Standards of Professional Conduct Under the Sarbanes-Oxley Act

December 12, 2002
14 minutes
David A. Fine
Jane D. Goldstein ,
Robert F. Hayes
Julie H. Jones , Christopher A. Klem

The SEC recently proposed rules to implement Section 307 of the Sarbanes-Oxley Act (the “Act”), which calls for minimum standards of professional conduct for attorneys appearing and practicing before the SEC. Section 307 of the Act specifically mandates a rule:

  1. requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation to the chief legal counsel or the chief executive officer; and
  2. if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee or to another committee of independent directors or to the board of directors.

The proposing release was issued on November 21, 2002, and comments are due by December 18, 2002. The Act requires the SEC to adopt final rules by January 26, 2003.

Attorneys Subject to the Rule
The Section 307 reporting obligation applies to “attorneys appearing and practicing before the Commission in any way in the representation of issuers.” The proposed rule defines these terms broadly:

  • Attorneys” include both domestic and foreign attorneys (inside and outside counsel), as well as nonlicensed individuals who hold themselves out as qualified to practice law. Attorneys other than securities lawyers would be covered if (a) their representation involves contact with the SEC, (b) they have reason to believe a document they have helped to prepare will be submitted to the SEC, or (c) they supervise an attorney who practices before the SEC. The rule would also apply to attorneys who may be employed by an issuer in a nonlegal capacity but who engage in activities qualifying as “appearance and practice” before the SEC (discussed further below).
  • Appearance and practice” before the SEC includes:
    • Transacting any business with the SEC, including communication (oral or otherwise) with the SEC, commissioners and staff;
    • Preparing or participating in the preparation of any statement, opinion or other writing which the attorney has reason to believe will be filed or incorporated by reference into any filing, submission or communication to the SEC or the staff (e.g., participation in drafting or reviewing a registration statement or periodic report, such as a Form 10-Q and 10-K);
    • Advising an issuer that a statement, opinion or other writing need not be filed, or that the document itself need not be so filed or submitted (e.g., advice that a given contract need not be filed as an exhibit to the issuer’s periodic report); and
    • Representing any party or witness in a SEC proceeding or in connection with a SEC investigation, inquiry or subpoena.
  • Attorneys acting “in the representation of an issuer” would include attorneys acting for an issuer’s benefit, regardless of whether the attorney is employed or retained by the issuer. This definition would include attorneys for a nonpublic subsidiary of the issuer if the scope of representation (for purposes of privilege or otherwise) is intended, even implicitly, to include the parent. Attorneys not retained or employed by an issuer may act for an issuer’s benefit in other ways, including, for example, where an attorney retained by an issuer’s subsidiary or by the investment advisor of a registered investment company contributes to the disclosure document. While not specifically addressed in the rule, the release suggests that counsel for the underwriters of an offering, by contrast, would not be viewed as acting in the “representation of an issuer.”

Circumstances that Give Rise to the Duty
The duty to report “up the ladder” at an issuer is triggered when an attorney becomes aware of evidence that a material violation of the securities laws, a material breach of fiduciary duty or a similar material violation (each a “material violation”) has occurred, is occurring, or is about to occur.

Evidence” means information that would lead a reasonably prudent and competent attorney reasonably to believe that a material violation has occurred, is occurring or is about to occur. The release notes that there must be “some factual basis” to believe a violation exists, but that the requirement is well short of actual knowledge or final adjudication. The attorney does not have a duty to investigate to determine whether a material violation has occurred. In addition, recognizing the risk that an ambiguous standard may chill the consultative process, the release offers the following examples of conduct that should not be regarded as evidence of a material violation:

  • Where an attorney advises that the law governing a proposed course of action is unsettled and there is some possibility that a court might hold in the future that the action violated the securities laws;
  • Where the issuer actually pursues a course of action despite being advised that the course of action has been held illegal by courts in three states, in none of which the issuer does business, even if the attorney thinks there is a reasonable argument that other courts would also be likely to find it illegal [the action is not “clearly illegal” in relevant jurisdictions];
  • Where an officer tells the attorney that he or she intends to pursue a course of action that the attorney thinks is clearly illegal [the officer might reconsider and not take the action].

It appears that a reasonable belief would not exist unless “the attorney can be sure that the officer or employee will actually pursue an illegal course of action.”

Securities law violations” include violations of state as well as federal securities laws.

Breach of fiduciary duty” is intended to cover any breach of fiduciary duty recognized at common law (examples include misfeasance, nonfeasance, abdication of duty, abuse of trust and approval of unlawful transactions).

Similar violations” is not defined in the proposed rule, the stated intention being to establish its meaning over time through SEC decisions.

Reporting Up-the-Ladder
Level One: Report to Officer
The proposed rule requires the attorney, upon becoming aware of evidence of a material violation, to report the evidence without delay to the chief legal officer or to both the chief legal officer and chief executive officer. The attorney must take reasonable steps to document the report (and the response) contemporaneously and retain the documentation for a reasonable time (which, the release suggests, would be at least as long as the applicable statute of limitations). The attorney may produce the report later if his compliance with the rule is challenged.

Level Two: Investigation/Response
The chief legal officer must conduct such investigation into the reported evidence as he or she reasonably believes is necessary to determine whether a material violation has occurred, is occurring or is about to occur. If the chief legal officer reasonably believes that no material violation exists, he or she must so advise the reporting attorney. If he or she believes a material violation has occurred, is occurring or is about to occur, the chief legal officer must:

  • take necessary steps to cause the issuer to adopt remedial measures (including appropriate disclosures) to stop, sanction, correct and/or prevent any such material violation;
  • report the remedial measures and any sanctions imposed to the chief executive officer, the audit committee or full board of directors, and the reporting attorney; and
  • document the inquiry and retain such documentation for a reasonable period of time.

Level Three: Report to Board/Committee
If the reporting attorney receives a timely response that he or she reasonably believes is appropriate (i.e., a response that provides a reasonable basis to believe no material violation has occurred or that sufficient remedial measures have been adopted to stop, prevent or rectify the violation), the reporting attorney need do no more than document such response. If the reporting attorney does not receive an appropriate response within a reasonable time, the attorney must report the evidence of material violation:

  • to the issuer’s audit committee; or
  • if the issuer does not have an audit committee, to another committee of directors without employment relationships (direct or indirect) with the issuer1 (an “Alternative Independent Committee”); or
  • if the issuer has neither an audit committee nor an Alternative Independent Committee, to the full board of directors.

Again, receipt and documentation of an appropriate and timely response would conclude a reporting attorney’s obligations.

Duties in the Absence of an Appropriate Response
It is the attorney’s responsibility in the absence of an appropriate response that has engendered the most controversy. This aspect of the proposal goes beyond what the Act requires and enters areas that have historically been the province of state regulation of the legal profession. This area continues to generate the most comment from the profession.

A reporting attorney who does not receive an appropriate and timely response has different obligations depending on whether the status of the suspected material violation. If the attorney reasonably believes that a material violation is ongoing or about to occur, and likely to result in substantial injury to the financial interest or property of the issuer or of investors, the attorney shall:

  • Promptly disaffirm to the SEC any opinion, document, affirmation, representation or similar material filed or submitted to the SEC that the attorney helped to prepare and that the attorney reasonably believes is or may be materially misleading; and
  • If the attorney is an outside attorney retained rather than employed by the issuer, make a “noisy withdrawal” by withdrawing from the representation immediately and notifying the SEC that a withdrawal has been made for “professional considerations.”

If the attorney reasonably believes, by contrast, that a material violation (a) has occurred but is not ongoing and (b) is likely to have resulted in substantial injury to the financial interest or property of the issuer or of investors, the attorney may, but is not required to, take the steps listed above. Note that an inaccurate disclosure that investors may continue to rely upon and that has not been corrected would be considered an ongoing violation.

Alternative Procedure Involving Qualified Legal Compliance Committee
The proposed rule contemplates an alternative reporting procedure, using a special Qualified Legal Compliance Committee (“QLCC”) formed at the option of the issuer. The QLCC alternative procedures (described below) would allow an attorney to report directly to this committee rather than to the successive “layers” at the issuer as described above.

An issuer could establish a QLCC by forming a committee of the board of directors, consisting of one member of the issuer’s audit committee and two or more nonemployee directors2, authorized to investigate evidence of material violations, determine appropriate remedial measures and notify the SEC that a material violation has occurred if remedial measures are not materially performed.

If an issuer has established a QLCC, an attorney who becomes aware of evidence of a material violation may report such evidence to the QLCC rather than the chief legal officer. Having made and documented this report, the attorney will have no duty to assess the issuer’s response and will have satisfied his or her obligations under Section 307. In addition, a chief legal officer who has received a report of evidence of a material violation may turn the report over to a QLCC for investigation and response (although doing so does not relieve a chief legal officer of all obligations as described below).

In either circumstance, the QLCC, rather than the chief legal officer, will conduct an inquiry into the reported evidence, determine whether a material violation exists, and, if so, take the following action:

  • Determine, and direct the issuer to adopt, appropriate remedial measures, including appropriate disclosures, sanctions, preventative and corrective measures; and
  • Inform the chief legal officer, chief executive officer and board of directors of the results of the QLCC’s investigation and the necessary remedial measures to be undertaken.

If the issuer fails in any material respect to implement any of the directed remedial measures, each member of the QLCC, as well as the chief legal officer and chief executive officer, has an obligation to notify the SEC that a material violation has occurred, is occurring or is about to occur and to disaffirm any document submitted or filed with the SEC that such person believes to be false or materially misleading.

Supervisory and Subordinate Attorneys
The proposal distinguishes between supervisory attorneys and subordinate attorneys under the proposed rule. An attorney working under the supervision, direction or supervisory authority of another attorney is a “subordinate attorney” and the other attorney is a “supervisory attorney.” A chief legal officer is always considered a supervisory attorney. The supervisory attorneys of a subordinate attorney who appears and practices before the SEC in the representation of an issuer are also deemed to so practice before the SEC.

Supervisory attorneys would be charged with reporting evidence of material violations that they discover on their own as well as such evidence as may be reported to them by subordinate attorneys. If a supervisory attorney believes that information reported by a subordinate attorney does not constitute evidence of a material violation, the supervisory attorney need not report it to the issuer but must document the basis for his or her belief.

Subordinate attorneys would be bound by the proposed rule regardless of whether they are acting on the direct instruction of a supervisory attorney. The reporting obligation of a subordinate attorney, however, only extends as far as his supervisory attorney. If a subordinate attorney believes that his supervisor has failed to comply with the rules, a subordinate attorney may, but is not required to, undertake himself to report up-the-ladder at the issuer.

The proposed rule explicitly authorizes, but does not require, an attorney’s disclosure of confidential information, without the issuer’s consent, if the attorney reasonably believes such disclosure is necessary in order to:

  • Prevent the issuer from committing an illegal act that the attorney reasonably believes is likely to result in substantial injury to the financial interest or property of the issuer or investors;
  • Prevent the issuer’s commission of an illegal act likely to perpetrate fraud upon the SEC; or
  • Rectify the consequences of an illegal act by the issuer in furtherance of which the attorney’s services were used.

Based on a stated objective of facilitating expeditious investigations and obtaining prompt relief for investors, the rule would also provide that an issuer’s sharing of information with the SEC pursuant to a confidentiality agreement shall not constitute a waiver of any otherwise applicable privilege or protection (e.g., attorney-client privilege and work-product protection) as to other persons.

As mentioned above, a reporting attorney is also explicitly authorized to use his or her documented reports to defend against a claim of noncompliance with the rule, even though client confidences may be revealed.

Violations of the rules by attorneys would be treated as violations under the Securities Exchange Act of 1934 (“Exchange Act”), subjecting the attorney to civil actions for injunctive or other equitable relief, civil penalties or cease-and-desist proceedings. No private right of action is created under the proposed rule. It is the staff’s view that violation of the proposed rule, in and of itself, would not meet the standard for the imposition of criminal penalties. The rules also provide an express scienter requirement for discipline under the Exchange Act’s rules of professional conduct which includes negligent conduct in the form of a single instance of highly unreasonable conduct resulting in a violation, or repeated instances of unreasonable conduct, each of which results in a violation.

The proposed rules also stipulate that violations will be subject to SEC disciplinary authority regardless of whether the attorney may also be subject to discipline for the same conduct at the state level. (See “Relationship with State Law” below.)

Relationship with State Law
With the expansion of the proposed rule into areas traditionally regulated by state ethical rules, such as required withdrawals from representation, notifications of withdrawal and authorized disclosures of issuer confidences, inconsistent obligations at the state and federal levels seem unavoidable. What should be the result when an action required by the federal securities law rules is prohibited by state ethical rules? The SEC view is clearly that the federal rules would pre-empt any conflicting state rule, but the release stops short of presenting this view as an absolute – comment is specifically solicited on the issue as well as others throughout the release.

The Act requires the “up the ladder” requirements to be adopted by January 26, 2003, and that portion of the proposal is certain to be adopted. The “reporting out” aspects of the proposal are far more controversial and commenters are already urging the SEC to delay their adoption pending further review and debate. We will be following the debate closely and will issue more client alerts as the situation warrants.

Contact Information
If you have any questions or would like to learn more about the proposed rules, please contact the lawyer who normally represents you.

1 In the case of registered investment companies, such directors may not be “interested persons” as such term is defined in the Investment Company Act of 1940 (the “1940 Act”).

2 With respect to registered investment companies, such directors may not be “interested persons” within the meaning of the 1940 Act.