United States: SEC Proposes A Rule Implementing Section 307 of the Sarbanes-Oxley Act of 2002

Originally published on 6 November, 2002

Today, the United States Securities and Exchange Commission ("SEC" or "Commission") approved the proposal of a rule implementing Section 307 of the Sarbanes-Oxley Act of 2002 (the "S-O Act"). Section 307 directs the SEC to issue rules addressing minimum standards of professional conduct for attorneys appearing and practicing before the Commission. The proposed rule will be included in a release to be issued shortly and posted on the SEC website. This summary is based on information provided at the SEC's open meeting and therefore may not reflect nuances that appear in the official text.

The SEC has indicated that there will be a 30-day comment period following publication of this proposal in the Federal Register. The S-O Act requires the SEC to issue final rules implementing Section 307 no later than January 26, 2003.

Section 307 directs the SEC to issue rules setting forth standards of professional conduct for attorneys "appearing and practicing before the Commission in any way in the representation of issuers," including a rule requiring attorneys to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by an issuer or its agent, to the chief legal counsel or the chief executive officer ("CEO") of the issuer. If the chief legal counsel or CEO does not "appropriately respond" to the evidence, the attorney must report the evidence to the board of directors, the board audit committee, or another board committee comprised solely of independent directors.

The proposed rule would impose an "up the ladder" reporting obligation if an attorney "reasonably believes" that a material violation of securities law or breach of fiduciary duty or similar violation has occurred, is occurring, or is about to occur. Under the proposed rules, the attorney would be obligated to report evidence of such a violation or breach to the company's chief legal officer ("CLO") or to the CLO and CEO. If the CLO and CEO fail to "appropriately respond" to the evidence (or if the attorney determines that reporting to such officers would be futile due to their involvement in the perceived violation), the attorney would be required to report the evidence to the board, the audit committee, or another independent board committee.

The attorney's obligation would not end with reporting evidence to the board or an independent board committee. Under the proposed rule, which goes beyond the requirements of Section 307, an outside attorney who believes that the board or board committee has not appropriately responded to evidence of an ongoing or potential violation that is likely to result in substantial injury to the financial interests or property of the issuer or investors must: (1) withdraw from the representation; (2) notify the SEC in writing of this withdrawal for "professional considerations"; and (3) disaffirm any "tainted" documents filed with the SEC. An inside attorney who believes that the board has not appropriately responded to evidence of an ongoing or potential violation need not resign, but must disaffirm any tainted documents filed with the SEC. The "noisy withdrawal," notification and disaffirmation obligations would be voluntary for attorneys with evidence of past violations or breaches.

In the alternative, the proposed rule would permit a company to create a Qualified Legal Compliance Committee ("QLCC"), comprised of one member of the company's audit committee and two or more other directors (all of whom must be independent). An attorney with evidence of a material violation or breach of fiduciary duty would have the option to report the evidence directly to the QLCC, rather than to the CEO and CLO. Attorneys who report evidence of a material violation to a QLCC would not be subject to the proposed "noisy withdrawal" requirement. Upon receipt of evidence of a material violation or breach, the QLCC would be responsible for notifying the CEO and CLO, determining whether an investigation is warranted, directing any investigation, and fashioning remedial measures. If the company fails to appropriately implement remedial measures prescribed by the QLCC, each QLCC member would be required to notify the Commission and disaffirm documents "tainted" by the misconduct.

The proposed rule would apply to all attorneys appearing and practicing before the Commission in any way in the representation of issuers. It appears that the term "appearing and practicing before the Commission" will be defined to include any communications with the SEC on behalf of an issuer and any conduct relating to the preparation of documents submitted to the SEC. Moreover, the rule would apply even when materials are not submitted to the SEC, if the attorney's advice causes the materials not to be submitted.

The term "attorney" would include anyone admitted, licensed or otherwise qualified to practice law in any jurisdiction (including foreign jurisdictions) and anyone holding himself or herself out as an attorney rendering legal advice to public companies. Moreover, the proposed rule would apply even if the "attorney" were not employed in a legal position. The Commission is soliciting comments on whether particular categories of persons should be excluded from the rule's requirements.

An attorney would be obligated under the proposed rule to report evidence of a "material violation" of securities laws or breach of fiduciary duty or similar violation by the company or any agent of the company. It is not clear how the SEC will define the terms "material violation" and "breach of fiduciary duty." At today's meeting, Chairman Pitt suggested that the proposed rule should be revised to clarify that any perceived violation or breach must "affect investors," requiring some nexus with the Commission's statutory mandate to protect investors. An SEC press release issued after today's meeting indicates that an attorney's reporting duty will arise only in instances where it is "appropriate to protect investors."

The proposed rule would not require an attorney to conduct his or her own investigation into potential violations; nor would it require the attorney to "know" that a violation has been committed before reporting it.

The proposed rule also would impose upon an attorney an obligation to take "reasonable steps" to document reports made to the CLO, CEO and QLCC, and to retain such documentation for a "reasonable time." The Commission is soliciting comments on whether the documentation requirements, which will be explained in more detail in the proposing release, are appropriate.

When presented with a report of a possible material violation or breach of fiduciary duty, a CLO would be required under the proposed rule to determine whether an inquiry is warranted. A CLO who reasonably concludes that there has been no violation would be required to provide notice of this conclusion to the reporting attorney and take steps to preserve the relevant evidence. A CLO who determines that a material violation or breach has occurred, is occurring, or is about to occur would have to share his or her conclusions with the reporting attorney and take reasonable steps to ensure that the company adopts appropriate remedial measures (including appropriate disclosures).

As noted above, the board or board committee's failure to appropriately respond to evidence of misconduct would trigger an attorney's obligation to disaffirm tainted filings and, in the case of an outside attorney, to "noisily withdraw" and notify the Commission in writing of a withdrawal for "professional considerations." Chairman Pitt indicated at today's meeting that notification of an attorney's withdrawal for "professional considerations" likely would trigger an automatic investigation of the matter by the SEC. Several SEC commissioners expressed concerns about how this provision could affect the attorney-client relationship, particularly with respect to clients' willingness to consult with attorneys about potential misconduct.

According to the SEC's press release, the proposed rule will provide that where an attorney files a notification with the Commission as part of a "noisy withdrawal," no violation of the attorney-client privilege would occur. The SEC is soliciting comments on how the proposed rule could affect the attorney-client privilege and other aspects of the attorney-client relationship.

The proposed rule will set forth specific circumstances under which an attorney would be authorized to disclose confidential information relating to his or her representation of an issuer. Under the proposed rule, an attorney would be permitted to use confidential information to defend against charges of attorney misconduct or to prevent the commission of an illegal act that the attorney "reasonably believes" will result either in the perpetration of a fraud upon the SEC or in substantial injury to the financial interests or property of the issuer or investors. At today's meeting, SEC staff suggested that the Commission will be amenable to confidentiality agreements to allow issuers and attorneys to reveal confidential information without waiving the attorney-client privilege.

Chairman Pitt expressed concerns at today's meeting about the effect the proposed rule could have on private securities litigation claims. He suggested that the Commission consider creating a "safe harbor" for attorneys who report information to the SEC in good faith (or with a reasonable belief of misconduct) or who conclude in good faith (or reasonably) that evidence need not be reported. The proposing release will solicit comments on whether such a provision is necessary and appropriate.

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