From: Jeff Schultz [jeff_schultz@ksg04.harvard.edu] Sent: Wednesday, December 18, 2002 2:32 PM To: rule-comments@sec.gov Subject: File No. S7-45-02 December 18, 2002 VIA E-MAIL TO RULE-COMMENTS@SEC.GOV Securities and Exchange Commission 450 Fifth Street, N.W. Washington, DC 20549-0609 Attn: Jonathan G. Katz, Secretary Re: Sarbanes-Oxley Act §307 – Implementation of Standards of Professional Conduct for Attorneys – SEC Release Nos. 33-8150; 34-46868; IC-25829; Proposed Part 205 to Title 17, Chapter II, C.F.R. (“Rule”) (File No. S7-45-02) Ladies and Gentlemen: I applaud the Commission’s Staff for proposing far-reaching measures that, if and when implemented, have the potential to redraw the contours of lawyer regulation in this country in a positive way. I believe I speak for many counsel when I say that the rules of legal ethics, as currently set forth in a hodge-podge of often contradictory state codes, bar opinions, restatements, learned commentary and court decisions, do not always provide clear guidance to attorneys endeavoring to satisfy both their client’s business goals and their own ethical duties. It is not just the legal profession as a whole that is self-regulated; each and every attorney who practices must consult his or her conscience many times a day. If, with the Commission’s prodding, the existing body of laws and regulations applicable to the legal profession can be harmonized and clarified, then the “Model Rules” will finally be worthy of their name and all lawyers and clients will benefit. I am concerned, however, that the Commission’s proposed Rule does not sufficiently take into account the important differences among attorneys in different practices or contexts, i.e., litigation vs. transactional and outside vs. in-house. I am primarily concerned with in-house counsel and their duties, and I believe that the Rule should be as well. Outside counsel should have no reporting duties except to the chief legal officer (CLO) of their client. Under cover of attorney-client privilege, they can give a full accounting of any actual or threatened violations to the CLO. Once they inform the CLO about a violation or any other matter, the sole responsibility should shift to the CLO and, if one exists, the qualified legal compliance committee (QLCC). In this way, expert outside securities lawyers can focus on their expert representation of the client Issuer before the Commission and can continue to be advocates under a more adversarial model than the one that should apply to an in-house counsel with pre-existing compliance duties to the client Issuer. I view the QLCC as a particularly helpful innovation. An in-house attorney generally does his or her best to balance competing roles as compliance officer and keeper of confidences, attempting along the way to identify the most efficient, advantageous and trouble-free path for the company’s transactions and general business activities. In a worst-case scenario, however—of which we have seen all too many lately—the in-house attorney becomes a “cop” who must try to halt misconduct, violations of law or breaches of legal obligations committed by executives or employees. All too often, even an in-house attorney with the prestige and credibility to deserve the title of “General Counsel” either feels obligated not to, or chooses not to, oppose misconduct by top management. He or she may feel more like a part of the company’s management team than a “cop.” This can be due to the influence of personal relationships, financial incentives, or the simple fear of losing employment (and, sometimes, paradoxically, professional reputation, since the obligation to stay silent may make self-defense or justification difficult). The creation by the Commission, under the proposed Rule, of the CLO title with specific statutory duties and ideally reporting to the QLCC recognizes these structural issues. The Rule’s differentiated approach to in-house and outside counsel suggests to me that the Commission understands the different roles and responsibilities of such counsel. The Commission also seems to understand what many state courts like the Illinois court in the case of Balla v. Gambro, Inc. (584 N.E. 2d. 104 (Ill. 1991)) still do not: the real, human costs of standing up to misconduct, and the difficulties that discharged attorneys face when they must remain silent about the cause of their discharge and can not seek professional redemption and/or monetary compensation in court because the claim of retaliatory discharge is not recognized in law for an employed lawyer. As the Release containing the proposed Rule states: “Requiring an in-house attorney employed by the Issuer to resign when that attorney receives an inappropriate response to the attorney's reported evidence of an ongoing or impending material violation appears to be unreasonably harsh.” (emphasis in the original) But what does the Commission expect will happen to an in-house attorney who disaffirms an opinion or other document he or she prepares, or otherwise “spills the beans” to the Commission? Whether the attorney can bring a retaliatory discharge claim will still be a matter of state law, and the fact that Section 205.3(e) of the Rule would bless the use of Issuer confidences by the attorney in “self-defense” is small comfort to an attorney who respects his client’s privilege and confidentiality and values his own reputation. It seems to me that this provision also puts a powerful weapon in the hands of a disgruntled attorney who may actually have been discharged for incompetence or, ironically, violating ethical rules. The Commission seems to conclude in its Release that: “The ‘noisy withdrawal ’ provision in Section 205.3(d) probably makes permissive disclosure of confidential information under the circumstances in Section 205.3(e) sufficient to protect investors.” But the requirement or option (depending if the violation is ongoing or imminent or has already occurred) to make a “noisy withdrawal” (which becomes a “noisy disaffirmance” requirement or option in the case of the in-house counsel), requires disclosure and disaffirmance only to the Commission. It does little to warn investors about what is going on at the Issuer. Under the ABA’s more restrictive version of Model Rule 1.13, counsel could theoretically notify the shareholders and avoid violating the separate obligation to keep client confidences under Mode Rule 1.6. In the case of a widely-held stock, however, direct notice is impracticable; for a publicly-traded company, the closest thing to notifying the shareholders is to inform the investing public at large. But under the Rule, counsel can only tell the public at large once they begin the process of self-defense and remedy-seeking as a consequence of being fired by the client. That is far too late to warn investors. I would propose an alternative to both the “noisy withdrawal” and the notification of successor counsel under Section 205.3(d)(1) and (2). My proposal would create an effective deterrent to management’s discharging the CLO or counsel for doing their job of investigating misconduct and other legal violations, without bestowing an individual power on a discharged attorney to use an Issuer’s confidential information as he or she sees fit. The Rule should provide for the amendment of Item 4 of Form 8-K under the 1934 Act to require the public reporting within five business days of the resignation or dismissal of an Issuer/Registrant’s CLO (or dismissal of a subordinate and/or outside attorney to which such CLO objects), in either case when the CLO invokes “professional responsibility” to justify his or her resignation or to contest the dismissal by the Issuer. Similar to the disclosure required regarding independent accountants under the guidelines contained in Regulation S-K Item 304 (applicable to Item 4 of Form 8-K), the Issuer/Registrant should be specifically required to state whether: (1) the former CLO (or other attorney, as applicable) resigned or was dismissed and the date thereof; (2) the former CLO (or other attorney, as applicable) has notified the Issuer or the Commission of his or her intention to disclaim or has actually disclaimed any opinion, document, affirmation, representation, characterization, or the like in a document filed with or submitted to the Commission; (3) the decision to accept the attorney’s resignation or to discharge the attorney was recommended or approved by (A) the Issuer/Registrant’s QLCC or audit or similar committee of the board, if it has such committee or (B) the board if not; and (4) the Issuer/Registrant has authorized the former attorney to respond fully to the inquiries of any successor attorney concerning the subject matter of any disagreement and, if not, describe the nature of any limitation thereon and the reason therefor. The Commission is right to focus on structure, and bolsters the credibility and status of the General Counsel with the CLO concept. By creating the QLCC, the Commission also opens up the possibility of using the QLCC for direct Board supervision of a company’s principal lawyer, which would shift the balance of power within management in a way that would support the CLO in trying to be a good compliance officer or “cop” for the company’s own good when necessary. An institutionalized QLCC that is solely responsible for determining the compensation of the company’s CLO, and hiring and firing the company’s CLO (who in turn would be invested with the delegated hiring and firing power over other attorneys in the organization) would provide significant protection. The Commission comments in its Release that it thinks the QLCC will be institutionalized in 25% of Issuers as a standing committee. I hope that number will go even higher and that it will spread to private companies as a “best practices” approach. Although the duties foreseen by the Commission Staff for the QLCC are limited to carrying out the “up-the-ladder” investigations required by the proposed Rule, it does not seem far-fetched to think that a standing QLCC might take on the additional duties described immediately above. I also believe some of the Rule’s definitions are problematic. One of several tricky concepts under the Rule is that of a “supervisory attorney” under Section 205.4. In an outside law firm, it should be fairly clear who the ultimate supervisory attorney is: the billing partner. Inside a company, however, it may not be entirely clear who is supervising whom. The Rule catches “supervisory attorneys” in its web under a “tag you’re it” principle. The definition includes supervisors even if they have no actual knowledge at the time that a subordinate attorney, who may be on the other side of the corporate structure chart, is deemed to have an obligation to report to them. Even an attorney who knows they are a supervisor to another may not realize that at a particular moment what the subordinate below them is doing counts as “appearing and practicing” before the Commission. As to the concept of “appearing and practicing,” the Commission has in the past with respect to enforcement matters under its Rule of Practice 102(e) set a hurdle that required at a minimum a “relational nexus with practicing securities law.” The Rule sets a lower hurdle, sweeping into the coverage of its definition a number of organizational and informational activities by subordinate attorneys that should not constitute “practicing securities law,” and by so doing, turns any of their superiors into securities law practitioners. The definition also includes any attorney representing an Issuer in the adversarial context of an administrative proceeding. I believe counsel representing an Issuer in an adversarial proceeding should have more leeway to keep communications with the client in the context of rendering legal advice absolutely confidential. This is very different from a case where an attorney is preparing disclosure for filing with the Commission. I also find it rather circular to bring an attorney investigating a violation of the Act or the Rule under the coverage of the Rule. Most likely this would be special outside counsel hired to do an internal investigation by the CLO or the QLCC. The start of an investigation indicates that the potential violation is already being dealt with at the highest levels of the Issuer. Requiring the investigating attorneys to disclose will likely only produce excessive disclosure and may well jeopardize the internal investigative process. Finally, the triggering events that the Rule requires an attorney to report—a “material violation of the securities laws” or “material breach of fiduciary duty”—are drawn too broadly. Since few of the in-house subordinate and supervisory attorneys who first come across a breach or violation will be experts in securities law, over-reporting will ensue. Such over-reporting would be exacerbated by the record-keeping required under the Rule, which mandates the creation and retention of a written report, even where no violation is deemed to exist, that could be miscontrued at a later date in the context of litigation or a Commission investigation. The Commission also applies an “objective standard”, under which, the Release states, “an individual attorney is not excused from reporting evidence of a material violation on the grounds that he or she does not personally believe that a material violation has occurred, is occurring, or is about to occur.” Coupled with a definition of “material” linked to a reasonable investor standard, and put into the hands of inexperienced attorneys, the reporting obligation is destined to be over-invoked unless the definitions are tightened. Other commentators on the proposed Rule have made the legislative history points at great length, so it is not worth repeating their citations to the legislative record in Congress. I share their conclusion that neither the author of Section 307 of the Sarbanes-Oxley Act, Senator Edwards of North Carolina, nor any of his fellow sponsors—such as Senator Enzi of Wyoming—intended anything but a restatement of the “up-the-ladder” approach that the Commission has been advocating for more than 20 years. The Rule as proposed by the Commission admittedly goes beyond this more limited mandate. I hope that my own proposal for signaling to the public the replacement by an Issuer of its attorneys offers a useful approach to bolstering the in-house attorney’s role as compliance officer—a goal which the Commission has advanced considerably through the creation of the CLO and QLCC concepts. Very truly yours, Jeffrey L. Schultz, Esq. (Jeff_Schultz@ksg04.harvard.edu)