Section 307 of the Sarbanes-Oxley Act of 2002 directed the SEC to issue rules that require an attorney to report evidence of a material violation of securities laws or a breach of a fiduciary duty "up the ladder" within an issuerto the issuer’s chief legal counsel (CLO) or chief executive officer (CEO) and, if that person fails to appropriately respond, to the issuer’s audit committee, another committee of independent directors or the full board of directors. The SEC has now issued final rules implementing those provisions, although it indicated an intention to issue additional rules on the matter of an attorney’s withdrawal from representing an issuer when the issuer does not appropriately respond in such a situation.

Attorneys Covered by the Rules

The new rules require an attorney -- appearing and practicing before the SEC in the representation of an issuer -- who becomes aware of evidence of a material violation by the issuer, or by any officer, director, employee or agent of the issuer, to promptly report the evidence to the issuer’s CLO or to both its CLO and CEO.

Attorney. The rules define an "attorney" as anyone licensed or otherwise qualified to practice law in any foreign or domestic jurisdiction, or holding oneself out as licensed or otherwise qualified to practice law. The rules nonetheless exempt "non-appearing foreign attorneys".

Non-appearing foreign attorneys are attorneys who:

  • are licensed to practice law outside the United States;
  • do not hold themselves out as licensed or qualified to practice U.S. federal or state securities laws, and do not give legal advice regarding these laws; and
  • either "appear and practice" before the SEC only incidentally to, and in the ordinary course of, the practice of law outside the United States, or "appear and practice" before the SEC only in consultation with counsel (other than another non-appearing foreign attorney) licensed in the United States.

Some commentators had been concerned that the definition of "attorney" would include individuals who do not hold legal positions or perform legal services, simply because they are licensed or qualified to practice law. However, the definition of "appearing and practicing" discussed below should avoid entangling those individuals.

Appearing and Practicing before the SEC. The rules define "appearing and practicing" before the SEC as:

  • conducting business with the SEC, including communications in any form;
  • representing an issuer in an SEC administrative proceeding or in connection with any SEC investigation;
  • advising an issuer regarding U.S. securities laws or the SEC’s rules or regulations with respect to any document that the attorney has notice will be filedwith or submitted to the SEC; or
  • advising an issuer regarding whether U.S. securities laws or the SEC’s rules or regulations require information or a statement, opinion or writing to be filed with or submitted to the SEC.
  • On the other hand, the rules make clear that "appearing and practicing" specifically excludes any attorney who:
  • conducts the foregoing activities outside the context of providing legal services to an issuer with whom the attorney has an attorney-client relationship (in other words, the existence of an attorney-client relationship with the issuer is a prerequisite); or
  • is a "non-appearing foreign attorney".

Based on the above exclusion, an attorney who is employed by an issuer as a financial officer (and who does not provide legal services to the issuer), for example, would not be covered by the rules. In addition, attorneys representing third parties, such as underwriters in a public offering, would not be covered with respect to their conduct in relationship to the issuer.

Attorneys should be mindful, however, that an attorney-client relationship may exist without an attorney-client engagement letter, and also may exist in some situations where the attorney-client privilege would not govern communications between the attorney and the issuer. The expectations and understandings between the attorney and the issuer may not be totally dispositive of the issue, but will be important factors in determining the existence or absence of the requisite attorney-client relationship.

The SEC emphasized that for an attorney to be covered by the rule, he or she "must have notice that the document that he or she is preparing or assisting in preparing will be submitted" to the SEC. While that provision operates to exclude an attorney who prepares a document that he or she does not have reason to believe will be submitted to the SEC, it does not exclude an attorney simply because he or she practices in a non-securities or non-corporate law area. Regardless of one’s practice area, the rules will extend to an attorney who reviews or prepares discrete portions of an issuer’s periodic reports, for example.

Also, the above focus on "documents" should not be viewed as a limitation of the rules’ coverage to matters that involve actual documentation work.

Representation of an Issuer. The SEC’s release emphasizes that an "issuer" includes entities controlled by the issuer, such as wholly-owned subsidiaries, when the attorney provides legal services to such an entity for the benefit or on behalf of the issuer. Accordingly, attorneys who work for a non-public subsidiary at the direction of the parent company issuer where the work will be submitted to the SEC, or who discover evidence of a material violation while working at the direction of the parent, would be deemed to be "representing" the issuer.

The Reporting Obligation

The rules trigger an obligation to report "up-the-ladder" only when the attorney becomes aware of evidence of a "material violation" of an applicable U.S. federal or state securities law, a "material breach of fiduciary duty" arising under U.S. federal or state law, or a "similar material violation" of any U.S. federal or state law.

Evidence of a Material Violation. The release defines "evidence of a material violation" as 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. The SEC attempted to formulate an objective standard, rather than a subjective one. The attorney may consider the circumstances known when assessing the issue, including the attorney’s professional abilities and experience, applicable time constraints, and prior experience and familiarity with the client. The rules do not define "evidence of a material violation" to include gossip or circumstances that, when assessed with the benefit of hindsight, could have led the attorney to different conclusions. The release emphasizes, however, that the attorney does not need to "know" of a material violation to trigger the obligation to report evidence "up-the- ladder".

Breach of Fiduciary Duty. The definition of "breach of fiduciary duty" is expansive, and includes any breach of a fiduciary or other duty recognized under applicable federal or state statutory or regulatory law or at common law. A breach of fiduciary duty includes, among other things, abdication of duty, abuse of trust and approval of unlawful transactions, and may be based on nonfeasance as well as misfeasance.

Material Violation. The SEC did not define materiality in the rules, but stated that materiality will have the same meaning for these purposes as under existing federal securities laws. Under existing standards, information is "material" if there is a substantial likelihood that a reasonable shareholder or investor would consider it important in making an investment decision, or if there is a substantial likelihood that a fact would have been viewed by a reasonable investor or shareholder as significantly altering the "total mix" of information otherwise available. Under the rules, a material violation will not include a violation of foreign laws.

Reporting "Up-the-Ladder"

As noted above, the Act required the SEC to prescribe standards that require an attorney to report evidence of a material violation or a breach of a fiduciary duty "up-the-ladder" within the issuer to the issuer’s CLO or CEO and, if that person fails to respond, to report the matter to the issuer’s audit committee, another committee of independent directors or to the full board of directors.

Under the SEC’s rules, once the attorney’s duty to report evidence of a material violation is triggered, the attorney must promptly report the evidence to the issuer’s CLO or to both its CLO and CEO. If an issuer does not have an inside CLO, then obviously the report must be made to its CEO. If an issuer does have an inside CLO, he or she must receive the report, regardless of whether the CEO is informed, unless the attorney uses the QLCC alternative discussed below, or makes a determination of futility as also discussed below.

The rules do not dictate the form that the report must take, but generally require the report to include sufficient information to evaluate the matter, including dates, times, locations and witnesses, as well as the substance of the evidence. Once the CLO/CEO receives the attorney’s report, the CLO/CEO must investigate the evidence that the CLO/CEO reasonably believes is appropriate to determine whether the reported material violation has occurred, is ongoing or is about to occur. If the CLO/CEO determines that no material violation has occurred, is ongoing or is about to occur, the CLO/CEO must notify the reporting attorney of the basis for reaching that conclusion. If the CLO/CEO does not determine that no material violation has occurred, is ongoing or is about to occur, then the CLO/CEO must take reasonable steps to cause the issuer to adopt an "appropriate response". Alternatively, the CLO/CEO could refer the report of the evidence of a material violation to the issuer’s qualified legal compliance committee (QLCC) for further action, as explained below.

The rules define an "appropriate response" as a response that causes the reporting attorney to reasonably believe that:

  • no material violation has occurred, is ongoing or is about to occur;
  • appropriate remedial measures have been adopted to stop any ongoing material violation, prevent any material violation that has not occurred, or remedy any material violation that has occurred; or
  • the issuer -- with the consent of the issuer’s board of directors, a committee of the board of directors composed entirely of directors who are not employed by the issuer, or the issuer’s QLCC -- has retained or directed another attorney to review the reported evidence, and either (i) has substantially implemented any recommendations from such other attorney after reasonable investigation, or (ii) has been advised by such other attorney that the issuer can assert a colorable defense in the context of any investigation or judicial proceeding relating to the material violation.

It is fair to say that the rules effectively require a reporting attorney to use his or her professional judgment to assess whether the reporting attorney has received an appropriate response.

Unless a reporting attorney reasonably believes that the CLO/CEO has provided an appropriate response within a reasonable period of time, the reporting attorney must report the evidence to the audit committee, another committee of the issuer’s board of directors composed entirely of directors who are not employed by the issuer, or (if no such committee exists), the issuer’s board of directors as a whole. In addition, the reporting attorney must explain the attorney’s reasons for concluding that he or she has not received an appropriate response within a reasonable period of time.

If the reporting attorney receives an appropriate response within a reasonable period of time, then the reporting attorney would have no further obligations.

The QLCC Alternative

The rules permit an attorney with evidence of a material violation to report that evidence to a "qualified legal compliance committee" in lieu of following the "up the ladder" requirements discussed above. A QLCC is defined as a committee established by the issuer’s board of directors that:

  • consists of at least one member of the issuer’s audit committee (or an equivalent committee, if the issuer does not have an audit committee), and two or more other directors who are not employed by the issuer;
  • adopts written procedures for the confidential receipt of evidence of a material violation; and
  • has authority to notify the CLO or CEO of a report, to assess whether an investigation is warranted (and conduct one, if necessary), and to direct the issuer to take appropriate remedial measures, including any necessary disclosures or sanctions to stop ongoing violations, prevent future violations or remedy past violations.

If an attorney reports evidence of a material violation to the QLCC, the attorney would have no further reporting obligation, and no obligation to assess the issuer’s response to the report.

The "Futility" Exception; Other Options

If the attorney reasonably believes that it would be futile to report the evidence of a material violation to the CLO and CEO, the reporting attorney may bypass the CLO and CEO and directly report the evidence to one of the three board of directors options discussed above. Of course, if the issuer has a QLCC, that alternative can be used without a determination of futility in reporting to the CLO and CEO.

It is also important to note that the SEC rules do not prohibit the attorney from discussing the matter, at any time, with other appropriate persons within the issuer whom the attorney might believe could act to produce a salutary result. Any such discussion simply would need to be in addition to, and not in lieu of, the reporting prescribed by the rules.

Sanctions and Discipline for Non-Compliance

Attorneys who fail to comply with the rules will be subject to the remedies and sanctions available to the SEC under the Securities and Exchange Act of 1934, including civil injunctions, monetary penalties and bars from appearing or practicing before the SEC. The rules include an express safe harbor provision that the rules do not create a private cause of action against an attorney, a law firm or an issuer, based solely on failure to comply with the rules.

Effect on Attorney-Client Privilege and Confidentiality

The rules provide that attorneys may use any report of evidence of a material violation, and the issuer’s response to the report, in connection with any investigation or proceeding relating to the attorney’s compliance with the rules. In short, the attorney may use records that he or she maintains in "self-defense". The SEC intends these provisions to be substantially similar to existing exceptions to the client confidentiality rules under state law.

The rules also permit, but do not require, an attorney to reveal confidential information to the SEC, without the issuer’s consent, to the extent necessary to prevent an illegal act by the issuer that the attorney reasonably believes is likely to cause substantial injury to the financial interests of the issuer or investors. The attorney also may, but is not required to, disclose confidential information to remedy the issuer’s illegal acts, when those illegal acts have been advanced by the issuer’s use of the attorney’s services.

The rules do not preempt ethical rules under state law that establish more stringent obligations. However, the SEC emphasized that the rules will prevail over conflicting or inconsistent provisions under state law.

Timing

The rules discussed above become effective on August 5, 2003.

Additional Consideration for a "Noisy Withdrawal"

Although the rules as proposed by the SEC in November 2002 would have required an attorney to effect a "noisy withdrawal" if an issuer failed to deliver an appropriate response after receipt of evidence of a material violation, the SEC took no final action on that matter in releasing the above rules. Instead, the SEC extended the comment period on those aspects of its earlier proposals to April 7, 2003.

Under those proposed rules, a reporting attorney who did not receive an appropriate response, and who reasonably believed that a material violation is ongoing or about to occur and is likely to result in substantial injury to the financial interests of the issuer or its investors, would be required (a) in the case of outside counsel, to withdraw from representing the issuer and notify the SEC that the attorney withdrew for "professional considerations", and (b) in all cases, to disaffirm any SEC submissions prepared by the attorney that the attorney believed may be materially false or misleading. In addition to seeking further comment on these proposed "noisy withdrawal" rules, the SEC also proposed an alternative provision that would require the issuer, as opposed to the attorney, to publicly disclose on Form 8-K the withdrawal of an attorney under the circumstances discussed above, within two business days of the withdrawal.

At the meeting approving the rules that were released as final, four of the five SEC Commissioners spoke in favor of a "reporting out" requirement. Several commentators have renewed earlier objections to such a requirement. We believe, in light of the overall thrust of recent corporate governance reform initiatives, that it is likely that the SEC will adopt some form of reporting out requirement when it revisits the issue this spring.

The information contained in this Legal Alert is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact the author(s) of this Legal Alert through our Web site at www.KilpatrickStockton.com