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SEC Final Rule for Attorney "Up the Ladder" Reporting and Proposed Rule for Attorney "Noisy Withdrawal" Under the Sarbanes-Oxley Act
On January 29, 2003, the SEC issued final rules under Section 307 of the Sarbanes-Oxley Act 2002, ("Sox") in connection with "up the ladder" reporting requirements for attorneys appearing and practicing before the SEC (the "Rule"). At the same time, in response to comments received from law firms and bar associations to its proposed rules for "noisy withdrawal" published by the SEC on November 21, 2002, the SEC extended the period for comments on noisy withdrawal by 60 days and proposed alternative rules for noisy withdrawal, all as described below. Our firm had submitted a lengthy letter to the SEC commenting on a number of points in the proposed rule, and we are pleased that many of our suggestions were adopted by the SEC, and the SEC referred to our firm and our comments throughout the Release announcing the final rules.
1. To whom does the Rule apply?
The Rule applies to an in-house or outside attorney, whether formally engaged or not, who renders legal services to an issuer in the context of an attorney-client relationship in connection with SEC matters as well as to attorneys representing the issuer, its officers or directors or witnesses in SEC proceedings. The Rule refers to these attorneys as "appearing and practicing before the SEC." Unlike the proposed rules of November 21, 2001, the Rule does not apply to attorneys at issuers who, although licensed to practice law, do not provide legal services within the context of an attorney-client relationship. The question whether an attorney-client relationship exists or not is one of fact which will be determined according to federal law and will turn, among other considerations, on the expectations and understandings between the attorney and the issuer. The legal services covered by the Rule may include advice or assistance in the preparation of periodic reports or even advice to the effect that an issuer need not file a report with the SEC or disseminate a press release or other communication to shareholders, or advice as to the appropriateness of the issuer's disclosure.
The legal services covered by the Rule may also include advice or assistance given with respect to any document, such as a real estate lease for example that the attorney knows will be filed as an exhibit to or in connection with an SEC filing. However, an attorney's preparation of a document, such as a contract, regarding which the attorney had no notice that the document would be submitted to the SEC, is not covered by the rule.
2. Does the Rule apply to non-U.S. attorneys?
The Rule does not apply to attorneys who: (1) are admitted to practice law in a jurisdiction outside the U.S.; (2) do not hold themselves out as practicing, or giving legal advice regarding U.S. law; and (3) conduct activities that would constitute giving legal advice in SEC matters only (i) incidentally to a foreign law practice, or (ii) in consultation with U.S. counsel. An attorney who satisfies all the above three conditions is referred to by the Rule as a "Non-Appearing Foreign Attorney" and is exempt from the Rule's application.
The effect of these definitions will be to exclude from the Rule many, but not all, non-U.S. attorneys. Foreign attorneys, who give legal advice in SEC matters, other than in consultation with U.S. counsel, are subject to the Rule. Thus, an attorney licensed in the U.K. who independently advises an issuer regarding the application of SEC regulations to a periodic filing, is subject to the Rule. Similarly, non-U.S. attorneys who hold themselves out as practicing U.S. law and give legal advice on SEC matters are subject to the Rule whether they act in consultation with U.S. counsel or not. Non-U.S. attorneys who do not hold themselves out as practicing U.S. law, but who give legal advice on SEC matters are subject to the Rule unless such rendering of legal advice is incidental to their foreign law practice or is given in consultation with U.S. counsel. Non-U.S. lawyers may therefore avoid being subject to the Rule either by declining to advise their clients on SEC matters or by retaining the assistance of U.S. counsel.
To the extent an attorney is not deemed to be a Non-Appearing Foreign Attorney and is therefore subject to the Rule, he or she will not be required to comply with the provisions of the Rule to the extent such compliance is prohibited by applicable foreign laws, provided, however, that he or she complies with the Rule to the maximum extent allowed by such foreign law.
3. What does the Rule require an attorney to do?
The Rule requires an attorney to report "evidence of a material violation" by an issuer to the issuer's chief legal officer ("CLO") and CEO. The issuer's CLO must inquire into the evidence of the misconduct and unless he or she believes that no misconduct has occurred, is ongoing or is about to occur, he or she must take reasonable steps to cause the issuer to adopt an appropriate response to the attorney's report. Unless the reporting attorney reasonably believes that the CLO or CEO has provided an appropriate and timely response to his or her report, the reporting attorney shall explain to the CLO and CEO why he or she is not satisfied with the response and report the misconduct "up the ladder" to the audit committee or another appropriate committee of the issuer's board of directors consisting solely of independent directors or to the whole board of directors.
The meaning of the term "evidence of a material violation" which triggers the attorney's reporting obligation described above was the subject of much debate. The Bar called for a subjective standard requiring that the attorney actually know that misconduct had occurred. The SEC wanted an objective standard that would lead an attorney acting reasonably to believe that misconduct had occurred whether or not the attorney actually knew it. The compromise between the two positions now encoded in the Rule is an awkward formulation of double negatives, as follows: "Evidence of a material violation" means "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." To be "reasonably likely" a material violation must be more than a mere possibility but it need not be more likely than not.
While adopting the objective standard, this formulation gives the attorney some latitude, within reason, to conclude whether or not there is evidence of a material violation. In determining whether the attorney evaluated the evidence appropriately, consideration must be given to the circumstances prevailing at the time the attorney decides whether or not he or she is obligated to report the information. These considerations may include, among others, the attorney's professional skills, background and experience, the time constraints under which the attorney is acting, the attorney's previous experience and familiarity with the client, and the availability of other lawyers with whom the attorney may consult.
The reporting attorney, may, if he or she believes it is appropriate, bypass the CLO and CEO and report the violation directly to the issuer's audit committee or to another appropriate committee of the issuer's board of directors consisting solely of independent directors or to the whole board of directors.
If the reporting attorney reasonably believes that the CLO or the CEO has provided an "appropriate response" to his or her report within a reasonable time, the reporting attorney need do nothing more. An "appropriate response" means either that (i) the CLO or CEO has satisfied the reporting attorney that in fact no misconduct has occurred, is ongoing or is about to occur, (ii) the misconduct has been corrected, disciplinary actions within the issuer have been taken and preventive measures have been put in place or (iii) independent directors of the issuer have instructed an attorney to investigate the reported evidence of misconduct and the issuer has either implemented the remedies recommended by such attorney or has been advised by such attorney that a colorable defense can be asserted on behalf of the issuer in any proceeding related to the reported evidence of misconduct.
In arriving at a "reasonable belief" that the issuer's response was appropriate, as that term is described above, the reporting attorney may take into account the amount and weight of evidence of misconduct, the severity of the misconduct, the scope and extent of the investigation conducted and the representations and legal determinations of persons upon whom a reasonable attorney would rely.
4. Does the Rule require that the reporting attorney, the CLO and others conducting investigations document reports and retain such documentation?
The proposed rule that the SEC published on November 21, 2002 would have required the reporting attorney to document his or her initial report and the responses of the CLO and the issuer thereto and to maintain them for a reasonable period. In response to objections from the Bar that such requirement would cause a conflict between attorney and client and create a "treasure trove of selectively damning evidence" for class action attorneys, the documentation requirement has been eliminated from the Rule. Whether or not the report of misconduct and its investigation should be documented is left to the discretion of the persons conducting the investigation.
5. Does an attorney, other than the original reporting attorney, who is instructed by the issuer to investigate the reported misconduct or to defend the issuer in any proceeding related to such misconduct, have an independent duty to report his findings up the ladder to the audit committee or board?
As long as the CLO keeps the board informed about the progress of the investigation or of the defense conducted by the instructed attorney, such attorney fulfils his or her obligation by reporting to the CLO and has no independent up the ladder reporting obligations.
6. Is an attorney, who did not receive an "appropriate and timely response" after reporting up the ladder, obliged or permitted to report the misconduct to the SEC or to other persons outside the isuer?
To date, the SEC has not adopted the proposed "noisy withdrawal" provisions described in our client advisory of December 4, 2002 which, under certain circumstances, would have required or permitted the reporting attorney to withdraw his or her representation, notify the SEC of the withdrawal and disaffirm issuer documents filed with the SEC. Instead, the SEC has extended the comment period on the "noisy withdrawal" provisions by 60 days and has also proposed an alternative noisy withdrawal provision, described in paragraph 6.4 below, which would put the onus on the issuer, rather than the attorney, to notify the SEC of the attorney's withdrawal.
The law today. Under the Rule as currently adopted, an attorney has no reporting out or noisy withdrawal obligations. A reporting attorney who does not reasonably believe that the issuer has made an appropriate and timely response to his or her reports of misconduct must explain to the CLO and other corporate agents of the issuer to whom the attorney reported, why he or she is not satisfied with the response. Then the attorney must report the misconduct up the ladder to the issuer's audit committee or to another appropriate committee of the issuer's board of directors consisting solely of independent directors or to the whole board of directors. Beyond that, the attorney has no further duty.
The proposed "noisy withdrawal" provision. Under the SEC's proposed noisy withdrawal provision, in respect of which the SEC has extended the comment period by 60 days, the attorney who reported up the ladder to the issuer's board and did not receive an appropriate timely response, would be required, under certain circumstances and permitted under other circumstances, to notify the SEC, provided he or she strictly adheres to the following steps:
the attorney must explain to the persons within the issuer to whom he or she reported the violation why the response is not appropriate or timely; and
(a) immediately withdraw from representing the issuer;
(b) indicate that the withdrawal is for "professional considerations;"
(c) notify the SEC in writing within one business day of the withdrawal that he or she has withdrawn for professional considerations; and
(d) immediately disaffirm to the SEC anything that the reporting attorney has been instrumental in submitting to the SEC that is materially misleading.
If the reporting attorney is an in-house attorney, he or she must do all of the above except that he or she does not have to resign.
if the reporting attorney believes that the violation has already occurred (as opposed to a violation that is ongoing or about to occur), and is likely to have caused substantial injury to the issuer or investors, the reporting attorney may, but is not obliged to take the steps described in (a) through (d) of this paragraph.
In any event, the proposed rule provides that none of the above steps will be deemed a violation of attorney client privilege, even if this would constitute such a violation under state rules.
The proposed alternative "noisy withdrawal provisions". Under the SEC's proposed alternative noisy withdrawal provision, the retained attorney who has reported up the ladder to the issuer's board and did not receive an appropriate timely response and who reasonably concludes that there is substantial evidence of misconduct either ongoing or about to occur which is likely to cause substantial injury to the issuer or investors, must withdraw from representing the issuer and notify the issuer in writing that the withdrawal is out of professional considerations. Two business days after receiving such notification, the issuer must report such notice of withdrawal and the circumstances surrounding it to the SEC on a current report on Form 8-K or in the case of a non-U.S public company on a Form 20-F or Form 40-F. These forms which till now were used by non U.S. companies exclusively for annual reports have been adapted to be used as a current report for the purpose of reporting the withdrawal of an attorney under the circumstances described above. In the event that the issuer does not so report to the SEC, the withdrawing attorney may, but is not obligated to inform the SEC of the withdrawal. The proposed alternative noisy withdrawal provision resembles a similar provision that has been on the books for a long time in the event of the resignation of the issuer's independent accountant.
An in-house attorney in the situation described would not be required to resign but would be required to immediately cease any involvement in any matter concerning the misconduct and would be required to notify the issuer that he or she believes that the issuer has not provided an appropriate and timely response.
The proposed alternative noisy withdrawal provisions do not oblige a withdrawing attorney to notify the commission or to disaffirm documents filed with the SEC. Neither do the proposed alternative noisy withdrawal provisions require a retained attorney to withdraw or an employed attorney to cease participation or assistance in a matter if he or she would be prohibited from doing so by a court or other administrative order.
The SEC believes that by placing the responsibility of reporting out on the issuer, the alternative proposal alleviates the client-attorney privilege concerns.
7. Is there any way under the Rule and the proposed alternative "noisy withdrawal" provisions that an attorney can avoid the "up the ladder" and "noisy withdrawal" obligations?
Yes, but he or she must follow the following steps and report the violation in the following way:
The attorney as an alternative to reporting the misconduct to the CLO and then up the ladder, may report the violation to a qualified legal compliance committee, ("QLCC"). A QLCC is a committee which the issuer may, but is not obliged to set up to investigate any report of misconduct. The QLCC must consist of at least one member of the audit committee or another committee of the issuer and two or more independent directors. A condition to this alternative reporting channel is that the QLCC must have been established by the board of directors of the issuer prior to the event of misconduct being reported.
The outside attorney who has reported the violation to the QLCC is not obliged to asses whether he or she received an appropriate response from the issuer or to report up the ladder and under the proposals for noisy withdrawal is not required to notify the SEC. All of these are the obligation of the QLCC.
If the issuer has no QLCC, the attorney must report up the ladder and under the proposed noisy withdrawal provisions may have to report to the SEC.
The QLCC having received the report of misconduct from the attorney would have to (i) notify the CLO and CEO of the misconduct, (ii) institute an investigation as appropriate, (iii) determine remedial measures, (iii) report the results of the investigation to the CLO, CEO and the Board, and (iv) notify the SEC if the issuer fails to implement any of the recommended remedial measures.
8. What is the responsibility of supervisory attorneys?
A supervisory attorney is a senior attorney who actually directs and supervises, (rather than just having supervisory authority) the actions of a subordinate attorney who gives advice on SEC matters. The Rule takes a functional approach to the question of who is a supervisory attorney rather than a titular approach. Thus a senior attorney who supervises or directs a subordinate attorney on non-SEC matters is not deemed a supervisory attorney. Accordingly, a partner in a law firm practicing environmental or real estate law who supervises the environmental work or real estate work of an associate in a matter which, to the partner's knowledge, will not be incorporated into any document filed with the SEC, is not deemed to be the supervisor of such associate in connection with any work the associate performs for another partner in the firm in connection with SEC matters.
A subordinate attorney for the purposes of the rule is an attorney that handles SEC matters under the direction or supervision of another attorney.
A supervisory attorney is responsible for complying with the Sox reporting requirements described above when a subordinate attorney has reported misconduct.
The subordinate attorney fulfills his or her reporting obligation under the Rule after he or she reports the misconduct to the supervising attorney. The Rule carves out from the term "subordinate attorney" any attorney, who reports directly to the issuers CLO in connection with SEC matters. Accordingly, the deputy general counsel has not fulfilled his or her reporting obligations under the Rule by simply reporting the misconduct to the general counsel. Thus, in the event that the deputy general counsel does not receive an appropriate response from CLO, he or she is obligated to report further up the ladder within the issuer.
If the subordinate attorney disagrees with the conclusion of the supervising attorney not to report the misconduct up the ladder or to the QLCC, the subordinate attorney may, but is not obliged, to go over the head of his or her supervisor and report the matter himself or herself up the ladder or to the QLCC.
9. What sanctions can the SEC bring against attorneys who violate the rules?
A violation by an attorney appearing and practicing before the SEC of the Sox reporting rules is considered a violation of the federal securities laws and also subjects the attorney to the disciplinary authority of the SEC. Only the SEC may bring an action against an attorney for such violation and there is no private right of action. An attorney whose compliance with the reporting requirements of the Rule caused a violation of state ethical or professional rules will not be subject to disciplinary action for such violations. An attorney practicing in a foreign country will not be subject to SEC sanctions for non-compliance if compliance would mean violation of laws and regulations of the country in which he or she practices, provided that the attorney must comply with the rule to the maximum extent allowed by such laws and regulations.
10. Preemption of State rules
The Rule provides that where the professional and ethical standards of a state where an attorney is admitted or practices conflicts with the standards of the Rule, the Rule governs to the extent that the state standards are more lenient that the standards of the Rule.
11. Effective Date of the rule
The Rule will be effective 180 days after its publication in the Federal Register.
Questions regarding Sarbanes-Oxley may be directed to Raphael S. Grunfeld (212-238-8653 or email@example.com), Steven J. Glusband (212-238-8605 or firstname.lastname@example.org), or Robert A. McTamaney (212-238-8711 or email@example.com) of our New York Office.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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