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Sarbanes-Oxley And New SEC Rules

Attorneys who represent issuers and companies controlled by issuers have significant duties and potential liabilities

By Denis T. Rice

Denis Rice
Rice

California practitioners who interface with foreign lawyers and accountants need to be sensitive to new Securities and Exchange Commission (SEC) rules that can apply to such non-U.S. professionals. In the wake of Enron and other management and accounting scandals, Congress enacted the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), which called for changes in the way U.S. corporations are governed and how they report to the SEC and to their shareholders. Pursuant to mandates in Sarbanes-Oxley, the SEC, beginning in 2002, adopted a series of rules and rule amendments. Those affecting non-U.S. lawyers and accountants are the focus of this discussion.

SEC Release No. 33-8185 (Jan. 29, 2003) (Attorney Conduct Release), which deals with attorneys practicing before the SEC, is important for non-U.S. lawyers to understand. To implement §307 of Sarbanes-Oxley, the Attorney Conduct Release adopted a final rule, codified as 17 Code of Federal Regulations, Part 205, establishing standards of professional conduct for attorneys appearing in practice before the SEC on behalf of issuers. Part 205 imposes significant duties and potential liabilities not only on attorneys who represent issuers, but also on companies controlled by issuers and attorneys who supervise such attorneys.

In determining application of the rules of practice on non-U.S. practitioners, the SEC’s definitions of four terms are critical. Put simply, the professional standards set forth in Part 205 apply to “attorneys” who (1)  “appear and practice before” the SEC or (2) “in the representation of” an “issuer.”

‘Attorneys’ who ‘appear and practice before’ the SEC defined

While §205.2(c) of Part 205 broadly defines “attorney” to include any person licensed or otherwise qualified to practice law in any jurisdiction, the new rules do not apply to “non-appearing foreign attorneys.” Section 205.2(a)(2)(ii). “Non-appearing foreign attorney” is defined by §205.2(j) as an attorney:

  • who is admitted to practice law in a jurisdiction outside the United States;
  • who does not hold himself or herself out as practicing, and does not give legal advice regarding, United States federal or state securities or other laws (except as provided in §205.2(j)(3)(ii)); and
  • who either: (a) conducts activities that would constitute “appearing and practicing before” the SEC only incidentally to, and in the ordinary course of, the practice of law in a jurisdiction outside the United States; or (b) “is appearing and practicing before” the SEC only in consultation with counsel, other than a non-appearing foreign attorney, admitted or licensed to practice in a state or other United States jurisdiction.

Section 205.2(a) of Part 205 defines “appearing and practicing before” the SEC to include two requirements. First, the lawyer must be engaging in one or more of the following six activities:

  • Transacting business with the SEC, including communications in any form;
  • Representing an issuer in an SEC administrative proceeding or in connection with any SEC investigation, inquiry, information request or subpoena;
  • Providing advice regarding federal securities laws on any document that the attorney has notice will be filed with, submitted to or incorporated into any document filed with or submitted to the SEC;
  • Advising the issuer as to whether information or a statement must be filed with, submitted to or incorporated into any document filed with or submitted to the SEC;
  • Conducting an investigation on behalf of the issuer pursuant to Rule 205; and
  • Supervising and directing an attorney who is appearing and practicing before the SEC in the representation of an issuer.

The more difficult questions arise when advice is provided “with respect to the federal securities regarding any document” to be filed with the SEC. Some examples follow:

  • If a lawyer gives comments on just part of an SEC filing, as where a lawyer comments on a section of a prospectus dealing with the issuer’s Canadian copyrights, this activity should not be deemed to constitute providing advice “with respect to the federal securities laws.” 
  • If the lawyer gives a formal opinion to be cited in the SEC filing, this would constitute practicing before the SEC.

Second, the lawyer must be engaged in the activity “in the context of providing legal services to an issuer with whom the lawyer has an attorney-client relationship.” Based on the SEC’s promulgating release, the following conclusions can be drawn:

  • An attorney-client relationship may exist even in the absence of a formal retainer or other agreement.
  • In some cases, an attorney and an issuer may have an attorney-client relationship even though the attorney-client privilege would not be available for communications between the attorney and the client.

Whether an attorney-client relationship exists for the purposes of this rule is a federal question and, in general, will turn on the expectations and understandings between the attorney and the issuer. Thus, whether the provision of legal services under particular circumstances would or would not establish an attorney-client relationship under the state laws or ethics codes of the state where the attorney practices or is admitted may be relevant to, but does not control, the issue under this part. The promulgating release, nevertheless, makes clear that the rule will not apply to individuals who, although members of the bar, are not providing legal services. Release 33-8185 at 6.

‘Issuer’ defined

Section 205.2(h) of Part 205 defines “issuer” to mean a person that issues or proposes to issue securities registered under §12 of the Securities Exchange Act of 1934, or that must file reports under §15(d) of that act, or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 and that has not been withdrawn, but does not include a “foreign government issuer.”

In measuring impacts on non-U.S. practitioners, for the purpose of the definitions of “appearing and practicing before” the SEC and “in the representation of an issuer,” special attention should be paid to §205.2(h). It defines “issuer” to include “any person controlled by an issuer, where an attorney provides legal services to such person on behalf of, or at the behest, or for the benefit of the issuer, regardless of whether the attorney is employed or retained by the issuer.” This language means that a lawyer employed or retained by a non-public subsidiary of a publicly held parent would likely be viewed as “appearing and practicing” before the SEC “in the representation of the issuer” whenever the lawyer acts “on behalf of, or at the behest, or for the benefit” of the parent.

In this context, the non-U.S. lawyer who represents a subsidiary covered by an umbrella representation agreement or understanding, whether explicit or implicit, under which the attorney represents the parent company and its subsidiaries, and under which the attorney can invoke privilege claims with respect to all communications involving the parent and its subsidiaries would be representing an issuer.

The result of these rules would be as follows:

  • A lawyer at a privately-held subsidiary who is assigned work by the publicly-held parent on a matter involving the SEC, such as preparing part of a disclosure document which will be incorporated in material filed with the SEC by the parent, would likely be deemed to be “appearing and practicing before” the SEC.
  • If the lawyer for the subsidiary discovers evidence of misconduct which is material to the parent, duties under Sarbanes-Oxley to report wrongdoing, discussed below, will arise. The definition of the term “issuer” is broad enough to include the duty of a lawyer retained by an issuer to report to the issuer evidence of misconduct by an agent of the issuer (e.g., an underwriter) if the misconduct would have a material impact upon the issuer. SEC Release No. 33-8185 at 14-15.
  • Where the legal department of a non-U.S. issuer handles legal matters of a non-public subsidiary, both the legal department lawyers and the outside counsel they supervise and direct could be viewed as acting “at the behest” of the issuer, and hence, be deemed to act “in the representation of” the issuer, even though they regarded the subsidiary, rather than the issuer, as their client.
  • A lawyer for a subsidiary who acts in such a way that the lawyer’s work foreseeably benefits the parent issuer, regardless of whether the lawyer’s act was expressly intended to obtain such benefit, might also be viewed as acting in the representation of the issuer, although there has been substantial disagreement over this interpretation.

‘In the representation of an issuer’ defined

Section 205.2(g) defines “in the representation of an issuer” to mean “providing legal services as an attorney for an issuer, regardless of whether the attorney is employed or retained by the issuer.” Some possible scenarios are described above under the definitions of “issuer.”  Part 205 does not define the situations when an attorney will be viewed as “providing services as an attorney for an issuer” even though the attorney is neither employed nor retained by the issuer. Release 33-8185 indicates that a relationship with an affiliate of the issuer could trigger issuer representation because of the affiliate’s role vis-à-vis the issuer. Thus:

  • A lawyer employed by a privately held investment adviser who prepares or assists in preparing, materials for a registered investment company that the attorney has reason to believe will be submitted to or filed with the SEC by or on behalf of a registered investment company is appearing and practicing before the SEC under this definition. SEC Release No. 33-8185 at 13-14.
  • The SEC would view an attorney employed by the privately held investment adviser and representing the investment company before the SEC in effect having joint clients, and the SEC takes the position that: “Fairness and candor between co-clients regarding matters of common interest normally preclude any expectation of confidentiality regarding communications with their attorney, even regarding a communication of which one co-client was unaware at the time it was made.” (Id. at 18-19.)

Determining who the client is

Section 205.3(a) provides that an attorney appearing and practicing before the SEC in the representation of an issuer “owes his or her professional and ethical duties to the issuer as an organization.” Accordingly, even if the attorney works with and advises the issuer’s officers, directors or employees in the course of representing the issuer, such individuals do not become the attorney’s clients.

Although the SEC release views this rule as a simple codification of existing law, many view it as conflicting with the rules of professional conduct in many states. In California, the State Bar’s Business Law Section has taken a position that the rule conflicts with the California Rules of Professional Conduct. Non-U.S. jurisdictions such as Canada have been equally concerned that the new rule, coupled with the “up the ladder” reporting requirement discussed below, transgresses the attorney-client privilege under their laws.

In addition, §205.3(d)(2) permits an  attorney appearing and practicing before the SEC to reveal confidential client information in connection with a “silent withdrawal,” also discussed below. The Corporations Committee of the BLS and the Committee on Professional Responsibility and Conduct of the State Bar this year issued an “Ethics Alert,” posted at calbar.ca.gov/archive/calbar/pdfs/SEC-ethics-alert.pdf, dealing with the tension between the new rule and California’s Rules of Professional Conduct. Importantly in this context, §205.6(d) provides that attorneys practicing outside the U.S. are not required to comply with the new rules to the extent that such compliance is prohibited by applicable foreign law.

Obligations to report wrongdoing

Section 307 of Sarbanes-Oxley required the SEC to adopt “minimum standards of professional conduct for attorneys appearing and practicing before the SEC in any way in the representation of issuers.” The final rules, which became effective Aug. 5, provide reporting obligations for attorneys as follows:

  • an “up the ladder” reporting obligation for attorneys who become aware of any evidence of material wrongdoing by issuers or their directors, officers, employees or other agents;
  • an alternative “up the ladder” reporting process which permits attorneys to report evidence of a material wrongdoing to a “Qualified Legal Compliance Committee” (QLCC) of the issuer; and
  • a “safe harbor” provision protecting attorneys, law firms, issuers and officers and directors of issuers from private lawsuits for alleged noncompliance with the final rules.

A so-called “noisy withdrawal” requirement that was originally contained in the proposed rules was omitted in the final rules, but the SEC is still considering implementing such a requirement. “Noisy withdrawal” would require attorneys, in certain situations, to notify the SEC that they were withdrawing from representing a company for “professional considerations,” and to disaffirm any filings made with the SEC that contain materially false or misleading information.

The final rule opted for a “silent withdrawal,” obligating an attorney who has reported evidence of a material violation “up the ladder” and has not received an appropriate or timely response to withdraw from representing the issuer, triggering an obligation for the issuer to report that withdrawal in a filing with the SEC. The key aspects are:

  • An attorney must report evidence of a material violation of U.S. federal or state securities law or material breach of fiduciary duty or similar material violation of any U.S. federal or state law by the issuer, or any agent thereof, to the chief legal officer (“CLO”) or chief executive officer (“CEO”) (or the equivalent).
  • Subordinate attorneys may satisfy the foregoing reporting obligation by reporting evidence of a material violation to their supervising attorneys rather than directly to the CLO.
  • This reporting obligation is triggered when the attorney becomes aware of “credible evidence, based upon which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing or is about to occur.”
  • The reporting trigger is based on an objective standard. An attorney is not required to conduct a personal investigation in an effort to proactively uncover wrongdoing, nor will a reporting attorney be required to document the report (or any responses).
  • After receiving a report of a possible material violation, a CLO (or its CEO, if the issuer does not have a CLO) will have the following duties under the final rules: 
  • The CLO must conduct a reasonable inquiry into the evidence to determine whether the reported misconduct has occurred, is ongoing, or is about to occur.
  • Following the investigation, a CLO who reasonably concludes that there is no material violation must inform the reporting attorney of this conclusion. Alternatively, if a CLO reasonably concludes that a material violation has occurred, is ongoing or is about to occur, he or she must take reasonable steps to ensure that the company adopts appropriate remedial measures to stop the violation and rectify the situation.
  • A CLO is not required to document a reported violation and is not required to document a record of his or her inquiry.
  • A CLO must report the violation and remedial measures up the chain within the organization.
  • A reporting attorney who receives an “appropriate response” to a reported violation has satisfied his or her responsibilities under the final rules. The attorney’s evaluation of the appropriateness of an issuer’s response is measured against an objective standard.
  • If a reporting attorney does not receive an “appropriate response” from the CLO within a reasonable period of time, the attorney must report the suspected violation “up the ladder” within the corporate organization to the audit committee, another committee of independent directors or the full board of directors.

Denis T. Rice is a founding member of the San Francisco law firm of Howard Rice Nemerovski Canady Falk & Rabkin and currently a member of the executive committee of the State Bar’s International Law Section. He practices in a broad range of legal areas as a corporate lawyer, business litigator and cyberlawyer.

Certification

  • This self-study activity has been approved for Minimum Continuing Legal Education credit by the State Bar of California in the amount of one hour of legal ethics.

  • The State Bar of California certifies that this activity conforms to the standards for approved education activities prescribed by the rules and regulations of the State Bar of California governing minimum continuing legal education.

Self-assessment test

Answer the following true-false statements after reading the MCLE article on Rule of Professional Conduct 2-100. Use the answer form provided to send the test, along with a $20 processing fee, to the State Bar. If you do not receive your certificate within four weeks, call 415-538-2504.

  1. Sarbanes-Oxley applies to both U.S. and non-U.S. lawyers.
  2. Sarbanes-Oxley imposes significant duties and potential liabilities only on attorneys who represent issuers, but not on non-public companies controlled by issuers or on attorneys who supervise those attorneys.
  3. The professional standards of Sarbanes-Oxley apply to both U.S. and non-U.S. attorneys who appear and practice before the SEC in the representation of an issuer.
  4. An attorney who transacts business with the SEC, such as writing to the SEC, is deemed to be appearing and practicing before the SEC.
  5. An attorney who simply provides advice regarding federal securities law on a document to be filed with the SEC, but who does not contact the SEC, is not deemed to be appearing and practicing before the SEC.
  6. An attorney who only supervises and directs an attorney appearing and practicing before the SEC but does not himself/herself appear before the SEC is not deemed to be appearing and practicing before the SEC.
  7. If an attorney gives a formal opinion to be cited in an SEC filing, he/she is not deemed to be appearing or practicing before the SEC.
  8. If an attorney gives comments on only a part of an SEC filing, such as commenting on a section in a prospectus regarding Canadian copyrights, he/she is not deemed to be appearing or practicing before the SEC.
  9. To be deemed appearing or practicing before the SEC, an attorney must have a written retainer agreement with the issuer.
  10. An attorney representing a non-public subsidiary of an issuer would likely be viewed as representing the issuer before the SEC if the attorney is acting on behalf of, at the behest of or for the benefit of the parent company.
  11. The term “issuer” is broad enough to include the duty of a lawyer retained by an issuer to report evidence of misconduct by an agent of the issuer (e.g., an underwriter) if the misconduct would have a material impact upon the issuer.
  12. If an attorney works with and advises an issuer’s officers, directors or employees in the course of representing the issuer, those individuals also become the attorney’s clients as a result.
  13. Attorneys practicing outside the U.S. are not required to comply with the new rules under Sarbanes-Oxley to the extent that such compliance is prohibited by applicable non-U.S. law.
  14. Attorneys are required to report to an issuer’s chief legal officer, chief executive officer or Qualified Legal Compliance Committee any evidence of material wrongdoing by the issuer or its directors, officers, employees or agents.
  15. Attorneys are also currently required in all cases to notify the SEC if the attorney withdraws from representation of an issuer for “professional considerations” (a so-called “noisy withdrawal”).
  16. A subordinate attorney may report evidence of wrongdoing to his/her supervising attorney rather than to the issuer’s CLO/CEO/QLCC.
  17. An attorney’s reporting obligation is triggered when he/she becomes aware of credible evidence upon which a prudent attorney would reasonably conclude a material violation of law has occurred, is occurring or is about to occur.
  18. An attorney must conduct a personal investigation to confirm the suspected wrongdoing and to document his/her findings.
  19. Upon receiving a report of potential wrongdoing, an issuer’s CLO/CEO/QLCC must conduct an investigation and take remedial measures to stop any violation and rectify the situation.
  20. If an attorney reporting a violation to an issuer’s CLO/CEO/QLCC does not receive a timely and appropriate response, the attorney must report the suspected violation to the issuer’s board of directors or a committee of the board.
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