescribe “minimum” standards of professional conduct for attorneys appearing and practicing before the SEC “in any way in the representation of issuers.” On February 6, 2003, the final rules were published in the Federal Register 68 Fed. Reg. 6295-6323. They are embodied in a new section of the SEC Rules, Part 205. In effect they supplement and amplify the Commission’s Rule of Practice, Rule 201e.
Part 205 supplements applicable standards of other jurisdictions where the attorney is admitted or practices, and is not intended to limit the ability of any jurisdiction to impose additional obligations not inconsistent with the rule. Where the standards conflict the standards of the Rule govern.
The standards require an attorney to report evidence of a “material violation of the securities laws or breach of fiduciary duty by an issuer.” The report is to be up-the-ladder within the company to the chief legal officer or the chief executive officer and if they do not respond appropriately to the audit committee, another committee of independent directors or the full boar d of directors. As an alternative, the issuer’s board may establish a QLCC, a “Qualified Legal Compliance Committee.” To qualify as a QLCC, a committee must be constituted as provided by the Rule. A QLCC is endowed with specified powers and, if an issuer establishes such a committee, its existence and proper operation relieves attorneys reporting alleged material violations and CLOs from specified follow-up and internal reporting requirements.
Companies and Lawyers Subject to the Rule: Part 205 is expressly limited to attorneys representing issuers in regard to their filings (and non-filings) with the SEC. That can be interpreted to mean that attorneys representing persons who attempt tender offers, or other takeovers, or controlling person s, or persons being advised on restrictions on sales of stock or exercise of options, and parties other than issuers in enforcement proceedings, are not subject to these rules per se. Nor does the Part apply to in-house or outside counsel who advise on all the fields of law other than what an issuer must report to the SEC unless they are on notice that the documents they draft will be filed with the Commission. That is a provision which may be much debated. The Part recognizes the special advocacy role of counsel representing issuers in enforcement proceedings but does not permit them to continue the perpetration of a fraud on the Commission.
The SEC estimated that approximately 18,200 issuers will be subject to the Rules, and estimated that 20% or 3,640 will choose to establish a QLCC. Obviously these will be the larger more institutionalized public companies. Issuers which are small businesses, that is, with less than $5 million in total assets and all investment companies are subject to the rules as are their attorneys. (It is estimated there are 2,500 such small business issuers and 211 small investment companies subject to the rule.)
II Effective Date
The effective date of the Rule is 180 days after the date of publication in the Federal Register, August 5, 2003.
III. Corporate Governance under the Rule
The Rule, by requiring lawyers to report evidence of material violations or breaches of fiduciary duty up-the-ladder within an issuer, defines a structure of corporate governance with specific reference to the attorney’s reporting obligations. The reporting attorney is supposed to first report evidence of a material violation to the chief legal officer and/or chief executive officer. But that is not the end of his responsibility. The reporting attorney must assess the response to his report. If he does not believe they have provided “an appropriate response within a reasonable time” he “shall” report to the audit committee, an equivalent committee of independent directors, or the full board. Only after going up this ladder in good faith, has the reporting attorney fulfilled his Part 205 obligations. He “may” also use these alternative routes if he has no faith the CLO and CEO will act on his report.
The QLCC: There is still another route the reporting attorney can use. He can report directly to a QLCC if one has already been established. The QLCC must comprise at least one member of the issuer’s audit committee (or the equivalent committee of independent directors) and two or more members of the board of directors “who are not employed directly or indirectly, by the issuer….”
The QLCC has to have authority and responsibility to inform the issuer’s chief legal officer and chief executive officer of a report of a material violation, determine whether an investigation is necessary, notify the audit committee or the board of directors, initiate an investigation to be conducted either by the chief legal officer or outside counsel and retain additional experts. The QLCC must adopt written procedures for the confidential receipt of information and consideration of a report of the evidence of material violation and must make a recommendation as to whether any action is to be taken. At the conclusion of the investigation the QLCC also has to have authority and responsibility to recommend by a majority vote that the issuer implement an appropriate response to the report and inform the chief legal officer, chief executive officer and the board of the results of investigation. Appropriate remedial measures, if recommended, have to be adopted. The QLCC has to have authority to “take all other appropriate action, including the authority to notify the Commission in the event that the issuer fails in any material respect to implement an appropriate response that the qualified legal compliance committee has recommended the issuer to take.” Although counsel to QLCCs and other counsel engaged to investigate and reports of material violation are deemed to be practicing before the Commission, the duty of these special investigators to report up-the-ladder is limited. They are deemed to be special counsel to a special committee. Moreover, if there is a duly constituted QLCC to which the reporting attorney brings evidence of the alleged material violation, he is relieved of any obligation to follow through, or assess their response.
IV. Standards of Reporting and Appropriate Response
What an attorney must report is explained by the Release accompanying the new Rule. It states:
Evidence of a material violation must first be credible evidence. An attorney is obligated to report when, based upon that credible evidence, “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.” This formulation, while intended to adopt an objective standard, also recognizes that there is a range of conduct in which an attorney may engage without being unreasonable. The “circumstances” are the circumstances at the time the attorney decides whether he or she is obligated to report the information. These circumstances may include, among others, the attorney’s professional skills, background and experience, the time constraints under which the attorney is acting, the attorney’s previous experience and familiarity with the client, and the availability of other lawyers with whom the lawyer may consult. Under the revised definition, an attorney is not required (or expected) to report “gossip, hear say, [or] innuendo.” Nor is the rule’s reporting obligation triggered by “a combination of circumstances from which the attorney, in retrospect, should have drawn an inference, as one commenter feared.”
On the other hand, the rule’s definition of “evidence of a material violation” makes clear that the initial duty to report up-the-ladder is not triggered only when the attorney “knows” that a material violation has occurred or when the attorney “conclude[s] there has been a violation, and no reasonable fact finder could conclude otherwise.” That threshold of initial reporting within the issuer is too high. Under the Commission’s rule, evidence of a material violation must be reported in all circumstances in which 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. To be “reasonably likely” a material violation must be more than a mere possibility but it need not be “more likely than not.” If a material violation is reasonably likely, an attorney must report evidence of this violation. The term “reasonably likely” qualifies each of the three instances when a report must be made. Thus, a report is required when it is reasonably likely a violation has occurred, when it is reasonably likely a violation is ongoing or when reasonably likely a violation is about to occur.
After the report is made by the reporting attorney, an “appropriate response” must be made to him or her. Unless his report was made to a QLCC, he or she may have a duty to assess the response and take further action up-the-ladder.
205.2(b) defines an appropriate response:
(b) [An] appropriate response means a response to an attorney regarding reported evidence of a material violation as a result of which the attorney reasonably believes:
(1) That no material violation, as defined in paragraph (i) of this section, has occurred, is ongoing, or is about to occur;
(2) That the issuer has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or
(3) That the issuer, with the consent of the issuer’s board of directors, a committee thereof to whom a report could be made pursuant to §205.3 (b)(3), or a qualified legal compliance committee, has retained or directed an attorney to review the reported evidence of a material violation and either:
(i) Has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or
(ii) Has been advised that such attorney may, consistent with his or her professional obligation, assert a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee, or agent, as the case may be) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation.
Whether the response is appropriate is judged on the basis of a standard of reasonableness. Attorneys are therefore permitted “to exercise their judgement as to whether a response to a report is appropriate, so long as their determination of what is an ‘appropriate response’ is reasonable.” Thus the lawyer’s judgement rule comes into play; the lawyer does not have to be right, only reasonable. The release goes on to explain the parameters of the attorney’s determination that the response was appropriate, i.e., reasonable under the circumstances. It states:
The standard set forth in the final version of Section 205.2(b) requires the attorney to ‘reasonably believe’ either that there is no material violation or that the issuer has taken proper remedial steps. The term ‘reasonably believes’ is defined in Section 205.2 (m). In providing that the attorney’s belief that a response was appropriate need only be reason able, the Commission has allowed the attorney to take into account and the Commission to weigh, all attendant circumstances. The circumstances a reporting attorney might weigh in assessing whether he or she could reasonably believe that an issuer’s response was appropriate would include the amount and weight of the evidence of a material violation, the severity of the apparent material violation and the scope of the investigation into the report. While some commenters suggested that a reporting attorney should be able to rely completely on the assurance of an issuer’s CLO that there was no material violation or that the issuer was undertaking an appropriate response, the Commission believes that this information, while certainly relevant to the determination whether an attorney could reasonably believe that a response was appropriate, cannot be dispositive of the issue. Otherwise, an issuer could simply have its CLO reply to the reporting attorney that ‘there is no material violation,’ without taking any steps to investigate and/or remedy material violations. Such a result would clearly be contrary to Congress’ intent in enacting Section 307. On the other hand, it is anticipated that an attorney, in determining whether a response is appropriate, may rely on reasonable and appropriate factual representations and legal determinations of persons on whom a reasonable attorney would rely.
An important factor to be considered is the timeliness of the response. Further, the Rule and the Release do not require immediate and automatic concession by the issuer of wrongdoing. If it is reported to the reporting attorney that there is a colorable defense that can be asserted in an investigation, or a judicial or administrative proceeding, nothing further need be done by the reporting attorney. The assertion of a colorable defense is an appropriate response.
The Release also states when the assertion of a defense is appropriate. It states “…[B]y including a requirement that this response be undertaken with the consent of the board of directors, or an appropriate committee…the definition is intended to protect against the possibility that a chief legal officer would avoid further reporting ‘up the ladder’ by merely retaining a new attorney to investigate so as to assert a colorable but perhaps weak, defense”. The colorable defense must be well grounded and warranted by existing law or a good faith argument for the extension, modification or reversal of existing law. The incorporation of “colorable defense” as an appropriate response protects the issuer’s right to a defense as well as to counsel without permitting the issuer to use an attorney to conceal and plan ongoing and further violations of law.
Supervising Attorneys: Attorneys who supervise and direct other attorneys appearing and practicing before the Commission in their representation of an issuer are supervisory attorneys. The supervisory attorney must make reasonable efforts to ensure the subordinate attorney’s compliance with Part 205. The supervisory attorney, when the subordinate attorney reports evidence of a material violation, is responsible with complying with the reporting requirements. The supervisory attorney when receiving such a report from a subordinate may report to the QLCC.
V. Appearing and Practicing before the SEC
Appearing and practicing before the SEC is rather straightforward once the limitation of representing an issuer is understood. It is “(t)ransacting any business with the commission, including communications in any form.” It is representing an issuer in SEC administrative proceedings or in connection with any SEC inquiry or investigation and its attendant process.
It is also:
(iii) Providing advice in respect of the United States securities laws or the Commission’s rules or regulations thereunder regarding any document that the attorney has notice will be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission, including the provision of such advice in the context of preparing, or participating in the preparation of, any such document; or
(iv) Advising an issuer as to whether information or a statement, opinion, or other writing is required under the United States securities laws or the Commission’s rules or regulations thereunder to be filed with or submitted to, or incorporated into any document that will be filed with or submitted to, the Commission;…
Based on the forgoing, and by way of example, an attorney that advises that the issuer is not required to submit or file any registration statement, notification, report, or other document is appearing and practicing before the SEC. The definition is broad and even intended to cover information prepared by individuals who are not necessarily responsible for the actual filing. However, the attorney has to be on notice that the information or document he or she is preparing or assisting in the preparation of will be submitted to the SEC. The Release limits the appearance standard by stating that:
To be appearing and practicing before the SEC the attorney must be providing legal services to the issuer. The services must be provided in the context of an attorney client relationship, albeit without a formal retainer agreement. Whether there is such a relationship will be a federal question rather than a state law licensure issue.
The commentary in the Release also states:
The definition in the final rule thereby also clarifies that an attorney’s preparation of a document (such as a contract) which he or she never intended or had notice would be submitted to the Commission, but which subsequently is submitted to the Commission as an exhibit to or in connection with a filing, does not constitute “appearing and practicing” before the Commission.
Non-appearing foreign attorneys are not covered by the Rule. A non-appearing foreign attorney is an attorney who is admitted to practice outside of the United States, and does not hold himself or herself out as practicing and giving legal advice regarding federal or state securities laws, although he or she may conduct such activities incidental to and in the ordinary course in his or her practice. Such activities may be engaged in, provided they are incidental to the foreign law practice or the attorney is acting in consultation with counsel admitted in the United States.
Whistle Blowers: Reporting attorneys may be considered whistle blowers; they may also be given far more pejorative descriptions by those less charitable. Reporting attorneys are expressly protected by 205.3b10. An attorney who has reported evidence of a material violation and believes that he has been “discharged” because of his report may notify the board of directors or a committee thereof. That is all the rule says. Then what? What if he/she is not discharged but is relegated to the windowless office in the damp warehouse to await his next assignment? The regulation is silent, but some stat e laws may protect such worthies.
Part 205 also recognizes there are circumstances where lawyers may, akin to being as officers of the Court, report perjury and/or false statements to the regulator. An attorney appearing and practicing before the SEC may reveal to the SEC, without the issuer’s consent, confidential information to the extent the attorney reasonably believes it is necessary to preventing the issuer from committing a material violation that is likely to cause substantial injury to the issuer or investors, to prevent the issuer in an investigation or proceeding from committing perjury or otherwise ma king a false statement that will commit a fraud upon the SEC, or “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.” Care must be taken by any such an intrepid reporter to make sure he is not violating state ethics rules.
IV. Ethical and Professional Responsibilities of Attorneys Appearing and Practicing before the Commission
No private cause of action is created by the Rule. However, attorneys should be aware if they fail to report and that failure is the proximate cause of actual harm to the issuer, an arguable legal malpractice claim could be asserted. However, there is no duty to report outside the issuer organization. The Commission has deferred addressing that issue. §205.3(b) prescribes the levels of authority to which the attorney reports evidence of a material violation. It states:
(b) Duty to report evidence of a material violation. (1) If an attorney, appearing and practicing before the Commission in the representation of an issuer, be comes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney shall report such evidence to the issuer’s chief legal officer… or to both the issuer’s chief legal officer and its chief executive officer…forthwith. By communicating such information to the issuer’s officers or directors, an attorney does not re veal client confidence or secrets or privileged or otherwise protected information related to the attorney’s representation issuer.”
If the attorney does not receive an appropriate and timely response to his or her report, the attorney under Section 205.3(b) 3 “…shall report the evidence of a material violation to:
(i) The audit committee of the issuer’s board of directors;
(ii) Another committee of the issuer’s board of directors consisting solely of directors who are not employed, directly or indirectly by, the issuer…
(iii) The issuer’s board of directors.”
The core obligation in the new Rule is that the attorney must report up-the-ladder what is considered evidence of a material violation of an applicable United States federal or state securities law or a material breach of fiduciary duty arising under United States federal or state law. The Rule also makes clear that the client is the issuer and not any officer, employee, or shareholder although the new reporting obligations are to be performed in the best interest of shareholders and creditors of the issuer. No new fiduciary obligation to shareholders, however, is created by the rule.
This new rule codifies pre-existing standards and customs and is not in our opinion a marked departure with the past. What is new is a formal structure. In giving clear guidance, however, to the attorneys for his or her reporting obligations the rule enhances the opportunity for honest counsel, and officers, and directors of corporate issuers to prevent the type of scandal our financial markets have recently experienced. The SEC’s new attorneys’ watchdog rule should be viewed as a positive.