Now it’s the lawyer’s turn.

Of the many changes brought about by the Sarbanes-Oxley Act of 2002, the new rules governing attorney conduct under Section 307 of the Act — effective Aug. 5 — may have the most dramatic and lasting impact on lawyers who advise or represent public companies.

The new “Standards of Professional Conduct for Attorneys,” were promulgated under Section 307 and have been codified at 17 CFR, Part 205.

In general, the new rules require attorneys who appear and practice before the SEC in the representation of an issuer to:

report evidence of a material violation of the securities laws, a material breach of fiduciary duty, or a similar material violation by an issuer or its officers, directors, employees or agents to the issuer’s chief legal officer or chief executive officer; and

if the issuer’s officer does not appropriately respond to the evidence, including, if necessary, adopting remedial measures or sanctions with respect to the violation, to report the evidence “up the ladder” to the audit committee, to another committee of independent directors or to the full board of directors.

Proposed ‘Noisy Withdrawal’ Rule

One suggested change has yet to be adopted by the SEC. The controversial proposed “noisy withdrawal” rule is still on the drawing table despite extensive public comment and consideration.

In response to overwhelmingly negative public comment, the SEC extended the comment period on the “noisy withdrawal” provisions of the proposed rules and issued a separate release proposing an alternative procedure to the noisy withdrawal provisions.

The extended comment period ended on April 7. The SEC still has not indicated when it plans to act on the proposed rules.

The proposed noisy withdrawal rules would require that a reporting attorney who believes that there has not been an appropriate response, and that the material violation is either ongoing or is about to occur and is likely to result in substantial injury to the financial interest or property of the issuer or investors, must:

withdraw forthwith from representing the issuer;

within one business day of withdrawing, give written notice to the SEC of such withdrawal, indicating that the withdrawal was based on “professional considerations”; and

promptly disaffirm to the SEC any statement in any document filed with or submitted to the SEC, or incorporated by reference into such a document, that the attorney prepared or assisted in preparing and that the attorney reasonably believes is or may be materially false or misleading.

In-house counsel would not be required to resign, but would otherwise be subject to the same requirements.

For past violations, a reporting attorney would be permitted, but not required, to affect a noisy withdrawal, provided that the attorney reasonably believes that the material violation is likely to have caused substantial injury to the issuer or investors.

If an attorney has undertaken a noisy withdrawal, the CLO would be required to inform any replacement attorney of the noisy withdrawal.

Alternative Proposal To ‘Noisy Withdrawal’

The alternative proposed by the SEC would require that a reporting attorney who believes that a response to a report of a material violation is insufficient to withdraw from representing the issuer, and notify the issuer in writing that the withdrawal was based on “professional considerations.”

In-house counsel would be required to cease any participation or assistance in any matter concerning the violation, and notify the issuer in writing that he or she believes that there has not been an appropriate response in a reasonable time to his or her report of evidence of a material violation.

An attorney formerly retained or employed by an issuer who has reported evidence of a material violation and reasonably believes that he or she was discharged as a result would be required to notify the CLO. If an attorney has given written notice under this provision, the CLO would be required to inform any replacement attorney of the withdrawal.

The proposed rules would require that the issuer, rather than the withdrawing attorney, report such written notice of withdrawal and the related circumstances to the SEC on Form 8-K within two business days of receipt. If an issuer did not comply with this reporting requirement, the reporting attorney may, but would not be required to, inform the SEC of his or her withdrawal.

Attorneys Subject To The Rules

For those rules effective Aug. 5, below is a brief summary and review of what is required of in-house counsel and outside attorneys.

The reporting obligation applies to attorneys, broadly defined, appearing and practicing before the SEC in the representation of an issuer. This includes both in-house counsel and attorneys at outside law firms. There is a limited exception for certain foreign attorneys.

“Appearing and practicing” before the SEC is expansively defined to include:

transacting any business with the SEC, including any communications (written, oral or otherwise) with it or its staff;

representing an issuer in an SEC administrative proceeding, investigation, inquiry, information request, or subpoena;

providing advice on federal securities laws, or the SEC’s rules or regulations, regarding any document the attorney has notice will be filed with or submitted to the SEC, or incorporated by reference into any document filed or submitted to the agency; or

advising an issuer on whether information or a statement, opinion or other writing is required to be filed with or submitted to SEC, or incorporated by reference into any document that will be filed with or submitted to the agency.

Duty To Report Material Violation

The duty to report is triggered when an attorney becomes aware of evidence of a material violation by an issuer or by any of its officers, directors, employees or agents.

A “material violation” includes a violation of an applicable federal or state securities law, or a breach of fiduciary or similar duty arising under federal or state statutory or common law.

The final rules do not define “material” but the adopting release states the term has a well-established meaning under federal securities laws meant to apply under the new rules. The release cited Basic, Inc. v. Levinson and TSC Industries v. Northway, Inc., both of which say information is material when a substantial likelihood exists that the information would be viewed by a reasonable investor as significantly altering the total mix of information available.

“Evidence of a material violation” is defined as credible evidence such that 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.

‘Up The Ladder’ Reporting

Step One: Report to CLO or to CLO and CEO

If an attorney appearing before the SEC on behalf of an issuer becomes aware of “evidence of a material violation” of a federal or state securities law, or material breach of fiduciary duty arising under federal or state law, or a similar material violation of any federal or state law by any officer, director, employee, or agent of the issuer, the attorney must report such evidence to the issuer’s chief legal officer (CLO), or to both its CLO and its chief executive officer (CEO).

If the reporting attorney believes it would be futile to report evidence of a material violation to the CLO and the CEO, the attorney may proceed immediately to the requirements described below in “Step Three: Report to Board/Committee” and report evidence of a material violation to the audit committee, to another committee of independent directors or to the full board of directors.

Step Two: Inquiry and Response

After receiving a report of evidence of a material violation, the CLO (or CEO, as the case may be) is required to conduct an inquiry into the matter. If the CLO determines that no material violation has occurred, is ongoing or is about to occur, the CLO must notify the reporting attorney of that determination and its basis.

Unless the CLO reasonably believes that no material violation has occurred, is ongoing or is about to occur, the CLO must take all reasonable steps to cause the issuer:

to adopt appropriate remedial measures, including appropriate steps or sanctions to stop any material violations that are ongoing, to prevent any material violation that has yet to occur, and to remedy any material violation that has already occurred and to minimize the likelihood of its recurrence; or

to retain an attorney to review the reported evidence, and either (i) substantially implement any remedial recommendations made by the retained attorney, or (ii) receive advice from the retained attorney that a colorable defense may be asserted on behalf of the issuer (or an individual, as the case may be) in any investigation or judicial or administrative proceeding relating to the reported evidence.

The CLO must report the steps taken to the reporting attorney. Receipt of an appropriate and timely response concludes the reporting attorney’s obligations.

Step Three: Report to Board/Committee

Unless the reporting attorney reasonably believes that the CLO has provided an appropriate response within a reasonable time, the reporting attorney must report the evidence of a material violation:

to the issuer’s audit committee;

if the issuer does not have an audit committee, to another committee of independent directors; or

if the issuer does not have an audit committee or another committee of independent directors, to the issuer’s full board of directors.

The audit committee (or other committee or the board as the case may be) will then be required to conduct an inquiry and to respond to the reporting attorney in accordance with the requirements initially imposed on the CLO and described above under “Step Two: Inquiry and Response.” Again, receipt of an appropriate and timely response concludes the reporting attorney’s obligations.

If a reporting attorney does not reasonably believe that the issuer has made an appropriate response to the report of evidence of a material violation, the reporting attorney must explain why to the CLO, CEO and directors to whom the attorney reported the evidence.

Qualified Legal Compliance Committee Alternative

The rules contain an alternative reporting procedure using a previously formed “qualified legal compliance committee,” or QLCC, to which attorneys could directly report evidence of a material violation.

An issuer is permitted, but not required, to establish a QLCC, composed solely of at least one member of the audit committee and two or more independent directors, with written procedures for the confidential receipt, retention and consideration of any report of evidence of a material violation.

An audit committee may also act as a QLCC. A QLCC cannot be established in response to a specific incident or report.

Sanctions And Discipline

Violations of the rules by attorneys will be treated as violations of the Securities Exchange Act of 1934, carrying the same civil penalties and remedies as other such violations.

Accordingly, the SEC may commence a civil action against an attorney and seek injunctive relief, monetary penalties or a cease and desist order.

In addition, the SEC may initiate an administrative disciplinary proceeding against an attorney, which could result in censure or temporary or permanent denial of the privilege of appearing and practicing before the SEC.

R. Todd Cronan is a partner at Goodwin Procter in Boston and co-chair of its securities litigation and corporate governance practice group. He specializes in securities litigation, and representing emerging growth and public companies and the venture capital firms that help finance their growth. He can be reached at [email protected]

New England Biz Law Update

New SEC Rules On Attorney Conduct Take Center Stage

New SEC Rules On Attorney Conduct Take Center Stage

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