The Fork in the Road: The SEC and Preemption

Under the SEC's Sarbanes-Oxley modus operandi, a capital markets lawyer may disclose “material violations” (past, current, future) to the commission. If a lawyer does not handle that “permissive” disclosure obligation correctly, he or she can be subject to a liability whipsaw: If she fails to disclose to the SEC and she is wrong, the SEC (and possibly the plaintiffs' bar) can go after her; if she discloses to the SEC and she is wrong, clients and stockholders can sue her. In judging the appropriateness of her conduct, the SEC (with the benefit of hindsight) will judge her under the “reasonable lawyer” standard (i.e., not based upon what she actually knew); and the commission has at its disposal the full panoply of sanctions under the Securities and Exchange Act of 1934 to punish the offending lawyer.

A number of the states have generally come into line with the SEC's “permissive” disclosure mandate, but a number of others have not. (There are, in essence, five different groupings of states in their approaches to Rule 1.6. See “The Pit, the Pendulum, and the Legal Profession,” and “Here's Johnny!,” supra.) Besides Washington and California, another principal outlier is New York. Under New York's Rule 1.6, New York lawyers may use their discretion to make permissive disclosure: 1) to prevent death or substantial bodily harm; or 2) to prevent a crime. New York specifically carves out financial fraud from permissive disclosure; furthermore, disclosure of past client conduct is prohibited.

New York also declined to adopt in Rule 1.13 a provision allowing lawyers representing corporations to “report out” if they are unable to get their clients to “do the right thing” (i.e., follow their advice) and the corporations face “substantial injury” relating to that advice (taken or not taken). New York also does not use the “reasonable lawyer” standard, opting instead to judge lawyers' behavior on an “actual knowledge” standard. This is a very important safeguard for lawyers, protecting them from harsh, 20-20 hindsight judgments. See, e.g., In re Jordan H. Mintz and In re Rex R. Rogers, SEC Release Nos. 59296 & 59297 (Jan. 26, 2009).

Preemption (Part One)

While acknowledging that “a number of commentators questioned the Commission's authority to preempt state ethics rules, at least without being explicitly authorized and directed to do so by Congress,” the SEC staff in the final release implementing its Sarbanes-Oxley rules and regulations also wrote: “[T]his … does not preempt ethical rules in United States jurisdictions that establish more rigorous obligations than imposed by this part. At the same time, the Commission reaffirms that its rules shall prevail over any conflicting or inconsistent laws of a state or other United States jurisdictions in which an attorney is admitted or practices.” See SEC Release Nos. 33-8185, 34-47276 (Jan. 29, 2003).

Some non-compliant states immediately challenged the SEC on the preemption issue. (Washington's and California's interplay with (and challenge to) the SEC's disclosure regime is set forth in detail in “Here's Johnny!” See supra.) In responding to those states, the SEC cited the U.S. Supreme Court's decision in Sperry v. State of Florida, 373 U.S. 379 (1963) — a ruling that is demonstratively inapposite on its face. Not only did that brouhaha end up in an unresolved standoff, when the New York State Bar authorities put forward New York's non-conforming Rule 1.6 in 2009, they did so: 1) in full awareness that it's Rule 1.6 would place materially different disclosure obligations on New York state lawyers than those required by the SEC; and 2) in full awareness of the SEC's position on preemption.

With the preemption issue thus pretty well teed up, what sayeth the courts (to date)?

Quest Diagnostics

On Oct. 25, 2013, the U.S. Court of Appeals for the Second Circuit affirmed the district court's 2011 dismissal of a False Claims Act qui-tam action by Mark Bibi, a former general counsel of Unilab. United States ex rel. Fair Lab. Practices Assocs. v. Quest Diagnostics, 734 F.3d 154 (2d Cir. Oct. 25, 2013), aff'm, 2011 U.S. Dist. LEXIS 37014 (S.D.N.Y. April 15, 2011). Bibi, together with two other former Unilab executives, sued Unilab's new owner, Quest Diagnostics, on the ground that the company had engaged in a pervasive kickback scheme. At the district court level, legal academic ethics experts proffered dramatically opposing opinions: Prof. Andrew Perlman of Suffolk University Law School supported Bibi, who had testified that he was entitled to “spill his guts” because he believed Unilab's actions were criminal; Prof. Stephen Gillers of New York University Law School opined that Bibi's disclosure violated his professional obligations to his former client. The district court sided with Gillers, and dismissed the case.

On appeal, the Second Circuit upheld the important ethical obligation that lawyers have in protecting client confidences (under Rule 1.6) and not breaching said confidences (especially to profit thereby). But in order to get to that ruling, the court had to first address Bibi's contention that the False Claims Act (FCA) preempted New York State's Rules of Professional Conduct.

Judge José Cabranes, writing for the panel, initially noted that courts have “consistently” looked to state ethical rules to determine whether attorneys have conducted themselves properly. He then looked at whether the federal statute did anything to change that traditional rule, but found that “[n]othing in the False Claims Act evidences a clear legislative intent to pre-empt state statutes and rules that regulate an attorney's disclosure of client confidences.” As authority for the “clear legislative intent” standard, Cabranes cited two Supreme Court precedents, both of which stand for the proposition that “we [the U.S. Supreme Court] assume a federal statute has not supplanted state law unless Congress has made such an intention clear and manifest.” Bates v. Dow Agrosciences, 544 U.S. 431, 449 (2005); Cipollone v. Ligget Grp., 505 U.S. 504, 516 (1992). AccordChadbourne & Parke v. Troice, 134 S. Ct. 1058 (2014); Gregory v. Ashcroft, 501 U.S. 452, 458 (1991); Santa Fe Industries v. Green, 430 U.S. 462, 479 (1977); Fla. Lime & Avacodo Growers v. Pauli, 373 U.S. 132, 144 (1963). See also ABA v. FTC, 430 F.3d 457, 466 (D.C. Cir. 2005) (Congress did not delegate to the FTC the authority to regulate the practice of law under Gramm-Leach-Bliley).

Conclusion

Judge Cabranes' ruling would seem to provide the answer to the SEC's preemption claim quite definitively, and in the negative. Why? Because there is absolutely no evidence of any kind that Congress expressed or manifested (or even implied) any intent to supplant state-based rules for lawyers when it passed Sarbanes-Oxley. See “Here's Johnny!,” supra. And if there is a further need for added authority on this point, the former Director of Enforcement of the SEC has publicly opined that the Commission's claim of preemption is legally infirm. See W. McLucas, L. Wertheimer, A. June, “Attorneys Caught in the Ethical Crosshairs: Secretkeepers as Bounty Hunters Under the SEC Whistlebower Rules,” 46 Sec. Reg. & L. Rep. (April 14, 2014) (citing, inter alia, the Quest Diagnostics ruling).

Next month, we will discuss a case that went the other way, and the reasons why Quest Diagnostics should still hold sway.

***** C. Evan Stewart is a partner at Cohen & Gresser. This article also appeared in the New York Law Journal, an ALM sibling publication of this newsletter.