SEC Proposes Rules to Federalize Professional Conduct for Lawyers Practicing Before the SEC
"This [provision of the Sarbanes Oxley Act] is about making sure those lawyers. . . don’t violate the law and, in fact, more importantly, ensure that the law is being followed."
-- Senator John Edwards, July 10, 2002
On November 21, 2002, the SEC proposed 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 the Standards are inconsistent with state law, the Standards pre-empt state law.
Provisions of the Sarbanes Oxley Act
Section 307 of the Sarbanes Oxley Act requires the SEC to “issue rules, in the public interest and for the protection of investors, setting forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission.” In addition to other rules the SEC may adopt, Section 307 directs the SEC to adopt a rule “requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof,” up the ladder within the company, first to the chief legal officer or the chief executive officer and then to the board of directors or a committee of the board.
Summary of the Standards
The Standards can be summarized as follows:
- in appearing and practicing before the SEC in the representation of an issuer,
- an attorney becomes aware of evidence of,
- a material violation by the issuer or any director, employee, or agent of 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 a satisfactory response is not received, to the board of directors or a committee of the board. If the board does not respond in a satisfactory manner, then, under certain circumstances, the attorney is required to effect a “noisy withdrawal” designed to alert the SEC of a problem.
Appearing and practicing before the SEC
Appearing and practicing before the SEC is broadly defined. It includes,
- communicating with the SEC;
- representing parties to and witnesses in an administrative proceeding, or in connection with an SEC investigation;
- preparing any document which the attorney has reason to believe will be filed with or incorporated into a filing or other submission to the SEC; and
- advising a person regarding the content of filings with or submissions to the SEC, or that such a filing or submission is not required.
In its release proposing the Standards, the SEC indicated that it was broadly defining the lawyers that would be subject to the Standards.
Becomes Aware of Evidence of
An attorney has “evidence of a material violation” if the attorney has “information that would lead an attorney reasonably to believe that a material violation has occurred, is occurring, or is about to occur.” The SEC characterizes the standard as objective. An attorney had evidence of a material violation if the attorney has information that would lead a reasonable attorney to conclude there is a violation. A particular attorney’s personal belief that a violation has not occurred does not relieve the attorney from compliance with the rule if the belief is not reasonable.
In its release proposing the Standards, the SEC notes that in determining whether or not an attorney becomes aware of evidence of a material violation the SEC will take into account the attorney’s training and experience. The same facts may cause a reasonable, experienced securities lawyer to become aware of a violation will not necessarily create awareness in an inexperienced lawyer.
A Material Violation
A material violation is defined as a material violation of
- the securities laws;
- a fiduciary duty; or
- a similar violation.
For purposes of the Statement, the SEC has defined
- “material” as “conduct or information about which a reasonable investor would want to be informed before making an investment decision;”
- a violation of securities laws to include violations of state blue sky laws; and
- breach of a fiduciary duty as a breach of “any fiduciary duty recognized at common law,” including “misfeasance, nonfeasance, abdication of duty, abuse of trust and, approval of unlawful transactions.
”Significantly, the SEC did not define a “similar violation,” but noted that it likely expends beyond a violation of the securities laws and a breach of fiduciary duty.
Up the Ladder Reporting
The Standards provide that an attorney who becomes aware of a material violation by the issuer or any director, officer, employee or agent of the issuer, must report the violation to the chief legal officer of the issuer (or the CEO, if there is no chief legal officer). The chief legal officer is required to investigate the alleged material violation and, if the chief legal officer determines a violation has occurred or is about to occur, take corrective action. If the attorney reasonably believes that the chief legal officer has not taken appropriate action with respect to the material violation, the attorney is required to report the violation to the board of directors or an appropriate committee. If the attorney does not receive an appropriate response within a reasonable period of time from the board of directors, and reasonably believes that a material violation is ongoing or about to occur and is likely to result in a substantial injury to the financial interest or property of the issuer or investors, the attorney must:
- withdraw as counsel;
- notify the SEC of the withdrawal, citing “professional considerations;” and
- promptly disaffirm any materials filed with the SEC which are affected by the material violation.
In-house counsel is not required to resign, but generally is required to take all of the foregoing steps.
The Standards also permit formation of a committee of the board of directors called the “qualified legal compliance committee.” If a company elects to form such a committee, it must have the authority and responsibility to handle reports from lawyers of material violations. If such a committee is formed and properly empowered, rather than report to the chief legal or executive officer, the attorney may report to this committee. Attorneys who report to the committee will not be required to effect a noisy withdrawal. However, if the chief legal officer of an issuer determines that the instructions of the committee to remedy the material violation are not being followed by the issuer, the chief legal officer must notify the SEC.
The concept of “up the ladder” reporting is generally included in state ethical rules applicable to attorneys who represent issuers. For example, the Model Rules and similarly the Texas ethical rules both provide that attorneys are allowed, and in some circumstances obliged to use an up the ladder reporting process where the attorney knows that the organization may be substantially injured by an action that is a violation of law. A withdrawal from the representation is optional as long as the attorney’s services are not being used to further a crime or fraud.
Supervising and Supervised Attorneys
The Standards provide that a supervising attorney is required to exercise reasonable efforts to ensure that his or her supervised attorneys comply with SEC rules. The Standards define supervising attorney broadly as an attorney who has supervisory authority over another lawyer. An attorney is a supervising attorney both for
- attorneys over whom the supervisor exercises supervisory matters routinely; and
- attorneys who are supervised on a specific matter.
In addition, the chief legal officer is the supervising attorney for all attorneys employed by an issuer.
Subordinate attorneys are required to report material violations to the supervising attorney and to keep a record of such report. 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 and, if the requirements for a noisy withdrawal are met, effect a noisy withdrawal.
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 injunctive relief and civil penalties. 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 SEC also states in the proposing release that the Standards do not create a private right of action.
Probably the most controversial provision of the Standards is the obligation to effect a noisy withdrawal. Considering the controversial nature of this provision, one wonders whether, since a noisy withdrawal was not required or contemplated by the Sarbanes Oxley Act, this provision will be included in the final rule.
Current ethical rules, embodied in Model Rule 1.6, provide that a lawyer may not disclose a client’s confidential information. The obligation of confidentiality, which is an ethical rule, is different from (but related to) the lawyer-client privilege, which is a rule of evidence. Under the Model Rules and state ethical rules, a lawyer’s obligation to treat client information confidentially extends to a much broader category of information than is the subject of the attorney-client privilege.
The Model Rule 1.6(a) provides that a lawyer is permitted (but not required) to disclose confidential information under very limited circumstances. Under the Model Rules, disclosure is permitted (but not required) where the failure to disclose is “likely to result in imminent death or substantial bodily injury to another person.” Most states, including Texas, have expanded a lawyer’s right to disclose client confidences. In these states, a lawyer may disclose client confidences if the lawyer reasonably determines that the client is about to commit a criminal or fraudulent act, or if the attorney reasonably believes that the disclosure is necessary to rectify the consequences of a client’s criminal or fraudulent acts provided that the lawyer’s services were used to perpetrate the crime or fraud. A small minority of states require that an attorney disclose client confidences to prevent criminal and fraudulent acts.
The SEC jumped in the middle of the debate over an attorney’s right and obligation to disclose client information by mandating “inferential disclosure” through the noisy withdrawal provisions. As the “investor’s advocate,” the SEC has proposed to expand the obligation to disclose confidential information well beyond current practices. Rather than begin, as do current ethical rules, with a broad statement of a lawyer’s obligation of confidentiality, and then define narrow exceptions, the SEC appears to begin with a broad statement of a lawyer’s obligation to disclose client confidential information, and then provide limited circumstances in which the lawyer is not required to disclose. In this light, the following provisions of the Standards are particularly troublesome:
- Unlike the vast majority of states, the rule mandates inferential disclosure of confidential information, rather than leaving it to a lawyer’s discretion.
- The SEC does not define “similar violation” other than to note that it “extends beyond” a violation of securities laws.
- The broad definition of fiduciary duty creates unnecessary problems. Should the lawyer be required to effect a noisy withdrawal if the lawyer “becomes aware of evidence” that the directors have breached their duty of care? This will be particularly problematic for mergers and acquisitions, going private and similar transactions, where the standards of care applicable to directors are extremely fact-specific and subject to change.
- The Standards may require a noisy withdrawal in situations where the material violation is not related to the lawyer’s representation of the client. Under most state rules disclosure is permitted only when the attorney’s services are used to cause the financial harm.
The existence of an independent bar, governed and regulated by the courts in which members of the bar practice, is a well established principle of American government. It is highly troubling that a significant portion of the bar is now regulated by the SEC in its self-styled mode as the “investor’s advocate”. It is equally troubling that an administrative agency feels competent to resolve issues of attorney-client confidentiality that have been debated among lawyers for decades. It would not be an overstatement to say that the Standards, if adopted as proposed, will dramatically change the role of a lawyer representing a public company.
We expect that the SEC will approve the proposed Standards by the end of the year after completion of the public comment period. We will regularly update you with regard to material developments concerning any changes to the proposed Standards as well as implementation of the final Standards.
This Alert is a publication of Haynes and Boone, LLP and should not be construed as legal advice on any particular facts or circumstances. This Alert is for general informational purposes only, and may not be quoted or referred to in any other documents or legal proceeding without our prior written consent. The publication of this Alert is not intended to create an attorney-client relationship.
If you would like to learn more about the proposed standards, please feel free to contact your regular Haynes and Boone attorney or any member of our Corporate Governance Practice Group above.