Up The Ladder: Litigator Responsibilities Under The Sarbanes-Oxley Act - Part III

Tuesday, February 1, 2005 - 01:00

Part I of this article appears in the December 2004 issue of The Metropolitan Corporate Counsel, Part II in the January 2005 issue and Part IV in the March issue.

For attorneys who are concerned that going over the CLO's head might damage their careers, the regulations fortunately allow for reporting to the corporation's CLO or to the corporation's chief legal and executive officers together. See 17 C.F.R. § 205.3(b)(1). (The attorney may skip this step if he "reasonably believes" that this report would be futile, see id. § 205.3(b)(4), for example because the CLO or chief executive officer is (or both are) implicated in the material violation, in which case the report might simply give one or both of them an opportunity to destroy evidence. See Proposed Rule I at 71,686.) The CLO will then either make a report to the QLCC, in which case the matter is concluded from the attorney's perspective just as if the attorney had reported directly to the QLCC, see 17 C.F.R. § 205.3(b)(2), (c)(2); or will inquire into the evidence and notify the attorney of the conclusion, either explaining why there is no material violation or outlining step(s) the corporation is taking to cure the material violation, see id. § 205.3(b)(2).

The attorney then must evaluate the response. If he "reasonably believes" that it is an "appropriate" response, the lawyer has no further obligations. Id. § 205.3(b)(8). An "appropriate" response is one that reasonably convinces the attorney that (1) there is no material violation; (2) the corporation adopted appropriate remedial measures; or (3) the corporation hired an attorney to investigate and either implemented the hired attorney's remedial recommendations or was advised that the hired "attorney may, consistent with his professional obligations, assert a colorable defense on behalf of the issuer in any proceeding related to the reported evidence of a material violation." Id. § 205.2(b). A colorable defense, put into more concrete terms that litigators can understand, is one that would not violate Rule 11 of the Federal Rules of Civil Procedure, see Final Rule at 6301, although neither the regulation nor the SEC's commentary specifically refers to that rule.

In evaluating the issuer's response, the attorney should take into account (because the SEC later will take into account, if it ever has a reason to evaluate the attorney's evaluation) "all attendant circumstances," such as "the amount and weight of the evidence of a material violation, the severity of the apparent material violation and the scope of the investigation into the report." Final Rule at 6300. As mentioned above, a litigator aware of a possible material violation outside his area of expertise may encounter substantial difficulties in evaluating the issuer's response unless the response is plainly inappropriate, such as one that "simply asserted that the reported evidence is no cause for concern without any hint of evaluation or inquiry." Proposed Rule I at 71,687; see also id. at 71,67677. To return to the patent litigator example, he might find it very difficult to evaluate a technical explanation from the CLO about why leaving the transactions off the Form l0-K financials was consistent with the securities laws and Generally Accepted Accounting Principles.

An attorney who decides that the CLO's response is not appropriate must explain his reasons for so believing to the CLO and report the material violation further up the ladder, to the board of director's audit committee, to another board committee composed solely of independent directors (if there is no audit committee), or to the entire board. See 17 C.F.R. § 205.3(b)(3), (b)(9). (By not explicitly contemplating a second-round report to the QLCC, the regulations might be read as assuming that the issuer does not have one, perhaps on the theory that the attorney would have reported to the QLCC initially if it existed. It appears, however, that the regulations would treat a second-round report to the QLCC the same as a first-round report, discussed above. See id. § 205.3(c)(1). Again the issuer responds, and again the attorney must evaluate the appropriateness of the response. If the response is inappropriate, the attorney must explain his reasons for so believing to the directors to whom he made the second report. See id. § 205.3(b)(9).

The regulations don't explicitly state the effect of the attorney's second explanation, but presumably he has discharged his responsibilities. The attorney may, however, reveal to the SEC confidential information "related to the representation" to (1) prevent the corporation from committing a material violation likely to substantially injure the financial interest or property of the issuer or investors; (2) prevent the corporation from committing perjury or similar crimes; or (3) rectify the consequences of an issuer's material violation "in furtherance of which the attorney's services were used" that caused or may cause substantial injury. Id. § 205.3(d)(2)(i-iii). It is unclear why this provision, unlike the provision about becoming aware of evidence of a material violation, ties the attorney's conduct to whether the information is "related to the representation." In any event, until the profession's strong norm against betraying client confidences softens (on which more below), few attorneys are likely to report voluntarily to the SEC.

Documenting The Events

At some point between becoming aware of the evidence of a material violation and coming to believe that the corporation responded appropriately (or when the lawyer offers a final explanation as to why the corporation has not done so), the prudent litigator is likely to wonder whether he should - or must - document what he has learned and the steps he has taken. The answer to the second question, whether he must, is easy: No. The proposed regulations included extensive documentation requirements that the SEC deliberately left out of the final regulations. See Proposed Rule I at 71,684-85; Pinal Rule at 6306.

The second question, whether he should, is more difficult. In the commentary accompanying the proposed rules, the SEC's sole justification for requiring documentation is that it "may protect the attorney in any proceeding in which his or her compliance with this rule is at issue by demonstrating that the attorney acted properly under the circumstances." Proposed Rule I at 71684. Even the least cynical attorney might find it difficult to take this statement at face value, because any documentation could just as easily be used by the SEC to demonstrate that the attorney, not to mention the client, did not act properly. The final rules, although not requiring documentation, provide a small incentive to document by allowing any attorney report or corporate response to "be used by an attorney" in a proceeding in which the attorney's compliance is at issue. 17 C.F.R. § 205.3(d)(I) (emphasis added); see also Proposed Rule I at 71,685 (referring to the attorney using the documentation "in self-defense"); Final Rule at 6310 (stating that the regulation allows attorneys to use the documentation to "defend" and "protect" themselves). The rules do not address whether those reports and responses may be used by the SEC against the attorney or the client.

On a related subject, it is not clear whether the attorney would be able to keep the documentation confidential as attorney-client communications. Any assertion of privilege would no doubt be met with "significant and prolonged legal challenges," Final Rule at 6307, and the federal government has of late made it difficult for corporations to resist waiving the privilege. See, e.g., John Gibeaut, "Junior G-MEN," ABA Journal (June 2003), at 46. A successful challenge or waiver would open the documentation to outside eyes and, possibly, open the attorney or the client to charges of Sarbanes-Oxley violations.

The regulations deal strictly with violations by attorneys. The commission may sue the attorney civilly "for a violation of the federal securities laws" or may discipline the attorney by censure or temporary or permanent bar on "the privilege of appearing or practicing before the Commission." 17 C.F.R. §205.6(a), (b). An attorney's violation is not a crime, see Proposed Rule I at 71697; Pinal Rule at 6314, however, and the regulations specifically provide that there is no private right of action against attorneys for noncompliance. See 17 C.F.R. § 205 .7(a), (b).

Dan K. Webb is a Partner at the Chicago office of Winston & Strawn LLP and the head of the firm's Litigation Department. He can be reached at (312) 558-5856. Scott P. Glauberman is an Associate in the firm's Litigation Department. He can be reached at (312) 558-8103.

Please email the authors at dwebb@winston.com or sglauberman@winston.com with questions about this article.