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Effective Aug. 5, 2003 the U.S. Securities and Exchange Commission (SEC) promulgated rule 17 CRF 205 (“Standards of Professional Conduct for Attorneys”), implementing the lawyers’ reporting obligations as provided for in the Sarbanes-Oxley Act. The rules set minimum standards of professional responsibility when lawyers are confronted with evidence of a material violation of: (1) the federal securities laws, (2) state securities laws or (3) a breach of fiduciary duty. The rule applies to any information that the attorney has on or after its effective date, whether the events in question took, or take, place before or after that date. The rule applies to all lawyers who represent issuers that are reporting companies under the 1933, ’34 or ’40 Acts. The lawyer, whether in-house or outside counsel, has the obligation to report up-the-ladder to the chief legal officer (CLO) and chief executive officer (CEO). If that report is not appropriately responded to, he must report to the audit committee or an equivalent committee of independent directors, the Qualified Legal Compliance Committee (QLCC) or the board of directors. The rule states that the report and the response are to be deemed privileged and confidential save in those instances where there is perjury, materially false filings, substantial injury to the issuer and its investors or where the crime-fraud exception to the attorney-client privilege applies. THE LIMITS ON THE STATUTORY AUTHORITY Section 307 of the Sarbanes-Oxley Act of 2002 explicitly provided for up-the-ladder reporting within the issuer to the chief legal officer (CLO), the chief executive officer (CEO), the audit committee, an equivalent committee of independent directors and the board itself — but not to the SEC. That is as far as the rule goes. It does not provide for reporting to the SEC, i.e., outside the corporate structure. The SEC originally proposed that an attorney confronted with inadequate compliance had to withdraw from the engagement and report the withdrawal to the SEC. The company also had to make an EDGAR filing (“EDGAR” is the SEC’s Electronic Data Gathering Analysis and Retrieval system), reporting the withdrawal. A great number of commenters opposed this “noisy withdrawal” provision, arguing that it was beyond the SEC’s authority as provided for in the statute. They also argued it would adversely affect longstanding state ethic requirements and undermine an attorney’s obligations based on the attorney-client privilege. As a result, the SEC deferred adopting the “noisy withdrawal” provision as part of 17 CFR 205 and invited further comments addressed to an alternative “noisy withdrawal” provision. The thrust of the SEC’s query is what should an attorney be obligated to do if, after reporting evidence of a material violation up-the-ladder, the attorney reasonably believes an issuer’s directors have either made no response in a timely fashion or have not made an appropriate response. This is a decades-old debate going back to the 1970s. The question should also be asked whether a “noisy withdrawal” provision may be an impediment to good advice and counsel. THE ORIGINAL PROPOSING RELEASE When the SEC published proposed rule 17 CFR 205 its “noisy withdrawal” provision, paragraph 205.3(d), would have required an attorney to report the evidence of material violation to the commission if he was not “reasonably satisfied” that the corporate structure had properly responded to his report up-the-ladder. Picture the position of the young attorney, working on a registration or 10K, who thinks a material violation has not been adequately disclosed in the 100-page document he is assigned to draft. He may be shouldered with an immense career-threatening burden and risks being branded as a loose cannon on the deck, dangerous and out of control. Under the originally proposed rule, an outside attorney who reasonably believed that the reported material violation was ongoing, or was about to occur, and was likely to result in substantial injury to the financial interest of the issuer or of investors, was required to withdraw from the representation, notify the SEC of the withdrawal and disaffirm any submission to the SEC that they participated in preparing that was affected by the violation. Withdrawal from representation for “professional considerations” was to be forthwith and the notice to the SEC was to be within one business day of withdrawal. An in-house counsel was not required to resign his employment. Instead, in-house counsel was required to disaffirm any tainted submission he participated in preparing and notify the SEC within one business day of his disaffirmation. If the violation had no ongoing effect, the reporting attorney was permitted, but not required, to notify the SEC. To make a permissive, as contrasted with a mandatory, report, the reporting attorney still had to reasonably believe that the material violation was likely to have caused substantial injury to the financial interest of the issuer or investors. Further, an attorney who reasonably believed he or she was discharged for fulfilling the reporting obligation was permitted to notify the SEC and disaffirm in writing any tainted submission he or she helped prepare. Notification to the SEC in these circumstances was not to be deemed a breach of the attorney-client privilege. THE ORIGINAL ALTERNATIVE PROPOSAL The SEC’s original proposal contained an alternative to the “noisy withdrawal” approach. It provided that if the reporting attorney had not received an appropriate response to his up-the-ladder report, he or she was to notify the issuer in writing of his or her withdrawal and that the withdrawal was based upon “professional considerations.” He was also to cease forthwith from participating in any matter concerning the violation and was to inform the issuer in writing that, in his view, an appropriate response had not been made to the report of a material violation. If the attorney was prevented from withdrawal by any court or authority having jurisdiction over the attorney, the attorney was to notify the issuer that, but for such prohibition, he or she would have withdrawn. If the attorney was discharged because of his report, the CLO was to be notified. The CLO was also required to notify any attorney, newly retained or employed to replace the reporting attorney, that the previous attorney withdrew, ceased to participate or had been discharged in connection with making a report of a material violation. Further, where an attorney had provided an issuer with written notice of his withdrawal, “the issuer [was required] within two business days of receipt of such written notice, [to] report such notice and the circumstances related thereto on Form 8-K, 20-F or 40-F … as applicable.” FINAL RULE The final rule contains a provision that keeps reporting within the strata of the issuer but does allow reporting to the SEC when the traditional crime-fraud exception to the attorney-client privilege applies. [FOOTNOTE 1] Section 205.3(10)d provides: (d) Issuer confidences.Any report under this section (or the contemporaneous record thereof) or any response thereto (or the contemporaneous record thereof) may be used by an attorney in connection with any investigation, proceeding, or litigation in which the attorney’s compliance with this part is in issue. I. An attorney appearing and practicing before the Commission in the representation of an issuer may reveal to the Commission, without the issuer’s consent, confidential information related to the representation to the extent the attorney reasonably believes necessary: II. 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; III. To prevent the issuer, in a Commission investigation or administrative proceeding from committing perjury, proscribed in 18 USC 1621; suborning perjury, proscribed in 18 USC 1622; or committing any act proscribed in 18 USC 1001 that is likely to perpetrate a fraud upon the Commission; or IV. To rectify the consequences of a material violation by the issuer that cause, or may cause, substantial injury to the financial interest or property of the issuer or investors in the furtherance of which the attorney’s services were used. COMMENT A fundamental issue arises as to why the final rule has to be supplemented with either alternative “noisy withdrawal” provision. The final rule, as promulgated, permits the reporting attorney to communicate with the SEC and report a serious violation that the lawyer would similarly and customarily have to report in other contexts. [FOOTNOTE 2]In permitting an attorney to go outside the issuer “to prevent … a material violation that is likely to cause substantial injury to the financial interest or property of the issuer or investors,” the current provision is both prophylactic and sufficiently broad in its coverage. Where the attorney’s services are exploited to further a substantial injury to the issuer or investors, the attorney can also report the violation to the SEC to rectify the consequences of the wrongdoing. The two parts of this particular provision are consistent with the core policy of the rule, which is not to allow lawyers to be used as instruments of wrongdoing but, at the same time, keeps the boundaries of privilege and confidential information intact. The same holds true for the sub-part of the rule that permits reporting when counsel becomes aware in the course of SEC representation before the commission of an intention to make a material false filing, or that perjury is about to be committed in an investigation or proceeding. Reporting to the SEC under the final rule requires more support, and takes place at a higher threshold than the “noisy withdrawal” provision in the proposing release. Lawyers are not merely advocates for their clients but also advocates to their client. Issuer clients and their personnel therefore will be encouraged to obtain legal advice and take corrective action when they know a report to the SEC will only be made when there is evidence of a crime or fraud and not just in those contexts in which their attorneys merely believe there is evidence of a material violation or breach of fiduciary duty. [FOOTNOTE 3]A “noisy withdrawal” provision will trigger an SEC investigation or proceeding that may have been legitimately avoided or minimized by a frank and full consultation with counsel. Norman B. Arnoff practices law in New York City. Martin Mushkin a member of Pomeranz Gottlieb & Mushkin co-authored this article. If you are interested in submitting an article to law.com, please click here for our submission guidelines. ::::FOOTNOTES:::: FN 1 In re Sealed Case, 754 F2d 395, 399 (D.C. Cir 1985); Trust Co. v. Gomez, 100 FRD 273, 277 (SDNY 1983). FN 2 Nix. Warden v. Whiteside, 475 US 157, 106 SCt 988 89 Led2d 123, 1986 U.S. Lexis 8, 54 USLW4194 (1986). FN 3 Upjohn Co. v. United States, 449 US 383, 389 (1981); FDIC v. Ogen Corp., 202 F3d 454 (1st Cir 2000).

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