They're Here! Sort of'

Apart from the proposed 'noisy withdrawal' provisions, the final rules make clear both their broad scope and their substantive significance. First, they expressly preempt state laws and rules to the extent those laws and rules are inconsistent with, or less stringent than, the SEC rules. The rules are not, however, intended to limit the ability of any jurisdiction to impose additional obligations on an attorney (17 C.F.R. ' 205.1). Second, violation of the rules is not only a matter for administrative discipline by the Commission. Thus, in addition to the possibility of censure or suspension, violations of the rules 'shall subject [an] attorney to the civil penalties and remedies for a violation of the federal securities laws available to the Commission in an action brought by the Commission thereunder' (' 205.6).

The basic scheme of the rules' 'up-the-ladder' reporting requirements is by now well-known, and was not significantly altered by the final rule. In short, an attorney representing an issuer before the Commission who has evidence of a material securities law violation, material breach of fiduciary duty, or a similar material violation of law must report such violation to the chief legal officer, or to both the chief legal officer and the Chief Executive Officer of the issuer. In the absence of an 'appropriate' response, the attorney is then required to report the violation to the issuer's audit committee, another committee of independent directors, or to the board of directors. (See further discussion in the article on page 3.)

The final rules and the Commission's discussion now make clear the standards the Commission will apply in determining: 1) whether an attorney had evidence of a material violation, and 2) whether the attorney's evaluation of the issuer's response to his or her initial report is appropriate. As to the former, ' 205.2(e) provides that '[e]vidence 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.' In explaining what it meant by 'reasonably likely ' to occur,' the Commission stated that an attorney is not required to report 'gossip or innuendo' and that 'reasonably likely' falls somewhere between 'mere possibility' and 'more likely than not.' The SEC expressly rejected the subjective 'actual knowledge' standard advocated by '[n]early all practicing lawyers,' in favor of what it characterized as 'an objective standard, [which] also recognizes that there is a range of conduct on which an attorney may engage without being unreasonable.'

Judging an 'Appropriate Response'

As to the appropriateness of the attorney's evaluation of the issuer's response, the Commission stated in its release that the attorney's response will be 'measured against a reasonableness standard' which will allow the attorney to take into account all of the surrounding circumstances, including 'the amount and weight of the evidence of a material violation, the severity of the apparent material violation and the scope of the investigation into the report.' Although the Commission explicitly rejected suggestions that an attorney could rely completely on the assurance of the issuer's chief legal officer that there was no violation, it stated that an attorney can as part of the mix of information 'rely on reasonable and appropriate factual representations and legal determinations of persons on whom a reasonable attorney would rely.'

Perhaps one of the more important changes in the final rule is the expansion of the definition of 'appropriate response' contained in ' 205.2(b)(3). Now, one 'appropriate response' is for the issuer (or a qualified legal compliance committee of the issuer) to direct an attorney employed or retained by it to conduct an internal investigation and either: 1) substantially implement remedial recommendations made after a reasonable investigation, or 2) assert a 'colorable' defense consistent with the attorney's professional obligations. A colorable defense includes 'requiring the Commission to bear the burden of proving its case.' Although these possibilities had been noted in the Commission's November 2002 release accompanying the proposed rules, so many comments expressed concerns about the potential chill on advocacy that the Commission felt it necessary to make these options explicit in the final rules.

Welcome Development

The fact that the Commission's release explicitly recognizes that a 'reasonable investigation' should precede the attorney's advice is a welcome development. All too frequently, issuers are told by federal prosecutors armed with the Justice Department's guidelines on corporate prosecutions that 'good corporate citizens' must immediately self-report, and that any delay is considered a negative factor in the exercise of prosecutorial discretion, if not obstruction of justice. It is welcome and somewhat refreshing to have a government agency with far-ranging enforcement powers recognize that a company facing allegations of misconduct should take the time to investigate the facts with the help of counsel before deciding how to respond.

The final rules provide that an attorney may, but is not required to:

• reveal confidential information to the Commission without the issuer's consent, if the attorney reasonably believes that such disclosure is necessary to 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';
• prevent perjury or other acts of fraud on the Commission; or
• rectify the consequences of material violations that have caused or may cause substantial injury to the issuer's or investors' financial or property interests (' 205.3(d)).

In adopting this rule, the Commission aligns itself with a majority of the states and with the rule proposed by the ABA's Ethics 2000 Commission but rejected by the ABA House of Delegates.

The final rule also adds a new ' 205.7, expressly providing that nothing in the rule is 'intended to, or does, create a private right of action against any attorney, law firm, or issuer based upon compliance or noncompliance with its provisions.' In a related vein, the final rule modifies the proposed rule's provision that an attorney 'shall act in the best interest of the issuer and its shareholders' to make clear that the rule is not meant to create fiduciary duties to shareholders that otherwise do not exist. In an era that is likely to see increased litigation against lawyers, these are welcome changes.

'Noisy Withdrawal'

Finally, a brief word on 'noisy withdrawal.' The November 2002 proposed rule required an issuer's attorney in specified circumstances to withdraw for 'professional considerations,' give notice to the Commission, and disaffirm filed documents. A new proposed rule, issued for comments on January 29, 2003, again would require withdrawal. But the new version heightens the triggering standard ('substantial evidence of a material violation that is ongoing or is about to occur') and eliminates the requirements of notice to the Commission and disaffirmance of documents. Somewhat curiously, given the Commission's preemption of inconsistent state rules elsewhere, the proposal relieves the attorney of the need to act if s/he would be prohibited from doing so by order of an authority with appropriate jurisdiction after a request to withdraw. The alternative places the burden of publicly reporting the lawyer's withdrawal on the issuer, and gives the lawyer the option to do so if the issuer does not.

The original 'noisy withdrawal' rules generated a massive volume of commentary in the 30-day comment period. We can expect at least the same over the next 60 days. The final rules are hardly final.

Howard W. Goldstein is a partner at Fried, Frank, Harris, Shriver & Jacobson in New York, and a former federal prosecutor.

They're finally here. Sort of. On January 29, 2003, the SEC issued its long-awaited, much-debated rules implementing 'Standards of Professional Conduct for Attorneys' pursuant to Section 307 of the Sarbanes-Oxley Act. But the rule-making process is far from over.

Faced with a firestorm of controversy over the 'noisy withdrawal' provision of the rules it proposed in November 2002, and facing a statutory deadline of January 23, the Commission chose not to include the 'noisy withdrawal' requirements in its final rules. But on the same day the 'final' rules were issued, the SEC proposed a modified form of the 'noisy withdrawal' rules, and initiated a 60-day comment period on its new proposal. The SEC also sought additional comments during that same period on the 'final' rules as issued. With the pressure of the Sarbanes-Oxley statutory deadline for issuance of the initial rules now behind it, with the effective date of the rules issued on January 29 postponed for 180 days after their publication in the Federal Register, and with a new chairman awaiting Senate confirmation, the next few months are almost certain to see intense debate and lobbying over the ultimate content of the rules.

What the Rules Contain

Apart from the proposed 'noisy withdrawal' provisions, the final rules make clear both their broad scope and their substantive significance. First, they expressly preempt state laws and rules to the extent those laws and rules are inconsistent with, or less stringent than, the SEC rules. The rules are not, however, intended to limit the ability of any jurisdiction to impose additional obligations on an attorney (17 C.F.R. ' 205.1). Second, violation of the rules is not only a matter for administrative discipline by the Commission. Thus, in addition to the possibility of censure or suspension, violations of the rules 'shall subject [an] attorney to the civil penalties and remedies for a violation of the federal securities laws available to the Commission in an action brought by the Commission thereunder' (' 205.6).

The basic scheme of the rules' 'up-the-ladder' reporting requirements is by now well-known, and was not significantly altered by the final rule. In short, an attorney representing an issuer before the Commission who has evidence of a material securities law violation, material breach of fiduciary duty, or a similar material violation of law must report such violation to the chief legal officer, or to both the chief legal officer and the Chief Executive Officer of the issuer. In the absence of an 'appropriate' response, the attorney is then required to report the violation to the issuer's audit committee, another committee of independent directors, or to the board of directors. (See further discussion in the article on page 3.)

The final rules and the Commission's discussion now make clear the standards the Commission will apply in determining: 1) whether an attorney had evidence of a material violation, and 2) whether the attorney's evaluation of the issuer's response to his or her initial report is appropriate. As to the former, ' 205.2(e) provides that '[e]vidence 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.' In explaining what it meant by 'reasonably likely ' to occur,' the Commission stated that an attorney is not required to report 'gossip or innuendo' and that 'reasonably likely' falls somewhere between 'mere possibility' and 'more likely than not.' The SEC expressly rejected the subjective 'actual knowledge' standard advocated by '[n]early all practicing lawyers,' in favor of what it characterized as 'an objective standard, [which] also recognizes that there is a range of conduct on which an attorney may engage without being unreasonable.'

Judging an 'Appropriate Response'

As to the appropriateness of the attorney's evaluation of the issuer's response, the Commission stated in its release that the attorney's response will be 'measured against a reasonableness standard' which will allow the attorney to take into account all of the surrounding circumstances, including 'the amount and weight of the evidence of a material violation, the severity of the apparent material violation and the scope of the investigation into the report.' Although the Commission explicitly rejected suggestions that an attorney could rely completely on the assurance of the issuer's chief legal officer that there was no violation, it stated that an attorney can as part of the mix of information 'rely on reasonable and appropriate factual representations and legal determinations of persons on whom a reasonable attorney would rely.'

Perhaps one of the more important changes in the final rule is the expansion of the definition of 'appropriate response' contained in ' 205.2(b)(3). Now, one 'appropriate response' is for the issuer (or a qualified legal compliance committee of the issuer) to direct an attorney employed or retained by it to conduct an internal investigation and either: 1) substantially implement remedial recommendations made after a reasonable investigation, or 2) assert a 'colorable' defense consistent with the attorney's professional obligations. A colorable defense includes 'requiring the Commission to bear the burden of proving its case.' Although these possibilities had been noted in the Commission's November 2002 release accompanying the proposed rules, so many comments expressed concerns about the potential chill on advocacy that the Commission felt it necessary to make these options explicit in the final rules.

Welcome Development

The fact that the Commission's release explicitly recognizes that a 'reasonable investigation' should precede the attorney's advice is a welcome development. All too frequently, issuers are told by federal prosecutors armed with the Justice Department's guidelines on corporate prosecutions that 'good corporate citizens' must immediately self-report, and that any delay is considered a negative factor in the exercise of prosecutorial discretion, if not obstruction of justice. It is welcome and somewhat refreshing to have a government agency with far-ranging enforcement powers recognize that a company facing allegations of misconduct should take the time to investigate the facts with the help of counsel before deciding how to respond.

The final rules provide that an attorney may, but is not required to:

• reveal confidential information to the Commission without the issuer's consent, if the attorney reasonably believes that such disclosure is necessary to 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';
• prevent perjury or other acts of fraud on the Commission; or
• rectify the consequences of material violations that have caused or may cause substantial injury to the issuer's or investors' financial or property interests (' 205.3(d)).

In adopting this rule, the Commission aligns itself with a majority of the states and with the rule proposed by the ABA's Ethics 2000 Commission but rejected by the ABA House of Delegates.

The final rule also adds a new ' 205.7, expressly providing that nothing in the rule is 'intended to, or does, create a private right of action against any attorney, law firm, or issuer based upon compliance or noncompliance with its provisions.' In a related vein, the final rule modifies the proposed rule's provision that an attorney 'shall act in the best interest of the issuer and its shareholders' to make clear that the rule is not meant to create fiduciary duties to shareholders that otherwise do not exist. In an era that is likely to see increased litigation against lawyers, these are welcome changes.

'Noisy Withdrawal'

Finally, a brief word on 'noisy withdrawal.' The November 2002 proposed rule required an issuer's attorney in specified circumstances to withdraw for 'professional considerations,' give notice to the Commission, and disaffirm filed documents. A new proposed rule, issued for comments on January 29, 2003, again would require withdrawal. But the new version heightens the triggering standard ('substantial evidence of a material violation that is ongoing or is about to occur') and eliminates the requirements of notice to the Commission and disaffirmance of documents. Somewhat curiously, given the Commission's preemption of inconsistent state rules elsewhere, the proposal relieves the attorney of the need to act if s/he would be prohibited from doing so by order of an authority with appropriate jurisdiction after a request to withdraw. The alternative places the burden of publicly reporting the lawyer's withdrawal on the issuer, and gives the lawyer the option to do so if the issuer does not.

The original 'noisy withdrawal' rules generated a massive volume of commentary in the 30-day comment period. We can expect at least the same over the next 60 days. The final rules are hardly final.

Howard W. Goldstein is a partner at Fried, Frank, Harris, Shriver & Jacobson in New York, and a former federal prosecutor.