News & Resources

Implementation of Standards of Professional Conduct for Attorneys

June 18, 2003

MEMORANDUM

To:   Our Clients and Friends
From:   Olshan Grundman Frome Rosenzweig & Wolosky LLP
Date:   June 18, 2003
Re:   Implementation of Standards of Professional Conduct for Attorneys

The Securities and Exchange Commission (the "SEC") has released final rules implementing Section 307 of the Sarbanes-Oxley Act of 2002 (the "Act").[1]    Section 307 of the Act directs the SEC to prescribe minimum standards of conduct for "attorneys appearing and practicing before the SEC" when representing an issuer.  The new rules impose "up the ladder" reporting obligations of material violations of securities laws and material breaches of fiduciary duties or similar violations on attorneys who appear and practice before the SEC on behalf of an issuer.[2]  An attorney's reporting obligations are triggered when an attorney becomes aware of credible evidence, based upon which it would be unreasonable for a prudent attorney not to conclude that it is reasonably likely that a material violation (by the issuer or an officer, director, employee or agent of the issuer) has occurred or is about to occur.

Attorneys Subject to the New Rules

The new rules specify that both in-house and outside attorneys who "appear and practice before the SEC" are subject to the new rules.[3]  The new rules define "appearing and practicing before the SEC" as:

  • transacting any business with the SEC, including communications in any form;
  • representing an issuer in an SEC administrative proceeding or in connection with any SEC investigation, inquiry, information request or subpoena;
  • providing advice regarding United States securities laws or the SEC's rules or regulations regarding any document that the attorney has notice will be filed with or submitted to the SEC, or incorporated into any such document (including providing such advice in the context of preparing, or participating in preparing, any such document); or
  • advising an issuer regarding whether information or a statement, opinion or other writing is required under United States securities laws or the SEC's rules or regulations to be filed with or submitted to the SEC, or incorporated into any such document.

Up the Ladder Reporting System

            Reporting Attorney's Responsibility[4]

An attorney who becomes aware of evidence of a material violation[5] or breach is obligated to report this finding to the issuer's chief legal officer ("CLO") or to both its CLO and chief executive officer ("CEO").[6]  Provided that the attorney reasonably believes that the CLO has provided an "appropriate response" within a reasonable time, the attorney's duties have been satisfied.  An "appropriate response" is a response that allows the attorney to reasonably conclude that:

  • no material violation is occurring, has occurred, is going on or is about to occur;
  • the issuer has, as necessary, adopted appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or
  • the issuer, with the consent of the board of directors, the audit committee, another committee of independent directors or a Qualified Legal Compliance Committee ("QLCC"), has retained or directed an attorney to review the reported evidence of a material violation and either:
  • has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence; or
  • has been advised that such attorney may, consistent with that attorney's professional obligations, assert a colorable defense on behalf of the company (or the company's officer, director, employee or agent) in any investigation or judicial or administrative proceeding relating to the reported evidence of a material violation.

If a reporting attorney reasonably believes that the issuer's response is inadequate, the reporting attorney must (1) report the material violation to the audit committee (or another board committee composed solely of non-employee directors or the full board of directors) and (2) provide the CEO, CLO and the directors to whom the violation was initially reported with the reasoning as to why the response was inadequate. 

Chief Legal Officer's Responsibility

When an issuer's CLO or CEO is presented with a report of a possible material violation, the CLO must cause an appropriate inquiry to be made to determine whether such material violation has occurred, is ongoing or is about to occur.  The investigation must be appropriate for each given situation.[7]  If the CLO determines that no material violation has occurred, is occurring or is about to occur, the CLO must advise the reporting attorney of this conclusion and the basis for so concluding.  If the CLO cannot so determine, the CLO must take all reasonable steps to cause the issuer to respond appropriately and advise the reporting attorney of such response.

Qualified Legal Compliance Committee

The new rules provide an alternate to "up the ladder" reporting.  An issuer may create a QLCC,[8] comprised of at least one member of the issuer's audit committee[9] and two or more additional independent directors.  If a QLCC has already been established, a reporting attorney could report directly to the QLCC, rather than to the CLO.  Upon receipt of evidence of a material violation, the QLCC must notify the CEO or CLO, determine whether an investigation is warranted, initiate any investigation and recommend an appropriate response.  The QLCC may act by majority vote to take all other appropriate actions including notifying the SEC if the issuer should fail in any material respect to implement an appropriate response to a QLCC recommendation.  An attorney who reports evidence of a material violation to a QLCC does not need to assess the isssuer's response.

Responsibilities of Supervisory and Subordinate Attorneys

The rules define a "supervisory attorney" as an attorney who actually directs or supervises one or more subordinate attorneys actually appearing and practicing before the SEC.  Examples of supervisory attorneys include CLOs in public companies and partners in outside law firms.[10]  When a subordinate attorney appears and practices before the SEC, that attorney's supervisory attorneys are also deemed to appear and practice before the SEC.  A supervisory attorney must make reasonable efforts to ensure that subordinate attorneys comply with the reporting rules.  A subordinate attorney is deemed to have satisfied his or her reporting obligations once a report is made to a supervisory attorney.  A subordinate attorney who has reported evidence of a material violation to a supervisory attorney, but who reasonably believes that the supervisory attorney has failed to comply with the reporting requirements is permitted, but not obligated, to report the evidence "up the ladder" in the manner summarized above.

Disclosure of Confidential Information

Under specific circumstances, the new rules authorize a reporting attorney to use documentation previously prepared to defend against charges of attorney misconduct. The new rules also permit, but do not require, an attorney to reveal confidential information to the SEC to the extent the attorney believes reasonably necessary to (1) prevent the issuer from committing a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors; (2) prevent the issuer, in an SEC investigation or administrative proceeding, from committing perjury or perpetrating a fraud; or (3) rectify the consequences of a material violation by the issuer that caused, or may cause, substantial injury to the financial interest or property of the issuer or investors in furtherance of which the attorney's services were used.  The new rules further provide that a mandatory disclosure requirement imposed by a state would be an additional requirement consistent with the SEC's permissive disclosure rule.

Sanctions

Attorneys who violate the new rules are subject to civil penalties and remedies, including administrative disciplinary proceedings.[11]  Possible sanctions include injunctions, cease-and-desist orders, censure, suspension or a bar from further practice before the SEC.  Sanctions may be imposed on an attorney irrespective of whether that attorney is also subject to discipline in the state where he or she practices or is admitted.  An attorney who complies with the rule in good faith will not be subject to discipline by the SEC for a violation of inconsistent standards imposed by any other jurisdiction.  The new rules do not provide for a private right of action against any attorney, law firm or issuer based on compliance or noncompliance with these rules.

Effective Date

The final rules become effective on August 5, 2003.

Proposed Rule: "Noisy Withdrawal and the Alternative"[12]

The original proposed rule provided that a reporting attorney who had not received an appropriate response within a reasonable time to a reported material violation that was either ongoing or was about to occur and was likely to result in substantial injury to the issuer or investors, would have been required to make a "noisy withdrawal".  A noisy withdrawal would have required the attorney to withdraw from the representation, notify the SEC that such withdrawal was based on professional considerations and disaffirm any false or misleading submissions to the SEC that the attorney participated in preparing.  As a result of the plethora of comments received, the SEC has extended the comment period for this aspect of the proposed rules and has solicited comments on an alternate proposal.

____________________

These are only brief descriptions of the SEC's new rules.  This memorandum provides general information only and does not constitute legal advice that may be applied to any particular situation.  Please contact the Partners in our Corporate Department for further advice and assistance.

Appendix A

            The SEC amended Title 17 C.F.R. 205.2(k) by providing issuers with the option of establishing a Qualified Legal Compliance Committee ("QLCC").  A QLCC may only be established by the issuer's board of directors.  The QLCC must adopt written procedures for the confidential receipt, retention and consideration of reports of material violations. 

            A QLCC must be composed of at least one member of the issuer's audit committee (or, if the issuer has no audit committee, one member from an equivalent committee of independent directors) and two or more members of the issuer's board of directors who are not employed, directly or indirectly, by the issuer. 

A QLCC must have the authority and responsibility to (1) inform the CLO and CEO of any reports of material violations and (2) determine whether an investigation is necessary regarding any report of evidence of a material violation.[13] If it determines an investigation is necessary or appropriate, it must be empowered to (1) notify the audit committee or the full board of directors, (2) initiate an investigation, which may be conducted either by the CLO or by outside attorneys and (3) retain additional expert personnel. 

Furthermore, at the conclusion of any such investigation, the QLCC must have the authority and responsibility to (1) recommend, by majority vote, that the issuer implement an appropriate response, (2) inform the CLO and the CEO and the board of directors of the results of the investigation and the appropriate remedial measures to be adopted and (3) act by majority vote to take all other appropriate action, including notifying the SEC if the issuer fails to implement an appropriate response that the QLCC has recommended.


[1] See SEC Release No. 33-8185 at http://www.sec.gov/rules/final/33-8185.htm.

[2] An "issuer" is defined as an issuer (as defined in section 3 of the Securities Exchange Act of 1934 (the "Exchange Act")), the securities of which are registered under section 12 of the Exchange Act, or that is required to file reports under section 15(d) of the Exchange Act, or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933, and that it has not withdrawn, but does not include a foreign government issuer. The term "issuer" also includes any person controlled by an issuer, where an attorney provides legal services to such person on behalf of the issuer, regardless of whether the attorney is employed or retained by the issuer.

[3] The rule specifically excludes an attorney who does not provide legal services to a company in the context of the attorney-client relationship as well as certain foreign attorneys. In addition, an attorney is not required to report evidence of a material violation if the attorney was retained by the issuer's CLO to investigate, reported the results of the investigation to the CLO and, except where the attorney and the CLO reasonably believe that no material violation has occurred, reports the results of the investigation to the issuer's board of directors or the appropriate committee. Similarly, an attorney is not required to report evidence of a material violation if the attorney was retained by the Qualified Legal Compliance Committee to investigate evidence of a material violation or to assert a colorable defense on behalf of the issuer in an investigation or judicial proceeding.

[4] An attorney formerly employed or retained by an issuer who reported evidence of a material violation and reasonably believes that he or she was discharged as a result may notify the issuer's board of directors or any other committee.

[5] A "material violation" is defined as a material violation of an applicable United States federal or state securities law, a material breach of a fiduciary duty arising under United States federal or state law, or a similar violation of any United States federal or state law. "Evidence of a material violation" is defined 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.

[6] If an attorney reasonably believes that it would be futile to report to the CLO or CEO, the attorney may alternatively report directly to the issuer's audit committee, another committee consisting solely of directors who are not employed directly or indirectly by the issuer or, if neither committee exists, to the board of directors.

[7] Alternatively, the CLO may refer a report of evidence of a material violation to the QLCC in lieu of conducting his or her own inquiry. The QLCC would then be responsible for conducting an appropriate inquiry. See Appendix A for a description of the composition and powers of a QLCC.

[8] Alternatively, the company could empower and use its audit committee or another committee that meets the composition requirements.

[9] This member could also be taken from an equivalent committee of independent directors.

[10] "Subordinate attorney" does not include one who is under the direct supervision or direction of the CLO (e.g. deputy general counsel).

[11] Foreign attorneys are not required to comply with the rule to the extent that applicable foreign law would prohibit such compliance.

[12] See SEC Release No. 33-8186 at http://www.sec.gov/rules/proposed/33-8186.htm.

[13] If the members of a QLCC reasonably believe that it would be futile to report to the CLO or CEO, the QLCC may alternatively report to the issuer's audit committee, another committee consisting solely of directors who are not employed directly or indirectly by the issuer or, if neither committee exists, to the board of directors.

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