The SEC has adopted new rules that establish standards of professional conduct for all attorneys who handle securities law matters on behalf of public companies. These standards, mandated by the Sarbanes-Oxley Act of 2002, take effect on August 5, 2003.
The attorney conduct rules are yet another safeguard designed by the SEC to protect the integrity of U.S. capital markets in the post-Enron era. Having previously addressed perceived problems with public company boards, executive management and independent auditors, the SEC’s attention has shifted to the legal community.
Public company directors and executives have always looked to securities lawyers for counseling and advice on matters of disclosure and SEC reporting. The attorney conduct rules now establish specific guidelines a securities lawyer must follow when representing a public company.
Securities lawyers will be obligated to adhere to "up the ladder" reporting if there are legitimate concerns about a public company’s compliance with the securities laws. Up the ladder reporting under the rules works as follows:
• An attorney who believes there is evidence of a material violation of the federal securities laws must report it to the company’s chief legal officer, and possibly the chief executive officer
• If the chief legal officer or chief executive officer does not provide a response considered appropriate by the attorney, the attorney must carry the purported violation "up the ladder" to the company’s audit committee, the independent directors or the full board of directors
• The attorney must then detail the purported violation and explain why the company has not made an appropriate response
The SEC is debating whether to also require "noisy withdrawal." This will force an attorney to resign from representing a company and notify the SEC of his or her withdrawal if the attorney is not satisfied with the company’s ultimate response to the purported violation.
The SEC estimates that nearly 18,200 companies will be affected by the new attorney conduct rules.
Evidence of a Material Violation
At the heart of the new conduct rules is the attorney’s duty to report evidence of a material violation of the federal securities laws. Evidence of a violation must be credible, not based on office gossip or innuendo. The obligation to report arises when, based on the credible evidence, it is unreasonable under the circumstances for an attorney not to conclude that it is reasonably likely a violation occurred. The determination whether a violation is reasonable likely falls somewhere between the conclusion that the violation is "a mere possibility" and "more likely than not" to have occurred. Certainty is not required. The belief that there is a reasonable chance that a violation occurred will trigger "up the ladder" reporting.
Evidence of a material violation of the federal securities laws relates not only to a violation that has occurred, but also to any violation that is continuing or is likely to occur.
Duty to Report
If an attorney becomes aware of evidence of a material violation, the attorney must report the violation to the company’s chief legal officer (or equivalent) or both the chief legal officer and the chief executive officer (or equivalent).
Company Investigation and Response
Once informed that an attorney believes a material violation has occurred, the chief legal officer must make an inquiry into the allegations. Once an investigation is completed, the chief legal officer must respond appropriately, i.e., take reasonable steps to correct the problem or inform the reporting attorney that no violation was in fact found. It is up to the reporting attorney to then determine whether the response is reasonable.
"Up the Ladder"
If the attorney is not satisfied with the response from the chief legal officer, the attorney must take the matter higher up in the organization and report the violation to one of the following:
• the audit committee of the board of directors
• if there is no audit committee, then to a committee of independent directors
• if there is no committee of independent directors, then to the full board
If from the outset of the process an attorney believes that it is futile to approach the company’s chief legal officer or chief executive officer, the attorney can take the matter directly to the audit committee, the independent directors or the full board, as the situation dictates.
"Noisy Withdrawal?"
Yet to be decided are the ultimate steps an attorney must take if the attorney has exhausted up the ladder reporting and is still not satisfied with the company’s response. The SEC is presently considering whether to impose a "noisy withdrawal" requirement. This would require an outside attorney to:
• resign from representing the company
• notify the SEC of the withdrawal indicating it is based on professional considerations
• disaffirm documents filed with the SEC that the attorney prepared or assisted in preparing
An in-house attorney would not need to resign from the company, but instead would notify the SEC that he or she intends to disaffirm filed documents and then proceed to in fact disaffirm such documents.
If a violation is ongoing or about to happen and it is likely to result in substantial injury to the financial interests or property of the company or investors, the attorney must give one business day notice to the SEC of the withdrawal or intent to disaffirm filings, as the case may be, and then promptly act.
As alternatives to noisy withdrawal, the SEC is considering whether to make SEC notice permissive instead of mandatory or simply drop the SEC notice requirement altogether. The SEC is also looking at requiring the company itself to file a notice of withdrawal or disaffirmation with the SEC on Form 8-K. The SEC is soliciting comments on these proposals through April 7, 2003.
Qualified Legal Compliance Committees
An attorney has the option of reporting material violations of the federal securities laws to a qualified legal compliance committee (QLCC) of the board of directors if the company has established one. This would be in lieu of up the ladder reporting. If a report is made to a QLCC, the attorney does not have to take the matter any further and is not required to assess the company’s response to the reported violation. The QLCC assumes full responsibility for the matter, which may include notifying the SEC of a violation and the company’s failure to respond to it.
A QLCC must consist of one member of the audit committee and two or more independent directors.
Confidential Information
The new SEC attorney conduct rules address situations where an attorney is permitted (but not required) to disclose confidential information without the consent of the company. This would include reports prepared by the attorney in any proceeding where the attorney’s compliance with the new SEC conduct rules is at issue. It also includes any information the attorney reasonably believes necessary:
• to prevent the company from committing a material violation that the attorney reasonably believes is likely to result in substantial injury to the financial interests or property of the company or investors
• to prevent the company from perpetrating a fraud upon the SEC
• to rectify the consequences of the company’s material violations that caused or may cause substantial injury to the company’s financial interests or property
These provisions are generally considered consistent with most codes of ethics for attorneys under current state law.
What Attorneys are Subject to the New Rules?
The new SEC conduct rules apply to any attorney appearing and practicing before the SEC in the representation of a company. Certainly, any securities lawyer that represents a company in an SEC administrative proceeding or provides federal securities law advice or services for a public company, including advising on whether information or a statement need be included in a filing with the SEC, will be subject to the conduct rules. However, any attorney who has notice that a document he or she is preparing for a public company client will be filed with the SEC will also be covered.
Safe Harbor
The new SEC attorney conduct rules do not give rise to a private right of action against an attorney, law firm or company for compliance or non-compliance with the rules. Thus, the conduct rules contain a "safe harbor" from civil suits. The SEC is the only party authorized to bring actions under the new rules.
Sanctions and Discipline
The SEC can impose sanctions on attorneys violating the new conduct rules as it would any other violators of the federal securities laws and, when appropriate, initiate disciplinary proceedings. The SEC can censure or temporarily or permanently enjoin an attorney from practicing before the SEC for failing to adhere to the standards established by the new rules.
Capital Markets and Securities bulletin is published by the law firm of Vedder, Price, Kaufman & Kammholz. It is intended to keep our clients and other interested parties informed of developments in corporate finance and securities matters. It is not a substitute for professional advice.
© 2003 Vedder, Price, Kaufman & Kammholz.
