The SEC Adopts Final Rules to Implement Sarbanes-Oxley Provisions Concerning Standards of Professional Conduct for Attorneys

By Kramer Levin Naftalis & Frankel LLP

Feb 2, 2003

Introduction. The Securities and Exchange Commission (the “SEC”) has adopted final rules on professional responsibilities of attorneys, implementing Section 307 of the Sarbanes-Oxley Act of 2002 (the “Act”).1 The new rules:

require attorneys who appear and practice before the SEC to report evidence of material violations of law by an issuer to its chief legal officer (“CLO”) and potentially to an independent board committee or the board as a whole;
require CLOs who receive these reports to investigate and, in certain cases, to take action to remedy, the possible violations outlined in the report; and
allow issuers, as an alternative to the process described above, to establish a qualified legal compliance committee (a “QLCC”) to which attorneys may report evidence of material violations of law. Such committees will be empowered to initiate investigations and recommend remedial action in response to reports of potential violations of law.

The SEC did not adopt the most controversial portion of the rules originally proposed in November 2002, the so-called “noisy withdrawal” provisions requiring an attorney to withdraw from representing an issuer and notify the SEC of such withdrawal in the event that the issuer did not adequately address a report of evidence of a material violation made by the attorney. The SEC extended the comment period on its original “noisy withdrawal” proposal for an additional 60-day period and put forward an alternative approach to noisy withdrawal which would require the issuer rather than the attorney to disclose the attorney’s withdrawal.

The new rules contained in Part 205 of the Rules of Practice will become effective on August 5, 2003 (180 days after publication of the rules in the Federal Register).2

Relationship of Part 205 to Other Applicable Law. Part 205 sets forth minimum standards of professional conduct for attorneys appearing and practicing before the SEC in the representation of an issuer. The standards supplement applicable standards of any jurisdiction in which the attorney is admitted to practice. Part 205 preempts any conflicting or inconsistent state or federal law. However, to the extent that local jurisdictions establish more rigorous obligations for attorneys than those set forth in Part 205, the SEC has clarified that Part 205 does not preempt the ethical rules of such jurisdictions.

Attorneys Covered by Part 205. Part 205 prescribes the duty of an “attorney” who “appears and practices” before the SEC “in the representation of an issuer” to report “evidence of a material violation” by the issuer of U.S. federal or state securities laws, a material breach of fiduciary duty arising under U.S. federal or state law or a similar violation of any U.S. federal or state law.

The term “attorney” is defined broadly to include any person who is admitted to practice law in any jurisdiction, domestic or foreign, or who holds himself or herself out as admitted to practice law. Thus, Part 205 applies to lawyers employed in-house by an issuer, attorneys retained to perform legal work on behalf of an issuer, and persons who hold themselves out as attorneys even if they are not admitted to practice law. In addition, the definition of attorney includes lawyers who are licensed in foreign jurisdictions, whether or not they are also admitted to practice in the United States (although certain foreign attorneys who qualify as “non-appearing foreign attorneys” are not covered by Part 205, as described below).

Part 205 defines “appearing and practicing” before the SEC as:

transacting any business with the SEC, including communications (oral or written) with the SEC in any form;
representing an issuer in connection with any SEC administrative proceeding, investigation, inquiry, information request or subpoena;
providing advice related to U.S. securities laws or SEC rules and regulations promulgated thereunder regarding any document that the attorney has notice will be filed with or submitted to or incorporated into any document filed with or submitted to the SEC, including providing advice in the context of preparing any such document; and
advising an issuer whether information or a statement, opinion or other writing is required to be filed with or incorporated into any document that will be filed with or submitted to the SEC.

Under the definition, attorneys who advise an issuer that a particular document is not required to be incorporated into an SEC filing will be “appearing and practicing” before the SEC. Further, the definition clarifies that an attorney must have notice that a document such person is preparing will be submitted to the SEC to be deemed to be “appearing and practicing.”. The Release indicates that attorneys need not be employed by the legal department of an issuer to be subject to Part 205, although they must be providing legal services to an issuer within the context of an attorney-client relationship. Attorneys who are licensed to practice law and transact business with the SEC, but do not work within an issuer’s legal department and do not provide legal services within the context of an attorney-client relationship, are not subject to the provisions of Part 205.

“Non-appearing foreign attorneys” are specifically excluded from the definition of appearing and practicing before the SEC and would not be subject to Part 205. These are defined as attorneys who:

are admitted to practice law in a jurisdiction outside the U.S.;
do not hold themselves out as practicing or giving advice with respect to U.S. law; and
conduct activities that would constitute appearing and practicing before the SEC only incidentally to foreign law practice or in consultation with U.S. counsel.

Part 205 contains a broad definition of what constitutes “in the representation of an issuer.” The term is defined as providing legal services as an attorney for an issuer and any person controlled by an issuer (including subsidiaries), whether or not employed or retained by the issuer. An attorney employed by an investment adviser who prepares materials for a registered investment company that the attorney has reason to believe will be filed with the SEC on behalf of the registered investment company is subject to Part 205. An attorney retained or employed by a nonpublic subsidiary of a public parent company would be appearing and practicing before the SEC in the representation of an issuer whenever acting on behalf of or for the benefit of the parent. Thus the definition would encompass any subsidiary covered by an umbrella representation agreement under which the attorney represents the parent company and its subsidiaries. Similarly, an inhouse attorney at a non-public subsidiary appears and practices before the SEC in the representation of an issuer when such attorney is assigned work by the parent which will be incorporated into documents submitted to the SEC by the parent company or if such attorney is performing work at the direction of the parent.

An attorney retained or directed by the issuer to investigate a report of evidence of a material violation is subject to Part 205 but is not required to report up the ladder if specified conditions are satisfied.

Issuer Conduct Covered by Part 205. Part 205 requires reporting by an attorney when he or she is aware of “evidence of a material violation” by an issuer or its officers, directors, employees or agents of:

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” 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.” The definition is intended to set forth an objective standard of what constitutes evidence of a material violation. The Release indicates that the circumstances which may be considered in determining whether the attorney’s determination is reasonable may include:

the attorney’s professional skills, background and experience;
the attorney’s previous experience with the client; and
the availability of other lawyers with whom the attorney may consult.

The Release also states that a reasonable likelihood of a material violation must be more than the mere possibility of a violation but need not be “more likely than not.”

Obligation to Report Material Violations Up the Ladder. If an attorney subject to the provisions of Part 205 has evidence of a material violation, he or she is required to report the material violation to the issuer’s CLO (or the equivalent thereof) or to the issuer’s CLO and CEO. The report may be made in person, by telephone, by e-mail, electronically or in writing. If the reporting attorney reasonably believes that reporting the violation to the CLO or CEO would be ineffective, the attorney may report the matter to:

the issuer’s audit committee; or
in the absence of an audit committee, to another committee composed solely of independent directors; or
in the absence of such a committee, to the board of directors.

The attorney is not required to document the report of evidence of a material violation or any responses received from the CLO or CEO.

Once an attorney has reported a possible material violation, the issuer’s CLO is obligated to conduct a reasonable inquiry to determine whether the reported violation has occurred, is ongoing or is about to occur. A CLO who determines that no material violation has occurred, is ongoing or is about to occur, must notify the reporting attorney of the basis of such determination. In the absence of such a determination, a CLO must take reasonable steps to cause the issuer to adopt an appropriate response.

A reporting attorney who receives an appropriate response from the CLO or CEO satisfies his or her obligations under Part 205. However, if the reporting attorney does not reasonably believe that the issuer has made an appropriate response within a reasonable time, the reporting attorney is required to explain his or her reasons to the CLO or CEO and directors to whom the attorney reported the evidence. The attorney must also report the alleged violation to:

the issuer’s audit committee; or
in the absence of an audit committee, to a committee of independent directors; or
in the absence of such a committee, to the board of directors.

An “appropriate response” is defined as a response as a result of which the attorney reasonably believes that:

no material violation has occurred, is ongoing or is about to occur;
the issuer has, as necessary, adopted remedial measures, including appropriate steps and/or sanctions to stop the material violation that is occurring, prevent the material violation that has yet to occur and/or rectify any material violation that has already occurred and minimize the likelihood of its recurrence; or
the issuer, with board or committee approval, has retained or directed an attorney to review the reported evidence of a material violation and either (x) has substantially implemented any remedial recommendations made by such attorney after a reasonable investigation and evaluation of the reported evidence or (y) has been advised a colorable defense on behalf of the issuer may be asserted, consistent with the attorney’s professional obligations, in any investigation or proceeding related to the reported evidence of a material violation.

The Release notes that all attendant circumstances may be taken into account in determining whether the reporting attorney “reasonable believes” either that there is no material violation or that the issuer has taken appropriate remedial steps. The circumstances an attorney might consider include:

the amount and weight of the evidence of a material violation;
the severity of the material violation; and
the scope of the investigation undertaken by the issuer.

The assurance of the issuer’s CLO, while relevant, will not be dispositive of the issue.

As noted above, an issuer may assert as an appropriate response that it has directed an attorney to undertake a review of the reported evidence of a material violation, or to assert a colorable defense. However, in either case, the attorney must have been retained with the consent of the board of directors, a committee of the board of directors composed solely of independent directors or a QLCC (see discussion below).

Use of Qualified Legal Compliance Committee as Alternative to Up the Ladder Reporting. As an alternative to the foregoing reporting procedures, Part 205 permits issuers to establish and use a QLCC (which may also be an audit or other committee of the issuer), consisting of at least one member of the issuer’s audit committee and at least two independent directors, to investigate reports of material violations made by attorneys. If a QLCC has been established before a reporting obligation has been triggered, in lieu of reporting evidence of a material violation to the CLO or the CLO and CEO, an attorney may report such evidence to a QLCC. An attorney who reports evidence of a material violation to a QLCC satisfies his or her obligation pursuant to Part 205 and is not required to assess the issuer’s response to the reported evidence of a material violation. In addition, a CLO may refer a report of evidence of a material violation to a previously established QLCC and, in such case, is required to notify the reporting attorney of the referral.

In order to qualify as a QLCC, the committee must have written procedures for the confidential receipt, retention and consideration of reports of material violations, and the authority and responsibility to:

inform the CLO and CEO of any report of evidence of a material violation;
determine whether an investigation regarding evidence of a material violation is necessary;
if the QLCC determines that an investigation is necessary, to (x) notify the audit committee and the board of directors, (y) initiate an investigation which may be conducted by the CLO or by outside counsel and (z) retain such expert personnel as the QLCC deems necessary;
at the conclusion of an investigation to (x) recommend by majority vote that the issuer implement an appropriate response to evidence of a material violation and (y) inform the CLO, CEO and the board of directors of the results of any investigation and the appropriate remedial measures to be adopted; and
take all other appropriate action, including notifying the SEC in the event that the issuer fails to implement an appropriate response recommended by the QLCC.

The SEC intends that QLCC members not have increased liability under state law.

Obligations of Supervisory Attorneys and Subordinate Attorneys. Part 205 requires supervisory attorneys to make reasonable efforts to assure compliance with the provisions of Part 205 by subordinate attorneys. To the extent that a subordinate attorney appears and practices before the SEC in the representation of an issuer, Part 205 provides that a subordinate attorney’s supervisory attorneys also appear and practice before the SEC. A supervisory attorney is defined as an attorney who supervises or directs another attorney who is appearing and practicing before the SEC in the representation of an issuer and includes an issuer’s CLO. The supervisory attorney is responsible for complying with the reporting requirements set forth in Part 205 when a subordinate attorney reports evidence of a possible material violation. Conversely, Part 205 provides that a subordinate attorney would be in compliance with the reporting requirements set forth in Part 205 by reporting the material violation to his or her supervisory attorney. If the subordinate attorney reasonably believes that the supervisory attorney to whom the subordinate attorney has reported the material violation has not complied with the reporting obligations, the subordinate attorney may, but is not required to, report the evidence to appropriate officers and directors of the issuer or to the issuer’s QLCC.

Sanctions. Violations of Part 205 by attorneys subject attorneys to civil (but not criminal) penalties and remedies available to the SEC for violations of U.S. federal securities laws. Part 205 specifically provides that no private right of action is created thereunder against attorneys, law firms or issuers based upon compliance or non-compliance with Part 205.

Suggested Actions. Both lawyers and public companies should establish procedures to implement compliance with Part 205. Law firms and law departments within public companies should consider the adoption of formal procedures for reporting and consulting with respect to potential violations by issuers to determine if action is required to comply with Part 205. Issuers should determine whether establishment of a QLCC is desirable. If so, a QLCC should be formed with authority in place prior to the effective date of Part 205.

If you would like to discuss these new rules, the Sarbanes-Oxley Act, or their implications, please feel free to call a Kramer Levin attorney

1 See Sarbanes-Oxley Act of 2002, Pub. L. No. 307, 116 Stat. 745 (codified as amended at 15 U.S.C. 7245 (2002)). Section 307 of the Act requires the SEC to prescribe minimum standards of professional conduct for attorneys appearing and practicing before the SEC in the representation of issuers including a rule:. (i) requiring an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any of its agents to the CLO or the CLO and CEO of the company or the equivalent thereof; and (ii) if the CLO and/or CEO does not appropriately respond to such report, requiring the attorney to report the evidence to the audit committee, another committee of the board of directors composed solely of individuals not employed by the issuer or the full board of directors.

2 See Final Rule: Implementation of Standards of Professional Conduct for Attorneys, Securities Act Release No. 8185, Exchange Act Release No. 47276, Investment Company Act Release No. 25919, (Jan. 29, 2003), available at http://www.sec.gov/rules/final/33- 8185.htm.