Businesspersons beware. Corporate attorneys “appearing and practicing” before the Securities and Exchange Commission (“SEC”) are now required to comply with stringent new responsibilities for reporting corporate wrongdoing “up the ladder” inside the company, with the possibility that those duties might eventually include “reporting out” outside of the company in the near future. Chalk this up to more fallout from the slew of recent corporate scandals including Enron, WorldCom, Global Crossing, Adelphia and Tyco, to name only a few. The practice of corporate law in the U.S. may never be the same again.
The Problem: Failure of Oversight by the Gatekeepers
As the former Chairman of the SEC Arthur Levitt has pointed out, the spate of recent corporate failures and scandals of the past few years could not have occurred without the widespread breakdown in the oversight system of American corporate markets.[1] In particular, too many corporate professionals, including officers, directors, analysts, investment bankers, and most notably the accountants and attorneys, appear to have forgotten that their fiduciary duties require them to represent the interests of the corporation and the shareholders first, above all other interests, including their own. Instead, Mr. Levitt noted that “a culture of ‘what can we get away with’ [took] hold” and as a result, public confidence in American financial markets has been seriously eroded in recent years.[2]
In public companies in the United States, the most important gatekeepers may be the accountants and the attorneys. Some scholars and prosecutors of corporate crime have observed that corporate fraud at public companies cannot occur over an extended period of time without either the direct or indirect participation of the accountants and attorneys.[3] Others have also noted that the bar associations have been notoriously lax in enforcing penalties against attorneys found to have violated their fiduciary duties, especially in the area of securities fraud.[4] Until the passage of the Sarbanes-Oxley Act of 2002,[5] both the accounting and the legal professions were allowed to set their own ethics rules with little or no oversight by the government. However, with the passage of Sarbanes-Oxley, the era of complete self-policing for attorneys and accountants representing public companies is now over. Sarbanes-Oxley includes provisions which authorize the creation of a Public Company Accounting and Oversight Board to set standards and practices for public accountants.[6] In addition, it authorizes the SEC to establish stringent new rules of conduct for attorneys who represent public corporations.[7]
This article will focus on the new tough federal ethics rules for corporate attorneys. While businesspersons have grown comfortable with the notion that all of their communications with both their outside and in-house attorneys must be kept confidential and will be protected by the attorney-client privilege, this appears to be less true when it comes to legal work performed for public corporations subject to the SEC’s jurisdiction.
The Role of Inside and Outside Attorneys In the Recent Corporate Scandals
A couple of well publicized examples involving both an outside law firm and an in-house General Counsel illustrate the depth of the problem. When Sherron Watkins, Enron’s Global Finance executive, wrote a letter to Enron’s CEO, Kenneth Lay, detailing the creation of the various off-books partnerships and stating that she was nervous about the possibility of a “wave of accounting scandals”, she advised against using Vinson & Elkins, one of Enron’s outside law firms, to investigate her concerns. Watkins feared there could be a conflict of interest since Enron’s General Counsel was a former Vinson & Elkins partner and Vinson & Elkins might be reviewing some of its own legal work.[8] Despite her objections, Enron did bring in Vinson & Elkins to conduct an internal inquiry of the company and Vinson & Elkins found nothing amiss. Shortly thereafter, the Enron scandal broke, Enron declared bankruptcy and its CFO and other Enron employees were indicted. Vinson & Elkins was later sued by Enron shareholders who alleged in a class action suit that Vinson & Elkins attorneys gave legal advice that enabled senior Enron executives to become rich at the expense of the corporation and its shareholders.[9]
In-house General Counsels have also been indicted in some of the latest scandals.[10] For example, Mark Belnick, the General Counsel at Tyco International, was indicted along with the CEO, Dennis Kozlowski, and the CFO, Mark Swartz. Kozlowski and Swartz have been accused of running a criminal enterprise, including 38 counts of grand larceny, conspiracy and falsifying business records involving $600 million of corporate funds.[11] Belnick was indicted for falsifying business records by failing to disclose and properly document a $14 million personal loan to him authorized by Tyco’s CEO, Kozlowski.[12] In addition, Belnick’s pay was exceedingly high, amounting to $20 million in 2000, with an unusual clause in his employment contract guaranteeing him immediate payment of millions of dollars should he be fired before October 2003 for committing a felony.[13]
Federal Regulation of Attorney Conduct Under Sarbanes-Oxley
Section 307 of Sarbanes-Oxley requires the SEC to issue rules setting minimum professional conduct standards for attorneys “appearing and practicing”[14] in any way before the Commission in the representation of issuers, which includes both in-house and outside attorneys.[15] According to Section 307, these standards must include a rule requiring an attorney to report evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by the issuer “up-the-ladder” within the company to the chief legal counsel or the chief executive officer (CEO) of the company (or the equivalent thereof). If either the chief counsel or the CEO does not respond appropriately to the evidence, the attorney must report the evidence to the audit committee, another committee of independent directors, or to the full board of directors.[16]
In response to Congress’s directive, the SEC on Nov. 21, 2002, proposed a new rule, Rule 205, which outlined the standards for professional conduct for attorneys practicing before the SEC.[17] The stated purpose of Rule 205 is “… to protect investors and increase their confidence in public companies by ensuring that attorneys who work for those companies respond appropriately to evidence of material misconduct.” Although initially the proposed regulations on attorney conduct included a “noisy withdrawal” provision, that part of the proposed rules has not yet become final and is still being considered by the SEC.[18] However, that part of the rule dealing with attorneys “reporting up the ladder” did become effective and final on August 5, 2003.[19]
The Response of the Bar Associations
As the new SEC ethics rules for lawyers took effect in August, 2003, the American Bar Association (ABA), with 410,000 members, revised its own model rules. The ABA had established a task force which issued a preliminary report (the Preliminary Cheek Report)[20] before the passage of Sarbanes-Oxley recommending that the ABA model rules be amended to clarify that attorneys have a mandatory requirement to report internally to higher corporate authority where there is crime or fraud, including violations of the federal securities laws and regulations.[21] This task force noted that “[i]n recent corporate failures, some legal advisers have been criticized for accepting management’s instructions and limiting their advice and/or services to a narrowly defined scope, ignoring the context or implications of the advice they are giving.”[22] When the ABA House of Delegates finally voted on amendments to its ethics rules in August, 2003, it voted only to make it permissible for attorneys to reveal client confidences in these circumstances, but stopped short of making it mandatory.[23] The ABA model rules have no force of law, but they are used as guides by states to develop their own rules for attorneys practicing law within their borders.
The Preliminary Cheek Report says that ” [f]orty-one states either permit or require disclosure to prevent a client from perpetrating a fraud that constitutes a crime[24] and eighteen states permit or require disclosure to rectify substantial loss resulting from client crime or fraud in which the client used the lawyer’s services.”[25] Therefore, the SEC mandatory requirements for attorney conduct may conflict with state rules. According to a recent Wall Street Journal article the Washington State Bar Association’s Board of Governors “voted in July to reaffirm state ethical rules that bar lawyers from revealing confidences without a client’s permission.”[26] Not surprisingly, this action drew a response from the SEC warning the Washington Bar Association that federal ethics rules would take priority over conflicting state ethics rules.[27] The SEC made it clear in its Final Rule on attorney conduct that their rule preempts all conflicting ethics rules or inconsistent laws of a state or other U.S. jurisdiction. The only exception to this would be where the ethics rules of another U.S. jurisdiction are more rigorous than those outlined in Rule 205.[28]
The SEC’s “Noisy Withdrawal” Requirement Is Still Pending
The SEC still has pending proposed rules which would require a “noisy withdrawal” by attorneys if the required “up-the-ladder” reporting to the Board of Directors did not yield an “appropriate response.”[29] The SEC extended the comment period for the “noisy withdrawal” provisions proposed last year, but a final rule has not yet been adopted.[30]>
The “noisy withdrawal” rule, if adopted, would apply “when an attorney, after reporting evidence of a material violation up-the-ladder of the issuer’s governance structure, reasonably believes an issuer’s directors have either made no response (within a reasonable time) or have not made an appropriate response.”[31] Under these circumstances, the proposed SEC rule would require the attorney to (1) “[w]ithdraw… from representing the issuer, indicating that the withdrawal is based on professional considerations; (2) [w]ithin one business day of withdrawing, give written notice to the Commission of the attorney’s withdrawal, indicating that the withdrawal was based on professional considerations; and (3) [p]romptly disaffirm to the Commission any opinion, document, affirmation, representation, characterization, or the like in a document filed with or submitted to the Commission, or incorporated into such a document, that the attorney has prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading…”[32]
Conclusion
The existence of attorney-client privilege and the duty of attorney confidentiality can no longer be automatically presumed. The SEC may yet pass its “noisy withdrawal” rule or some variation of it. In addition, when companies come under investigation, prosecutors at the Justice Department are now almost routinely requesting that the companies waive their attorney-client privilege and turn over all records to the Justice Department.[33] In addition, where companies have been accused of serious fraud, some judges are insisting that privileged documents be unsealed.[34]
While some may bemoan the loss of independence of the legal and accounting professions, governmental intrusion is no surprise given the circumstances of some of the recent scandals. The definitions of fiduciary duties are very broadly worded to ensure that officers, directors, attorneys, accountants, investment bankers and analysts all understand that they must not only follow the letter of the law, but the spirit of the law as well. The purpose of fiduciary duties is to establish trust and to clearly outline the responsibilities one has when handling other people’s money and property.
In today’s scandals, it was all too often the fiduciaries themselves, who walked away with huge sums of money while the corporations declared bankruptcy and the shareholders lost most or all of their money. Arguing “technical compliance” with the rules in a situation like this is not likely to be well received. No matter how strongly the various groups protest, government intrusion is no doubt here to stay for the foreseeable future. Sadly, such government oversight is probably the only way that trust in American capital markets will eventually be restored.
[1] http://www.businessweek.com/bwdaily/dnflash/feb2002/nf20020219_2045.htm
[2] Id.
[3] Susan P. Koniak, “Who Gave Lawyers a Pass?” FORBES, Aug. 12, 2002, p. 58; Ashby Jones, “Caught in the Fire”, Corporate Counsel, August 2003, p. 17.
[4] Koniak, supra note 3; Chairman Harvey l. Pitt, “Speech by SEC Chairman: Remarks Before the Annual Meeting of the American Bar Association’s Business Law Section, Aug. 12., 2002, http://www.sec.gov/news/speech/spch579.htm
[5] Pub. L. 107-204 (H.R. 3763), 1 Stat. 745, Sections 101 et seq (Sarbanes-Oxley); “On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, which he characterized as ‘the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt.’ The Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the “Public Company Accounting Oversight Board,” also known as the PCAOB, to oversee the activities of the auditing profession. The full text of the Act is available at http://www.law.uc.edu/CCL/SOact/soact.pdf. You can find links to all Commission rulemaking and reports issued under the Sarbanes-Oxley act at http://www.sec.gov/spotlight/sarbanes-oxley.htm.” (taken directly from the SEC’s webpage at http://www.sec.gov/about/laws.shtml)
[6] Id.
[7] Id. at Section 307.
[8] “Vinson & Elkins Discounted Warnings by Employee”, The Wall Street Journal, Jan.21, 2002.
[9] Anthony Lin, “Kirkland Protected By Silence In Enron Unlike Vinson & Elkins, Firm Made No Disclosure”, New York Law Journal, Vol. 228; Pg. p1, col. 5 Dec. 30, 2002 (as reported at Stanford Law School Securities Class Action Clearinghouse, http://securities.stanford.edu/news-archive/2002/20021230_Headline09_Lin.htm
[10] For example, another General Counsel also indicted was the General Counsel of Rite-Aid, Franklin C. Brown, “Accounting Scandal:Rite Aid GC Still Scheduled for Trial”, The National Law Journal, June 23-30,2003, p. 17; see also “GCs Scrutinized Amidst Scandals”, The National Law Journal, Dec. 2, 2002, p. A14.
[11] Nicholas Varchaver, “Fall From Grace”, Fortune, Oct. 28, 2002, pp. 113-120; Laurie P. Cohen and John Hechinger, “Tyco Dismisses General Counsel After a Dispute —Belnick Refused to Assist Internal Probe, Boies Says; Plus $20 Million Question”, The Wall Street Journal, June 11, 2002, at p. A3.
[12] Id.
[13] Id.
[14] Sarbanes-Oxley, supra note 5, Section 307.
[15] Final Rule: Implementation of Standards of Professional Conduct for Attorneys, 17 CFR Part 205 (Release Nos. 33-8185; 34-47276; IC-25919; File No. S7-45-02), (“Final Rule”), Summary, p. 1, et seq; The definition of attorneys who are covered by the standards established in the Final Rule is very broad. It includes attorneys who ” (1) [transact] any business with the SEC, including communications in any form; (2) [represent] an issuer in a SEC administrative proceeding or in connection with any SEC investigation, inquiry, information request or subpoena; (3) [provide] advice on U.S securities laws or the SEC’s rules or regulations regarding any document that the attorney has notice will be filed with or submitted or incorporated into any document that will be filed with or submitted to the SEC, including providing advice or participating in preparing such documents; or (4) [advise] an issuer as to whether information or a statement, opinion, or other writing is required under U.S. securities laws or SEC rules or regulations to be filed with or submitted to or incorporated into any document that will be filed with or submitted to the SEC. Id. at Section 205.2(a). The definition does not include an attorney who conducts the activities listed above other than in the context of providing legal services to an issuer with whom the attorney has an attorney-client relationship or is a non- appearing foreign attorney; see also, www.sec.gov/rules/final/33-8185.htm
[16] Id.
[17] Id..
[18] Id. (The full text of the final rule on attorney conduct is available on the SEC’s website, supra note 5).
[19] Proposed rules become final 180 days after publication in the Federal Register.
[20] “Preliminary Report of the American Bar Association Task Force on Corporate Responsibility”, July 16, 2002 , Thomas H. Cheek, III, Chair (“the Preliminary Cheek Report) at p. 32, www.abanet.org
[21] Id. at p. 32
[22] Id. at p. 33-34, citing Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp by William C. Powers, Jr., Chair, dated February 1, 2002, at 25-26, available at http://news.findlaw.com/hdocs/docs/enron/sicreport/.
[23] ” ABA Code Targets Corporate Crimes”, Los Angeles Times, Aug. 17, 2003, p. C2. http://news.findlaw.com/hdocs/docs/enron/sicreport/. (NOTE: There was a later final report of that same task force, “Report of the American Bar Association Task Force on Corporate Responsibility, Mar. 31, 2003, Thomas H. Cheek, III, Chair, American Bar Association, (the “Final Cheek Report), http://www.abanet.org)
[24] Id. at p. 32, listing Alaska, Arizona, Arkansas, Colorado, Connecticut, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Massachusetts, Maryland, Maine, Michigan, Minnesota, Mississippi, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Tennessee, Texas, Utah, Vermont, Virginia, Washington, Wisconsin, West Virginia and Wyoming (permit); Florida, New Jersey, Virginia and Wisconsin (require).”
[25] Id., listing Connecticut, Hawaii, Maryland, Massachusetts, Michigan, Minnesota, Nevada, New Jersey, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, South Dakota, Texas, Utah, Virginia and Wisconsin (permit); Hawaii and Ohio (require).
[26] Judith Burns, “Attorneys Face a Paradox in the SEC’s Conduct Rules”, THE WALL STREET JOURNAL, Aug. 19, 2003, p. C1.
[27] Id. at C14.
[28] “Final Rule”, supra note 15, Section 205.1.
[29] Proposed Rule: Implementation of Standards of Professional Conduct for Attorneys , CFR Parts 205, 240 and 249 (Release Nos. 33-8186; 34-47282; IC-25920; File No. S7-45-02), (“noisy withdrawal rule”), “Whether an attorney receives “appropriate response” will be measured by a reasonableness standard. The attorney must reasonably believe that (1) no material violation… has occurred, is ongoing, or is about to occur; (2) [that] the issuer has, as necessary, adopted appropriate remedial measures, including steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy or otherwise appropriately address any material violation that has already occurred and to minimize the likelihood of its recurrence; or (3) [t]hat the issuer, with the consent of the issuer’s board of directors [or authorized committee] has retained or directed an attorney to review the reported evidence of a material violation and either (i) has substantially implemented any remedial recommendations made by such attorney after a reasonably investigation and evaluation of the reported evidence, or (ii) [h]as been advised that such attorney may, consistent with his or her professional obligations, assert a colorable defense on behalf of the issuer (or the issuer’s officer, director, employee or agent, as the case may be ) in any investigation, or judicial or administrative proceeding relating to the reported evidence of a material violation.” Evidence of a material violation means 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.” ; Final Rule, supra note 15 at Sec. 205.2(b) , www.sec.gov/rules/final/33-8185.htm
[30] Proposed Rule: Implementation of Standards of Professional Conduct, SEC, 17 C.F.R. Parts 205, 240, and 249 [Release Nos. 33-8186; 34-47282; IC- 25920; File No. S7-45-02]
[31] Noisy Withdrawal Rule, supra note 29.
[32] Id.
[33] Lorraine Woellert, “How Much Can You Still Tell Your Lawyer?”, BUSINESS WEEK, Sept. 1, 2003.
[34] Id.
