Standards of Professional
Conduct for Lawyers Under
Topics to be Covered
What Section 307 of the Sarbanes-Oxley Act of 2002 and
the implementing SEC rules in Part 205 require.
Overview: Changes in the Law Require
Implementation
of New Procedures
Under Section 307 of the Sarbanes-Oxley Act of 2002 (the “Act”), attorneys who appear and practice before the Securities and
Exchange Commission (“SEC” or “Commission”) must “report-up” evidence of a material violation by an issuer.
The Act required the SEC to draft rules to effectuate this
requirement. Those rules are codified in Part 205 of the SEC’s rules (17 CFR Part 205) and went into effect August 5, 2003. The SEC is still contemplating requiring attorneys/issuers to “report-out” evidence of a material violation through a process of “noisy withdrawal.”
The area is complex and there are interpretation issues. In addition, there may be potential conflicts with state ethics rules. Obligations under Section 307 fall on individual attorneys, but the
rules expressly provide that there is no private right of action, only SEC enforcement.
Duty to Report Evidence of a
Material Violation
Key Elements
“Appearing and practicing before the Commission,” “Issuer,”
“In representation of an issuer,” “Evidence of a material violation,”
“Subordinate attorney” and “supervising attorney,” and “Appropriate response.”
Note – An attorney appearing and practicing before the SEC in the representation of an issuer owes his or her professional
duties to the issuer as an organization. The fact that the attorney may work with or advise the issuers’ officers, directors or
employees does not make such individuals the attorney’s client. This tracks State Ethics Rules (e.g., NY DR 5-109, Cal. R.P.C. 3-600).
Duty to Report Evidence of a
Material Violation
Appearing and Practicing Before the Commission includes:
Transacting any business with the SEC, including communications in any form;
Representing an issuer in an SEC administrative proceeding or inquiry;
Providing advice concerning U.S. securities laws or SEC rules or regulations regarding any document that the attorney has notice will be filed with or submitted to the SEC, including providing advice in the context of participating in preparing any such document;
• Note – this is interpreted to include “non-securities” practitioners if they advise as to portions of disclosure documents.
Duty to Report Evidence of a
Material Violation
Appearing and Practicing Before the Commission includes (cont’d):
Advising an issuer as to whether information or a statement,
opinion or other writing is required under U.S. securities law or the SEC rules or regulations to be submitted to the SEC.
• An attorney who advises that under U.S. securities laws, a particular document need not be incorporated into a filing, registration statement or other submission to the SEC is “appearing and practicing.”
• This is interpreted to include advice that registration is not required, i.e., private placements and other exempt offerings.
Supervising attorney of subordinate attorney who is appearing and practicing before the SEC is also deemed to be appearing and practicing.
An attorney who is retained specifically to investigate evidence of a material violation is deemed to be appearing and practicing before the SEC and may have a reporting obligation, depending on the circumstances.
Duty to Report Evidence of a
Material Violation
An “Issuer” means:
Rule is applicable to the following types of companies: US
and non-US entities required to make periodic filings with
the SEC or with a pending registration statement on file
(collectively, an “issuer”). Foreign governments are not
covered.
Duty to Report Evidence of a
Material Violation
“Representation of an Issuer” means:
Providing legal services as an attorney for an issuer.
• Includes in-house lawyers and outside counsel. Counsel retained by third parties also covered, but only if for the benefit of the issuer.
– Counsel for an investment adviser of an investment company may have reporting obligations to the investment company.
– Counsel for underwriters do not have duties to the issuer under Section 307.
• “Issuer” includes non-public subsidiaries.
• “Non-appearing foreign attorneys” not covered.
• Those performing a non-legal function are not covered (i.e., business people with a law degree).
Duty to Report Evidence of a
Material Violation
“Evidence of a Material Violation” means:
The test is objective (with some subjective elements): credible evidence 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 on-going, or is about to occur.
• The Commission has commented that the “material” has a “well-established meaning under the federal securities laws and the Commission intends for that same meaning to apply.”
• To be “reasonably likely,” a material violation must be more than a mere possibility, but it need not be more likely than not. An attorney is not required (or expected) to report gossip, hearsay, or innuendo; nor is a reporting obligation triggered by a combination of
circumstances from which the attorney, in retrospect, should have drawn an inference.
Duty to Report Evidence of a
Material Violation
“Material Violation” means:
A material violation of an applicable federal or state securities law, a material breach of fiduciary duty, or similar material violation of any federal or state law.
• “Breach of Fiduciary duty” includes misfeasance, nonfeasance, abdication of duty, abuse of trust and approval of unlawful
transactions.
• The SEC has not defined what is meant by the phrase “or similar material violation” of any U.S. federal or state law, but the phrase is plainly very broad and comes from the Act.
• Reporting obligations are not triggered by violation of non-US law or breach of duty imposed by non-US law.
Duty to Report Evidence of a
Material Violation
“Subordinate Attorney” means:
An attorney who appears and practices before the Commission in the representation of an issuer on a matter under the supervision or direction of another attorney.
Mid-level and even senior attorneys may be subordinate attorneys if they are supervised by another attorney, even someone junior in terms of years of practice.
“Supervising Attorney” means:
Only a senior attorney who actually directs or supervises the
actions of a subordinate attorney appearing and practicing before the Commission is a supervisory attorney.
• A senior attorney who supervises or directs a subordinate on other matters unrelated to the subordinate’s appearing and practicing before the Commission would not be a supervisory attorney.
Duty to Report Evidence of a
Material Violation
Duties of Supervising and Subordinate Attorneys
A subordinate attorney complies with his/her reporting
obligations if the subordinate attorney reports to his/her
supervising attorney under Part 205 evidence of a material
violation.
Consequence: The supervising attorney is then
responsible for promptly complying with the reporting
requirements under Part 205.
A supervising attorney must make reasonable efforts to
ensure that subordinate attorneys fulfill their obligations
under Part 205.
Duty to Report Evidence of a
Material Violation
No nexus required between the scope of an attorney’s engagement in
Once the attorney becomes subject to the rules because
he/she is representing an issuer in a matter that constitutes
appearing and practicing before the commission, that
attorney’s reporting obligation may be triggered by any
“material violation” of which he/she becomes aware, even if
completely unrelated to the scope of the attorney’s
engagement.
“appearing and practicing
before the Commission in
representation of an
issuer”
and
“evidence of a material
Duty to Report Evidence of a
Material Violation
Duty to Report Promptly to
Whom?
Chief Legal Officer/
Chief Executive Officer
orQualified Legal
Compliance Committee
• At least three non-employee
directors, including at least one audit committee
member.
• Written procedures for
confidential receipt,
retention, and consideration of reports of evidence of a material violation.
• Authority to report violations
to the SEC and regulatory
• In most instances report
should be made to the Chief Legal Officer.
Duty to Report Up-the-Ladder Evidence
of a Material Violation
Threshold for Triggering Up-the-Ladder Reporting
•
If reported to chief legal officer/chief executive officer,
failure by the chief legal officer or chief executive officer to
provide an “appropriate response” within a reasonable time
to the reporting attorney triggers a duty to report-up the
evidence of a material violation to the issuer’s audit
committee or board of directors.
•
If reported to a qualified legal compliance committee, the
attorney has satisfied his/her obligation to report such
evidence and is not required to assess the issuer’s
response. (A potential advantage if SEC adopts
noisy-withdrawal rule.)
Duty to Report Up-the-Ladder
Appropriate Response means:
•
A response to the reporting attorney as a result of which
the attorney reasonably believes:
♦
no material violation has occurred or is about to occur,
♦
the issuer has adopted appropriate measures, or
♦
the issuer has retained or directed an attorney to
review the reported evidence and such attorney has
advised that the issuer has a colorable defense.
•
Investigating attorney/defense counsel need not report-up
if retained by Chief Legal Officer, and Chief Legal Officer
keeps board apprised of any violations and progress of
proceedings.
Retaliation
Whistle-blowers
Whistle-blower who believes discharged because of
reporting may so notify the company’s board or
appropriate committee.
SEC explains that this will stop the chief legal officer from
blocking a report by discharging the reporting attorney.
Withdrawal and Disclosure
Revealing Client Secrets
The SEC has proposed additional rules (so-called “noisy withdrawal”
requirement) that would require attorneys or issuers to make disclosure of the resignation of counsel as the result of Part 205 issues.
These additional rules and the existing Part 205 provision permitting
voluntary disclosure by the attorney to the SEC may conflict with some state laws or rules of professional conduct requiring attorneys to preserve the secrets of their clients.
• The Washington State Bar Association issued a formal opinion stating that
disclosure of client confidences permitted by Part 205 may be in conflict with Washington State’s rules of professional conduct for Attorneys. (Interim Formal Ethics Opinion, at:
(http://www.wsba.org/lawyers/ethics/formalopinion.doc)
• The California State Bar Association has written the SEC stating the same
and also citing potential conflict with provision in the California Business & Professional Code barring attorneys from disclosing confidences.
(http://www.calbar.ca.gov/calbar/pdfs/SEC-ethics-alert.pdf)
Since the SEC has not yet required such disclosures, most attorneys are likely to refrain from any conduct that would disclose clients’ confidences in violation of applicable state laws or rules of professional conduct.
Withdrawal and Disclosure (cont’d)
Resignation
There are situations where counsel has no choice but to
withdraw from an assignment and possibly resign from
representing the client and withdraw opinions counsel has
issued:
• Where a client or third party has misrepresented to the SEC an opinion or other position of the lawyer.
• Where a client is making ongoing misrepresentations to the public or the SEC, the lawyer becomes aware of it and the lawyer may be associated with the fraud.
• The board of directors does not appropriately respond to a 307 report.
Establishing a set of procedures
Steps an Issuer Should Take
Develop a written policy – to whom to report, form of
report, records documenting report and response.
Circulate policy to inside and outside counsel.
Train lawyers on policy’s terms and create consultative
mechanism.
Monitor compliance.
Issues
Scenario One – In-house Attorney
• An in-house litigator for a subsidiary of a large public company is asked by a senior member of the legal
department of the parent company (who is responsible for external reporting and compliance) to update a description of pending litigation relating to the intellectual property of the subsidiary. The litigation description is from an SEC filing made by the parent company and will be included in the next filing as well.
– Is the subsidiary an “issuer”?
Issues
Scenario One, continued
• The litigator discovers that the prior description misstates the substance of the litigation, overstates the likelihood of
success, and underestimates the potential exposure of the subsidiary. The prior description is thus probably materially inaccurate.
– What is the litigator required to do, if anything?
– If a report is required, to whom and in what form should it be made?
Issues
Scenario One, continued
• The litigator reports her concerns to the colleague who asked her to perform the review (the one who is responsible for
external reporting and compliance for the parent company and reports to the General Counsel).
– What obligations if any does the colleague have?
– What is required if the colleague does nothing? What should the litigator do?
Issues
Scenario Two – Outside Counsel
• Environmental activists have conducted an investigation of a large chemical company listed on the NY Stock Exchange. They locate foreign government documents showing that bribes were paid to avoid foreign environmental protection rules. These bribes and the potential environmental
exposure have never been disclosed. The cost to the chemical company of compliance and remediation would likely be billions of dollars. The environmental activist sends a memo detailing the situation, together with the foreign
government documents, to a law firm partner who handles the chemical company’s bond offerings.
– What should the partner do?
– What should be done if the matter is reported and the only response from the general counsel is: “We know about this garbage, don’t worry.”
Issues
Scenario Three – Outside Counsel
• A private hedge fund tells the partner in the law firm handling its work that the fund is planning to unload shares in a public company it is holding because it has been tipped by the
president of that company that the highly touted new drug the company was developing has fizzled. The partner tells the managing director of the fund that a sale of these shares would be insider trading and the fund should not make the sale. The managing director says that it is too late because the contract with another fund to swap these and shares in several other companies has already been signed and there will never be a lawsuit.
– Does the partner have any obligations under the Act?
Issues
Scenario Four – In-house Attorney
• An in-house environmental lawyer is working on
environmental disclosure to be made in connection with a private placement of a NASDAQ-listed company’s
convertible debt. She reviews some files that, although irrelevant for her assignment, show that the CFO of the company will be paid a “consulting fee” by the purchaser of the debt. The CFO does not appear to be doing any work for the payment and, to the lawyer’s knowledge, this
arrangement is unknown to the general counsel or other members of management. The lawyer also notes that the terms of the debt are particularly unfavorable to the
company.
– Is the lawyer covered by the Act?
– Is her discovery covered by the Act?
