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Sarbanes-Oxley instructed the SEC to adopt rules by Jan. 26 to prohibit officers and directors of a public company, or persons acting under their direction, from taking action to “fraudulently influence, coerce, manipulate or mislead” any accountant engaged in an audit for the purpose of rendering the company’s financial statements materially misleading. The Securities and Exchange Commission’s proposed “up-the-ladder” and “noisy withdrawal” rules for lawyers representing public companies [FOOTNOTE 1]are not the only pending SEC proposals that threaten to significantly change the lawyer’s role as an adviser to public companies. While the public and the bar have been focusing on the lawyer conduct proposals, the SEC has proposed a separate set of rules that would have a similar dramatic effect on the lawyer’s relationship with the client’s auditor. Section 303(a) of the Sarbanes-Oxley Act instructed the SEC to adopt rules by Jan. 26 to prohibit officers and directors of a public company, or persons acting under their direction, from taking action to “fraudulently influence, coerce, manipulate or mislead” any accountant engaged in an audit for the purpose of rendering the company’s financial statements materially misleading. The SEC recently proposed its rules, [FOOTNOTE 2]which on their surface appear to substantially track the statutory language. In the accompanying release, however, the SEC immeasurably expands the reach of the rules. Moreover, the release asks for comment on expanding the rules to cover an even wider range of conduct. Without question, the SEC is laying the groundwork for adopting rules later this month that will dramatically affect how lawyers and others communicate with public companies’ auditors. It is nothing new for aggressive agencies like the SEC to seek to expand their authority, especially when they can do so under cover of extraordinary events such as those that led up to the passage of Sarbanes-Oxley. As in the case of the lawyer conduct proposals, however, the short time available for public comment on the proposed rules greatly increases the risk of a major policy mistake. CONDUCT COVERED Nothing could better illustrate the SEC’s opportunistic approach to rule-making under Sarbanes-Oxley than the standard of conduct contemplated by the proposed “improper influence” rules. As noted above, Sarbanes-Oxley directed the SEC to adopt rules to prohibit acts “to fraudulently influence, coerce, manipulate or mislead” an accountant engaged in an audit. The proposed rules use the same language while adding “directly or indirectly.” The proposing release, however, points out — in a footnote — that the SEC views the word “fraudulently” as modifying only the word “influence.” The SEC’s conclusion about the limited reach of the word “fraudulently” is contrary to accepted principles of statutory construction. It also ignores internal evidence that Congress clearly intended the opposite result. MODIFYING ADVERB Sarbanes-Oxley is not the first federal statute to place a modifying adverb imposing a scienter condition before a “string” or “series” of words identifying prohibited conduct. For example, 18 U.S.C. � 111(a) imposes criminal penalties on any person who “forcibly assaults, resists, opposes, impedes, intimidates, or interferes with” any designated federal officer. The 4th U.S. Circuit Court of Appeals relied on “ordinary rules of grammatical construction” to conclude that “[t]he use of the adverb ‘forcibly’ before the first of the string of verbs, with the disjunctive conjunction used only between the last two of them, shows quite plainly that the adverb is to be interpreted as modifying them all.” [FOOTNOTE 3] The U.S. Courts of Appeal for the District of Columbia, and the 2nd and 8th Circuits have all come to the same conclusion. [FOOTNOTE 4] Internal evidence provides an even stronger basis for concluding that the SEC is wrong on this issue. Only two of the four verbs in the � 303(a) prohibition (“coerce” and “manipulate”) suggest a fraudulent purpose. Two of them (“influence” and “mislead”) suggest a variety of purposes, including entirely benign conduct or simple negligence. In prefacing all four verbs with the word “fraudulently,” Congress obviously intended to focus on fraud. In addition, � 303(b) of Sarbanes-Oxley states that in any civil proceeding the SEC shall have “exclusive authority” to enforce the provision and related SEC rules. The exclusion of a private right of action would have been unnecessary if Congress had intended to reach non-fraudulent conduct, since no provision of the federal securities laws supports an implied private right of action for the conduct described in � 303(a) unless that conduct is fraudulent. Finally, the statute specifies that the prohibited acts must be “for the purpose of rendering [the] … financial statements materially misleading.” Such words clearly require an intent to achieve a forbidden purpose. In other words, Congress did not only once state that the conduct reached by � 303(a) had to reach the level of fraud, it said it three times. It is clear from the release, however, that the SEC does not really care what Congress had in mind. The release asks for comment on substituting “improperly” or some other word for “fraudulently” so that the SEC’s or its staff’s judgment about the “propriety” of a communication will determine the outcome of an administrative proceeding. It is a bold agency that expects the courts to uphold its case-by-case determinations about the “propriety” of communications. PERSONS COVERED The statute refers to officers and directors of an issuer and to persons acting “under the direction” of an officer or director. The release states that the SEC intends the proposed rules to apply to “officers” as defined in existing SEC rules and requests comment on whether the definition should be further extended. The release also states that the proposed rules would extend to people who are “not under the supervision or control of [an] … officer or director” (including, according to a footnote, any person who acts pursuant to an “explicit instruction”). The release then offers illustrations of people who might be included within the expanded covered group, such as customers, vendors or creditors, as well as attorneys, securities professionals or other advisers. As far as the definition of “officer” is concerned, the current definition in the SEC’s Rule 12b-2 leaves it to issuers to decide who is an officer based on whether or not a person routinely performs functions corresponding to those of persons in specifically-identified positions. The definition works well enough for issuers, but it has unacceptable ambiguities for people on whom the SEC would impose direct obligations whenever they communicate with the issuer’s auditors. The ambiguities extend even further, since third persons such as co-workers and perhaps lawyers and others outside the company could be found to have communicated with an auditor at the “direction” of a corporate employee who turns out to have been an “officer” under Rule 3b-2. The release’s expansive view of “direction” also creates problems, particularly for those outside the company. It should be obvious that an officer or director cannot “direct” or “instruct” a customer, vendor, lawyer or creditor to exert influence of any kind on an auditor. At most, the officer or director can seek to persuade such a person to take such action. But it could be easily alleged after the fact that those outside the company who communicated with the company’s auditors did so as the result of one or another varieties of “persuasion.” Congress’ choice of the word “direction” clearly implies that the people induced to exert improper influence must in fact be subject to the officer’s or director’s supervision or control. Attorneys, securities professionals or other advisers to the issuer should generally not be covered. Again, however, the SEC makes clear in the release that it is not looking to the statute for support for its proposals. It solicits comment on abandoning even the notion of an “explicit instruction,” proposing instead to reach those who act “at the behest of” or “on behalf of” an officer or director. The SEC is imagining conspiracies where none exist. The SEC proposals would have the perverse effect of making the auditor’s job more difficult as a company’s employees, lawyers, customers, suppliers and other third parties are reluctant to have any communication with the auditor at any time. COMMUNICATIONS COVERED The statute covers communications with an accountant “engaged in the performance of an audit.” The release, on the other hand, states that the term “engaged in the performance of an audit” includes any activity by an accountant prior to, during and subsequent to the auditor’s retention to perform an audit. The SEC has offered not a shred of evidence to support its broad approach. It should assume that Congress intended a common sense meaning of the term “engaged in the performance of an audit,” that is, any time the auditor is performing field work or making judgments about the audit of a particular period’s financial statements. FORBIDDEN PURPOSE As noted above, the statute specifies that the prohibited acts must be “for the purpose of rendering [the] financial statements materially misleading.” Finding this language inconvenient, the SEC simply ignores it. The proposed rules substitute the concept that the officer or director or another person had known that his or her action could, if successful, result in the financial statements becoming materially misleading or that the person was unreasonable in not knowing that that could be the result. Not surprisingly, the release also requests comment on whether the watered-down purpose required to constitute a violation of the revised rule should be further watered down to action undertaken either for the purpose of or that would have the effect of rendering the financial statements materially misleading. As the release frankly points out, it would thus be unnecessary to prove any particular purpose or intent. HARMFUL EFFECT The proposed rules end up contemplating the following: Any officer or director, or someone acting at his or her “instruction” or “behest,” who communicates with an accountant (who may or may not at the time be engaged in an audit) in a way that the SEC decides — with the benefit of hindsight — was “misleading” may be charged with a violation of � 303(a) if the SEC decides — again with the benefit of hindsight — that the person either was unreasonable in not knowing that the communication could result in the financial statements being materially misleading or that the communication (whatever the person’s knowledge or state of mind) had the effect of rendering the financial statements materially misleading. Any lawyer making an allegedly misleading statement in an auditor’s letter would be subject to prosecution under the SEC’s version of � 303(a). So would any banker confirming balances, any customer confirming receivables, any supplier confirming payables. The SEC could not have come up with a better way to discourage third-party cooperation with an audit. This cannot be what Congress intended. As noted above, Sarbanes-Oxley does not authorize the SEC to adopt rules that would prohibit communications with auditors in the absence of fraudulent intent. Neither does any other provision of the 1934 Act. The SEC therefore lacks power to adopt rules that prohibit non-fraudulent communications with auditors. Indeed, the SEC has not demonstrated any need to pursue non-fraudulent conduct in this area. If it believes that there is such a need, it should make its case to Congress. A CAUTIOUS APPROACH As noted in the release, much of the conduct sought to be reached by the proposed rules is already actionable by the SEC under its existing authority. This includes the ability to bring aiding and abetting charges or cease-and-desist proceedings. The release justifies the extension of coverage simply by stating that the proposed rules provide “an additional means” of pursuing such conduct. This is hardly a sufficient reason to go beyond the statutory mandate. The SEC undoubtedly has a heavy burden in meeting the Sarbanes-Oxley rule-making deadlines. Particularly given the short time for public comment on these rules, there is a significant risk of one or more major policy mistakes. The SEC should not increase this risk by needlessly going beyond what the statute requires. In the case of the lawyer conduct and improper influence proposals, it should concentrate on implementing by Jan. 26 the express commands of Sarbanes-Oxley and leave to another day whether or not additional “confidence-enhancing” measures are needed. Joseph McLaughlin is a partner at Sidley Austin Brown & Wood ( If you are interested in submitting an article to, please click herefor our submission guidelines. ::::FOOTNOTES:::: FN1 See, e.g., Audrey Strauss, “SEC’s Rules on Up-the-Ladder and Outward Reporting,” NYLJ, Jan. 2, 2003. FN2SEC Release No. 34-46685 (File No. S7-39-02) (Oct. 18, 2002). FN3 Long v. United States, 199 F.2d 717, 719 (4th Cir. 1952). FN4 United States v. Arrington, 309 F.3d 40 (D.C. Cir. 2002); United States v. Bamberger, 452 F.2d 696 (2d Cir. 1971), cert. den. 405 U.S. 1043 (1972) ( see also United States v. Giampino, 680 F.2d 898 (2d Cir. 1982); United States v. Camp, 541 F.2d 737 (8th Cir. 1976) ( see also United States v. Schrader, 10 F.3d 1345 (8th Cir. 1993)).

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