United States: Client Advisory: SEC Adopts Rule on Standards of Professional Conduct for Attorneys

At its meeting on January 23, 2003, the Securities and Exchange Commission adopted a portion of proposed Rule 205 to implement Section 307 of the Sarbanes-Oxley Act, while deferring other portions of the proposed rule. For a description of the proposed rule, see our prior advisory on proposed Rule 205, sent in December 2002, and our comment letter to the SEC included with that advisory.

Generally, the portion of the proposed rule that the SEC adopted relates to internal "up the ladder" reporting within the issuer. The deferred portion relates to the highly controversial provisions of the proposed rule which would have required

• "noisy withdrawal" of an attorney (if the corporation’s response to the reporting attorney was not "appropriate"),
• notice by the attorney to the Commission of its withdrawal for "professional" reasons, and
• "disaffirming" by the attorney of filings with the Commission related to the noisy withdrawal.

The final Rule is effective 180 days after publication of the rule (not available when this advisory was prepared), but the Commission will accept further comments on the adopted provisions of the Rule during the extended comment period referred to below. The most significant features of the Rule are summarized below.

• Reporting Obligation. As adopted, the Rule will require inside and outside attorneys to report "evidence of a material violation" of law up-the-ladder within the issuer, either to (A) a "qualified legal compliance committee" of directors (meeting certain criteria specified in the rule and permitted but not required by the rule) or (B) first, the chief legal officer or chief executive officer and, second, if the response from those officers is not "appropriate," to the audit committee, another committee of independent directors or the full board.
• Attorneys Covered. The Rule applies to attorneys "appearing and practicing before the Commission," the definition of which has been clarified to mean attorneys providing legal services to an issuer, in an attorney-client relationship, who "have notice" that documents they are preparing or assisting in preparing will be filed with or submitted to the Commission. Foreign attorneys would be covered only if they meet that description and they provide advice regarding U.S. law without doing so in consultation with a U.S. lawyer.
• Standard of Conduct. As modified from the proposal, the Rule nonetheless continues to use an "objective" standard of attorney conduct in defining what is evidence of a material violation. The attorney’s duty to report will be triggered if he or she has "credible evidence, based 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."
• Permits Disclosure of Confidential Information. Attorneys will be permitted, but not required, to reveal confidential client information to the extent the attorney reasonably believes it is necessary to
• prevent the issuer from committing a material violation likely to cause substantial financial injury to the financial interests or property of the issuer or investors,
• prevent the issuer from committing an illegal act or
• rectify the consequences of a material violation or illegal act in which the attorney’s services have been used.

The Rule asserts that it controls attorney conduct over state law to the extent the Rule and state law are in conflict (and state law does not impose a higher obligation) but does not otherwise supersede or preempt state ethics rules. While the Rule also expressly states that it does not create a private right of action, it does not provide a safe harbor, as requested by many commentators. In any case, lawyers should expect that plaintiffs’ lawyers, judges and juries will find ways to use asserted violations of Rule 205 in claims brought under state and federal securities laws notwithstanding that only the Commission can directly enforce the Rule.

Extended Comment Period on Proposed Noisy Withdrawal Rules and Alternative Proposal

In the face of extensive comment on the originally proposed rule, the Commission has extended for 60 days the comment period on the noisy withdrawal provisions of the originally proposed rule. The Commission has also proposed a possible "compromise" alternative to the noisy withdrawal and related provisions of the proposed rule. The "compromise" is an attempt to address the concerns raised with respect to the proposal that would have required disclosure of confidential client information. The alternative would require withdrawal by an attorney in the event that the response to reporting by the attorney internally was not appropriate, but would not require the attorney to directly report withdrawal to the Commission or to disaffirm any Commission filings or submissions. Instead, the alternative would require the issuer to report the attorney’s withdrawal (or notice that he or she has not received an appropriate response from the issuer) within two days on a Form 8-K (or other applicable reporting form). Under this proposal, the attorney would be permitted, but not required, to report his or her withdrawal to the Commission if the issuer does not so disclose the attorney’s withdrawal or notice.

Impact of Commission Actions

The deferral of action on the noisy withdrawal provisions of the proposed rule may, however, only be a temporary reprieve. It is clear both from the comments of certain of the Commissioners and from the Commission’s press release that the broad thrust of these provisions is still considered to be necessary. It may be the case that the comment period has been extended to give sufficient time for the Commission to garner additional support for the noisy withdrawal provisions in order to counteract the nearly unanimous negative commentary by the practicing securities bar.

Based on what we now know, the Rule continues to include several of the deficiencies previously discussed and deserves additional comment. When the actual text of the Rule is available, we will further analyze these provisions and provide further advisory information to clients and friends of the Firm. We also intend to submit further comments to the Commission concerning the Rule as adopted as well as with respect to the deferred proposals and the new proposals. Please feel free to call your regular Jones Day contact if you have any questions or would like to discuss this matter further.