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

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

Duty To Report

Supppose you are now, one way or another, appearing and practicing before the SEC. What are your responsibilities? In short, if you learn that the issuer or its officer, director, employee, or agent has committed a "material violation" (on which more in a moment), you must begin the reporting process. It is imperative to note that the duty to report does not depend on the attorney having learned of the material violation through work for the issuer: There is no requirement in the regulations that the attorney's knowledge of the material violation must have any connection to the legal services the attorney provides. Suppose that a partner at a patent litigation firm. around the time he is supervising an associate who is preparing a settlement agreement that is to be attached to a Form 8-K, learns from a personal friend employed by the issuer of a preliminary decision by the issuer's CFO not to include certain transactions in the financial statements appearing in the corporation's upcoming Form lO-K. Requiring reporting in this situation quite obviously risks the attorney's having to "make up the line reports on the basis of possibly second-hand or incomplete information, on matters about which the attorney is not adequately informed, matters that the attorney cannot effectively monitor, [and] matters concerning which the attorney has no basis to evaluate the appropriateness of the issuer's response." Comments of ALAS at 7; see also Comments of ABA at 10. A patent litigator with little knowledge of financial statements and of the company's business would suffer from all of these problems.

These problems would be compounded. moreover, by the regulations' sometimes problematic standard for when reporting must begin. An attorney appearing and practicing before the SEC must begin reporting up the ladder when he "becomes aware of evidence of a material violation," meaning "credible evidence, based on 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." See 17 C.F.R. §§205.2(e), 205.3(b)(1). A "material violation," in turn, is defined (somewhat self-referentially) as "a material violation of an applicable United States federal or state securities law, a material breach of fiduciary duty arising under United States federal or state law, or a similar material violation of any United States federal or state law." Id. §205.2(i). (One of those securities laws is Sarbanes-Oxley itself, so one attorney's improper failure to report must be reported by another attorney who is aware of it. See Larry Cata Backer, "Federalizing Norms for Officer, Lawyer, and Accountant Behavior." 76 St. John's Law Review 897, 928 (2002)). Finally, "material" is not defined in the regulations because it "has a well-established meaning under the federal securities laws." Final Rule at 6303.

The patent litigator aware of the CFO's preliminary decision not to report certain transactions on the Form 10-K financial statements must therefore conduct the following analysis. First, would leaving those transactions off the financials violate any federal or state securities law, fiduciary duty, or other law? Being a patent litigator, he may not be familiar with the securities laws or with corporate fiduciary duties, particularly the complicated regulations governing what information must be reflected in financial statements. In addition, the regulations give no hint about what a "similar material violation of any United States federal or state law" could be, although clearly it "extend[s] beyond a breach of fiduciary duty or a violation of the securities laws." Proposed Rule I at 71.679, leaving the patent litigator without any guidance when attempting to evaluate the CFO's conduct.

Second, would the violation, if it is a violation, be material? With a little bit of investigation the patent lawyer could learn that "material" violations means "violations that a reasonable investor would want to know about." Id. (quoting Senator John Edwards, who proposed §307); see also Basic, Inc. v. Levinson, 485 U.S. 224, 231-36 (1988); TSC Industries v. Northway. Inc., 426 U.S. 438, 449 (1976). This definition is of little assistance. Without knowing precisely how the transactions should be reported and what effect they would have on the corporation's bottom line, and without a good understanding of how the magnitude of that effect compares to the corporation's reported numbers, the patent litigator will be ill-equipped to come to any reasoned decision about whether the CFO's conduct will have a material effect on the financial statements.

Finally, does the patent litigator have "credible evidence" that "it is reasonably likely" (that is, "more than a mere possibility." Final Rule at 6302) that this possibly material possible violation "is about to occur?" Perhaps, depending on the circumstances-which the attorney may (but is not required to) investigate. See Proposed Rule I at 71.682-83, 71.685. If, for example, his friend is the CFO's assistant and was confident that the CFO's preliminary decision was about to be made final with the submission of the Form lO-K to the SEC in a day or two, it seems that the patent litigator could answer this question in the affirmative. If, however, his friend was a member of the corporation's marketing staff who heard from an unnamed friend that the CFO was merely considering whether or not to include the transactions on the financials, the patent litigator might have no duty to report. The attorney's duty to report is not activated by "gossip, hearsay, or innuendo." Final Rule at 6302.

If the patent lawyer ultimately - and, suppose, wrongly - decides against reporting the CFO's conduct up the ladder, he will not be able to defend his actions later by arguing that he did not personally know whether the CFO's conduct was a violation of the law, whether it was material, whether the evidence was credible, or whether the violation was reasonably likely to occur. The attorney's decision will be judged under an objective standard - whether the decision was "unreasonable, under the circumstances, for a prudent and competent attorney." 17 C.F.R. §205.2(e). "[T]he initial duty to report up-the-ladder is not triggered only when the attorney 'knows' that a material violation has occurred. . . . That threshold for initial reporting within the issuer is too high." Final Rule at 6302. Paradoxically, given the regulation's emphasis on an objective "prudent and competent attorney" standard, the SEC has stated that it will consider the attorney's own "professional skills, background and experience" in determining whether the attorney's decision was reasonable. A truly prudent and competent attorney, however, must assume that his conduct will be judged by an entirely objective standard, which may, depending upon the attorney's tolerance for risk and relationship with his client, encourage overreporting.

Up The Ladder

A word is in order, at the outset, about the logic and rationale of up-the-ladder reporting. Although many outside counsel when thinking of or referring to "my client" have in mind a corporation's general counselor a specific in-house attorney contact, the attorney's true client is the corporation itself. See 17 C.F.R. §205.3(a). The regulations accordingly state, "An attorney. . . owes his or her professional and ethical duties to the issuer as an organization. That an attorney may work with and advise the issuer's officers, directors, or employees in the course of representing the issuer does not make such individuals the attorney's clients." Id. Evidence of material violations by the corporation's officers or employees is evidence of injuries against the corporation itself or evidence that the corporation is being misused to injure others. The regulations do not allow the attorney, as the corporation's fiduciary, to keep this evidence from corporate authorities, such as the chief legal officer, chief executive officer, or board of directors, who are in a position to prevent or redress these injuries. This explains why the attorney's reports up the ladder, which are always made inside the corporation, are not considered to "reveal client confidences or secrets or privileged or otherwise protected information." ld. §205.3(b)(1). It also explains why the attorney's required reports always stop (at least under the regulations now in effect) with the board of directors, the corporation's highest authority.

The actual ladder up which an attorney must report depends on the identity of the attorney. Associates take note: A "subordinate" attorney - meaning an attorney who is providing legal services under the supervision of another attorney, see 17 C.F.R. §205.5(a) - discharges all reporting obligations simply by informing the supervising attorney of the violation. See id. §205.5(c). (Deputy general counsels take note: This special subordinate provision does not apply to an attorney working at the direction of or under the direct supervision of the corporation's chief legal officer. See id. §205.5(a). It is then up to the supervisory attorney to report the violation up the ladder inside the corporation. See id. §205.4(c). The subordinate may, however, choose to report the violation up the ladder inside the corporation if he "reasonably believes" that the supervisory attorney failed to comply with the up-the-ladder rules. see id. §205.5(d), but it seems highly unrealistic in all but the most unusual circumstances that a subordinate attorney would take this step, thereby implicitly accusing his supervisor, on whom he may depend for his livelihood, of a violation of the SEC's rules. Only the most righteous subordinate attorneys will do more than simply inform a supervisor and breathe a sigh of relief.

Non-subordinate attorneys, including supervisors, attorneys without a supervisor, and deputy general counsels, have two ladders up which they can report. At first blush, the most attractive (and shortest) ladder might be a direct report to the qualified legal compliance committee (QLCC) of the corporation's board of directors. See id. §§205.3(c)(I), 205.4(d). The QLCC is a creature of the regulations. basically defined as a committee of independent directors with written procedures for dealing with attorney reports and with the ability to recommend corrective action or, if necessary, make its own report to the SEC. See id. §205.3(k). The advantage to the attorney of reporting directly to a QLCC is that doing so completely discharges all reporting obligations; the attorney is not responsible for assessing whether the corporation adequately responded to the report. See id. §205.3(c)(I). An attorney who reports directly to a QLCC is off the hook.

On further reflection, however, reporting directly to the QLCC might not be the best option for many attorneys. As an initial matter, the regulations do not require issuers to establish a QLCC, and the SEC has assumed that only 20 percent of issuers will eventually do so. Final Rule at 6317. So the issuer itself in many instances may make reporting to a QLCC impossible. But even if the issuer has established a QLCC, a prudent outside attorney who wants to maintain the relationship with the client, and also the flow of business from the client, must consider whether it makes sense to report first to the corporation's chief legal officer (CLO), who often determines which law firms the corporation will hire. In-house attorneys similarly may wish to consider whether their careers will be damaged by going over the CLO's head.

Status and Options

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