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Special to The National Law Journal Corporate legal officers and private attorneys were scrambling last week to put a process in place to deal with a new federal rule requiring attorneys to report securities violations to upper management, the so-called “reporting up the ladder” rule. Others were waiting to see if the U.S. Securities and Exchange Commission (SEC) adopts an even tougher proposal. It would require public disclosure under a so-called “reporting out” rule. An SEC spokesman said the agency has received about one question a week about the reporting rules, and the majority are asking about reporting out. That proposal is pending, the spokesman said. Many attorneys believe that the SEC is waiting for the 410,000-member American Bar Association to act on its own reporting rule this week at its annual meeting in San Francisco. “So most companies are simply asking ‘What should we be doing now?’ ” said Michael L. Hermsen, a partner in the securities practice of Chicago’s Mayer, Brown, Rowe & Maw. The answer for now, Hermsen said, is to make sure that company executives and their in-house lawyers understand the reporting-up requirement, which the SEC put into effect on Aug. 5. Hermsen, former assistant director and special counsel for the SEC, said some clients were preparing to formalize written procedures while others were relying on informal talks. Under the new rule, adopted under the Sarbanes-Oxley Act of 2002, an attorney for a public company must report evidence of a material securities violation up the chain of authority within the company to the chief legal counsel or the chief executive officer. If the attorney does not receive an adequate response, the rule requires reporting the evidence to an appointed committee or the full board of directors. Hermsen said some companies were identifying a “go to” person or position, often an attorney, who would hear the initial report, which in some cases could simply be a rumor or a piece of gossip. Hermsen and other attorneys said most clients are asking questions such as what constitutes a material violation, when is a response considered adequate, and exactly who is covered by the rule? “We don’t have a good feel yet for how the SEC is going to interpret ‘material’ or ‘adequate,’ ” Hermsen said. The rule defines evidence of a material violation as involving credible evidence on which a prudent and competent attorney could reasonably conclude that a material violation has occurred, is ongoing or is about to occur. As to what is an adequate response, attorney Mark S. Radke advised, “Do objectively what is reasonable.” Radke, a partner at Washington-based Howrey Simon Arnold & White, said, “Time and experience will help answer these questions. The big thing we’re telling people is to document the timeliness of your response, and any remedial action you take.” For example, Radke said, a report of a leak in investor relations that could lead to insider trading might be difficult and time-consuming to track down, but the company should immediately issue a memo ordering all such information to be kept confidential. Radke, a former chief of staff to ex-SEC Chairman Harvey Pitt, oversaw the SEC’s input into Sarbanes-Oxley as well as rule-making to implement the act. Breadth of the new rule? Another key question being asked concerns the breadth of the rule’s coverage. It covers in-house attorneys for public companies “who appear or practice before” the SEC, as well as outside lawyers who have an attorney-client relationship with a company on business matters involving the SEC. Radke said that some lawyers are confused. For example, he said, the average litigator or environmental attorney might think they have nothing to do with the SEC, but they create reports that can be included in SEC filings. “The better practice is to sensitize the in-house legal departments and be overbroad in coverage at the moment,” Radke advised. Richard W. Painter, an author and professor of law at the University of Illinois who led a group lobbying for the SEC rule, advised that when there is confusion, “Communicate, instead of trying to figure out where the rule absolutely requires you to. The best approach is, if there is a risk of legal exposure, then go up the chain of command. “I’ve talked with directors,” Painter said, “and they don’t want to hear the argument that the lawyer didn’t think it fit within rules. Directors want to be informed about legal risks.” Michael P. McCloskey, a partner in Foley & Lardner’s San Diego office, joined Painter and several other attorneys in the view that reporting up is simply a good business practice that most firms already employ. “We have a law that tells us we are going to do what we were already doing in first place,” McCloskey said. Some companies are implementing new procedures to assure compliance. Michael S. Caccese, a partner in the Boston office of Kirkpatrick & Lockhart, said he is seeing some company boards designating a legal officer to report all such complaints to a committee of the board, often the audit committee. The new rule allows a company to establish a “qualified legal compliance committee,” or QLCC, as an alternative procedure for “reporting up” a violation. A compliance committee would consist of at least one member of the company’s audit committee, or an equivalent committee of independent directors, and two or more independent board members. Serge G. Martin, a partner at Miami’s Steel Hector & Davis, said the compliance committee “is trickier than at first thought.” “The question of whether to have a QLCC is one in which the general counsel, and even the company’s external day-to-day counsel, may have a conflict of interest,” he said. A general counsel, he said, may not want to be left out of the loop by a committee. Or outside counsel may see an advantage in letting one handle such problems and protect them from liability. Attorneys said companies are delaying decisions about compliance committees and procedures until the SEC acts on the reporting-out proposal. That rule would require the chief legal officer to report a violation internally and to withdraw from representing the client in the absence of an adequate response. Senior management would have to tell the SEC about the withdrawal and the reasons for it. The SEC has placed the reporting-out rule on temporary hold, along with a more controversial “noisy withdrawal” rule, which would require the attorney to report the withdrawal to the SEC. The rule has drawn strong criticism from attorneys who say it would violate attorney-client privilege. The SEC will watch how the American Bar Association House of Delegates votes this week on recommendations to amend its Model Rules of Professional Conduct on reporting out. Proposed changes would permit lawyers to reveal information to prevent criminal or fraudulent conduct “that is reasonably certain to result in substantial injury to the financial interests of others when the lawyer’s services are being used to further the fraud or crime.” A majority of state ethics rules already permit this. Another proposed change would clarify when corporate lawyers should disclose up the ladder within a company, and when lawyers may externally disclose “conduct by the corporation or its executive officers, which a reasonable lawyer would conclude violates law or a fiduciary duty and will result in substantial corporate injury.” The recommendations include a requirement that lawyers who are fired because they report violations internally or who quit working for a corporation because it refuses to address violations adequately assure that the board is informed of the discharge or withdrawal. Several attorneys predicted that if the ABA doesn’t make the rule changes, the SEC is more likely to adopt its reporting-out or noisy-withdrawal proposal.

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